Assignment 1: Absorption Versus Variable Costing

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Explain the differences between absorption costing and variable costing.

Explain, with the help of an example, how a company could use a variable costing system, as well as an absorption costing system. You have the option of using the company you work for as an example. Explain which method is better for the company being discussed.

Respond to the following: Through the end of the module, review and comment on at least two peers’ responses. Write your initial response in 300–500 words. Your response should be thorough and address all components of the discussion question in detail, include citations of all sources, where needed, according to the APA Style, and demonstrate accurate spelling, grammar, and punctuation.

Paper For Above instruction

Costing methods are crucial in managerial accounting, influencing how a company allocates overhead costs to products and determines profitability. Two widely used methods are absorption costing and variable costing. This paper aims to elucidate the differences between these two systems, provide practical examples of their application, and discuss which method may be more advantageous for a particular company.

Differences Between Absorption and Variable Costing

Absorption costing, also known as full costing, allocates all manufacturing costs—both fixed and variable—to units of production. This means that the cost of a product includes direct materials, direct labor, and both variable and fixed manufacturing overheads. Conversely, variable costing considers only variable manufacturing costs in product costing, while fixed manufacturing overhead is treated as a period expense and expensed in the period incurred (Garrison, Noreen, & Brewer, 2018).

This fundamental difference leads to contrasting impacts on financial statements and decision-making. Under absorption costing, inventory values on the balance sheet include fixed manufacturing overheads, which can influence reported profits depending on inventory levels. Variable costing provides more clarity on the contribution margin of products by isolating variable costs, aiding managerial decisions like pricing and in-house efficiency improvements (Drury, 2018).

Application Examples of Each Costing System

Consider a manufacturing company producing custom furniture. Using absorption costing, the company would allocate both fixed and variable manufacturing overhead to each piece of furniture based on a predetermined rate. For instance, if the company incurs $200,000 in fixed overhead and produces 10,000 units annually, the fixed overhead per unit would be $20. Thus, each furniture piece's cost includes direct costs plus this allocated fixed overhead, which influences the product's total cost and pricing strategy.

In contrast, if the same company uses variable costing, it would only assign variable manufacturing costs—such as materials and direct labor—to each unit. Fixed overhead costs would be treated as a period expense, reflecting directly in the income statement of the current period. This approach allows management to analyze variable costs per unit, make decisions about product lines, and evaluate profitability without the distortion of fixed costs (Hilton & Platt, 2018).

Which Method Is Better for the Company?

The choice of costing method depends on the company's operational focus and managerial needs. Absorption costing aligns with external reporting requirements mandated by GAAP, as it provides a comprehensive view of product costs needed for financial statements and regulatory compliance (FASB, 2020). However, it can obscure the understanding of variable costs and marginal profitability, potentially leading to suboptimal pricing or production decisions.

Variable costing, on the other hand, is valuable for internal decision-making processes. It clearly shows contribution margins and helps managers assess the impact of production levels on profitability. For companies focusing on cost control, profitability analysis, and strategic planning, variable costing offers more transparency. Nonetheless, it is not accepted for external financial reporting under GAAP.

In the context of a manufacturing business aiming to optimize cost control and decision-making, variable costing provides more actionable insights. Conversely, for reporting financial performance to investors and regulators, absorption costing remains essential. Therefore, each method has its strengths, and the optimal choice depends on the company's specific operational and reporting needs (Kaplan & Atkinson, 2015).

Conclusion

Understanding the differences between absorption and variable costing enables managers to select the most appropriate method for internal decision-making and external reporting. Absorption costing, being compliant with GAAP, suits external financial statements, while variable costing provides clearer insights into cost behavior and profitability for internal analysis. Companies must evaluate their strategic priorities and regulatory requirements to determine the most beneficial approach.

References

• Drury, C. (2018). Management and Cost Accounting. Cengage Learning.
• Garrison, R. H., Noreen, E. W., & Brewer, P. C. (2018). Managerial Accounting (16th ed.). McGraw-Hill Education.
• Hilton, R. W., & Platt, D. E. (2018). Managerial Accounting: Creating Value in a Dynamic Business Environment. McGraw-Hill Education.
• Kaplan, R. S., & Atkinson, A. A. (2015). Advanced Management Accounting. Pearson.
• Financial Accounting Standards Board (FASB). (2020). Accounting Standards Update No. 2014-09.
• Horngren, C. T., Datar, S. M., & Rajan, M. V. (2015). Cost Accounting: A Managerial Emphasis. Pearson.
• Weygandt, J. J., Kimmel, P. D., & Kieso, D. E. (2018). Managerial Accounting: Tools for Business Decision Making. Wiley.
• Anthony, R. N., & Govindarajan, V. (2014). Management Control Systems. McGraw-Hill Education.
• Drury, C. (2020). Cost and Management Accounting. Cengage Learning.
• Alexander, D., & Britton, A. (2019). Financial Reporting. Cengage Learning.