There Are Several Ways A Company Can Allocate Overhead Costs To Produ
There are several ways a company can allocate overhead costs to products produced or services provided. Two of these methods are absorption costing and variable costing. This assignment will allow you to explore the two methods of costing and compare/contrast the different uses of each costing system. Using the module readings and the Argosy University online library resources, research absorption and variable costing. Use your research and/or your experiences as a working professional to complete this assignment.
Respond to the following: Explain the differences between absorption costing and variable costing. Explain, with the help of an example, how a company could use a variable costing system, as well as an absorption costing system. You have the option of using the company you work for as an example. Explain which method is better for the company being discussed. By the due date assigned, post your response to the Discussion Area.
Through the end of the module, review and comment on at least two peers’ responses. Write your initial response in 300–500 words. Your response should be thorough and address all components of the discussion question in detail, include citations of all sources, where needed, according to the APA Style, and demonstrate accurate spelling, grammar, and punctuation.
Paper For Above instruction
There Are Several Ways A Company Can Allocate Overhead Costs To Produ Introduction
Overhead costs are indirect expenses incurred in the production of goods or services and are essential for the overall operational costs of a business. Proper allocation of these costs is crucial for accurate product costing, financial reporting, and strategic decision-making. Among the various methods available, absorption costing and variable costing are two prominent approaches, each serving different managerial and external reporting purposes. This paper compares and contrasts absorption and variable costing, illustrating their applications through examples and assessing their suitability for different business contexts.
Differences Between Absorption and Variable Costing
Absorption costing, also known as full costing, assigns all manufacturing costs—direct materials, direct labor, and both variable and fixed manufacturing overhead—to products. This method complies with
generally accepted accounting principles (GAAP) and is used for external financial reporting. Under absorption costing, fixed manufacturing overhead is allocated across all units produced, regardless of whether they are sold during a period (Garrison, Noreen, & Brewer, 2021).
In contrast, variable costing, often referred to as direct or marginal costing, considers only variable manufacturing costs—direct materials, direct labor, and variable overhead—in product costing. Fixed manufacturing overhead is treated as a period expense and is expensed entirely in the period incurred (Drury, 2018). This approach provides clearer insight into the variable costs associated with production and aids in short-term decision-making.
**Key differences include:**
- Treatment of Fixed Manufacturing Overhead: Absorption costing allocates fixed MOH to products; variable costing expenses it immediately.
- Impact on Inventory Valuation: Under absorption costing, inventory includes fixed MOH, which can inflate asset values; variable costing does not.
- Profitability Analysis: Variable costing facilitates analysis of contribution margin per unit, aiding in break-even analysis, while absorption costing links profit to sales volume directly.
Examples of Application
Consider a manufacturing company producing 10,000 units of a product per month. Suppose total fixed manufacturing overhead is $200,000, and variable costs per unit are $10 (materials and labor).
**Using Absorption Costing:**
The fixed manufacturing overhead per unit is $20 ($200,000 ÷ 10,000 units). The cost per unit includes variable costs ($10) plus fixed overhead allocations ($20), totaling $30. If the company produces all units but sells only 8,000, the ending inventory valuation on the balance sheet will include fixed overhead costs allocated to unsold units, influencing reported profits and assets.
**Using Variable Costing:**
The variable cost per unit remains $10; fixed manufacturing overhead is expensed in total ($200,000) in the period’s income statement. This provides clearer insight into the contribution margin per unit ($30 sales price minus $10 variable cost = $20) and the impact of sales volume on profitability, independent of
**Implications for Decision-making:**
- Absorption costing is useful for external reporting and tax purposes, as it complies with GAAP.
- Variable costing is advantageous for internal decision-making, such as pricing, product line analysis, and cost control.
Application for a Specific Business
In a retail company, where inventory turnover is high and fixed manufacturing overhead is minimal, variable costing offers significant advantages—it aids in assessing the true contribution of each product to profit, facilitating better pricing and marketing strategies. Conversely, in a manufacturing environment with significant fixed costs and inventory holdings, absorption costing aligns better with financial reporting requirements, aligning profit recognition with GAAP standards.
Conclusion
Both absorption and variable costing have their applications, advantages, and limitations. Absorption costing provides a comprehensive view of total manufacturing costs, aligning with external reporting standards, but may obscure cost behavior and short-term profitability insights. Variable costing emphasizes variable costs, offering clearer managerial insights but does not conform to GAAP for external reporting. The choice between these methods depends on the company's specific operational context, managerial needs, and compliance requirements, with each method serving different strategic and financial purposes.
References
Drury, C. (2018). Management and Cost Accounting. Cengage Learning.
Garrison, R. H., Noreen, E. W., & Brewer, P. C. (2021). Managerial Accounting (16th ed.). McGraw-Hill Education.
Hilton, R. W., & Platt, D. E. (2019). Managerial Accounting: Creating Value in a Dynamic Business Environment. McGraw-Hill Education.
Weygandt, J. J., Kimmel, P. D., & Kieso, D. E. (2020). Managerial Accounting. Wiley.
Horngren, C. T., Datar, S. M., & Rajan, M. (2019). Cost Accounting: A Managerial Emphasis. Pearson.
Blocher, E., Stout, D., Juras, P., & Cokins, G. (2019). Cost Management: A Strategic Emphasis. McGraw-Hill Education.
Anthony, R. N., & Govindarajan, V. (2018). Management Control Systems. McGraw-Hill Education.
Kaplan, R. S., & Atkinson, A. A. (2018). Advanced Management Accounting. Pearson.
Warren, C. S., Reeve, J. M., & Fess, P. E. (2020). Financial & Managerial Accounting. Cengage Learning.
Libby, T., & Libby, R. (2018). Financial Accounting. McGraw-Hill Education.