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The costing techniques are the tool for the establishment of accounting records, today even the managers are confused either to use the Absorption Costing or the Direct Costing technique for making up the reports and records. The proponents of Absorption Costing state that production is not possible without fixed factory cost so the portion of fixed cost should be charged. On the other hand, the proponents of direct costing techniques state that the fixed cost expires with time and therefore should be included in the total per unit cost Absorption costing and marginal costing are two different techniques of cost accounting. Mostly for the purpose of cost control, absorption costing is used while for managerial decision making managerial costing is used.
ABSORPTION COSTING OR FULL COSTING SYSTEM:
DEFINITION AND EXPLANATION:
All production cost weather it is variable or fixed is treated as product cost under absorption costing. The cost of a unit of product under absorption costing method consists of direct materials, direct labor and both variable and fixed overhead. Absorption costing allocates a portion of fixed manufacturing overhead cost to each unit of product, along with the variable manufacturing cost. In absorption costing all production cost whether fixed or variable is taken as product cost so it is known as Full costing.
VARIABLE, DIRECT OR MARGINAL COSTING:
DEFINITION AND EXPLANATION:
Under variable costing only those costs are treated as product cost that varies with production volume. This would usually include direct materials, direct labor and variable portion of manufacturing overhead. Fixed manufacturing cost is treated as period cost like selling and administrative expenses rather than product costs and entirely charged in the period in which it is occurred. Consequently the cost of a unit of product in inventory or cost of goods sold under this method does not contain any fixed overhead cost. Variable costing is also referred to as direct costing or marginal costing. For comparison purpose, selling and administrative expenses are always treated as period cost regardless of the costing system used. These expenses are never treated as product costs. Thus under either absorption or variable costing, both variable and fixed selling and administrative expenses are always treated as period costs and deducted from revenues as incurred
Which costing method to use for internal and external reporting purposes is an controversial issue.
Dr. Fekrat (1972) is of the point of view, that the division of cost into variable and fixed, exists in short run only, because it is a traditional theory, He states according to the micro Economics Theory of Business that the variable cost also remains fixed up to a certain level of production, and the per unit cost remains the same.
Moreover, he states that the costs are divided according to the services we use them, as evidence he states that, all the assets have fixed cost when purchased, their use makes them either variable or fixed, at the initial point all the cost was indivisible, therefore the cost of the particular product should be added into the cost of goods sold. Furthermore, the cost of assets is fixed, but their future cash flow is continuous and at random, even it could be greater than its original value.
Gordon and Cook(1973) commented on Dr. Fakrat's statements on the following grounds .i.e. The cost of fixed assets are related with the service of their use, but at the time factor has been ignored, because if we defer the services the value of fixed cost are not lost, .i.e. if production is increased and is compared with the present value of the future maintenance and repair cost with the present value of the additional contribution the production capabilities shall be fixed not only because of the maintenance and repair cost, but obsolescence plays the most vital role. Therefore the fixed cost must be treated as the Period cost rather than product cost.
However the arguments placed by Gordon and Cook seem quite impressive but in the conclusion thy stated that "the factor should be charged to production, based on its divisibility of use" makes up the stated arguments blur, and opens the door for Absorption costing
Dr. Fekrat (1973) replied that time and the value of the asset are interwoven, however this factor becomes neutral when we determine the value of asset after subtracting the obsolete value (the straight line method of deprecation), therefore according to the micro economics theory of business and the generally accepted accounting principles the cost of fixed factor should be charged to the units produced.
Messers (1961), Horngren and Sorter (1961), Fremgen (1962), states, that the fix cost will be reincurred in the future, they don't avoid any future costs, and hence the fixed costs should not be included in inventory. Horngren and Sorter (1961) state that fixed cost represents the cost of the total capacity available, production comes out of the total capacity there fore, the total capacity cost should not be included in the total inventory costs, so the both authors find the superiority of variable costing over absorption costing in external reporting.
Fregman (1962) commented on Hongren and Sortrer (1961), that the distance between the production and sales is the special assumption of the writers in addition to the going concern concept of the business.
JAHAN and AKHTER (2006) direct costing and absorption costing both consider direct material ,labor and variable FOH as product cost but point of difference between both is that absorption costing treats fix FOH as product cost while direct costing treats it as period cost and is considered to provide better management information about cost behavior but it is restricted to be used for external reporting despite of the fact that using direct costing is crucial for decision making both for external and internal purposes. By using direct costing helps in evaluating individual performance on consistent data based on current period activity and tends to provide help in controlling period cost. All fixed cost is treated as period cost in direct costing and production is assigned with variable production cost only. While absorption costing treats all production costs (variable +fix) as product cost and a portion of fixed FOH is assigned to each unit of product.
Required for outside reporting
Includes fixed overhead as an inventoriable cost
Stresses gross profit
Has a higher net income when production exceeds sales
Not accepted for outside reporting
Does not include fixed overhead as an inventoriable cost
Stresses contribution margin
Has a higher net income when sales exceed production
under absorption costing fixed FOH of current period is deferred to future period, until and unless product is sold
inventory value will be different under both system because direct costing don't take FOH(fix) for inventory valuation while absorption costing takes fix FOH as inventor able cost
direct cost provides information about cost behavior and is useful for company
If we assume fixed OH as fixed in total over the year and per unit variable cost as constant over the years following generalization can be made:
when production equals to sales, inventories don't change and there will be no change in fixed FOH costs in inventories under absorption costing and under both costing system profit will be same
when production is greater than sales, the inventory grows .a part of fix FOH will deferred in inventories until sold under absorption costing but fix FOH under direct costing will be changed as period costs. so net income of absorption costing will be greater then direct costing
When a sale is greater than production, the inventory shrinks. Under absorption costing some of fixed FOH that had been deferred in previous period will be released to income statement of current period and also current fix FOH cost is charge to CGS. while under direct costing only current fix FOH is charged to income statement so profit under direct costing shall be greater than absorption costing
In long term, cumulative net operating income figures become same whenever ending inventories are reduced to zero.
net operating income under direct costing don't affected by change in production level ,while net operating income under absorption costing will increase as production increase and inventory increased.
DEBATE OVER WHICH METHOD TO USE:
Schulte (1975) summarized literature of debate on which method to choose, Neilsen (1954) favored direct costing for external reporting because it avoided the "questionable and arbitrary allocation of manufacturing expense to product".
Brumment (1955) favored absorption costing and says when it comes to an honest attempt for a clear reflection of income and at the same time a presentation of meaningful inventory valuations it is difficult if not impossible to defend the direct concept.
Seiler (1959) justify direct costing for external reporting. He argues that the best way to represent inventory value in balance sheet is to show working capital of the company tied up in unsold products. fix cost are beyond management. Short run control, while variable production costs requires current managerial decisions that affect working capital effects of heavy investment in fix costs and changes in such controllable costs e.g. Material, labor, variable FOH should be shown in financial statements. (Sailer, 1959)
Fren and Ferrara (1961) supported the absorption costing by arguing that it is impossible to produce any products without fixed cost so it should be a part of cost revenue matching process.
Fremgen (1964) conclude the arguments for and against direct costing and say
"The conceptual differences between variable and full costing are so great that their concurrent general acceptance would not be in the best interest of financial statement readers of the accounting profession". The debate was won by absorption costing supporters direct costing is widely acceptance for managerial planning and control and decision making but not accepted for external reporting and income tax purposes."
GAAP requires for external reporting and tax purposes when companies use just in time (JIT) methods for production process the manipulation of income that can occur under absorption costing due to deferred fix cost (FOH) largely or completely disappear.
James C. Stallman (1979) in this articles two graphs are constructed to display
Changes in sales volume affect on absorption costing profit (at any specified product level).
Show changes in production level and its affects on absorption costing income at any specific sales level.
Each construction is on graph based on direct income with the result that a useful picture of relationship between absorption costing income and direct costing income is achieved.
Graphs showed that absorption costing profit is a function of production and sales while profit under direct costing is a function of sales only.
Boris Popesko (2010) the major limitation of absorption costing can be best described in relation of other costing method i.e., ABC and Variable costing. ABC was designed to eliminate problems associated with absorption costing that is "averagization". One challenge when applying ABC in cost allocation is the manner of applying ABC methodology (popesko, 2010).
in modern days traditional costing become obsolete due to two major reasons
1. Ever increased competition in marketplace for cost reduction
2. Major portion of cost structure of companies is consisting of overhead costs (Drury, 2001).
Kaplan and Johnson (1987) were the first who criticize the concept of traditional costing for the first time. According to Kral (2006) differentiation absorption costing is solution for averagization, that is the basic factor that cause wrong allocation of overhead cost (popesko,2008). Averagization means that allocation of any type of cost in average proportion to each cost object. Differentiation absorption costing means using many types of overhead with different allocation bases instead if summing absorption costing which uses universal overhead and one allocation base.
Drury, (2001) said application of const-center overhead rates instead of p and -wide rate is another solution for averagization problems.
Under absorption costing, product costs are vague due to allocation of cost proportionally to the portion of direct cost.
Glad and Becker (1996) identifies a number of basic drawbacks in traditional costing system
labor as a base for allocating factory overhead is irrelevant for those overheads which have no relationship with labor hours,
different products use different level of technology, but allocation of technology cost is not on its usage,
service related cost has increased many times but costing for such services was not considered in past,
Customer related cost are not related to products cost. Objects customer profitability has become important as product profitability.
Stanek (2003) said, in some case where company produces homogeneous output and have similar overheads and customers with few departments then using absorption costing provide accurate results despite its limitations.
The important merit of absorption costing is that it is very simple to use while ABC is relatively more costly.
Kim and Ballard (2002) define some limitations of traditional costing:
cost misrepresentation hampers profit analysis
management gives less attention to activities or processes of employs
the rational solution for overcoming limitations of absorption costing was to develop a costing system which would able to integrate and use cause and effect instead of using illogical allocation principles(drury,2001), (lucas,1997).
In situation when overhead cost portion exceeds 50% of total company costs, then using absorption costing with single measures of allocation can lead to risk of in accurate cost allocation .the ABC process is able to add in both physical measures and casual principles in costing system.
Kara et al (2009) study of show a comparison of variable costing and absorption costing with the use of linear programming and optimal product mix decisions directed to maximizing accounting income typically based on direct or variable costing but this article use linear programming model to establish optimal sales and production levels to maximize income under absorption costing. Appropriate decisions regarding production and sales levels may differ depending upon whether management needs to maximize accounting income under direct or absorption costing systems. To ensure linear objective function, there are two assumptions:
Each product has normalized unit fixed overhead cost.
Any fixed overhead volume variances are treated as period costs.
Linear profit equations based on direct costing is:
P(DC)=total contribution margin-total fixed manufacturing cost-total fixed non manufacturing costs
Linear profit equations based on absorption costing is:
P(AC)=total gross profit-total volume variance for all department-total variable no manufacturing costs.
Linear constraints to be considered are production and sales limits, inventory liquidation limits because sales cannot exceed current production plus beginning stock and in case of absorption costing an inventory buildup limit related to the space shortage are there. According to each period, Direct and absorption costing is calculated with different constraints and parameters of linear programming. By using both methods, the authors conclude that AC method is more consistent than DC method.
Basically, they show that AC can be calculated by using linear programming, which is similar with the DC method calculation using linear programming that is mostly well known operation.
Alles and Datra (1998) develop in their paper a model of how two oligopolistic firms strategically chose their cost-based transfer prices. Transfer prices has a strategic component because product prices, which are based on firm's transfer prices, communicates manufacturing costs to the marketing departments. Author's emphasis is that costing is only a means toward the end of profit maximization, and not the end in itself.
Tang (1992) gives empirical proof of the transfer pricing methods used by firms. According to him, 143 Fortune 500 firms used the transfer price methods,, 46.2% are cost based and of these, only 7.7% use variable cost of production, 53.8%use full production costs, and 38.5% use full production cost plus a markup.
Mills (1988) stated that the key basis for determining prices under normal conditions is to use cost-based method depending on absorption costing. Determination of the prices under normal conditions the most important factor due to which these cost based prices were modified, is "reference to competitor's prices".
Govindarajan and Anthony (1983, p.30) stated that, profit maximization model is mostly used in pricing in mostly academic literature. This model assumes that firms earn profit when marginal revenue equals marginal cost. Here marginal costs means variable cost only. Many economists therefore support variable cost pricing. They further stated that,
Fixed costs, allocated costs, and full costs (which is the sum of the variable and allocated costs)
should be ignored by managers. These cost constructions are said to be immaterial in determining the selling prices.
Horngren, Foster, and Datar (1994) and Kaplan and Atkinson (1989) clearly considered that costs which are used for product pricing are influenced by strategic factors.
"Some corporations deliberately allocate all corporate overhead expenses to operating departments with allocation bases that have little to do with the consumption or causes of the overhead costs. Senior managers apparently want operating managers to be aware of centrally determined and controlled costs. Perhaps the fully allocated costs are meant to encourage more aggressive pricing decisions by the centralized managers". (p.247)
According to Robert W. Lentilhon (1964), Any article to present a contrast should give three fold comparison of full absorption costing, standard cost (based on an efficient level of operation as its normal capacity) and the variable cost.
Variable costing understate the inventory value by ignoring all fixed costs; clearly, full absorption costing overstate the inventory value in case of less than capacity operations. And clearly, both variable and absorption costing misrepresent the gross income. Just like variable cost, fixed costs add value to the product if it is properly allocated to the production. In fact, due to automation technology, the variable cost portion decreases while fixed cost portion increases. So it should be account for in product cost. We should take all those charges as period cost which do not add value to the manufactured product. In between absorption and direct costing is standard costing. If we set proper standards for labor, material and overhead (both fixed and variable), then inventories represent relevant value-not overstated due to inefficient production derived under absorption costing, nor understated by ignoring fixed FOH in direct costing.
The basic purpose of this article is to focus attention towards the " third man" in direct and absorption costing debate. Standard cost, use meaningful fixed overhead application base, can supply beneficial facts regarding realistic inventory value and true income statement values. Although there is no doubt regarding usefulness of direct costing for internal management decisions and absorption costing for external reporting.
Gietzmann, Monahan (1996) The relative performance of absorption versus direct costing procedures is examined in this paper. One ground to defend absorption costing is that it acts a proxy for difficult to measure opportunity cost but the validity of this defense is based on how much absorption costing calculations provides good proxies. Analysis of authors shows that sometimes absorption costing overstate opportunity costs so much that in such situation it is favored to use direct costing even though it absolutely assume opportunity costs as zero. It mean that one cannot always use existence of opportunity cost as a defense for absorption costing.The basic enduring question of this research is that which method, absorption or direct costing, should be used in uncertain environment for operating decision making.
Zimmerman (1979) has proposed that
' . . . cost allocation can act as a lump-sum tax which reduces the manager's consumption of perquisites and that cost allocations can serve as useful proxy variables for certain difficult to observe costs' .
It means cost allocation reduce agency cost problem and difficulty to determine opportunity cost.
Devine (1950) supports absorption costing practices on the grounds that
' . . . the distribution of fixed overhead to jobs or products is normally on a time basis , and the relative total fixed overhead charged to jobs do therefore measure more or less imperfectly the relative usage of the firm's scarce factor of production' .
Two findings of his work are:
Direct costing procedure is imperfect in a sense that they did not consider opportunity costs arising from the capacity constraints.
He did not clearly recommend absorption costing, because in situations where firm is operating below its capacity, Devine's rational for absorption costing did not apply.
Debate over whether absorption costing or alternatively direct costing procedures should be used to appraise product order acceptance decisions is concluded in a way that the traditional defense of absorption costing, based on its ability to proxy hard to observe opportunity costs, is used only when absorption cost based proxies are really 'good'.
Vercio(2008) stated three aspects of the absorption costing that is good, bad and ugly. As absorption costing takes into account full manufacturing cost into account (variable and fix) while costing a product so it is the good aspect of absorption costing. Combining different costs with different cost drivers into unit cost and allocate them with single absorption rate. When managers take strategic decisions about a product or customer on the basis of such combined costs based unit cost under absorption costing is the ugly aspect.
Staubus et al (1963) identified three weaknesses of direct costing while it is used as product cost and inventory valuation. Firstly the historical cost is weak basis to value an asset secondly; there is criticism about the notion that cost of providing capacity to produce varies less as compared to the cost of utilizing that capacity. But author showed that there is a relationship between future construction of productive capacity and current inventory levels. Thirdly when financial statements under absorption and direct costing are compared, absorption costing is unable to distinguish between wastage of productive capacity and its usage.
This study is based on desk research i.e., use secondary data sources. The secondary data sources include books, published research articles and journals as well as online articles. Group discussion among researchers and research supervisor is used to conclude our study. Internet and library are major sources of data collection.
Discussion based on literature shows the following facts regarding absorption costing:
Absorption costing takes into account the full product cost including both fix and variable product cost, so profit under absorption costing is more accurate than marginal costing.
Proponents of marginal costing said that fixed cost re-incurred in future so it should not be included in inventory. Fixed cost represents the cost of the total capacity available, production comes out of the total capacity therefore, and the total capacity cost should not be included in the total inventory costs. It shows the superiority of variable costing over absorption costing in external reporting.
Both marginal and absorption costing takes direct material, direct labor and variable FOH as product cost but the point of difference is the treatment of fixed FOH because marginal costing treats fixed FOH as period cost while absorption costing treats fixed FOH as product cost.
Absorption costing treats Fix FOH as inventoriable cost while marginal costing treats Fix FOH as inventoriable cost.
Absorption costing stresses gross profit while marginal costing stresses gross contribution margin.
When production exceeds sales, net income is higher under absorption costing and when sales exceed production, marginal costing has a higher net income.
Marginal costing provides information regarding behavior of the cost which is helpful for CVP analysis and other internal managerial decisions.
Strong argument in favor of absorption costing that the best way to represent inventory value in balance sheet is to show working capital of the company tied up in unsold products. Fix cost are beyond management. Short run control, while variable production costs requires current managerial decisions that affect working capital effects of heavy investment in fix costs and changes in such controllable costs. Proponents of Absorption costing argue that it is impossible to produce any products without fixed cost so it should be a part of cost revenue matching process.
The problem of Averagization under absorption costing can be overcome by using ABC costing means using appropriate base for each overhead item according to the activities level. Differentiation absorption costing is solution for averagization, that is the basic factor that cause wrong allocation of overhead cost.
If Just in time production concept is implemented in organizations, then the one of the major drawback of absorption costing, regarding piling up of fixed cost into unsold stocks and forwarding it to next periods which overstate the profits of current period, can be removed. Because in such case inventory levels are constant or negligible.
Distortion in profit under absorption costing is possible due to changes in production and sales volumes, because profit under absorption costing is a function of production and sales rather than sales only as in marginal costing. So if autonomy over sales and production is not given to managers then this drawback can be overcame.
Absorption costing is the recommended for external reporting because GAAP and IAS made it mandatory to follow absorption costing for external reporting. A form of absorption costing must be used when filling out income tax forms.
If the owners and managers of manufacturing companies use absorption costing as the basis to report inventories under GAAP, they will be able to manage reported earnings by managing finished goods inventories.
After the discussion based on the literature we conclude that absorption costing is rightly suggested by GAAP and IAS for external reporting because the benefits of absorption costing outweigh its drawbacks. The drawbacks of absorption costing like "averagization" can be overcome by using differentiation costing and the problem of fix FOH which is carried forward to next periods with unsold stock can be overcome by using Just -In-Time (JIT) system. So the outweigh benefits of absorption costing answer the question of Why absorption costing?