Full Costing VS Variable Costing - Essay Example

Full costing versus variable costing: Does the choice still matter Introduction The evaluation of the needs of organizations in terms of the funding of their activities is a challenging task. Expenses in regard to the various phases of organizational processes may be differentiated under the influence of market turbulences and the organization’s internal environment. Two major costing approaches have been developed for ensuring the accurate measurement of costs of products in organizations operating in different industrial sectors: the full costing, also known as absorption costing, and the variable costing. Both these approaches are based on different criteria for evaluating the cost of products, as derived from all organizational activities, which are involved in the production process. In accordance with Larkin and DiTomasso (2010) cost can be described as ‘the sum of expenditures and charges required for bringing an article to its existing condition and location’ (Larkin and DiTomasso 2010, p.297). The aspects of full and variable costing, as developed in organizations worldwide, are described in this paper. Reference is made to the characteristics of the two approaches but also to their advantages and disadvantages as elements of the organizational planning. The examination of the above approaches led to the assumption that both full and variable costing are important for understanding the priorities of each organization in terms of the funding of its operation. However, under certain terms, full costing may be more effective in understanding an organization’s actual weaknesses in expanding its operations. Since the requirements of full costing are increased, compared to variable costing, the full costing is more likely to reveal any gap in regard to the financial status of a particular organization. It is for this reason that full costing has remained the key costing approach in external reporting whereas variable costing mainly serves organizations internal reporting needs. 2. Full and variable costing 2.1 Conceptual framework of each approach In order to understand the framework of full costing, as differentiated from that of variable costing, it would be necessary to refer primarily to the definition of these two approaches, as developed in the literature. In accordance with Kinney and Raiborn (2008) the full costing, also known as absorption costing, ‘treats the costs of all manufacturing components as product costs’ (Kinney and Raiborn 2008, p.73). On the other hand, variable costing ‘includes only direct material, direct labour and variable overhead as product costs’ (Kinney and Raiborn 2008, p.73). In accordance with the definition of full costing included in the study of Maher, Stickney and Weil (2007), in the context of the full costing ‘all types of manufacturing costs are assigned to units produced’ (Maher, Stickney and Weil 2007, p.547). Furthermore, it should be noted that two are the key differences between the full costing and the variable costing: ‘the first difference refers to cost accumulation while the second one refers to cost presentation’ (Kinney and Raiborn 2008, p.73). More specifically, in the context of the full costing, the fixed manufacturing overhead (FOH) is considered to be a product costs while for variable cost the above cost is a period cost (Kinney and Raiborn 2008). The above classification of FOH, as accepted by the full costing approach, is based on the following fact: FOH ensures products capacity, a fact that is vital for the products available by each organization; from this point of view, products are closely related to FOH and for this reason, FOH costs are regarded as product costs (Kinney and Raiborn 2008). The second important difference between the full costing and the variable costing is related to the presentation of costs, as developed in the context of each of these approaches. In full costing, all expenses are classified in accordance with their function (Kinney and Raiborn 2008); reference is made to the classification of expenses as developed in ‘the income statements and the management reports of each organization’ (Kinney and Raiborn 2008, p.74). On the other hand, in variable costing, the classification of expenses is based primarily on their behaviour and then on their function (Kinney and Raiborn 2008, p.74). These two differences between the full costing and the variable costing are variable in order to understand the relationship between these two approaches. The particular characteristics and aspects of these two approaches are further discussed above using the views of researchers who studied the specific subject. The identification of full costs of a particular plan requires the understanding of all the plan’s aspects. This means that before estimating the cost related to a particular organizational activity it would be necessary to examine the conditions in the internal and the external environment in which the specific activity will be developed. In this context, the measurement of full cost requires an in-depth understanding of the organization, its activities, its finance and its IT systems (Jiambalvo 2009). In any case, each organization is likely to set its own procedures for estimating the full costs of its projects. This fact is highlighted in the study of Markow (2011) where reference is made to an indicative plan for measuring the full cost of a particular organizational activity, and specifically a line activity and not a support activity. This plan incorporates the following phases: a) the allocation of information related to the organizational activities, b) the classification of activities to line and support activities, c) the organization’s programs and expenditures need to be identified and classified as ‘line, support or special’ (Markow 2011, p.43), d) the enterprise support ‘is aligned with line programs’ (Markow 2011, p.44) and e) at the final level, the cost of line activities is reviewed taking into consideration ‘the maintenance program and the enterprise support expenditures’ (Markow 2011, p.45) which are necessary for the development of the specific activity; in this way, the full cost of line activities can be precisely estimated. As for the variable costing, the specific approach has been considered as the result of the involvement of IT systems in budgetary control (McWatters, Zimmerman and Morse 2008, p.422). Moreover, from 1960s onwards, the increased needs of firms in terms of tax reporting, had led to the need for an alternative approach of costing, in addition to full costing (McWatters, Zimmerman and Morse 2008, p.422). Variable costing, also known as marginal costing, has been characterized as quite valuable in the decision making process (Rajasekaran and Lalitha 2010, p.127). On the other hand, Rachchh (2010) notes that the variable costing is not ‘a distinct method of costing’ (Rachchh 2010, p.121). It is rather characterized as a technique available to managers in order to estimate the profitability of their organization. From this point of view, variable costing should not be used as the exclusive method for estimating cost (Needles, Powers and Crosson 2010); it should be combined with other costing approaches in order to understand the actual status of a firm’s profitability (Rachchh 2010). In the study of Hoque (2005) reference is made to the following characteristic of variable costing: the specific costing approach incorporates ‘variable selling and administrative costs’ (Hoque 2005, p.128); these costs are not incorporated in full costing. 2.2 Advantages and disadvantages of full costing compared to variable costing Full costing is the only option in regard to certain organizational activities. For example, when having to value inventories, manufactures are obliged to use the full costing approach, since no other costing approach can be used for developing the specific task (Smith, Harmelink and Hasselback 2008, p.13-32). Moreover, as noted in the study of Stickney, Weil, Schipper and Francis (2009) the level of an organization’s cost flow for each financial year is estimated using the information related to the inventory of the previous financial year. From this point of view, full costing is critical for valuing the inventory of each year and for estimating the level of cost flows of the following year (Stickney, Weil, Schipper and Francis 2009). In this way, it is easier for managers to manage costs and protect their organization from major risks in regard to its daily operations. On the other hand, full costing is more appropriate for tax reporting, especially in regard to the income statements. More specifically, through the variable costing the profits of organizations seem to be lower compared to the full costing, which reveals the actual level of organizational profits for the financial year involved (McWatters, Zimmerman and Morse 2008, p.422). However, variable costing is valuable for internal purposes, meaning especially the internal reporting (McWatters, Zimmerman and Morse 2008, p.422). Since both costing approaches are important for measuring the financial status of each organization, there are many organizations that prefer to keep both costing approaches, despite the increase of costs involved in the specific strategy. The National Bank of Canada has chosen the above practice, i.e. to keep two different costing approaches for ‘supporting its strategy’ (McWatters, Zimmerman and Morse 2008, p.422). It should be noted that variable costing does not offer a clear view of organization’s expenses. This problem is related to the following fact: in the context of variable costing, product costs incorporate only variable costs and not fixed costs. However, product costs, by their nature, reflect both the fixed and variable costs related to a particular product (Berry, Jarvis and Jarvis 2005). From this point of view, variable costing can lead to false assumptions in regard to an organization’s current financial status. Because of this risk, variable costing is generally avoided for tax and external reporting purposes and it is only used for internal reporting (Lal and Srivastava 2009). From another point of view, variable costing does not set limits in regard to the potential change of volume in products or services involved; indeed, in the context of variable costing, costs in regard to products/ services can be changed as the volume of the products/ services is increased (Bhattacharyya 2011). For this reason, the variable costing is considered as advantageous for ‘ the cost-volume-profit analysis’ (Hoque 2005, p.128), compared to the full costing approach. Narsis (2009) emphasizes on the value of the variable costing as a critical tool for ‘profit planning and decision making’ (Narsis 2009, p.136). It is implied that variable costing is likely to be preferred, rather than full costing, when such tasks need to be developed. 3. Conclusion The review of the literature published in the issue under discussion has revealed that full costing has a significant advantage compared to the variable costing: it refers to all manufacturing costs as product costs (Garrison 2009, p.276). For this reason it has been considered as more appropriate for external reporting purposes, where accurate information in regard to a firm’s actual performance is involved. In accordance with Weetman (2006) a key advantage of full costing, compared to variable costing, is that it helps to check whether a particular organizational activity is ‘sustainable in the long term’ (Weetman 2006, p.120), meaning that full costing can reveal the potential hidden costs for monitoring the safety of a particular organizational activity (Weetman 2006, p.120), a task which is not feasible through the variable costing. However, the plans of each organization need to incorporate a wide range of information (Botten and Sims 2006); moreover, they have to refer not only to the organization’s current performance but, mainly, to its future performance (Tonchia and Quagini 2010), as estimated through the figures available in regard to the organization’s past performance. In other words, full costing and variable costing serve different organizational needs. From this point of view, their differences are not of major importance in order to define their value. In this context also, the choice between the two approaches becomes of no value, especially since both approaches can be used in modern organizations for identifying the financial status and the perspectives of each organization, as proved through the literature published in the particular field. References Berry, A., Jarvis, P., Jarvis, R. 2005. Accounting in a Business Context. Belmont: Cengage Learning. Bhattacharyya, D. 2011. Management Accounting. New Delhi: Pearson Education India. Botten, N., Sims, A. 2006. CIMA Learning System 2007: Management Accounting - Business Strategy. Oxford: Butterworth-Heinemann. Garrison, R. 2009. Managerial Accounting. New York: Tata McGraw-Hill Education. Hoque, Z. 2005. Handbook of cost & management accounting. London: Spiramus Press. Jiambalvo, J. 2009. Managerial Accounting. Hoboken: John Wiley and Sons. Kinney, M., Raiborn, C. 2008. Cost Accounting: Foundations and Evolutions. Belmont: Cengage Learning. Lal, J., Srivastava, S. 2009. Cost Accounting. Delhi: Tata McGraw-Hill Education. Larkin, R., DiTommaso, M. 2010. Wiley Not-for-Profit GAAP 2010: Interpretation and Application of Generally Accepted Accounting Principles. Hoboken: John Wiley and Sons. Maher, M., Stickney, C., Weil, R. 2007. Managerial accounting: an introduction to concepts, methods, and uses. Belmont: Cengage Learning. Markow, M. 2011. Determining Highway Maintenance Costs. Washington: Transportation Research Board. McWatters, C., Zimmerman, J., Morse, D. 2008. Management Accounting: Analysis and Interpretation. Essex: Pearson Education. Narsis, I. 2009. Theory In Cost Accounting. New Delhi: Atlantic Publishers & Dist. Needles, B., Powers, M., Crosson, S. 2010. Financial and Managerial Accounting. Belmont: Cengage Learning. Rachchh, M. 2010. Financial Accounting and Auditing. New Delhi: Pearson Education India. Rajasekaran V., Lalitha, R. 2010. Cost Accounting. New Delhi: Pearson Education India. Smith, E., Harmelink, P., Hasselback, J. 2008. Federal Taxation: Comprehensive Topics 2009. Chicago: CCH. Stickney, C., Weil, R., Schipper, K., Francis, J. 2009. Financial accounting: an introduction to concepts, methods, and uses. Belmont: Cengage Learning. Tonchia, S., Quagini, L. 2010. Performance Measurement: Linking Balanced Scorecard to Business Intelligence. New York: Springer. Weetman, P. 2006. Management accounting. Essex: Pearson Education. Read More