This paper examines the absorption costing and variable costing methods in the context of a manufacturing firm producing fishing lures. It explains why absorption costing is preferable when units produced exceed units sold, how each method treats fixed overhead, and the distinct management benefits each approach offers. The paper also addresses which method supports better decision-making when a competitor submits a lower bid, concluding that absorption costing is optimal for firms that do not sell all manufactured goods within an accounting period. References draw on foundational management accounting texts by Horngren, Izar and Hontoir, and Riahi-Belkaoui.
Management accounting offers two primary approaches to assigning manufacturing costs to products: absorption costing and variable costing. Each method treats fixed manufacturing overhead differently, which in turn affects reported product costs, net income, and the quality of information available to management. Selecting the appropriate method depends on the firm's production patterns, sales volume, and the specific decisions managers need to support.
In this case, the absorption costing method is the best choice due to the way it incorporates overhead. Under this method, overhead is allocated across the 80,000 units sold. The variable costing method, by contrast, treats fixed overhead as a period expense, meaning that fixed overhead for the period is calculated on the basis of all 95,000 units produced. Under the absorption method, fixed overhead is calculated only on the basis of the 80,000 units actually sold. This approach also provides management with a more precise picture of the profitability of the fishing lures, making the absorption costing method the optimal choice in this situation.
Under an absorption costing system, the product cost consists of all variable costs plus fixed manufacturing costs. When the variable costing system is used, fixed costs — including both manufacturing and non-manufacturing costs — are treated as period costs and are therefore not included in the product cost. One key benefit of the variable costing method is that it allows for accurate communication of product cost data to management. It is also beneficial because it produces a net income figure closer to the actual cash flow of the business, making it particularly useful for firms that face cash flow constraints.
In short, the variable costing method gives management a more accurate picture of the effect that fixed costs have on the total profitability of the company (Horngren, 1981, p. 26). Absorption costing, on the other hand, is required for external financial reporting and ensures that all manufacturing costs are matched to the revenues generated by the units sold, which is consistent with the matching principle in financial accounting.
"Absorption costing best for competitive bid decisions"
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