Absorption Costing versus Variable Costing - Essay Example

Absorption Costing versus Variable Costing Introduction Absorption and variable costing are one of the important costing techniques which facilitatean organization to allocate organizational expenses against revenues and determine profits. Both the techniques follow different processes. Absorption costing is however considered to be more appropriate than variable costing as it is recognized by GAAP. The absorption costing technique is more favourable as the profits estimated under this system are more accurate. Variable costing is seen to inflate expenses and reduce the level of profits. Both the methods are usually adopted to analyse the organizational efficiency and to estimate the expenses incurred under various heads related to manufacturing. Adopting absorption costing and variable costing by a firm is not considered mandatory however. They are essentially tools for the management to assess profitability. a) Absorption costing and Variable costing Absorption costing broadly refers to the manufacturing costs which get absorbed by a unit of product that is manufactured (Garrison, Noreen and Brewer, 2003). Absorption costs include raw material costs, labour costs, fixed and variable manufacturing expenses. The absorption costing system includes taking into consideration all types of fixed and variable costs and allocating the same under different heads and accordingly estimating the overall costs of the product (Garrison, Noreen and Brewer, 2003). A product, in the course of its manufacturing may absorb a number of different types of costs. As per the regulations of GAAP (Generally Accepted Accounting Priniciples), it is essential that the firm recognizes the value of its inventory on the basis of absorption costing (Garrison, Noreen and Brewer, 2003). However these costs are not recognized till the firm sells the goods and revenues are earned. They are not recognized when an entity makes payment for the same and therefore remains in the inventory cost as an asset (Garrison, Noreen and Brewer, 2003). Variable costing is considered to be suitable a management tool for assessing efficiency. It is often used as an alternative for absorption costing. GAAP does not allow the usage of variable costing for estimating the cost of production. However, managers are seen to use the same for assessing internal operations affectivity. The variable costing technique includes only the variable production costs. Fixed manufacturing expenses under this method are treated as period cost and are deducted from the income earned during the period (Hilton, 1994). Differences between absorption and variable costing (Horngren, 2012): Absorption costing Variable costing It includes direct materials, direct labour, variable manufacturing overhead and fixed manufacturing overhead in the product costs category. It includes direct materials, direct labour and variable manufacturing overhead in the product costs category. It includes variable and fixed selling and administrative expenses in the period cots category. It includes Fixed manufacturing overhead and both fixed and variable selling and administrative expenses in the period costs category. It is not considered suitable for cost volume profit analysis. It is considered to be a suitable cost volume profit technique. b) Strengths and weaknesses Absorption costing is seen to be useful when all manufactured goods are not sold and hence a portion of the same is held as inventory. This is useful because the system facilitates having higher values of net assets (Zimmerman and Yahya-Zadeh, 2011). It also improves the profit position as part expenses trapped in such inventory are not recorded till the time they are sold. A major weakness of the absorption costing system is that it inflates the overall profits of the firm (Zimmerman and Yahya-Zadeh, 2011). Hence, the correct financial position does not get revealed. However, if the expenditure incurred for production is included in the costing process even when the products are not sold, it may lead to the loss of profits as revenues against such expenses have not been obtained (Zimmerman and Yahya-Zadeh, 2011). The variable costing techniques depicts the profits after all relevant payments have been made. Under this system it is not essential that the manufactured products have been sold and revenues have been obtained (Hilton, Maher and Selto, 2003). Since it accounts for all payments made, it shows accurate position of expenses incurred. Profits under this system is ascertained when the goods are finally sold and surplus is gained. However, variable costing technique suffers from the weakness of part inclusion of revenue and full accounting of expenses (Hilton, Maher and Selto, 2003). This creates discrepancies and actual financial results do not reveal a clear picture of the firm. This system therefore shows less profits and higher expenses (Hilton, Maher and Selto, 2003). c) Profits under absorption costing and variable costing The profits obtained under both variable and absorption costing would be identical when the LIFO (last in first out) system of accounting is used. They are also seen to be identical when the manufacturing cost for both the current and the prior periods are similar. Profits under both the systems are seen to be identical when sales are equal to production. Under such circumstances both methods will show same profits as fixed manufacturing costs deducted remains to be the same (Drury, 2006). When production levels are higher than sales, it is seen that absorption costing profits are higher. This is due to the aspect that few of the fixed manufacturing overhead costs for the present accounting period remains trapped in the inventory as assets. However, under variable costing the net expenses incurred for the current accounting period is deducted, thereby reducing the profits (Lambert, Leuz and Verrecchia, 2007). When production volumes are lower than sales, then variable costing technique yields high profits than absorption costing. This is due to the aspect that few of the fixed cots for the previous accounting time span are included in the current period. Additionally, all the fixed expenses related to manufacturing for the current period also gets included in the costs of goods sold. It is seen that under the variable costing technique, only the current periods fixed costs are deducted from the profits (Armstrong, 2002). d) External and internal reporting External reporting refers to the informational obligations that a firm requires to fulfil towards external factors associated with business such as shareholders, investors, suppliers, consumers, government and the society at large. External reporting is essential so that such interest groups may gauge whether firms are using resources efficiently and to estimate the financial position to take various types decisions (Offenbacker, 2004). Internal reporting on the other hand refers to the conveying of important organizational information to the mangers and administrators of the organization so that crucial corporate and functional decisions in respect of the activities of the organization can be taken (Offenbacker, 2004). Variable costing is considered suitable for internal reporting as per accounting standards and policies (Brigham and Houston, 2011). It has very less appropriates in terms of external reporting. The manner, in which variable costing technique treats inventory and the costs associated with it, is not accepted by GAAP and is therefore not considered suitable for external reporting. However, since variable costing technique provides adequate information regarding the manner in which mangers attain profit, it can be used by internal administrators for decision making (Brigham and Houston, 2011). Profit depicted under the absorption costing technique is more widely accepted by accounting regulators and authorities (Horngren, et al., 2002). Hence they can be used to provide information to the external interest groups in respect of the manner in which a firm operates and accounts for different expenses. Absorption costing is also used alongside of income statements to provide easy and better understanding of the profits attained by the business Horngren, et al., 2002). Therefore, it can be stated that from the reporting perspective, absorption costing has more importance and acceptability than variable costing (Horngren, et al., 2002). e) Negative decision making and unethical behaviour Absorption costing makes profits decline when production is less. This is due to the aspect that even when production is less, cost per unit rises (Mohamed, 2006). Perceiving such a situation, mangers increase the level of production further so as to make the unit costs decline. This is mainly done to present a better organizational picture to the shareholders. The extra units produced however do not get sold as demand is low and therefore remain as inventory. This creates double benefits for the organization (Cornett and Saunders, 2003). It can show a higher level of inventory and thereby triggering up its asset levels and raising distribution and production expenses over more number of units. Hence it can be stated that through absorption costing, mangers can take advantage of the low demand conditions and present a false organizational financial position (Van Horne and Wachowicz, 2008). Shareholders and investors would not be able to easily identify such manipulation unless they pay closer attention to the demand conditions existing in the market and the units produced by the organization. However, in the long run such actions on behalf of the organization may lead to negative consequences. As the inventory levels rise, much revenue gets trapped in goods produced. Since demand conditions remain unfavourable, sales do not occur as expected and therefore costs cannot be converted to income. This hampers the liquidity position and also causes lack of timeliness in meeting the liabilities of the organization. Such a condition may raise the debt levels and cause the firm to attain a high risk position (Hansen, Mowen and Guan, 2007). Very recently a case of misappropriation of profits was seen to occur in Tesco. The company had to suffer losses and poor reporting due to improper accounting and the management mainly claims that absorption costing technique was the culprit. The company was also unsuccessful at recognising and reducing the negative impacts which arise out of such accounting method which led to falsified decisions (The economist, 2014). f) Ways of reducing negative impacts of absorption costing 1) Absorption costing must be compared with income statements and accurate information must be recorded. Managers must ensure that all costs taken into consideration in the absorption costing system remains aligned with the actual costs incurred by the firm (Michalski, 2008). 2) Managers must assess whether production is being carried out as per the demand condition and not just to reduce per unit costs of production. This requires careful analysis of the market (Drury and Tayles, 2005). 3) Fixed costs decline overtime when size of the organization enhances. Hence instead of focussing upon increasing units produced, mangers must take concrete efforts to expand the organizational size as a whole (Al-Omiri and Drury, 2007). 4) Absorption costing must be practised alongside of variable costing. The variable costing technique provides more accurate information to managers in respect of cost volume profit analysis (Becker, Chen and Greenberg, 2013). 5) One of the most effective ways through which the negative impacts of absorption costing can be reduced is through the use of just in time inventory system (Grinblatt and Titman, 2002). Conclusion Both absorption costing and variable costing are helpful tools to assess the manner in which a firm allocates finance to different overheads. A firm may conduct absorption and marginal costing techniques either before or after the transactions are completed. If the costing procedures are carried out before the actual production and sales occur, it may help the management to take important decisions regarding how revenue and returns can be maximized. Although absorption and variable costing are not mandatory techniques to be included in the financial process, it is essential for a firm to conduct utilize the same for assessing how costs related to manufacturing have been handled. Stakeholders usually do not analyse such costing techniques adopted by the firm. The attention is drawn towards such processes only when the financial position is weak and it is seen that the management suffers from lack of efficiency. Reference List Al-Omiri, M. and Drury, C., 2007. A survey of factors influencing the choice of product costing systems in UK organizations. Management Accounting Research, 18(4), pp. 399-424. Armstrong, P., 2002. The costs of activity-based management. Accounting, Organizations and Society, 27(1), pp. 99-120. Becker, B., Chen, J. and Greenberg, D., 2013. Financial development, fixed costs, and international trade. Review of Corporate Finance Studies, 2(1), pp. 1-28. 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