Full Costing Versus Variable Costing: Does The Choice Still Matter - Essay Example

Cost Control And Performance Management: Full Costing Versus Variable Costing: Does The Choice Still Matter? Table of Contents Table of Contents 2 Introduction 3 Critical Evaluation 5 Recommendation 9 Conclusion 9 References 10 Bibliography 13 Introduction Cost management is one of the crucial functions performed by any organisation. In every company the budget should be efficiently and effectively managed. According to the present trends, most of the companies show their concern for cost management. The major objective of organisations has been to minimise costs. The companies believe that the sales volume does not matter in case of earning profitability, what matters is the cost effectiveness, i.e. to keep the costs as low as possible. The decision regarding finance in an organisation virtually influences each and every aspect of a business. The financial decisions or the management of cost in an organisation involves certain objectives such as, deciding the selling price, cost control, motivation towards the organisational goals, ascertaining the profit out of the cost, providing ‘decision-making’ information and also it helps in preparing the financial statements and reports (National Institute of Open Schooling, 2011). The management of cost accounting process is an important aspect of the ‘information system’ of an enterprise. It involves the tracking of costs and also the tracking of expenditures and cost through certain systems. There is no set regulation to keep an eye on the flow of the internal cash but there are certain methods to execute the function of tracking the cost internally. An effective cost accounting would help an organisation to predict the profitability based on their current activities as well as the future activities (Conway-Schempf, 2011). There are two kinds of approaches in cost management i.e. full costing and variable costing. Full costing is also known as absorption costing. Full costing method contains several factors like manufacturing costs allocation, and variable costs inclusion such as, raw materials. It also includes fixed costs such as, buildings and machineries, and also costs regarding individual finished products. For an example, if the amount of variable cost to manufacture a cricket bat is $3 and fixed overhead cost for it is $1 million for one year, then a firm which manufactures a million cricket bats should allot $4 as total cost for each cricket bat sold (Taylor, 2011). Full cost accounting or full costing is the method which describes the ways by which the price for the services and the goods are determined and the ways by which the price of goods would replicate the actual cost of production. It involves the cost of society and environment as well. Considering the full costing process, the GDP calculation of a nation would include the natural resources as a factor (Khan & Jain, 2006). Variable costing considers the overhead cost for the manufacturing, based on a certain period comparing to the per-unit basis. Variable costs are the only directly related costs to the production of every single unit. For an example, when leather is used to manufacture a bag, the amount of the leather would come under the measurement of unit. All the costs related to the fixed overhead, the variable costs, the fixed costs for selling goods and the expenses for administration are allotted for each period, instead of putting it into inventory (Khan & Jain, 2003). When cost of manufacturing varies with the quantity of output, this cost is known as product cost, which comes under variable costing. The variable costing involves direct materials, variable part of production overhead and direct labour. The fixed overhead of manufacturing does not come under the treatment of product costs (McGraw-Hill Higher Education, 2011). Critical Evaluation Strength of Full Costing The full costing method includes the entire variable and the fixed costs. It is an important aspect of cost management. Full costing acts like strength in an organisation, but it also include certain weaknesses. The full costing method helps in achieving clarity by aligning all kinds of costs together which are related with the manufacturing of the goods to reflect the total or the gross margin of an organisation. Full costing method ensures the effective management of the various costs related to the various produced goods. It provides an organisation a clear idea of all the cost inputs. Full costing accounting also helps to maintain a balance between the variable and the fixed costs (The Institute of Cost and Works Accountants of India, 2008). Weaknesses of Full Costing When it becomes easy to envisage the full costing in the statement of the income, it involves a challenge of invisibility of the costs until the goods are sold. Full costing method influences and increases the incentives, which lead to over production of goods, as the fixed cost of the manufacturing stays intact and same regarding the produced units and the rate of overhead cost becomes lower with more produced units (Kotler, 1972). Strength of Variable Costing Variable costing is also an essential element for an organisation. Variable costing helps to make it easy to manage the fixed overhead related with production of goods over a year. It also helps to obtain the actual information regarding a regular level of cost related with the facilities of production, whether the goods are sold or not sold. It is an important tool to take major decisions regarding the closing down of the firm or any product line (Jackson & et. al., 2008). Weaknesses of Variable Costing The variable costing, at times reduces the efficiency to manage accounting, as it takes too much time to account the employees and the expenses related to them. It at times creates complications for preparing financial reports in an organisation. Variable costing helps to report the profitability for the inventory related items, but it becomes useless in the time of making reports for the users within the organisation. Due to variable costing the firms also face the problem of cost fluctuations, as the cost of production may increase or decrease (Horngren & et. al., 2009). Similarities and Differences between Full Costing and Variable Costing The comparison between full costing and variable costing is as follows, When the inventories under full costing method increase, a part of the fixed overhead cost of the production is transferred to the account of the inventory. After the sales of those goods from the inventory the transferred fixed cost becomes a part of the cost of the sold goods. Variable costing involves merely the variable cost for manufacturing which is incorporated in inventory and full costing involves both fixed and variable cost for manufacturing which is also incorporated in inventory. Variable costing is helpful to supply information for Cost-Volume-Profit (CVP) computation as it categorises the costs by its nature or behaviour but full costing method is not suitable to provide information for CVP computation, as it does not distinguish the variable costs and the fixed cost (Lal & Srivastava, 2008). The Advantages of Full Costing The full costing identifies the significance of the fixed costs in manufacturing. It has been adapted by ‘Inland Revenue’ as the supply is not underrated. This is the main method which is used to prepare financial statements. Full costing is helpful to demonstrate less variation in the net profit, which is caused due to constant production and oscillated sales. The full costing method identifies the significance of incorporation of the fixed cost of the production to the unit cost. The price of units decided under the full costing method assures that every cost would be included within it. The full costing technique helps in reduction of the load of separation of cost with the returns for a specific period. It verifies the accrual conception through correspondence of the costs with the return for a specific time period. This method involves the inventory which can be valued within the total cost (Rajasekaran & Lalitha, 2010). Disadvantages of Full Costing When the level of output is constant, the full costing method can be utilised otherwise it would be of no use. In this method, the cost of unit would vary with the products and its nature. The different costs at different output level make the control and comparison of the costs difficult. According to various accountants, the fixed cost can be considered as period costs, and this period cost does not generate further benefits, thus the fixed costs should not be incorporated with the unit costs of the production. Full costing involves only cost of production, ignoring the other costs like distribution, selling and administration costs (Bhattacharyya, 2011). The Advantages of Variable Costing The variable costing method supplies useful information for the decision making process of the management. The variable costing is very helpful in planning the profit margin of an organisation. The variable cost provides assistance to control the variable cost, avoiding the random distribution or allotment of the fixed costs. The variable costing method assists in reduction of the difficulties related to the computation of the appropriate factory overhead which is fixed. Variable costing method supports the management in the cost control process with the help of full concentration alone on the ‘variable cost’. The reason behind this is the impossibility to control fixed costs in short period of time (Gupta, 2009). The Disadvantages of Variable Costing The variable costing method involves a separation of the semi variable cost in two divisions. This separation results into two elements i.e. variable and fixed elements. Within the variable costing method, this separation is a very complicated task to perform. The variable costing technique does not include the fixed costs in the decision making process, which at time results in a faulty conclusion. The variable costing method is less useful for the assessment of inventory related to losses which are abnormal and the auditors or the tax authorities do not acknowledge such estimations. Variable costing method is not able to solve the complexities related to the distribution of the ‘variable overheads’ (Eldenburg & Wolcott, 2007). Recommendation In relation to the above discussion, it can be recommended that the full costing and the variable costing both methods are helpful for an organisation. It depends on the organisation’s features and the capacity, based on which they would select the costing method. It is noticeable in the present trend that every organisation wants to save cost to get maximum output. Full costing method and variable costing method would provide the prediction or the acquired result of the financial statements but the cost effectiveness would be acquired with the help of proper operations management and effective cost accounting based on the previous records. Proper cost accounting would facilitate a company to put proper amount of the total cost which would help in managing the variable cost while manufacturing. Conclusion In relation to the above study, conclusively it can be stated that both full costing and variable costing methods have their strengths and weaknesses and both of them are useful for business organisations. Both the methods have their own features to be utilised according to the needs. Every organisation has its own ways of accounting the costs and its benefits, and the current trends of the businesses and enterprises suggest, the value for cost management and the effective and appropriate cost management methods have supreme importance. References Bhattacharyya, D., 2011. Management Accounting. Pearson Education India: India. Conway-Schempf, N., 2011. A Course Module on Incorporating Environmental and Social Costs Into Traditional Business Accounting Systems. Overview. [Online] Available at: http://www.ce.cmu.edu/GreenDesign/gd/education/FCA_Module_98.pdf [Accessed December 30, 2011]. Eldenburg, L. G. & Wolcott, S. K., 2007. Cost Management: Measuring Monitoring And Motivating Performance. John Wiley & Sons: US. Gupta, K. P., 2009. Cost Management: Measuring, Monitoring and Motivating Performance. Global India Publications: India. Horngren, C.T. & et. al., 2009. Cost Accounting. Pearson Education India: India. Jackson, S. R. & et. al., 2008. Managerial Accounting: A Focus on Ethical Decision Making. Cengage Learning: US. Kotler, P., 1972. Marketing – Management. Pearson Education India: India. Khan, M. Y. & Jain, P. K., 2006. Management Accounting. Tata McGraw-Hill Education: India. Khan, M. Y. & Jain, P. K., 2003. Cost Accounting. Tata McGraw-Hill Education: India. Lal, J. & Srivastava, S., 2008. Cost Accounting. Tata McGraw-Hill Education: India. McGraw-Hill Higher Education, 2011. Variable Costing: A Tool for Management. Business Focus. [Online] Available at: http://highered.mcgraw-hill.com/sites/dl/free/0073527076/775838/Bonus_Variable_Costing_Chapter.pdf [Accessed December 30, 2011]. National Institute of Open Schooling, 2011. Cost Accounting: An Introduction. Objectives. [Online] Available at: http://www.nos.org/srsec320newE/320EL27a.pdf [Accessed December 30, 2011]. Rajasekaran, V. & Lalitha, R., 2010. Cost Accounting. Pearson Education India: India. The Institute of Cost and Works Accountants of India, 2008. Cost Accounting and Management Accounting. Intermediate. [Online] Available at: http://www.myicwai.com/StudyMaterial/Cost_Mgmt_Ac.pdf [Accessed December 30, 2011]. Taylor, E., 2011. Full-Costing Income Statement vs. Variable-Costing Income Statement. Hearst Communications Inc. [Online] Available at: http://smallbusiness.chron.com/fullcosting-income-statement-vs-variablecosting-income-statement-20350.html [Accessed December 30, 2011]. Bibliography Banerjee, B., 2006. Cost Accounting Theory And Practice. PHI Learning Pvt. Ltd: India. Drury, C., 2006. Cost and Management Accounting: An Introduction. Cengage Learning EMEA: US. Hansen, D. R. & et. al., 2007. Cost Management: Accounting & Control Cengage Learning: US. Murthy, A. & Gurusamy, S., 2009. Cost Accounting 2E Tata McGraw-Hill Education: India. Williamson, R. W. & Lynch R. M., 2001. Accounting for Management: Planning and Control Tata McGraw-Hill Education: India. Read More