Brought to you by Disadvantage: Non-Conforming Method A significant disadvantage with variable costing is that it does not conform to generally accepted accounting principles. When sales increase to eliminate the previously produced inventory, the phantom profits disappear. Forecasting of costs and contribution margins, flexible budget analysis, relationship of costs to sales volume and sales price, and many other cost relationships can be readily studied. No particular accounting problems are created by using both costing methods--the variable costing method for internal reports and the absorption costing method for external reports. Another benefit of variable costing is that production managers cannot manipulate income by producing more or fewer products than needed during a period. Critics of absorption costing refer to this phenomenon as one that creates illusionary or phantom profits. Firms that use absorption costing choose to allocate all costs to production.
With all of these advantages one might wonder why absorption costing continues to be used almost exclusively for external reporting purposes and why it is predominant choice for internal reports as well. Understanding variable costing system makes the use of those methods easy. Marginal costing shows more clearly the impact on profit of fluctuations in the volume of sales. If fixed costs are an especially large part of total , it is difficult to determine variations in costs that occur at different production levels. This guide will provide the job order costing formula and how to calculate it. The project would be worth exploring further, since the net operating income percentage comfortably exceeds the break-even point analysis. Also, you can use absorption as an trick to increase by moving fixed costs from the to the.
Unlike marginal costing which take the fixed cost as period cost. Disadvantages of Marginal Costing The disadvantages, demerits or limitations of marginal costing are briefly explained below. You show reduced income because of unsold products but full expenses for overhead. In addition, absorption costing takes into account all costs of production such as fixed costs of operation, factory rent, and cost of utilities in the factory. Absorption Costing Absorption costing is a method whereby you apply part of your fixed overhead costs to the cost of manufacturing products. You add the full cost of fixed overhead for the period.
Thus the variable costing although useful is not a perfect managerial tool. An effective and efficient management information system is also required so as to provide employees and managers with reliable, accurate and timely feedback regarding their performance. Presenting segmented income statements on a variable-costing rather than on absorption-costing basis is preferable because it results in more accurate studies of relative profitability of divisions, plants, products, territories, activities, and other segments of an organization. Following are the principal advantages of direct costing: Advantage 1. The result is that losses will be reported during out of season periods and large profits will be reported in the periods when the goods are sold. This creates motivation for the employees as they feel part of the system. Direct costs refer to costs that can be traced directly to the product itself, such as direct materials or direct labor.
The contribution margin sales minus variable costs must be large enough to cover all fixed expenses such as salaries, rent, and taxes and also provide a reasonable income and an adequate return on investment. Advantages and disadvantages of variable costing Essay Many managers use variable costing for internal reporting and decision making since it has number of advantages Myers par. Direct costing can help to pinpoint responsibility according to organizational lines; individual performance can be evaluated on reliable and appropriate data on the basis of current period activity. You must learn the implications of each before making this choice. Top executives are typically evaluated based on the earnings reported to shareholders on the external financial reports. Marginal cost pricing is suitable for pricing over the life-cycle of a product. Profit in variable costing is not affected by changes in inventory as it is in absorption costing.
It is not possible to prepare a flexible budget without making this distinction. The following are the advantages of absorption costing:- i Consideration of Fixed Costs: Absorption costing rightly recognises the importance of including fixed production costs in product cost determination and in determining a suitable pricing policy. Advocacy of direct costing has a long history in accounting and finance. The result is that losses will be reported during out of season periods and large profits will be reported in the periods when the goods are sold. The fixed costs are constant only for short period. The optimum production volume is that at which increase in total cost due to the addition of one more unit of volume is just equal to the increase in total revenue or a zero increase in total profit.
A proponent of this method would argue that it is most effective. The marginal costing technique is very simple to understand and easy to operate. Although variable costing is useful for internal reports and decision making, it is not acceptable for external reports in United States and almost all other countries, and tax authorities require companies to use absorption costing for calculating income taxes Fremgen. Advantages of Absorption Costing Absorption costing offers an advantage when you do not sell all of your manufactured products during the accounting period. They therefore lose their control and motivational effects.
Fixed Cost Inclusion in Cost not Justified: Many accountants argue that fixed manufacturing, administration and selling and distribution overheads are period costs and do not produce future benefits and, therefore, should not be included in the cost of product. The company accepts business opportunities that provide revenue above the absorption cost and rejects business opportunities that provide revenue below the absorption cost. This situation has the effect of inflating the profit for the period. This can especially benefit a small manufacturer that can't support a separate budgeting department. The company multiplies this total-cost per unit by the number of units sold during the year to determine the cost of goods sold.