Module 05 Course Project – Marketing Plan Phase 5

Fixed and Variable Costs

Accounting for Business Managers

Jeff Rover

Rasmussen College

12/2/17

Introduction

An import function of any manufacturing company is determining the cost of sold goods. The determination is vital for the company to employ effective pricing, manufacturing decisions, and marketing decisions. In the current economic market, firms have to consider decisions whether to outsource manufacturing or make the products in-house or combine the two to be able to bring the product to the market at the right time, quality and price. As much as there are several variables that affect decision making, the ability to monitor and calculate cost regarding production is the most important step during the process (Gong, 2007). The most commonly used accounting methods of cost are absorption costing and variable costing.

Definition Of absorption Costing and Variable Costing

According to Mangena (2010), in the absorption costing method, all the costs which are associated with the final products are included the goods sold costs. This includes all the mixed costs like expenses, variable costs and fixed costs that are either indirectly or directly related to the products manufacture such as direct materials, direct labor, sales variable costs, fixed costs of selling, fixed costs of manufacturing and variable costs of manufacturing.

In the variable costing method, only the product variable costs are included in the calculation of the costs of the sold goods to determine the margin contribution which is not the same as the gross margin that is determined by absorption costing. This normally involves direct costs, a variable portion of the overhead of manufacturing and direct labor (Banker et al., 2010). The fixed costs of manufacturing are not treated as a cost of products in variable costing. The fixed costs of manufacturing are rather treated as period costs and like administrative and selling expenses. They are charged wholly with revenue in every period.

Effects of Absorption Costing and Variable Costing on Production

Absorption costing has got both positive and negative effects on production. Absorption costing affects the company’s production positively when it is not selling its manufactured products during the period of accounting as the company may have finished inventory goods and since it assigns each unit an amount for expenses that are fixed. Every product that is in inventory has a value which involves the fixed overhead part. The company does not reveal the expense until the items in the inventory are sold. This improves profits in the particular period. This is one positive effect of absorption costing on the company. However, absorption costing also has negative effects on the production (Myers, 2009). At some accounting periods, absorption costing makes the profit levels of the company look better than they are actually. This comes as a result of the fixed costs that are not subtracted from the revenue unless every product that is manufactured by the company is sold. This leads to profit and loss statements skewing and misleads the management of the company, investors and potential investors.

The positive effect of variable costing on production is that the company gets a clear picture of the actual costs of increment associated with every product that the company manufactures. The company is able to get financial records that are accurate and an actual representation of what goes into the production costs. The company enjoys a report of costs which is a representative of the inputs of the products. However, variable costing also has a negative effect on production since ignoring the fixed costs of manufacturing; the variable costs undertake the overall costs of the products (Alkaraan et al., 2006). This can be explained by the fact that even if the costs that are included in the overhead don’t contribute directly to product creation, they have a residual effect on production that drives the production cost.

Company Example

The company to study its system of costing is Apple Plc. This is a confectionary company that is involved in the production of chews, sweets and candy bars. The company currently uses the absorption cost method with the cost structure shown below.

The company assigns both variable and fixed costs to the products and uses criteria that are based on a volume such as machine hours and labor hours to assign the expenses of a company to the individual products (Bhimani et al., 2008). The allocation of full costs to their products is however against the stance of researchers that says that variable costs are important factors in making decisions regarding products and therefore might not give accurate data about the costs of products. Also, the absorption costing does not measure effectively the resources cost that is used in the production of products since the resources demand in production are not equivalent to the units amount produced and sold. The outcome of Apple Plc. from using absorption method of costing is over-costing of the big volume products and under-cost of the small volume products. This is the scenario in Apple Plc. currently. Even though there is a commonality in other aspects of the process of production of the three products it manufactures, every product finally goes into a phase that is peculiar to it. The products, therefore, may have varied methods of cooking, packing and mixing and manpower and labor needs. In additional aspects of the material needed for production like flavors quantity and type differ and every product is produced in different quantities (Dekker, 2003). This leads to wrong product pricing due to a system of costing which is not an actual representative of the demand for each product.

Examples

For a company that uses the following structure of costing

The produced units number 5000

The variable costs for every unit

Direct labor $3

Direct materials $2

Variable of overhead of manufacturing $2

Variable administrative and selling expenses $3

The fixed costs annually

The manufacturing fixed overhead $30,000

Fixed administrative and selling expenses $10000

Example 2: Computing the product cost per unit with the absorption method of costing

Direct labor $4

Direct material $2

Variable overhead of manufacturing $1

Total variable cost of production\fixed overhead of manufacturing $7

Fixed overheard of manufacturing $5

Product cost of unit $12

Under the method of absorption, all the fixed, variable and production costs are included in the determination of the product unit cost. Therefore if the company sells one unit product, it means $7 will be subtracted from the gods sold costs and the units not sold will be carried within the inventory sheet account at $7 only (Mangena, 2010). This can make the profit levels of the company look better than they are actually as a result of the fixed costs that are not subtracted from the revenue unless every product that is manufactured by the company is sold.

Example 3: Calculating the cost per unit product using the method of variable costing

Direct labor $2

Direct materials $4

Variable overhead of manufacturing $1

Product unit cost $7

Under the method of variable costing, all the variable production costs are included the in the costs of the product. Therefore if the company sells one unit product, $7 will be subtracted from the goods sold costs and the units that are unsold will be carried on the inventory sheet at $7. The company will get a clear picture of the actual costs of increment associated with every product that it manufactures (Myers, 2009).

References

Alkaraan, F. and Northcott, D. (2006). Strategic Capital Investment Decision-Making: A Role for Emergent Analysis Tools? A Study of Practice in Large UK Manufacturing Companies, British Accounting Review, vol. 38, pp. 149-173.

Banker, D. and Johnston, H. (n.d.). Strategic Management Accounting and Control. Available at http://astro.temple.edu/~banker/Accounting/StrategicManagementAccountingHandbookChapter.pdf (accessed 5 April, 2010).

Bhimani, A., Horngren, C., Srikant, D. and Foster, G. (2008). Managemant and Cost Accounting, 4th edition, Prentice Hall.

Dekker, H. (2003) ‘Value Chain Analysis in Interfirm Relationships’; A Field Study, Journal of Management Accounting Research, vol. 14, pp. 1-23

Gong, L. (2007). Study on the Methods and Applications of Strategic Management Accounting. International Journal of Business and Management, vol. 2, no. 5, pp. 189-192. Available at http://www.ccsenet.org/journal/index.php/ijbm/article/viewFile/2081/1961 accessed 8 April, 2010.

Mangena, M. (2010). Strategic Accounting Lecture notes, University of Bradford, School of Management.

Myers, J. (2009). Traditional vs Activity Based Product Costing Methods: A Field Study In Defence Electonics Manufacturing Company. ASBSS Annual Conference.