This week, we learned that there are two different ways of reporting the contribution margins variable and absorption costing. The authors made a point that one method is more useful for internal purposes, and the other is more useful for external reporting.
Lets think about a company that produces dinner ware (plates, bowls, cups and saucers, for example). Some of the dinner ware is intended for daily use (stoneware that is dishwasher and microwave safe), and other dinner ware is for special occasion (fine china or bone china, with gold trim that cannot go in the microwave!) Daily use dinnerware is less expensive than special occasion dinnerware. Imagine that there is consistent demand year-round for the daily use dinnerware, but there are seasonal spikes in demand for the special occasion dinnerware (i.e. wedding season and the holiday season). Additionally, gold is an important component of special use dinner ware, yet the price of gold varies.
Explain how fixed manufacturing overhead costs are shifted from one period to another under absorption costing. Would you recommend absorption costing for the daily dinner ware, the special occasion dinner ware, or both?
What arguments are there in favor of treating fixed manufacturing overhead costs as product costs? As period costs?
Under absorption costing, how is it possible to increase net operating income without increasing sales? Explain using the dinner ware example.
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Absorption costing treats all manufacturing costs as product costs whether they are variable or fixed (Noreen, 2017). For this reason, fixed manufacturing overhead costs would be included in the cost of goods sold under the absorption costing model. Additionally, a portion of fixed manufacturing overhead cost is allocated to each unit of product along with the variable costs. In variable costing, the fixed manufacturing overhead is not included in the product costs.
It would make sense to imply absorption costing be used for the special occasion dinner ware. In absorption costing, costs are transferred to finished goods and only when the units are sold do these costs flow through to the income statement as part of cost of goods sold (Noreen, 2017). In variable costing, fixed manufacturing overhead costs are considered to be period costs just like selling and administrative costs and are taken immediately to the income statement as period expenses (Noreen, 2017). Since the special occasion dinnerware demand fluctuates, at times the company may have significant inventory on hand. Implementing the absorption method will allocate some of the fixed manufacturing overhead to be absorbed in inventory, otherwise the variable method would immediately expense the inventory on the income sheet. The benefit is that that if inventories increase, fixed manufacturing costs are deferred in inventories. Thus, there is an increase net operating income.
Treating manufacturing overhead as a period cost will expense them as they incur. Treating manufacturing overhead as a product cost by absorption will attach a cost to each product that takes into accountant all costs of production. The benefit is that absorption costing can provide a company with a more accurate picture of profitability than variable costing (Maverick, 2019). Additionally, absorption costing methods are compliant with generally accepted accounting principles.
Maverick, J., Absorption Costing: Advantages and Disadvantages. Investopedia. March 12, 2019.
Noreen, E. (2017). Managerial Accounting for Managers (4th Edition). Mcgraw-Hill Education.
Once again I find that what appears to be very complex when introduced is actually not. Accounting seems to have a way to make things as complex as they can be. It may be that I am not comprehending the complete meaning, but I will try to demonstrate an understanding of the concept in as simple of terms as possible.
The difference between the way that the two methods report contribution margins comes down to a single factor. The Absorption method treats fixed manufacturing overhead (FMOH) as a product cost (cost of goods). The Variable method treats FMOH as a period cost.
The way this can be used in different situations is as follows.
Absorption method shifts costs from one period to the next as sales/production varies, which is better for products that have varying demand, varying market value and varying fixed costs. The Variable method keeps values more stable by spreading the FMOH evenly across periods, which is better for products whose value and fixed costs are more stable.
I would recommend the Absorption method for the for the special occasion dinner ware, whose market value varies during different seasons, and whose materials (gold) also vary throughout the year. I would recommend the Variable method for the every day dinner ware whose value and materials remain more stable.
I do have one question – It is easy to see that the Absorption method would work great for those products with varying values and materials costs, but would not that method work out the same in the long run for stable products, because while it allows for the variables, if those numbers do not vary, wont the figures then work out as stable? I really hope that someone can address this question for me.
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