Acounting 202 final project due on 09/28/2017

Yelitza Cotts

Raulin Farinas

ACC-202

09/20/2017

Variable Costing and Absorption Costing.

Variable Costing is defined in the textbook as where direct materials, direct labor and variable overhead cost are included in product cost. This method allows for a manufacturing company to have a better and clearer picture of actual product cost. Unfortunately, this method cannot be used for external financial reporting and is not the method that the GAAP.

A key factor in Variable cost is that under this specific method, fixed overhead cost is expensed right away. This means that when each unit or product is made the cost of that unit is accounted at that time rather than waiting to expense the cost of the unit or product at the time of the sale of the good. Is important to know that the cost that are included in the variable costing method are cost that will increase by the volume of production. In this method the expenses can be expected to fluctuate proportionally with the quantity output. As the company produces more the variable cost will have a direct relationship and go up as well. Same can be expected if the activity of production falls then can be expected that the variable cost will decrease. The formula to calculate variable cost is Total variable cost= Total quantity of output x Variable cost per unit of output.

In order for us to carry out this equation we must understand and know how to classify the different types of cost and determine which fall under variable cost. Variable cost are those cost that do not stay the same all the time. Variable cost are cost that change and therefore, consider variable. As to fixed cost the cost stays the same all the time and example is rent. The rent cost will stay the same no matter how many items or product the company produces.

An example of variable cost are materials, production labor, and sales commission. In an employee's compensation, we can have regular sale which will fall under fixed cost but the commission bonus that the employee receives from making more sales will fall under the variable cost.

A real-life example in which we can break down the cost to further understand the concept and the method of fixed is the following:

Let's say that I decided to open a Smoothie Store and the materials to make the smoothies are fruit and yogurt. And as said before the variable cost, is the cost that changes as the activity of the Smoothie Store changes. Let's say that it was determined that the cost of producing one smoothie (fruits and yogurt) was $1 and they are sold for $4. And in the first that the store opened there was a total of 100 smoothies sold at $4 each and the total cost of material was $100. Then the second day the store opened the store sold 200 smoothies at $4 per smoothie, the variable cost of materials was $200 and then the third day the store sales 250 smoothies then total material cost was $250. The activity of the store (the amount of smoothies sold) increased and as the amount continue to increase the amount of variable cost also increase. To help illustrate this activity change lets graph it out and observe how variable cost behaves

:

As seen in the graph the arrows show how the cost per units of smoothies when up every time the amount of smoothies sold increase.

To calculate the product cost per unit we have to add Direct materials, Direct labor, and Variable manufacturing overhead. which would look as follow:

Direct Materials …………….............……….…....... $1 per unit

Direct Labor……………………..….................…… $12 per unit

Overhead Cost

Variable Overhead Cost………......................$800

Fixed Overhead……………......................… ---

Total product cost per unit………........................…..$813

Absorption Costing per the textbook is where direct materials, direct labor, and both variable cost and fixed overhead cost are included in product cost. This is the type of costing that must be used for external financial records under the US GAAP.

Unlike the Variable costing, Absorptions cost is expensed at the time in which the items or product get sold. Meaning that the cost was expensed at a later time and not right away like in variable costing. Absorption cost allocates a portion of fixed overhead cost to each unit produced along the variable cost per unit which a difference when compared to the variable cost method. All cost in this method would fall under product cost. When compared absorption vs variable cost the cost per unit in absorption cost will be much higher because it the cost per unit, the total fixed cost is being included. In absorption cost we can see how the the fixed cost of a company will remain constant as the level of activity increases.

An example of absorption cost in reference to the previous example of the Smoothie store. Fixed cost can be referred to the cost that’s allocated to pay for the rent of the store. The cost of the rent of the store per month is $1,500. The cost of the rent is not affected by the level of activity the store produces. In the first day the store sold 100 smoothies the second day 200 smoothies were sold and the third day 250 smoothies were sold. As the days progressed the stored sold more and more smoothies but these changes do not affect the expenses. The rent would not increase and the store yields more profits.

In the graph we can observe that the rent was not affected by the level of the activity

In the Absorption method to calculate the product cost per unit we have to add Direct materials, Direct labor, Variable manufacturing overhead and Fixed overhead cost, which would look as follow:

Direct Materials …………….............……….…...... $1 per unit

Direct Labor……………………...…................…… $12 per unit

Overhead Cost

Variable Overhead Cost……….......................$800

Fixed Overhead……………......................… $1,500

Total product cost per unit……….........................…..$2,313

In conclusion the main difference between Variable and Absorption costing is that in Absorption Costing, fixed cost is included were as in Variable Costing, fixed cost is not. Absorption can be considered as way to calculated the full costing of production and it's there required method for external financial reporting under GAAP. Variable is useful for internal purposes to help with decision making and for cost product analysis. Absorption is through product cost and variable cost uses product cost and period cost for fixed overhead cost.