Variable costs or expenses are costs that change in proportion to the activities or operations of the company or business. For example, labor and other overheads or conversion expenses or cost as they are referred to. Also the prime cost is also a variable cost i.e. direct labor and direct material. Traditional costing concepts separate and split costs between fixed and variable. The time scales that are relevant and applicable to most major projects make this method of costing unsuitable and redundant. Fixed costs are firm’s expenditure that is unrelated or dependent on the amount of items or services produced by the company. They include overhead expenditure and other indirect expenses of business. (Kaplan, Robert and Bruns, 2001) They tend to be related to time such as wages, security, marketing, administrative expenses or even monthly or quarterly rent payment. Fixed expenses or other costs are used to control and maintain the prices of items or services to maximize the profits to ensure appropriate income and profitability for the investment made. Costs are normally classified in terms of short or long run since most strategic decisions are meant to cover between three to five years during which period some costs turn and become variable. (Garrison, Noreen, Brewer, 2009) Semi variable costs are costs that remain fixed for sometime then they become variable costs. For instance, satellite television costs of acquiring the sets are fixed costs while later the monthly costs payable to get additional contents are variable costs. . Items whose volumes are smaller take a disproportionate length of time and material to produce but will only be apportioned and allocated a minor proportion of the support cost. (Khan, 1993) Some of the costing methods are founded on financial costing method and systems and are inappropriate for final decision making purposes. For purposes of inventory valuation, only overheads related to production may be later absorbed into the cost of the product while overheads from selling and distribution are ignored.
Marginal costs are costs that a firm incurs in the production of additional or extra unit of a good. The marginal cost of selling two items instead of one, MC (2nd item) = TC (2items) – TC (1item) For example;
The marginal cost obtained in selling 2nd item is 50 – 30 = 20
Item number 2 calculation of marginal revenue
MC (2nd item) = TC (2nd item) – TC (1st item)
= 50 – 30 = 20
Item number 3 calculation of marginal Cost
MC (3rd item) = TC (3rd item) – TC (2nd item)
= 80 – 50 = 30
Item number 4 calculation of marginal cost
MC (4th item) = TC (4th item) – TC (3rd item
= 120 – 80 = 40
The rest of the figures on the table above have been obtained in the same way.
(Sullivan and Sheffrin, 2003)
When the total revenue, quantity and total costs increase the marginal costs also increases at a constant rate. When the quantity is 4, TR is 540, TC 120 then the marginal cost is 40. (Sullivan and Sheffrin, 2003)
The marginal cost increases at an increasing trend.
Absorption costing apportions all the overheads to the individual products. In order to achieve this, the companies must directly apportion and allocate each service overhead to the major production department. All the direct labor/machine hourly rates are then calculated. All the costs are allocated to various individual departments and it’s assumed that the overhead costs relate directly and precisely to the level of production. The major problem with this concept is that the allocation or the apportionment of the costs is done arbitrary and may not give an accurate view of the activities which are responsible for the costs. (Hermanson, Ewards, & Invacevich, 2011). A certain product or an activity may show a big loss just because the method used to allocate the costs have changed. Absorption costing is time consuming and requires a lot of concentration and energy to determine and implement an accurate basis of overall overhead allocation and eventual apportionment. Variable costs are involved in its calculations of the contribution and the cost of sales and transfer most of the values of the closing stock to later dates while the absorption income statement involves part of the fixed costs and the variable costs in its determination of the closing stock in its cost of sales. (Kieso, Weygandt & Warfield, 2007)
The determination of closing stock under absorption costing.
|Materials @ 100||Materials @ 130|
|Closing stock under absorption costing|
|Variable cost + part of fixed costs.|
|200000 + 300000/10000 = 50 per unit||260000 +300000/10000 = 56|
|Cost of sales=||2000 @ 50 = 100000||2000 units each 56 = 112000|
|variable o/h cost 240000||240000|
|variable cost o/h 80000||80000|
|Cost of sales=||1620000||1872000|
The net income between the contribution income statement and the absorption income statement can never be the same. The absorption income statement utilizes both the variable expenses and the fixed expenses when determining the closing stock while computing the cost of sales. (Drucker, 1999)
The variable income statement only utilizes the variable cost while calculating its contribution margin and the cost of sales and it completely ignores the fixed expenses. The need for companies to create another income statement comes in because of the calculation of the closing stock on rates that are similar to the current rates of the sales to give a true and fair view of the cost of sales. (Khan, 1993)
The major advantage of absorption costing is that it’s convenient and simple to apply. The costing methods may give different results. Absorption costing is reliable as it includes also fixed in its allocation of costs. The other two methods are not inclusive. (Vance, 2003) The following is an example of both the costing methods i.e. variable and absorption costing methods.
Direct materials variable cost increase from 100 to 130
|and sales per unit is 250 per unit|
|Absorption income statement|
|For the period ending Dec 31st 2011.|
|cost of goods sold||1872000|
|Selling n adm exp||180000|
|Variable costing /Contribution method|
|Variable cost o/h||240000|
|variable cost selling n adm||80000|
|cost of sales||2020000|
|Fixed man o/h||200000|
To conclude, the most important information from the above argument is that a company can utilize absorption costing as a tool in making decisions in the valuation of closing stock and the way the different methods of absorption and contribution (variable) income statements affect the net income. The absorption income statement valuation of the closing stock utilizes most of the cost in the current income statement by also including the fixed costs together with the variable costs i.e. it’s very realistic while some methods like the contribution income only uses the variable cost while determining the closing stock and it excludes the fixed costs
Drucker, F. (1999) Management Challenges of the 21st Century. New York: Harper Business,
Garrison, H., Noreen, E., Brewer, C. (2009) Managerial Accounting. McGraw-Hill Irwin. 2009.
Hermanson, R.H., Edwards, J.D., & Invacevich, S.D. (2011). Accounting Principles: A Business Perspective. First Global Text Edition, Volume 2 Managerial Accounting, 37-73.
Kieso, D. E., Weygandt, J. J., & Warfield, T. D. (2007) Intermediate Accounting (12th Ed.). Hoboken, NJ: John Wiley & Sons,
Khan, M. Theory & Problems in Financial Management. (1993) Boston: McGraw Hill
Kaplan, Robert S. and Bruns. (2001) W. Accounting and Management: A Field Study Perspective (Harvard)
Vance, D. (2003) Financial analysis and decision making: tools and techniques to solve
financial problems and make effective business decisions. New York: McGraw-Hill.
Sullivan, A. and Sheffrin, S. (2003). Economics: Principles in action. Upper Saddle River, New Jersey, Pearson Prentice Hall.