Managerial Accounting - Absorption, Variable & Throughput Costing
Profit is the yard-stick for evaluating performance of any business concern. Since ultimate profit depends upon plan and control, cost accounting plays a vital role. Previously, cost accounting was mostly engaged in ascertaining costs of products or service on the basis of time-series analysis. Due to competition and technological development, the role has shifted to cost reduction which depends upon availability of relevant information well in time.
In financial accounting, a company has to follow generally accepted accounting principles, called GAAP, for arriving at profitability. No such restriction is imposed in case of costing accounting since it is used internally for decision making.
Different Cost Terms
Product Cost or Period Cost?
In many industries, manufacturing costs are the major costs incurred in the value chain. In such industries, distinction between product cost and period cost is quite simple.
Product costs are manufacturing costs such as raw materials, labor and manufacturing overheads. The products are inventoriable. If a carpet manufacturing concern has produced 10,000 square meters of carpet but sold only 2,000 square meters, it could be still profitable as there may be enough profit margin per square meter. (The remaining 8,000 are part of its inventories and may be sold at much higher prices next year.)
Period Costs are, however, non-manufacturing costs though essential to sell a product. Such costs are not considered in stock-valuation and are charged in the years in which these were incurred. Continuing the carpet example, if the company had made selling and administrative arrangement for disposal of 10,000 sq. mtrs but unfortunately only 2,000 were sold, the S&A costs would not be apportioned between sold and not sold but would be matched, fairly and squarely, against revenues generated by sale of 2,000 sq.mtrs. There may be still some profit though only 20% of output was sold.
Different Costing Techniques
Distinction between product costs and period costs is necessary for working out profit for a certain period of time. Finalization of accounts takes time. This creates a problem when an executive needs cost-information instantly about a product or a process. Over the period, the accounting profession has come up with a variety of techniques for providing useful and timely information.
In the side diagram, three such techniques are displayed. Since the last one, 'Throughput Cost' considers only raw materials as product costs, cost information is available instantly. If a university provides every student with a laptop and set of books on admission, the direct costs are available even before the student leaves the admission office.
In an automated process direct material may be the only unit-level level activity and so is the only product cost. It would reduce incentive to overproduce. Moreover, average unit cost will not vary with the changes in production levels.
Throughput costing is a relatively new development. This would discussed later in the hub.
CIMA has defined Absorption Costing as "a method of costing that, in addition to direct costs, assigns all, or a proportion of, production overheads costs to cost units by means of one or more number of absorption rates."
According to this:
- It is a costing technique which accumulates all costs associated with production of goods or services.
- It is also known as full costing as it creates a complete picture of the financial situation.
- It ensures that all costs incurred for the manufacture of a product are well recovered from the selling price assuming the customers are willing to pay for it.
- The theoretical justification for absorption costing is to honor the matching principle for all manufacturing costs.
- This method shows a higher net income when production exceeds sales.
Variable costs are directly related to production. These are also called formula cost since one can calculate before hand toal variable costs of a planned production. A tailor knows how much cloth and stitching time is required for one shirt. Similarly, a manufacturing concerns can work out variable cost per unit by adding up raw-materials, labor plus a part of variable manufacturing overheads (power usage and auxiliary raw materials). Main features of the variable costing method are given as under:
- It is used for internal purpose only.
- It is not acceptable for external reporting or income tax purposes.
- Its use includes: (i) Break-Even Point, (ii) relevant cost analysis, and (iii) short term decision-making.
- Firms with high variable costs are less prone to business risk compared to high fixed cost firms such as hotel or airlines.
- The difference between hi-variable and hi-fixed costs, affects financial structure and break-even points. The latter resort to more debt financing and their Break-Even Points are usually high.
- There would a higher net income when sales exceed production
Throughput costing treats all costs as period expenses except for direct materials. It is also called super-variable costing. It is very suitable for those companies where labor and overheads are fixed costs. Assembly-line and continuous processes that are highly automated are most likely to meet this criterion. In such company, workers are usually well-educated engineers or technicians employeed on permanent basis.
Main features are:
- It helps incremental analysis for meeting special orders when there is an excess capacity. An airline can take passengers much below the normal fare when it observes that some seats are empty for want of booking or cancellation or no-show passengers.
- It is a dynamic, integrated, principle-based approach.
- It provide managers with decision support information for optimization of resources.
Absorption, variable and throughput costing are alternative product-costing methods. The difference is treatment of certain cost elements. Under absorption or full cost method, all manufacturing costs are treated as product costs. In financial accounting, this method is used in inventory valuation and is acceptable to tax authorities.In fact all annual accounts are prepared on this basis to facilitate inter-company comparison or calculation of industrial ratios.
Variable costing covers only variable costs while all fixed costs are treated as period costs. This type is more suitable for operational decisions as fixed cost, being committed, is irrelevant for most decisions.
In present high tech, environment, direct labour has disappeared. Generally, a few engineers operate the plant. Hence, the only throughput costs (raw material costs) vary with the change in production. This would reduce the incentive to over produce to cut down cost per unit.
The only common feature among the various methods is the focus or stress on providing information for decision-making. Since some techniques are used only internally, the company image or standing is not affected which is certainly reflected by annual reports prepared after taking into account industrial norms and GAAP.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.