There Are Several Ways A Company Can Allocate Overhead Costs

There Are Several Ways A Company Can Allocate Overhead Costs To Produc

There are several ways a company can allocate overhead costs to products produced or services provided. Two of these methods are absorption costing and variable costing. This assignment will allow you to explore the two methods of costing and compare/contrast the different uses of each costing system. Respond to the following: 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. 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

Overhead cost allocation is a fundamental aspect of managerial accounting, influencing pricing strategies, financial analysis, and decision-making processes. Two predominant methods employed in allocating overhead costs are absorption costing and variable costing, each with distinct principles, applications, and implications.

Absorption costing, also known as full costing, allocates all manufacturing costs—direct materials, direct labor, and both fixed and variable manufacturing overheads—to the cost of a product. Under this system, fixed manufacturing overheads are treated as product costs and are included in inventory valuation until the product is sold, at which point they are expensed as cost of goods sold (Coggins & Wada, 2018). This method aligns with generally accepted accounting principles (GAAP), making it necessary for external financial reporting.

In contrast, variable costing—or direct costing—only assigns variable manufacturing costs to the product. Fixed manufacturing overheads are considered period expenses and are charged in full to the income statement in the period incurred, regardless of sales volume (Hilton & Platt, 2019). This approach provides more precise information about the contribution margin of each unit sold and is often favored for internal decision-making because of its clarity in cost behavior.

To illustrate, suppose a manufacturing company produces 1,000 units of a product. Under absorption costing, both variable costs such as direct materials and labor, as well as a proportionate share of fixed overheads, are added to each unit’s cost, say $50 per unit. When inventory is sold, the entire unit cost—say $70—per unit, comprises fixed and variable costs, affecting the gross profit reported (Coggins & Wada, 2018). Conversely, under variable costing, only the variable cost components, such as $40 per unit, are included in the product cost, with fixed manufacturing overheads expensed immediately (Hilton & Platt, 2019).

The choice between these methods hinges on the company's reporting needs and decision-making context. For external reporting, absorption costing is mandatory, as it aligns with GAAP and provides a comprehensive view of product costs. For internal management, variable costing offers valuable insight into the cost behavior, assisting in profit analysis, breakeven assessment, and decision-making regarding production levels and pricing strategies (Garrison et al., 2021).

Considering a specific company scenario, a manufacturing firm that emphasizes long-term profitability analysis might favor absorption costing for its alignment with external financial statements. However, the same firm may utilize variable costing internally to evaluate the impact of production volume changes on profitability, as fixed costs are treated separately and do not distort per-unit cost calculations.

In summary, while absorption costing provides a comprehensive view suitable for external reports, variable costing offers detailed insights into cost behavior, making it a vital tool for internal decision-making. The selection of the appropriate method depends on the company's strategic focus, reporting requirements, and internal analysis needs.

References

• Coggins, J. R., & Wada, R. K. (2018). Cost accounting: A managerial emphasis. McGraw-Hill Education.
• Garrison, R. H., Noreen, E. W., & Brewer, P. C. (2021). Managerial Accounting (17th ed.). McGraw-Hill Education.
• Hilton, R. W., & Platt, D. (2019). Managerial accounting: Creating value in a dynamic business environment. McGraw-Hill Education.