This report discusses the concepts of full costing and variable costing in detail. The complete framework of both these approaches will be discussed. This report will also highlight the use of both these approaches from point of view of a manager that how both these approaches are used by managers in their decision making process. What is the use of variable approach for a manager while making decisions about pricing and production and what is the use of full costing and how these approaches are used in financial reporting. This report will also state the differences between full and variable costing and point out the strengths and weaknesses of each approach. Both these approaches are evaluated in product costing and service costing. At the end, this report will conclude about the impact of choosing these accounting methods.
It must also be noted that,
“There is no such thing as the ‘cost’ of anything ... cost is what it is defined to
be” (Morris, and Hall, n.d).
Like other systems of costing (job costing, batch costing, process costing and operating costing), variable and full costing are not systems of costing. Full costing is a technique in which total costs are considered for product costing, inventory assessment and for other decisions which are important for middle and top management from their future prospective. While in variable costing, only variable costs are taken into account. Variable costing technique is in contrast to the full costing technique which is also known as conventional and absorption costing. The main difference between these two techniques of costing is that in variable costing, production costs are only variable costs. Variable costing is composed of direct material, direct labor and only variable overhead. But full costing method absorbs all the costs require to produce a product or services and have it in saleable shape. The product cost in full costing is made up of direct material, direct labor, variable overheads and also fixed overheads. Hence both these techniques are changes only in aspect of fixed manufacturing overheads. The use of any technique by the management depends upon the purpose like variable costing technique is helpful for management when they are in process of making decisions about profit maximization (Brewer, Garrison and Noreen 2009).
a) In variable costing, fixed costs are belonged to a particular period so that they should be charged to that period of time only. But while in full costing, fixed cost are carried forward over next period.
b) In full costing technique, some agreed recovery method has been used through which fixed costs are recovered from production. Fixed overheads calculated by these recovery methods are not correct and may misinform the company while making decisions about future. Moreover, fixed overheads are associated with time like insurances etc and they have nothing to do with the volume of output. So they should recover in period to which they are related and should not carry forward. The second important assumption in variable costing is that fixed costs of product or services cannot be allocated or assigned to products/services because there is no method of doing so. While in full costing fixed costs are allocated to product.
The impact of variable costing and full costing would be least effecting the service industry because of non availability of closing inventories in case of service sector further, it is very difficult to divide total revenues in service units. And if somehow it is possible, they would not be identical in nature therefore, per unit cost cannot be calculated in service industry. In service industry, revenues are gross margins and then operating expenses are deducted from gross margin to find out the net profit.
The main assumption which is taken under variable costing is that for a company to be able to produce product or render services, some investment are required to get facilities and other factors without which a company cannot produce its product or cannot deliver its services. For example, a company may need a building on rent to starts is production or for delivering services, in case of manufacturing unit, a company has to install machinery against which depreciation would be charged, factory insurance, property taxes salaries of production staff etc are the expenses which a company has to incur either in initial stage or throughout the year. Hence, as per this technique, the fixed costs generated due to such kind of investments are period cost not the product cost. A company whether a manufacturing unit or service provider has to incur these expenses to start a setup and in each coming each these expenses will recur. Therefore fixed costs should not be part of cost of inventory and should be charged each year.
In other words, fixed overheads are not inventor-able costs. Hence these are period costs and should be matched against the revenue of that year. As for as the absorption costing is concerned, fixed overheads are inventoriable costs and are product costs not the period cost. So, these fixed overheads should be charged against the revenue of the year in which sale is occurred.
The difference in both these techniques can be seen in figures 3 and 4. These two income statements are prepared under variable and full costing to show the difference. As it is evident from Figure 3 and 4 that everything is same except the fixed overhead costs which becomes the component of production cost in full costing. While in case of variable costing, fixed overheads are non production cost. Moreover, in both case, the handling of other overheads like selling and administrative is same in both techniques.
Effects of Using Full Costing & Variable Costing
Production Effects on income in Full &Variable Costing:
1. There is no effect on the net income of a company, if number of units produced is equal to number of units sold. It does not make difference in the net income whether a variable costing method is used or full costing method is used.
2. Net income is greater in full costing as compare to variable costing, if the number of units produced is greater than the number of units sold.
3. Net income is less in full costing approach as compare to variable costing, if the number of units produced is less than the number of units sold.
These effects are explained with example in Appendix 1.
Effects of Full Costing & Variable Costing on JIT:
Using of Just-in-Time inventory system means low level of inventory which leads to little difference in production and sales of a company. So whether a company is using full costing or variable costing in case of JIT inventory system, there should be no difference or a little bit difference in net income of company.
Advantages of Variable Costing:
1. As all fixed overheads are considered as period cost, so there is no problem of assigning fixed overheads in variable costing. But in full costing, there is problem of assigning fixed overheads to products through some agreed recovery method which may give incorrect results.
2. The data for CVP can be taken directly from income statement prepared on variable costing technique.
3. This approach is very useful for managers in making decisions and “what-if” analysis. This approach is used by managers for their internal reports.
4. No issue of over absorption or under absorption of factory overheads in case of variable costing as compare to absorption costing. Therefore, income statement is easy to prepare and understand in variable costing technique in contrast to full costing technique.
5. Measure of income provided by variable costing is more accurate as compare to full costing.
6. Income statement, prepared by using variable costing, shows profit fluctuations in response to change in sale levels not on the combination of sales and production levels, as in case of full costing. Therefore, from management point of view, it is more reliable and easier to understand as compare to full costing.
7. Variable costing gives relevant inputs for decision making. Without it, management may take wrong decisions which affect the profits of the company. Variable costing is used a profit planning tool in many industries and its acceptance is increasing day by day.
Limitations of Variable Costing:
There are also some limitations of variable costing with respect to income measurement and profit planning.
1. It is a complicated and difficult job to divide the total costs into fixed and variable costs elements.
2. Variable costing may encourage the short term approach to profit planning instead of long term approach. There is a possibility in variable costing that sales may be done at price which is slightly higher than variable cost which may result into very low profit or may be loss is some situations. Managers should not forget that, there is need to recover all the cost from the selling price not only variable costs. They may get incorrect signal of only recovering the variable cost from selling price.
3. Variable costing may give wrong interpretation in case where variable cost is only a small portion of total cost as in a case of an automated manufacturing unit. In this case, variable cost is a very small portion on total cost.
4. It may be dangerous for management to be only focused on variable costing and not giving attention to full costing.
5. This approach is not acceptable by GAAP for financial reporting. If a company uses variable costing for its external reports, auditors may not accept its financial statements in compliance with GAAP. But this approach can be used by managers for their internal reports.
Advantages of Full Costing:
1. Full costing better matches costs with the revenue. Supporters of full costing technique believe that all cost of a product or services should be assigned to product/services. So that cost of each unit should be matched with revenue of each unit sold.
2. Full costing technique recognizes the significance of fixed costs in production.
3. In this method stocks are not undervalue, so this method is allowed by Inland Revenue.
4. This costing approach is required by Generally Accepted Accounting Principle (GAAP) for financial reporting. In world over the world tax law may also require the full costing approach for filing of income tax returns.
5. As top management is evaluated on the basis of earnings mentioned on external financial statements, not on the basis of internal statements so may they also base their decisions on full costing instead of variable costing.
6. Full costing technique shows less variations in net profit, when production is constant but sales change.
Limitations of Full Costing
1. It is difficult for managers to make strategic decisions by using this approach because this method is a blend of fixed and variable overheads.
2. The cost volume profit (CVP) relationship is overlooked in full costing, as mangers are focusing on total cost of production. They have to use their own perception for decision making.
3. In full costing, a part of fixed cost is carried to next accounting period in shape of closing stock. This is not a healthy practice because cost belong to one period should not be make faulty by the addition of cost which belongs to previous period.
4. The sole reliance by managers on full costing may lead to bad decisions.
5. Profitability is doubtful, unclear and difficult to understand in full costing technique due to the arbitrary assignment of fixed costs.
? There is no conflict between these two techniques as far as accounting of costs is concerned. Both are important, variable costing for internal reporting and full costing for external reporting. Variable costing is used for decision making internally and full costing is used by external users.
? Absorption costing does not support CVP analysis and hence does not provide any information for decision making to mid level managers. While variable costing supports the CPV analysis and helpful to mid level managers for decision making. So, for internal recording managers should use variable costing approach to make more appropriate decisions.
? While taking into account the variable overheads in variable costing, mangers should not ignore the fixed costs also while deciding the price of product. In case of ignorance of fixed overheads, the manager may leads to low profits or even losses.
? It is easier to estimate the profitability of products on the basis of variable costing. So management finds it more useful technique for internal working. But top management should not ignore the significance of full costing as financial statements are prepared by using full costing technique. As, top management is evaluated based on external reports to shareholders, they may feel that decisions should be based on absorption cost income.
Let’s conclude the discussion of variable and full costing. By using the, variable costs and contribution approach in the accounting system, decisions can be made by management about expected profits. Both these techniques have their own advantages and at the same time both techniques have some limitations. Top management cannot deny the importance of full costing, as financial statements are based on it. And the performances of top management, their bonuses are based on those profits mentioned on these financial statements. For top level management, full costing is more significant while for middle level management involve directly in production activities, variable costing is important. From all the discussions, we find out that choice does matter; the use of full and variable costing has their impact of inventory level and net income. But the point of focus is that, a company should first define the purpose for which it wants to use one of these costing techniques and the selection of costing technique for that purpose should be appropriate.
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