Absorption and Variable Costing and their effects on production
Absorption costing is the method of product costing, which allocates all variable as well as the fixed manufacturing costs to the respective product. Under absorption costing, the fixed plant overhead is treated as a cost of the product and the assigns it to the amount of units of production in the respective period. On the other hand, variable costing is the method of product costing that allocates only the variable costs of manufacturing to the product. Under the variable costing, the fixed factory overhead is treated as an expense of the particular period and charges the entire incurred amount to the income of the respective production period.
Essentially, absorption costing method presents the costs entered on the statement of income in their functional groupings without taking into consideration the behaviour of the cost. In variable costing, the costs are reflected on the income statement as fixed or variable. Under absorption costing, the fixed overhead can be considered as inventory cost or taken as some form of asset. This is because there would be no production of any kind without the basic production capacity, which is reflected by the fixed overhead cost. For the variable cost, fixed overhead cost cannot be treated as an inventory cost, reason being it is incurred regardless of the level of production.
In an attempt to reflect the actual cost a product or service offered, the organization uses the absorption costing method as it includes all the costs associated with the production such as the cost of direct labor, direct materials, fixed as well as well as manufacturing overheads like the utilities and the factory rent. It is therefore, an effective method in external reporting. Absorption costing provides the organization with a more precise accounting for the net profitability. However, when the organization deals with different lines of products, this costing method may not be effective. Using the absorption costing method may have an effect on the level of production especially when the projected levels are higher, meaning that the estimated cost of production will also be high and the organization may want to reduce the cost of production by reducing the level of production in effect. Generally, the production cost will not equal the cost of sales for the manufactured goods. Under variable costing, the company is able to determine, through the cost-volume profit analysis, the level of production that it can undertake because the method reveals the break-even point for the production. This aspect enables the organization to determine the level of production as well as to project some sales volume to expect in order to attain the required profitability. Variable costing has a direct correlation to production as it changes proportionately and directly with production, as variable costs rises with the rise in the production costs and falls with the drop on the production costs.
Possible effects of absorption and variable costing on Bridgestone Corporation