Managerial Accounting - Absorption, Variable & Throughput Costing

Updated on July 25, 2016

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.

Users

Absorption Costing

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 Costing

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

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.

Summary

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.

Comments

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    • profile image

      ELIZABETH MEADOWS 

      12 months ago

      Can I use Throughput Costing when I calculate my COG for US federal income tax? Very small business, we don't use financial statements, are on periodic inventory, cash basis, producing one product. Calculating overhead per unit would be time-consuming. Would prefer to expense during the period.

    • profile image

      Tholang 

      14 months ago

      what are the differences between marginal cost and throughput

    • hafeezrm profile imageAUTHOR

      hafeezrm 

      6 years ago from Pakistan

      ABC is only useful where products differs much. If products are the same or require equal resources, ABC would not be appropriate. It is up to you to consider if one reports takes too much time than the others or requires a much expensive expertise. Otherwise simple costing would do.

    • profile image

      misu 

      6 years ago

      Dear Sir,

      I'm searching which costing system to use in a regulation advisory company for my MBA paper, where they produce regulation reports on multiple sectors and have clients having yearly membership for access to reports. In this case, marginal cost of producing one more report is close to zero and most of their costs are fixed costs, except the salary of analysts producing the reports.

      I have applied full costing & variable costing, but I think ratio of fixed costs is too high that those 2 methods do not give a fair view. Would you advise ABC costing or is there any other methods advised for similar cases?

      Thanks for the support,

    • hafeezrm profile imageAUTHOR

      hafeezrm 

      6 years ago from Pakistan

      I like Cost Accounting by Charles T. Horngren.

    • profile image

      Annu 

      6 years ago

      Sir, Could you please suggest some good titles on Costing?Most of the books are written from academic perspective but for professionals,there aren't many. Would you be aware of any such author?Thanks.

    • profile image

      wendy 

      6 years ago

      thank u very much

    • hafeezrm profile imageAUTHOR

      hafeezrm 

      6 years ago from Pakistan

      Dear Wendy,

      Maybe it is an over-statement or the difference is not important. I would advise you to search it on the Internet and if anything significant is found, you may advise me as well.

    • profile image

      wendy 

      6 years ago

      why no difference in costing between service and manufacturing firms?

    • hafeezrm profile imageAUTHOR

      hafeezrm 

      6 years ago from Pakistan

      There is no difference between service and manufacturing firms in regard to costing. While in service, the output is not physical, the inputs are.

      ABC involves a lot of preliminary work. NGO can start it on small scale. All they have to do is to breakdown their traditional accounts into activities performed and then pooled it together.

      On a small scale both systems can run side by side till benefits of one is obvious.

    • profile image

      Bayu Pradnyana 

      6 years ago

      Hi, i am just wondering.

      what do you think the differences between service and manufacturing firm in terms of their costing system?

      and, how about NGOs, will they be able to use ABC costing system or it depends on their capacity?

      thank you, hope to get a reply ASAP

    • hafeezrm profile imageAUTHOR

      hafeezrm 

      6 years ago from Pakistan

      Thank Niha for visiting my hub.

      Fixed Cost for carpet manufacturer: Depreciation, Salaries of Permanent Staff, fixed manufacturing overheads.

    • profile image

      niha 

      6 years ago

      can u tell me a fixed cost for carpet manufacturer?

    • hafeezrm profile imageAUTHOR

      hafeezrm 

      6 years ago from Pakistan

      Thanks Fred for your comments.

    • profile image

      fred 

      6 years ago

      very valuable info.thanks

    • hafeezrm profile imageAUTHOR

      hafeezrm 

      6 years ago from Pakistan

      @Sanjay

      Perhaps you mean absorption costing and variable costing. There is no such thing as fixed costing.

      Absorption costing is full costing i.e. it includes variable manufacturing costs and fixed manufacturing costs. Whereas in variable costing, only variable costs is included for inventory valuation while fixed costs is expensed out in the same year and not included in inventory. (As stated in my article, it is only for internal purposes)

      I hope it answers your question. Please do not hesitate if you require any additional explanation.

    • profile image

      sanjay 

      6 years ago

      what is the main difference between fixed costing & variable costing in managerial decision.

    • hafeezrm profile imageAUTHOR

      hafeezrm 

      6 years ago from Pakistan

      Thanks @htodd for your comments.

    • htodd profile image

      htodd 

      6 years ago from United States

      Great post..Thanks

    • hafeezrm profile imageAUTHOR

      hafeezrm 

      7 years ago from Pakistan

      Dear Luisa and Anna,

      Variable Costing and Throughput costings are generated by the accounting system and are already department-wise or job-wise or product-wise. As against this, fixed overheads have to distributed among departments, jobs or products which is a human decision and fraught with many dangers. Accounting profession is always on the looking to find ways and measure to computes costs as soon the product is compelte with full transparency so that its price can be acertained. Variable and Throughput costing are useful in this regard.

    • profile image

      Anna 

      7 years ago

      Could you please tell me what are the desadvantages of Throughput costing?

      Many thanks

    • profile image

      Luisa 

      8 years ago

      Dear Sir,

      I am very impressed by your deep knowledge and your ability to explain these tricky issues.

      Could you please explain more about the advantages of variable costing system?

      Thank you in advance for your assistance!

      Kind regards

    • hafeezrm profile imageAUTHOR

      hafeezrm 

      8 years ago from Pakistan

      Dear Athar,

      I have no idea about IMA-USA. I am MBA myself. I have found an interesting disussion which may be of interest to you. Please go to the following link:

      http://www.facebook.com/topic.php?uid=2327702058&a...

    • profile image

      Athar 

      8 years ago

      Sir,What about IMA-USA CMA Program. Is it better than CIMA /ICMAP CMA?

    • profile image

      Accounting firm 

      8 years ago

      More good informations thanks for helping me out. Always a pleasure to see information that is useful, thanks again

      http://www.kpmgaccountingfirm.info

    • Rufi Shahzada profile image

      Rufi Shahzada 

      8 years ago from Karachi

      Yes Sir!

      Thanks a lot for your guidance. Truly you are a great source of help.

      Regards,

      RUFI SHAHZADA

    • hafeezrm profile imageAUTHOR

      hafeezrm 

      8 years ago from Pakistan

      Thanks Creativeone59 for your constant encouragement.

    • hafeezrm profile imageAUTHOR

      hafeezrm 

      8 years ago from Pakistan

      You mean CIMA and ICMAP? Well while CIMA is much better, ICMAP is much less costly, being in your own home town. On the basis cost:benefit analysis, I would advise you to complete ICMAP and then go for a 'fast track' route into CIMA’s strategic level examinations, leading to CIMA membership.

    • Rufi Shahzada profile image

      Rufi Shahzada 

      8 years ago from Karachi

      Dear Sir,

      Costings are defined so well... Thanks for adding and refreshing knowledge constantly.

      I want to ask you one thing that if I want to opt between the two CIMA or ICMA. What should I select ?

      RUFI SHAHZADA

    • creativeone59 profile image

      benny Faye Douglass 

      8 years ago from Gold Canyon, Arizona

      Thanks for a very informative hub. Godpeed. creativeone59

    • hafeezrm profile imageAUTHOR

      hafeezrm 

      8 years ago from Pakistan

      Thanks for your query. CIMA & ICWA are professional bodies in different countries but for the same purpose i.e. professional development for cost and management accountants. The acronyms stand for:

      CIMA - Chartered Institute of Management Accountants

      ICWA - Institute of Cost and Works Accountants ( of India)

      ICMAP - Institute of Cost & Management Accountsnt of Pakistan.

    • Trsmd profile image

      Trsmd 

      8 years ago from India

      what's the difference between CIMA & ICWA ?

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