Meaning, Advantages and Disadvantages Article shared by: In this article we will discuss about Absorption Costing:
Advantages and Limitations of Variable Costing Article shared by: Advantages and Limitations of Variable Costing!
Advantages of Variable Costing: The following are the advantages of variable costing: Financial planning requires managers to estimates future sales, future production levels, future costs etc.
In order to determine the level of expenditure at different production levels, knowledge of cost behaviour and distinguishing between fixed and variable costs is essential for making accurate cost estimates at the different levels of production and sales.
Thus a financial plan will highlight expected production level and related expected costs.
This financial plan can be used to monitor the actual performance as it is done. In case actual performance is different from the budgeted activity level, corrective action can be taken by management.
Thus control is exercised by management through taking corrective actions. Absorption costing ignores cost behaviour and is not able to isolate and relate accurate costs to different sales and product volumes. It is not reliable because of the arbitrary allocation of manufacturing over-headed.
These allocations may not reflect accurate charging of manufacturing overhead to different production levels. Variable costing income statements are more useful internally for short-term planning, controlling and decision making than absorption costing statements.
To carry out their functions, managers need to understand and be able to project how different costs will change in reaction to changes in activity levels. Variable costing, through its emphasis on cost behaviours, provides that necessary information.
Management requires knowledge of cost behaviour under various operating conditions and business decisions.
The identification and classification of costs as either fixed or variable, with semi-variable expenses properly subdivided into this fixed and variable components, provide useful framework for the accumulation and analysis of costs and further for making decisions. Relevant costs are required for a variety of short-term decision such as changes in production levels, make or buy, entry into new markets, product mix, plant expansion or contraction or special promotional activities.
These decisions require that costs be split into their fixed and variable components and this is possible only under variable costing.
Therefore, projection of future costs and revenues for different activity levels and the use of relevant cost decision-making techniques are facilitated and highlighted in variable costing and not in absorption costing.
The utility of variable costing rests upon the fact that, within a limited volume range, fixed costs tend to remain constant in total when activity level changes, under such conditions, only variable costs are relevant in ascertaining costs of additional output and sales or in other short-term decisions.
Another benefit of variable costing is that the favourable margin between selling prices and variable cost should provide a constant reminder of income forgone because of lack of sales volume.
A favourable margin justifies a higher production level. Variable costing provides more useful information to management for pricing decisions than absorption costing. It is rightly contented that the best or optimum price is that which produces the maximum excess of total sales revenue over total cost.
The fixed costs of depreciation, taxes, insurance, supervisory, salaries, and so on, are just as essential to manufacturing products as are the variable costs. Advocates of variable costing argue that fixed manufacturing costs are not really the costs of any particular unit of product. Fixed costs include overhead expenses and other indirect costs of doing business that are not directly attributable to the production or delivery of a product or service. Cost Vitiated because of Fixed Cost included in Inventory Valuation: In absorption costing, a portion of fixed cost is carried forward to the next period because closing stock is valued at cost of production which is inclusive of fixed cost.
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.
The price at which this volume can be achieved is the optimum product price. Variable costing serves as the basis of product pricing in many cases. Under variable costing, management has the data to determine when it is advisable to accept orders if other than normal conditions exist.Fixed costs are easier to account for as costs do not change relative to the volume of goods produced.
This is the complete opposite of variable costs, which can experience multiple price variances.
For example, variable costs are subject to price increases related to low supply. The use of fixed costs The greater proportion of fixed cost the greater from ACCT at CUHK80%(5).
Under variable costing, which is the other option for costing, only variable costs are considered for production. Overhead costs, such as rent and wages, are considered separately.
Variable costing provides a better understanding of the effect of fixed costs on the net profits because total fixed cost for the period is shown on the income statement.
Various methods of controlling costs such as standard costing system and flexible budgets have close relation with .
Fixed costs include overhead expenses and other indirect costs of doing business that are not directly attributable to the production or delivery of a product or service. Examine the absorption costing method for accounting purposes, and learn about the advantages and disadvantages associated with absorption costing.
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