Stellar Packaging Products uses absorption costing to compute additional compensation eligibility for managers. In December Stellar Packaging Products controller Robin Simmons noted that a considerable production overrun was experienced resulting in increased ending inventories for its major customer Estrella Coffee Company. Simmons approached Frank Moses the production manager regarding these facts. Moses indicated that indeed the production overrun was deliberate and completed in order that more overhead application would occur in December and everyone would make their year-end bonus.
Would the situation have changed if the company used variable costing as a basis of additional compensation? Why or why not?
For this discussion:
Peer Post !:
Absorption Costing is a GAAP compliant method of accumulating costs involved in a production process and assigning the costs to an individual product (Garrison Noreen & Brewer 2015). A given product has many fixed and variable costs but under absorption costing they are not expenses when the company pays for them (Garrison et al 2015). Instead they remain in inventory as a tracked asset until the product is sold; then it is listed as cost of goods sold (Garrison et al 2015). The advantages of absorption costing is that it given a more accurate view of net profitability and is especially helpful when a company manufactures product during a time frame but does not sell them (Maverick 2015). It is also the most standardized format and used by the most companies because the IRS requires its use and if companies use variable costing they still have to comply with the IRS requirements of filing in a absorption costing format as well (Maverick 2015). The main disadvantage would be that the company has a tendency to carry fixed costs if the products are not sold in real time (Maverick 2015). This can lead to the company appearing to be more profitable that it actually is.
Variable Costing is a non-GAAP compliant method of accumulating costs that varies with the output of production (Garrison et al 2015). These costs are more variable because they depend of the outcome of the company’s production volume for a given timeframe (Garrison et al 2015). Variable costs will go up if production volume rises and go down if production falls (Garrison et al 2015). The advantages to the variable costing method is that it allows a company to get an accurate break even and use cost value profit analysis (CVP) (Garrison et al 2015). This knowledge of break even can be helpful as companies are figuring out the profitability of a given line of production vs. a different line. It provides an apples-to-apples comparison of profitability (Maverick 2015).
Based on the example question it appears that by using absorption method alone it had a net operating profit loss of $11009. It appears that having an element of variable costing methods would not allow the numbers to be worked to get to a bonus that Moses does not deserve.
References:
Garrison G. H. Noreen E. W. & Brewer P. C. (2015).Managerial accounting(15th ed.). New York City NY: McGraw-Hill Education.
Maverick J. B. (2015 May 27).What are some of the advantages and disadvantages of absorption costing?Retrieved fromhttp://investopedia.com
Peer Post 2:
Absorption costing is frequently referred to as full costing method. It is a costing system that treats all costs of production as product costs regardless if they are variable or fixed. The cost of a unit of product under absorption costing method consists DM DL and both fixed and variable overhead. It allocates a portion of fixed and variable manufacturing overhead to each unit produced. Absorption costing includes all costs of production as period costs.
Variable costing is sometimes referred to as direct costing or marginal costing. Fixed manufacturing overhead is treated as a period cost. It includes DM DL and a portion of manufacturing overhead to each unit. The cost of production that vary with the output are treated as product costs. The cost of a unit of product in inventory of COGS under this method does not contain any fixed overhead costs.
Under absorption costing and variable costing different net operating incomes are produced. Reason being is that product cost and period costs differ. For example while both factor direct materials direct labor and variable manufacturing overhead as product costs only absorption cost includes fixed manufacturing overhead for product cost. As far as period costs both account for fixed and variable selling and administrative as period cost but only variable costing accounts fixed manufacturing overhead as period cost.
Relation between production and sales for the period
Effects on inventories
Relation between absorption and variable costing net operating incomes
Units produced = Units sold
No change in inventories
Absorption costing net operating income = Variable costing net operating income
Units produced > Units sold
Inventories increase
Absorption costing net operating income > Variable costing net operating income
Units produced < Units sold Inventories decrease Absorption costing net operating income < Variable costing net operating income Net operating income is higher under absorption costing because fixed manufacturing overhead cost is deferred in inventory under absorption costing as inventories increase. If Stellar Products were to use a Variable costing system a lower net operating income would have been reported and less if any year-end bonus would be compensated. Reference Garrison G. H. Noreen E. W. & Brewer P. C. (2015). Managerial accounting (15th ed.). New York City NY: McGraw-Hill Education.