Which of the following is an advantage of using variable costing *?

Advantages and Limitations of Variable Costing!

Advantages of Variable Costing:

The following are the advantages of variable costing:

1. Planning and Control:

Financial planning requires managers to estimates future sales, future production levels, future costs etc. Sales forecasts determine production plans, which in turn determine the level of expen­ditures required for raw materials, direct labour and variable manufacturing overhead. In order to determine the level of expenditure at different production levels, knowledge of cost behaviour and distinguishing between fixed and variable costs is essential for making accurate cost estimates at the different levels of production and sales.

Thus a financial plan will highlight expected production level and related expected costs. This financial plan can be used to monitor the actual performance as it is done. In case actual performance is different from the budgeted activity level, corrective action can be taken by management.

Thus control is exercised by management through taking corrective actions. But, for the control function to work and succeed, cost should be divided into fixed and vari­able components which is achieved only under variable costing and not under absorption costing.

Absorption costing ignores cost behaviour and is not able to isolate and relate accurate costs to different sales and product volumes. It is not reliable because of the arbitrary allocation of manufacturing over-headed. These allocations may not reflect accurate charging of manufacturing overhead to different production levels.

Variable costing income statements are more useful internally for short-term planning, controlling and decision making than absorption costing statements. To carry out their functions, managers need to understand and be able to project how different costs will change in reaction to changes in activity levels. Variable costing, through its emphasis on cost behaviours, provides that necessary information.

2. Managerial Decision- Making:

Management requires knowledge of cost behaviour under various operating conditions and business decisions. The identification and classification of costs as either fixed or variable, with semi-variable expenses properly subdivided into this fixed and variable components, provide useful framework for the accumulation and analysis of costs and further for making decisions.

Relevant costs are required for a variety of short-term decision such as changes in production levels, make or buy, entry into new markets, product mix, plant expansion or contraction or special promotional activities. These decisions require that costs be split into their fixed and variable components and this is possible only under variable costing.

Therefore, projection of future costs and revenues for different activity levels and the use of relevant cost decision-making techniques are facilitated and highlighted in variable costing and not in absorption costing. The utility of variable costing rests upon the fact that, within a limited volume range, fixed costs tend to remain constant in total when activity level changes, under such conditions, only variable costs are relevant in ascertaining costs of additional output and sales or in other short-term decisions.

Another benefit of variable costing is that the favourable margin between selling prices and variable cost should provide a constant reminder of income forgone because of lack of sales volume. A favourable margin justifies a higher production level.

3. Product Pricing Decisions:

Variable costing provides more useful information to management for pricing decisions than absorption costing. It is rightly contented that the best or optimum price is that which produces the maximum excess of total sales revenue over total cost. The optimum production volume is that at which increase in total cost due to the addition of one more unit of volume is just equal to the increase in total revenue or a zero increase in total profit.

The price at which this volume can be achieved is the optimum product price. A higher price will decrease the sales revenue; a lower price tends to increase the sales volume and leads to abnormal production costs due to overtime, produc­tion inefficiencies, etc. Variable costing serves as the basis of product pricing in many cases.

Under variable costing, management has the data to determine when it is advisable to accept orders if other than normal conditions exist. In some cases, a sales order can be accepted even if it contributes partly to fixed costs. New short-term businesses or orders should be accepted as long as the variable cost of making and selling are recovered—variable costs represent the minimum sales price under these conditions. Knowledge of the contribution margin provides guidelines for the most profitable pricing policies.

However, the full cost and not only the variable cost should be the basis of product pricing in the long-run. The full cost is the cost which includes variable manufacturing cost and fixed manufacturing cost incurred in the production process.

4. Cost Control:

For the purpose of cost control, costs should be pooled into separate variable and fixed totals. Separation of variable and fixed costs supports the use of standards, budgets and responsibility report­ing to help management in controlling costs. All costs are controllable in the long run by someone within a business enterprise. But they are not all controllable at the same level of management.

For example, supervisors in production department are responsible for controlling the use of direct materials in their departments. They have no control, however, over insurance costs related to the production department building. For a specific level of management, controllable costs are costs that it controls directly and non controllable costs are costs that another level of management controls. This distinction, as applied to specific levels of management, is useful in fixing the responsibility for incurrence of costs and then for reporting cost data to those responsible for cost control.

The variable costing includes only variable manufacturing costs, which varies with change in the volume of production, in the cost of product and thus makes variable manufacturing costs controllable at cost centre level by operating management. Fixed production costs may not be con­trollable at departmental level and therefore should not be included in the production costs at costs centre level, as it is important to match control with responsibility.

The fixed manufacturing costs are reported as separate item in the variable costing income statement, they are easier to identify and control (by a higher level of management) than when they are spread among units of product as in absorption costing. Similarly, under variable costing, each other variable and fixed operating expenses (e.g., variable and fixed selling and administrative expenses) are reported separately and thus become easier to identify and control than in absorption costing where they are not reported separately but combined together.

5. Inventory Changes do not Affect Profit:

In variable costing, profit is a function of sales volume only. But under absorption costing sales and production (production creates inventory) both influence profit of a period. Profit in variable costing is not affected by changes in inventory as it is in absorption costing. In absorption costing, profit may decline although sales have increased. When inventory levels fluctuate greatly, profits calculated under absorption costing may be distorted since inventory changes will influence the amount of fixed manufacturing overheads charged to an accounting period.

6. Avoiding the Impact of Fixed Costs:

Variable costing avoids the arbitrary apportionment of fixed factory overheads and also avoids problem of determining a suitable absorption basis which is needed for a predetermined overhead absorption rate. Fixed production costs are charged to the period in which they are incurred and are not carried forward in stock which may be un-saleable, resulting in earlier profits being overstated. It is argued that managerial decisions can be easily made if fixed production costs are separated and are not mixed in inventory or cost of sales.

Since most fixed costs are committed and can-not be avoided, these costs should not be part of inventory. In addition, the presentation of the total amount of fixed costs on variable costing income statement emphasizes their full impact on net income, an effect partially hidden in inventory values under absorption costing.

Another benefit of variable costing is that production managers cannot manipulate income by producing more or fewer products than needed during a period. Under absorption costing, however, a production manager could increase income simply by producing more units than are currently needed for sales.

Morse, Davis and Haitgraves observe: “when considering the financial accounting principle of matching, variable costing has advantage over absorption costing because it matches revenue with the direct cost of producing those revenues. This results in net income varying only with sales and not with both sales and production, as is often found in absorption costing. In absorption costing, over production especially distorts net income during a period because the excess inventory is assigned fixed costs that would otherwise be assigned to the units produced and sold.”

7. Performance Evaluation of Managers:

The evaluation of managers is often linked with the profitability of units they manage and control. The changes in income from one period to another and difference between the actual income and budgeted income are used to judge managerial performance and efficiency. For example, if a manager has worked hard and has increased sales while controlling costs simultaneously, income will increase indicating the success and better performance of manager.

The variable costing income statement highlights the relationship between sales and income whereas the absorption costing income statement does not generally show any association between sales and income. For example, under absorption costing income may decrease although sales have increased or sales may decrease but income reported may be higher due to large inventory being created due to higher production. Vari­able costing always produces an increase in income corresponding to the improved sales performance.

Furthermore, the variable costing can be used to evaluate the profit contributions of plants, product lines and sales territories. The separation of fixed and variable costs which are basic to vari­able costing is critical for making accurate evaluations. Thus, variable costing can make a significant contribution to management decision- making in such and similar areas.

8. Segmental Reporting:

Segmented reporting provides information about the contribution of organizational subunits. Segmented income statements differ from other income statements because they display amounts for direct (traceable) fixed costs (costs avoidable if the segment is eliminated) and for common or allocated fixed costs (costs that will continue to be incurred even if the segment is eliminated).

Presenting segmented income statements on a variable-costing rather than on absorption-costing basis is preferable because it results in more accurate studies of relative profitability of divisions, plants, products, territories, activities, and other segments of an organization. It concentrates on the contribution (the segment margin) that each segment makes to the recovery of common fixed costs. Marginal income data facilitate appraisal of segments without the bias (cross-subsidies) introduced by allocated common fixed costs.

9. Customer Profitability Analysis:

Customer profitability analysis is an application of segmented reporting in which a customer group is treated as a segment. This analysis may be done using variable costing to determine a customer contribution margin or absorption costing to determine a customer gross margin based on full-cost cost of sales. It is especially helpful when combined with an activity-based costing approach that determines which activities are performed for each group and assigns costs based on appropriate drivers.

Activities include those required to gain new customers and to maintain relationships with current customers as well as ordering, packaging, handling, customer service, etc. Furthermore, assignment of costs for a customer profitability analysis is based on cost-hierarchy concepts similar to those used in product profitability analysis.

For example, activities, their drivers, and their costs may be classified as order level, customer level, channel level, market level, or enterprise level. Assignment of revenues is also a critical concern in customer profitability analysis. Thus, sales returns and allow­ances, the effects of coupon offers, price discounts, etc., should be traced to specific customer groups.

Limitations of Variable Costing:

The following are the limitations of variable costing:

(i) Separation of Costs into Fixed and Variable:

The variable costing method requires that all costs should be divided into fixed and variable elements. Also variable costing assumes that the relation between the sales and the variable costs is direct, proportionate, and linear. It cannot be true under all circumstances. Examples of factors that might affect this assumption include quantity discounts on materials, and labour efficiency variance.

(ii) Product Costs Not without Fixed Costs:

Complete product cost does not depend only on variable costs. Fixed costs should be considered in determining the product cost and for long-range pricing and other long-run policy decisions. The product is not complete until it is in a form and place and at a time desired by the customer, and this product completion involves distribution just as essentially as it does manufacturing.

(iii) Temptation to Cut-Prices:

It is also argued that if managers are given only variable cost (as is done in variable costing) they will be tempted to cut prices to the degree that company profits will suffer. Despite the many, other advantages of the method for internal purposes, variable costing generates product figures providing little basis for long range pricing policies.

(iv) Use of Net Income Figure:

Income figures obtained under variable costing have to be use a carefully if management decides to expand business or drop a product line. Management has to consider other factors also before deciding to drop a product line such as customer goodwill. .The loss in customer goodwill which might result from dropping a product with a low contribution margin could easily offset any gain from products with higher contribution ratios. Thus the variable costing although useful is not a perfect managerial tool.

(v) Unwise Decisions:

Sometimes variable costing may be unnecessarily given a broader significance than it deserves. For instance, when sales are higher than production, variable costing net income will be more than absorption costing net income. In this case, sometimes, management may take unwise actions due to ‘increased profits’ reported by variable costing.

It may prompt the marketing managers to go for lower selling prices, may inspire the managers and employees to demand higher salary or bonus. But, in fact, there can be no justification for such actions. At the other extremes, variable costing results may mislead management during a business recession during which variable costing profit will be minimized due to sales being extremely lower than production.