Question

In order to comply with Generally Accepted Accounting Principles (GAAP), companies must use absorption costing to report income statement. However, the most successful companies use variable and absorption costing methods for their managerial purposes.

• Coca Cola is a publicly owned company so visit its website to find bout the company’s products and operations.
• Discuss the pros and cons of absorption and variable costing as the basis for the selected company’s product costing.

Answer 1

ANS:

Variable costing is generally used for internal reporting purposes. Managerial decisions are taken on the basis of variable costing. Absorption costing is used for reporting to the external stakeholders as well as for the purpose of filing taxes.

Coca Cola-

A global business that operates on a local scale, in every community where do business. Coca cola able to create global reach with local focus because of the strength of the Coca-Cola system, which comprises our company and our nearly 225 bottling partners worldwide.

The Coca-Cola Company (NYSE: KO) is the world’s largest beverage company, refreshing consumers with more than 500 sparkling and still brands and nearly 3,900 beverage choices. Led by Coca-Cola, one of the world’s most valuable and recognizable brands, our company’s portfolio features 21 billion-dollar brands, 19 of which are available in reduced-, low- or no-calorie options. These brands include Diet Coke, Coca-Cola Zero, Fanta, Sprite, Dasani, vitaminwater, Powerade, Minute Maid, Simply, Del Valle, Georgia and Gold Peak. Through the world’s largest beverage distribution system, we are the No. 1 provider of both sparkling and still beverages. More than 1.9 billion servings of our beverages are enjoyed by consumers in more than 200 countries each day.

While many view company as simply "Coca-Cola," system operates through multiple local channels. The primary way that our products reach the marketplace starts with Coca-Cola, which manufactures and sells concentrates, beverage bases and syrups to bottling operations. Coca-Cola also owns the brands and is responsible for consumer brand marketing initiatives. Our bottling partners manufacture, package, merchandise and distribute final branded beverages to our customers and vending partners, who then sell our products to consumers.

All bottling partners work closely with customers –grocery stores, restaurants, street vendors, convenience stores, movie theaters and amusement parks, among many others –to execute localized strategies developed in partnership with company. Customers then sell products to consumers at a rate of 1.9 billion servings a day.

The Coca-Cola Company markets, manufactures and sells:

• beverage concentrates and syrups; and,
• finished beverages (including sparkling soft drinks; water and sports drinks; juice, dairy and plant based drinks; and tea and coffee).

In coca cola concentrate operations, The Coca-Cola Company typically generates net operating revenues by selling concentrates and syrups to authorized bottling partners.

Its bottling partners combine the concentrates with still and/or sparkling water, and/or sweeteners, depending on the product, to prepare, package, sell and distribute finished beverages.

Its finished product operations consist primarily of company-owned or -controlled bottling, sales and distribution opera.

Absorption Costing

Absorption costing, sometimes called full absorption costing, is a managerial accounting method for capturing all costs associated with manufacturing a particular product. The direct and indirect costs, such as direct materials, direct labor, rent, and insurance, are accounted for using this method. Absorption costing is required by generally accepted accounting principles (GAAP) for external reporting.

• Absorption costing differs from variable costing because it allocates fixed overhead costs to each unit of a product produced in the period.
• Absorption costing allocates fixed overhead costs to a product whether or not it was sold in the period.
• This type of costing means that more cost is included in the ending inventory, which is carried over into the next period as an asset on the balance sheet.
• Because more expenses are included in ending inventory, expenses on the income statement are lower when using absorption costing.

Absorption costing, also called full costing, includes anything that is a direct cost in producing a good in its cost base. Absorption costing also includes fixed overhead charges as part of the product costs. Some of the costs associated with manufacturing a product include wages for workers physically working on the product; the raw materials used in producing the product; and all of the overhead costs, such as all utility costs, used in production. In contrast to the variable costing method, every expense is allocated to manufactured products, whether or not they are sold by the end of the period.

Assets, such as inventory, remain on the entity’s balance sheet at the end of the period. Because absorption costing allocates fixed overhead costs to both cost of goods sold and inventory, the costs associated with items still in ending inventory will not be captured in the expenses on the current period's income statement. Absorption costing reflects more fixed costs attributable to ending inventory.

Absorption costing ensures more accurate accounting for ending inventory because the expenses associated with that inventory are linked to the full cost of the inventory still on hand. In addition, more expenses are accounted for in unsold products, which reduces actual expenses reported in the current period on the income statement. This results in a higher net income calculation when compared to variable costing calculations.

Because absorption costing includes fixed overhead costs in the cost of its products, it is unfavorable when compared to variable costing when management is making internal incremental pricing decisions. This is because variable costing will only include the extra costs of producing the next incremental unit of a product.

In addition, the use of absorption costing generates a unique situation in which simply manufacturing more items that go unsold by the end of the period will increase net income. Because fixed costs are spread across all units manufactured, the unit fixed cost will decrease as more items are produced. Therefore, as production increases, net income naturally rises because the fixed cost portion of the cost of goods sold will decrease.

Advantages of Absorption Costing

These are some of the primary benefits of absorption costing:

GAAP Compliant

One of the main advantages of choosing to use absorption costing is that it is GAAP compliant and required for reporting to the Internal Revenue Service (IRS).

Accounts for All Production Costs

Absorption costing takes into account all of the costs of production, not just the direct costs, as variable costing does. Absorption costing includes a company's fixed costs of operation, such as salaries, facility rental, and utility bills. Having a more complete picture of cost per unit for a product line can be helpful to company management in evaluating profitability and determining prices for products.

Tracks Profits More Accurately

Absorption costing also provides a company with a more accurate picture of profitability than variable costing if all of its products aren't sold during the same accounting period when they are manufactured. This can be especially important for a company that ramps up production well in advance of an anticipated seasonal increase in sales.

Disadvantages of Absorption Costing

Can Skew Profit and Loss

Absorption costing can cause a company's profit level to appear better than it actually is during a given accounting period. This is because all fixed costs are not deducted from revenues unless all of the company's manufactured products are sold. In addition to skewing a profit and loss statement, this can potentially mislead both company management and investors.

Doesn't Help Improve Operational Efficiency

Absorption costing fails to provide as good an analysis of cost and volume as variable costing does. If fixed costs are an especially large part of total production costs, it is difficult to determine variations in costs that occur at different production levels. This makes it more difficult for management to make the best decisions for operational efficiency.

Not Useful for Comparison of Product Lines

Variable costing is more useful than absorption costing if a company wishes to compare the potential profitability of different product lines. It is easier to discern the differences in profits from producing one item over another by looking solely at the variable costs directly related to production.

Variable Cost

A variable cost is a corporate expense that changes in proportion to production output. Variable costs increase or decrease depending on a company's production volume; they rise as production increases and fall as production decreases. Examples of variable costs include the costs of raw materials and packaging.

• A variable cost is a corporate expense that changes in proportion with production output.
• Variable costs are dependent on production output.
• A variable cost can increase or decrease depending on several factors, as opposed to a fixed cost which is one-time or constant.

The total expenses incurred by any business consist of fixed costs and variable costs. Fixed costs are expenses that remain the same regardless of production output. Whether a firm makes sales or not, it must pay its fixed costs, as these costs are independent of output.

Examples of fixed costs are rent, employee salaries, insurance, and office supplies. A company must still pay its rent for the space it occupies to run its business operations irrespective of the volume of product manufactured and sold. Although fixed costs can change over a period of time, the change will not be related to production.

Variable costs, on the other hand, are dependent on production output. The variable cost of production is a constant amount per unit produced. As the volume of production and output increases, variable costs will also increase.

Conversely, when fewer products are produced, the variable costs associated with production will consequently decrease. Examples of variable costs are sales commissions, direct labor costs, cost of raw materials used in production, and utility costs. The total variable cost is simply the quantity of output multiplied by the variable cost per unit of output.

There is also a category of costs that falls in between, known as semi-variable costs (also known as semi-fixed costs or mixed costs). These are costs composed of a mixture of both fixed and variable components. Costs are fixed for a set level of production or consumption and become variable after this production level is exceeded. If no production occurs, a fixed cost is often still incurred.

Advantages and Limitations of Variable Costing

1. Planning and Control:

Financial planning requires managers to estimates future sales, future production levels, future costs etc. Sales forecasts determine production plans, which in turn determine the level of expen­ditures required for raw materials, direct labour and variable manufacturing overhead. 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. But, for the control function to work and succeed, cost should be divided into fixed and vari­able components which is achieved only under variable costing and not under absorption costing.

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.

2. Managerial Decision- Making:

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.

3. Product Pricing Decisions:

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 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. A higher price will decrease the sales revenue; a lower price tends to increase the sales volume and leads to abnormal production costs due to overtime, produc­tion inefficiencies, etc. 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. In some cases, a sales order can be accepted even if it contributes partly to fixed costs. New short-term businesses or orders should be accepted as long as the variable cost of making and selling are recovered—variable costs represent the minimum sales price under these conditions. Knowledge of the contribution margin provides guidelines for the most profitable pricing policies.

However, the full cost and not only the variable cost should be the basis of product pricing in the long-run. The full cost is the cost which includes variable manufacturing cost and fixed manufacturing cost incurred in the production process.

4. Cost Control:

For the purpose of cost control, costs should be pooled into separate variable and fixed totals. Separation of variable and fixed costs supports the use of standards, budgets and responsibility report­ing to help management in controlling costs. All costs are controllable in the long run by someone within a business enterprise. But they are not all controllable at the same level of management.

For example, supervisors in production department are responsible for controlling the use of direct materials in their departments. They have no control, however, over insurance costs related to the production department building. For a specific level of management, controllable costs are costs that it controls directly and non controllable costs are costs that another level of management controls. This distinction, as applied to specific levels of management, is useful in fixing the responsibility for incurrence of costs and then for reporting cost data to those responsible for cost control.

The variable costing includes only variable manufacturing costs, which varies with change in the volume of production, in the cost of product and thus makes variable manufacturing costs controllable at cost centre level by operating management. Fixed production costs may not be con­trollable at departmental level and therefore should not be included in the production costs at costs centre level, as it is important to match control with responsibility.

The fixed manufacturing costs are reported as separate item in the variable costing income statement, they are easier to identify and control (by a higher level of management) than when they are spread among units of product as in absorption costing. Similarly, under variable costing, each other variable and fixed operating expenses (e.g., variable and fixed selling and administrative expenses) are reported separately and thus become easier to identify and control than in absorption costing where they are not reported separately but combined together.

5. Inventory Changes do not Affect Profit:

In variable costing, profit is a function of sales volume only. But under absorption costing sales and production (production creates inventory) both influence profit of a period. Profit in variable costing is not affected by changes in inventory as it is in absorption costing. In absorption costing, profit may decline although sales have increased. When inventory levels fluctuate greatly, profits calculated under absorption costing may be distorted since inventory changes will influence the amount of fixed manufacturing overheads charged to an accounting period.

6. Avoiding the Impact of Fixed Costs:

Variable costing avoids the arbitrary apportionment of fixed factory overheads and also avoids problem of determining a suitable absorption basis which is needed for a predetermined overhead absorption rate. Fixed production costs are charged to the period in which they are incurred and are not carried forward in stock which may be un-saleable, resulting in earlier profits being overstated. It is argued that managerial decisions can be easily made if fixed production costs are separated and are not mixed in inventory or cost of sales.

Since most fixed costs are committed and can-not be avoided, these costs should not be part of inventory. In addition, the presentation of the total amount of fixed costs on variable costing income statement emphasizes their full impact on net income, an effect partially hidden in inventory values under absorption costing.

Another benefit of variable costing is that production managers cannot manipulate income by producing more or fewer products than needed during a period. Under absorption costing, however, a production manager could increase income simply by producing more units than are currently needed for sales.

7. Performance Evaluation of Managers:

The evaluation of managers is often linked with the profitability of units they manage and control. The changes in income from one period to another and difference between the actual income and budgeted income are used to judge managerial performance and efficiency. For example, if a manager has worked hard and has increased sales while controlling costs simultaneously, income will increase indicating the success and better performance of manager.

The variable costing income statement highlights the relationship between sales and income whereas the absorption costing income statement does not generally show any association between sales and income. For example, under absorption costing income may decrease although sales have increased or sales may decrease but income reported may be higher due to large inventory being created due to higher production. Vari­able costing always produces an increase in income corresponding to the improved sales performance.

Furthermore, the variable costing can be used to evaluate the profit contributions of plants, product lines and sales territories. The separation of fixed and variable costs which are basic to vari­able costing is critical for making accurate evaluations. Thus, variable costing can make a significant contribution to management decision- making in such and similar areas.

8. Segmental Reporting:

Segmented reporting provides information about the contribution of organizational subunits. Segmented income statements differ from other income statements because they display amounts for direct (traceable) fixed costs (costs avoidable if the segment is eliminated) and for common or allocated fixed costs (costs that will continue to be incurred even if the segment is eliminated).

Presenting segmented income statements on a variable-costing rather than on absorption-costing basis is preferable because it results in more accurate studies of relative profitability of divisions, plants, products, territories, activities, and other segments of an organization. It concentrates on the contribution (the segment margin) that each segment makes to the recovery of common fixed costs. Marginal income data facilitate appraisal of segments without the bias (cross-subsidies) introduced by allocated common fixed costs.

Limitations of Variable Costing:

(i) Separation of Costs into Fixed and Variable:

The variable costing method requires that all costs should be divided into fixed and variable elements. Also variable costing assumes that the relation between the sales and the variable costs is direct, proportionate, and linear. It cannot be true under all circumstances. Examples of factors that might affect this assumption include quantity discounts on materials, and labour efficiency variance.

(ii) Product Costs Not without Fixed Costs:

Complete product cost does not depend only on variable costs. Fixed costs should be considered in determining the product cost and for long-range pricing and other long-run policy decisions. The product is not complete until it is in a form and place and at a time desired by the customer, and this product completion involves distribution just as essentially as it does manufacturing.

(iii) Temptation to Cut-Prices:

It is also argued that if managers are given only variable cost (as is done in variable costing) they will be tempted to cut prices to the degree that company profits will suffer. Despite the many, other advantages of the method for internal purposes, variable costing generates product figures providing little basis for long range pricing policies.

(iv) Use of Net Income Figure:

Income figures obtained under variable costing have to be use a carefully if management decides to expand business or drop a product line. Management has to consider other factors also before deciding to drop a product line such as customer goodwill. .The loss in customer goodwill which might result from dropping a product with a low contribution margin could easily offset any gain from products with higher contribution ratios. Thus the variable costing although useful is not a perfect managerial tool.

(v) Unwise Decisions:

Sometimes variable costing may be unnecessarily given a broader significance than it deserves. For instance, when sales are higher than production, variable costing net income will be more than absorption costing net income. In this case, sometimes, management may take unwise actions due to ‘increased profits’ reported by variable costing.

It may prompt the marketing managers to go for lower selling prices, may inspire the managers and employees to demand higher salary or bonus. But, in fact, there can be no justification for such actions. At the other extremes, variable costing results may mislead management during a business recession during which variable costing profit will be minimized due to sales being extremely lower than production.