Absorption Costing vs. Variable (Direct) Costing Absorption cost systems are widely used to prepare financial accounts. These systems are designed to absorb all production costs (variable or fixed) into costs of units produced. Absorption costs techniques allow manufacturing costs to be traced and allocated into product costs. There are different types of absorption costing systems: job order costing, process costing, and ABC costing. In job order costing, costs are assigned to products in batches or lots, and the costs of each specific batch are traced separately using job order cost’ sheets.
In process costing, products are produced in a continuous process and costs are systematically assigned to the product. In ABC costing, costs are assigned from cost centers to products. Because a unit’s cost in the absorption cost systems are made of variable and fixed costs, they can be very misleading. Absorption cost systems can incentive overproduction when the overhead rate is calculated based on units produced, and units produced is higher than units sold. In order to calculate this overhead cost, one should divide the total fixed cost by units produced and multiply the result by units sold.
This overhead rate will be lower when more units are produced and when variable and fixed costs remain constant. In this process, fixed costs are being spread over more units, thus lowering unit’s cost. This technique allows profit to increase when production increases, and quantity of units produced is higher than quantity of units sold. In this case some of the fixed costs are divided by units and part of the total production (including its costs) is inventoried.
The costs inventoried are not transferred to the income statement, thus increasing profits for that period, and misleading managers to overproduce. In some cases, managers do not understand how this costing process works. In the majority of the cases, they are only worried about increasing production and lowering units’ cost. Other managers that have their compensation linked to the period’s profit also feel motivated to overproduce, once profit increases as quantity produced increases. There are many ways to decrease the incentive of overproduction.
The first one charges inventory holding costs against profits. In this process, inventory values are increased by the costs of capital plus warehousing costs. Managers that are evaluated based on residual income, tend to dislike this system; first, because it increases data processing complexity, and second, because it decreases residual income when there is an overproduction and an increase in inventory. This system does not eliminate completely the incentive to overproduce, but it makes overproduction less profitable to managers.
The second technique that aims to reduce the incentive of overproduction is based on a strict policy against building inventories. This can be done through contracts stating that bonuses tied to net income will not be paid if inventories exceed a certain amount. A third method would be to base managers’ compensation on stock prices instead of accounting earnings. This method will inhibit managers’ actions that could damage the company’s profit maximization plan. However, in cases where the company has more than one plant, overproduction has a small effect on the value of the firm.
This factor decreases the efficiency of stock-based compensation to eliminate or reduce overproduction incentive. The forth method consists of the implementation of just-in-time production systems. Because this process does not begin until a part or a total order is made by customers, it reduces inventory levels. In this system, the decision rights are made by demand-driven market orders. Here the production levels are determined by demand, not by managers. Just-in-time systems reduce inventories, thus reducing the incentive to overproduce.
Companies can control managers’ incentive to overproduce by adopting variable costing systems. These systems write off all fixed manufacturing costs as a period cost, which will not allow profit increases with overproduction. In variable costing, product costs are made up only of variable costs. Fixed manufacturing costs are considered period costs and are written off. Variable costing and absorption costing differ from each other in the way that they treat fixed costs. Under variable costing, fixed manufacturing costs are written off as a period expense.
As for absorption costing, fixed manufacturing costs are included as part of product costs. The advantages of variable costing are that the product’s cost does not change depending on volume change, and it reduces the incentive for overproduction. It is important to notice that when production and sales are equal, absorption costing and variable costing will have the same profit amount. Variable costing systems’ benefits might not exceed its total costs, a fact that contributes to the systems unpopularity.