Models of Costs of Production and Profits - Essay Example

Variable and Absorption Models Of Costs of Production and Profits Variable and Absorption Models of Costs of Production and Profits Introduction The absorption costing method has other terms used to refer to it such as Traditional and Full Cost Methods. The method uses determination of expense of a product upon consideration of both variable and fixed costs. The variable costs include labor and cost of materials. Variables for this purpose have direct charges borne by specific products. Contrary, fixed costs are apportioned suitably on varying products produced during a period. For absorption costing, both fixed and variable costs have a bearing on the determination of a product’s price. There are implications that for absorption costing, all costs need determination about products produced. Product prices mean both fixed and variable factors and the cost unit bears a full burden of all the costs. The paper focus to illustrate the validity of the variable and absorption models of costs of production, which determines the levels of profitability of a product. It outlines the justification for difference in profits when using variable and absorption costing systems. Justification for the Differences in Profits when Using Variable and Absorption Models It is imperative to note the main difference in profits when using variable and absorption costing systems. In absorption costing methods, fixed overhead costs are applicable to manufacturing costs, calculated per unit. That is, fixed costs divided by the units manufactured and sold over a period considered during costing. It results to the cost, per unit, of every unit that the firm manufactured or sold over a period. In variable costing, the fixed overhead is applied as a lump sum expense, rather than a unit. The fixed overhead include the summation of all variable costs such as raw materials and supplies among other costs. A sum of fixed overhead costs over a period is added. Instead of figuring the expenses on a unit basis, they are subtracted from the revenue as a lump sum figure. The unit profit calculated under absorption costing, therefore, is lower than that calculated under variable costing. Purpose of Objective Costing Managements have interests that each product should have its total cost, both fixed and variable, and still generate profits. For every business, generating profits is the key target. If a product does not give benefits, then the management may consider discontinuing production over time. That implies that a product needs to recover all the costs involved in its production as well as provide returns to warrant profitability. Not all the goods provide the same contribution towards profitability. Some products may sell at a cost that covers variable costs to the maximum levels but fail to meet the fixed costs of production. For such products, it is not realistic to attain profitability using the absorption costing in the short-run. The management, therefore, continues to produce the products for future profitability. On the contrary, management has the concern of recovering variable costs under the use of variable costing model. There is an implication that such an objective is a short-run ambition. All managements should not ignore the fact the fixed costs have a bearing in terms of profits from trading activities. Variable costing, therefore, is suitable for short-term profit calculations. Objectives of these two types of costing differ in terms of recovery of costs incurred. The two methods have different roles, which they play and depend on the applicable situations. In the case of particular order for export considerations, using absorption costing may give an impression that the cost the product will not give any profits. It leaves an option for the consideration of variable costing because export and import orders happen in the short-run. For profits, in the short-run, a manager should consider the use of variable costing method because it gives firms chances to make profits. The variations given in terms of benefits calculated for both variable absorption methods resulted from the exclusion and inclusion of fixed costs respectively. The differences in benefits make most managers want to adopt variable costing method for the fact that they all would like to make profits. In the case Bohemia Industries, the manager was unhappy that the profits of the company had gone lower in August than July. Effect of Fixed Costs on Production Costs for Absorption Costing Fixed costs have a direct relation to fundamental characteristic of a product such as a percentage of direct labor, or material. Regardless of the relationship, it would be misleading to indicate that there is an exact and definite apportionment. There are some problems created out of charging fixed costs. Absorption costing gives a higher cost of production rate if compared to variable costing. A simple demonstration would be as illustrated below. Firm’s Cost sheet as under: Labor per unit= € 4 Direct material=€ 6 Fixed overheads= € 100,000 A unit of prime cost= € 10 The capacity of production of the firm is 10,000 units Working to full capacity gives the following result for the company Labor= € 40,000 Direct labor=€ 60,000 Fixed overheads= € 100,000 Total costs=€ 200,000 Average costs per unit=€ 100 The firm producing only 1,000 units, cost of production would exist follows: Direct material = € 6,000 Direct Labor = € 4,000 Fixed costs = € 100,000 Total cost = € 110,000 Total cost per unit = € 110 From the illustration above, the cost of production per unit rose to € 110 when there was partial production up from € 20 of complete capacity. There were no increases in the cost of inputs such as labor, material, and others. The production cost still rose by € 90, which represented about 495 per cent increase resulting from small volumes of output. Some people may find such factors illogical and still argue for inclusion of fixed costs in the computation of production cost for products. For variable costing model, fixed costs are against a fixed fun, which may result from excessive selling price against the variable cost. Factually, this finding presents the logic involved in variable costing. The manager of Bohemia industries, therefore, should understand the logic of both variable and absorption costing models in finding the costs of production. Opening and closing stock valuations have an effect on the two methods of costing. For instance, when production and sales rhyme (as is the case when there are neither opening nor closing stock values) profit would be similar under both variable and absorption costing. In a case where closing stock exceeds opening stock, profit for the absorption model would exceed that of variable costing. A reason for such a conclusion is using absorption costing there charging of a constant overhead for the closing stock that proceeds to the next trading period. The case would be different if the overhead cost were for the current year. For a case where there is less closing stock, as compared to opening stock, then variable costing would give more profit than absorption costing. A reason for this scenario is that a fixed charge for the past period applies to the present period. The paper vividly demonstrates to the manager the validity of both variable and absorption methods of costing in determining the costs of production. Read More