Differential cost analysis for product decision-making in managerial accounting

Managerial Accounting -- Budgeting: Differential Analysis

This assignment considers variable costing as a decision-making tool for evaluating whether to accept an order to manufacture Product C, which is a product proposed by an existing customer for whom Lewis Company is manufacturing Product B. Two general methods for valuing inventory and for determining the cost of goods sold are absorption costing and variable costing. The data in this case study is presented in the absorption costing format. Absorption costing is typically associated with financial reports, as in this case, with the Absorption Income Statement. Managers prefer variable costing as a tool for making business decisions ("Accounting for Management," 2012). Variable costing must be employed when the contribution margin format is used in an income statement ("Accounting for Management," 2012). To say that these two methods are simply alternative approaches would be a misstatement since the two costing systems can generate substantively different figures with regard to net operating income ("Accounting for Management," 2012).

Absorption costing treats all production costs as product costs whether fixed or variable (Hermanson, 2011). The unit costs in absorption costing include direct labor, direct materials, fixed overhead, and variable overhead (Hermanson, 2011). A portion of fixed overhead manufacturing cost and a portion of variable overhead manufacturing costs are allocated to each unit manufactured (Hermanson, 2011). Absorption costing is also referred to as a full costing approach since it categorizes all production costs as product costs (Hermanson, 2011).

Variable costing treats the production costs that vary with the manufacturing output as product costs (Hermanson, 2011). Including in this category, as product costs are direct labor, direct material, and the variable overhead manufacturing costs (Hermanson, 2011). Fixed overhead manufacturing costs are not treated as part of the product costs in a variable costing approach (Hermanson, 2011). Rather, fixed overhead manufacturing costs are treated as a period cost and is completely charged off in each revenue period, in the same manner as administrative costs and selling costs (Hermanson, 2011). Variable costing may also be referred to as marginal costing or direct costing (Hermanson, 2011).

It should be apparent from this brief comparison of variable costing and absorption costing that a primary reason that different cost figures are generated by these two methods is due to the absence of any fixed overhead manufacturing costs under variable costing methods, whether for cost of goods sold or in the valuation of a unit of product in the inventory. Selling expenses and administrative expenses are not treated as product costs in either absorption costing or variable costing approaches (Hermanson, 2011). Variable and fixed selling expenses and variable and fixed administrative expenses are treated as period costs under both costing approaches (Hermanson, 2011). As such, these variable and fixed selling and administrative expenses are deducted from revenue as they occur (Hermanson, 2011).

In this case, the information received by Lewis Company indicates that the new Product C. will have the same cost structure as Product B, except for three costs: The direct materials costs will be $15 less for Product C, the customer will purchase Product C. At $245 per unit, and only 1,100 units of product C. will be manufactured. No additional variable selling costs or administrative costs will be incurred by Lewis Company during the manufacture of Product C.

The Cost of Goods Sold (COGS) includes any direct costs that are associated with manufacture of the product sold by a company (Walter, 2011). COGS reflects the cost of purchasing raw materials used in the manufacturing processes and the cost of producing the finished goods, which is generally a reflection of the cost of labor (Walter, 2011). COGS is considered to be the amount that was paid for products that were sold during an accounting period (Walter, 2011). Cost of Goods Sold is equal to the beginning inventory plus the COGS purchased during that same period, less the ending inventory (Walter, 2011). This means that COGS is figured for the accounting period by counting unsold inventory at the end of the accounting period and subtracting the cost of the unsold inventory from the total cost of the product available for sale (Walter, 2011). The simplest way to think of COGS is the product unit inventory at the start of the accounting period (often referred to as the opening stock) plus all purchases related to the production of the product, less the unsold inventory at the end of the accounting period (often referred to as the closing stock) (Walter, 2011).

Make a list of the expenses and amounts that are relevant for this decision.

The easiest way to consider the expenses associated with production under the two approaches to costing is to establish tables for calculating the per unit selling cost under absorption costing and variable costing, as shown below:

Absorption Costing Method

Product B

Direct materials

$120

Direct labor

$60

Variable manufacturing overhead

$40

Total variable production cost

$220

Fixed manufacturing overhead

$25

Unit product cost

$245

Variable Costing Method

Product C

Direct materials

$105

Direct labor

$60

Variable manufacturing overhead

$40

Unit product cost

$205

How much with the sale of this product contribute to the profitability of Lewis?

If the customer pays $300 per unit, under the absorption costing method, the profit is $65 per product unit and under the variable costing method, the profit is $95 per product unit.

Absorption Costing Method

Product B

Direct materials

$120

Direct labor

$60

Variable manufacturing overhead

$40

Total variable production cost

$220

Fixed manufacturing overhead

$25

Unit product cost

$245

Selling price @ $300

$65

Variable Costing Method

Product C

Direct materials

$105

Direct labor

$60

Variable manufacturing overhead

$40

Unit product cost

$205

Selling price @ $300

$95

What if the company only pays $225 per unit? How does this change the contribution towards profitability?

When using the absorption costing system, the sale of this manufactured product to the customer does not result in a profit, if -- as stated in the case -- the customer is only willing to pay $225 per unit -- as this is also the product manufacturing cost. At this price, the loss per unit product is negative $20.

Absorption Costing Method

Product B

Direct materials

$120

Direct labor

$60

Variable manufacturing overhead

$40

Total variable production cost

$220

Fixed manufacturing overhead

$25

Unit product cost

$245

Selling price @ $225

$-20

Variable Costing Method

Product C

Direct materials

$105

Direct labor

$60

Variable manufacturing overhead

$40

Unit product cost

$205

Selling price @ $225

$20

If you were the manager, would you accept this order? What considerations, other than financial would enter into your decision?