Costing Approaches: The Top 3 Methods

Impact of Production on Variable and Full Costing Approaches Income 

The effect of production on full and variable costing income depends on how the two costing methods deal with fixed production costs. Full costing considers both fixed cost and variable costs in determining unit production cost, while variable costing only considers variable costs. “In full costing, inventory costs include direct material, direct labor, and all manufacturing overhead” (Jiambalvo, 2018 p176) . In variable costing, fixed costs are treated as period costs and expensed in the period occurred. There is no difference between the contribution margin for variable costing and the profit calculated based on full costing whenever all inventory produced is sold. The variance only occurs when the quantity sold differs from the quantity produced because some fixed costs end up in the ending inventory under full costing. In contrast, the entire fixed cost is expensed as a period cost in variable costing. When quantity produced is greater than quantity sold, full costing income is usually more than variable costing income and vice versa.

Just-in-Time (JIT) is an inventory management system that companies adopt to enhance production efficiency and cut inventory holding costs. The purchase of inventory is scheduled such that supplies are only ordered when needed and utilized immediately; hence no storage cost is incurred. This means that the units they produced is equal to units sold because production is done on orders. Therefore, “ the difference between variable costing income and full costing income is likely to be very small for companies that use JIT” (Jiambalvo, 2018 p185) . Just-in-time inventory management harmonizes the differences in full costing and variable costing income statements.

Variable costing is mostly used for internal reporting purposes only because the international reporting standards only validates full costing for external reporting. “Generally accepted accounting principles (GAAP) imply that variable costing is not acceptable for external reporting purposes. Since it’s not allowed, it isn’t used!” (Jiambalvo, 2018 p181) . Variable costing is beneficial in internal reporting because it facilitates the cost-profit volume (CVP) analysis which subsequently aids in decision making and planning. CVP analysis is mainly used to determine the volume to yield a particular level of sales and profit. The analysis can only rely on variable costing because it separates fixed costs from variable costs and makes the CVP computations easier. Internal reporting using variable costing also limits managers from inflating earnings by increasing production volumes, as in full costing. An increase in production volume does not affect variable costing income because the fixed is entirely expensed as a period cost.

Chapter 5. Problem 5-2 

5- 2 a. Determination of Profit And the Value of End Inventory 

Use of full Costing Method
	2017	2018	2019
Production costs	50,000	50,000	50,000
Units Produced	5,000	6,000	4,000
Fixed costs per unit	10	8	13
Per unit variable cost	75	75	75
Total cost	$85	$83.33	$88
Determining Profit
Units sold	5,000	5,000	5,000
Unit selling price	225	225	225
Total Sales	$1,125,000	$1,125,000	$1,125,000
Cost of sales	425,000	416,666.67	437,500
Gross Profit	700,000	708,333.33	687,500
Less: Selling and admin expenses	5,000	5,000	5,000
Net profit	$695,000	$703,333.33	$682,500
Ending Inventory Value
Units produced	5,000	6,000	4,000
add balance brought forward	-	-	1,000
Less: Units sold	5,000	5,000	5,000
End inventory in units	-	1,000	-
Value of ending inventory		$83,333.33

5-2b. The Explanation for the Fluctuating Profit Under the Full Costing Approach 

The full costing approach incorporates all fixed, variable and direct costs into the finished product. The costs factored in include direct materials cost, direct labor cost, fixed and variable manufacturing overheads. Therefore, the method allows for the produced units to be reported at full cost. As the production levels fluctuate, so does the total unit cost used in determining the cost of sales—a fluctuating cost of sales results in a fluctuating gross profit and net income.

5-2c. Determination of Profit and the Value of End Inventory 

Use of Variable Costing Approach
	2017	2018	2019
Units sold	5,000	5,000	5,000
Unit selling price	225	225	225
Total Sales	$ 1,125,000	$ 1,125,000	$ 1,125,000
Cost of sales	375,000	375,000	375,000
Gross income	750,000	750,000	750,000
Less: Total Fixed production costs	50,000	50,000	50,000
Selling and admin expenses	5,000	5,000	5,000
Net profit	$ 695,000	$695,000	$695,000
Ending inventory in units	-	1,000	-
Variable cost per unit	75	75	75
Value of end inventory	-	$ 75,000	-

5-2d. Explanation of the Constant Net Income Under the Variable Costing Approach 

The marginal valuation approach factors variable production costs only. The valuation of sales and inventory costs comprises variable costs only, while the fixed production costs are regarded as period costs and expensed in the period in which they occur. The result is a constant gross profit irrespective of the levels of production.

C. Indirect Cost Allocation 

Indirect costs are incurred in various activities and cannot be identified with a specific cost object. This is why indirect costs are distributed to various cost objects through the cost allocation process. This process contributes to decision-making by quantifying the opportunity cost of using the company resources. The management can decide whether to use the resources and incur extra allocation costs or choose to outsource the service required if the opportunity cost exceeds the cost of outsourcing. In the process, the management also ensures that resources are used appropriately to enhance the efficiency of services provided. Allocation of overheads also helps in absorption costing to come up with the full cost of production used in financial reporting.

The cost allocation process is a three-step process; “ (1) identify the cost objectives, (2) form cost pools, and (3) select an allocation base to relate the cost pools to the cost objectives.” (Jiambalvo, 2018 p209) . The cost allocation base is selected on a cause-and-effect relationship basis, which means that the cost must be allocated based on cost drivers and their impact on various cost centers. After the cost allocation basis are determined, the overheads are apportioned according to benefits attributed to user departments. The benefits have to be assessed since the measure of benefits for each department might be unique.

The service department provides indirect support to the other departments. Products only pass through the production departments, and thus service costs must be allocated to user departments. The direct cost allocation method is used to apportion service department costs to various production departments, after which the costs are charged to final products. In this approach, services provided to other service departments are ignored. Methods such as repeated distribution method and the algebraic approach are used to allocate services offered to other service departments . 

D. Problem 6-3 

6-3 a. Determination of the Opportunity Cost 

Direct labor	$ 5.00
Direct materials	$ 25.00
Overheads	$ 6.00
	$ 36.00

6-3b. Bid Price Consideration 

The incremental cost of producing a single unit of the motor is $36. Thus, if Binder can bid with a unit price of $39 per unit, then the contract would be profitable for the company. The recommendation would be for the company to accept the tender offer because the pricing would deliver a $3 profit per unit. Besides, the opportunity cost calculation shows that the minimum pricing per unit the company can offer is $36. Pricing below that threshold would be result in a loss.

6-3c. Opportunity Cost As an Overheard Allocation Base 

Allocation of production overheads based on opportunity cost allows managers to focus attention on incremental costs regarding the decision of maximum and minimum profits to be realized on a given product. The method enables decision-makers to compare the advantages and disadvantages of various prices, thus enabling them to arrive at the most optimum pricing decision. Using Binder’s case, the adoption of opportunity cost as an allocation base has enabled the company to fix the highest bid and the lowest bid for the motor production tender. The company has determined that a $39 or above proposal will result in profit maximization, while any offer below $36 will result in a loss.

Conclusion 

The variable and absorption costing approaches enable decision makers to determine the cost per unit of production. Adoption of either method has an impact on the profits reported in the financial statements. The full costing approach provides a more realistic profit but only when not all production is sold within the reporting period, which proves to be helpful to firms that increase production in anticipation of seasonal rise in product demand. In practical terms, neither method is preferred over the other and companies prefer one approach over the other mainly depending on the behavior, organizational design and attitude of management. However, with the increased adoption of JIT, the traditional costing approaches are losing significance since fewer expenses and costs are incurred in the production processes. Allocation of costs is a critical component in determining which department takes the highest cost proportion which is important in evaluating alternatives in the short run and long run planning horizons. Cost allocation process aid in improving efficiency as managers strive to avoid unnecessary cost buildup. Thus, cost determination and allocation are a planning tool employed in achieving minimal production costs and maximize profitability.

Reference 

Jiambalvo, J. (2018).  Managerial accounting  (6th ed., pp. 174-230). New Jersey, United States: 

John Wiley & Sons, Inc.