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Chapter 9: Problem 6

The main trouble with variable costing is that it ignores the increasing importance of fixed costs in manufacturing companies. Do you agree? Why?

Short Answer

Expert verified
Yes, the criticism holds because ignoring fixed costs in variable costing can misrepresent true production costs and impact decision-making.

Step by step solution

01

Understand Variable Costing

Variable costing is a method where only variable manufacturing costs are included in the product cost. This means that costs that change directly with production volume, like raw materials and labor, are considered, while fixed manufacturing costs, such as rent and salaries, are treated as period expenses and not included in the product cost.
02

Identify Fixed Costs

Fixed costs refer to expenses that do not change with the level of production, such as rent, salaries, and equipment depreciation. These costs remain constant regardless of how much is produced.
03

Recognize the Argument Against Variable Costing

The argument against variable costing is that it ignores fixed costs in its calculation of product costs, which can misrepresent the true cost of production, especially in companies where fixed costs form a significant portion of the total cost.
04

Consider the Importance of Fixed Costs

In many manufacturing companies, fixed costs are becoming increasingly significant due to automation and high initial capital investments in machinery and technology. Ignoring these costs can lead to poor decision-making as it does not provide a complete picture of production costs.
05

Evaluate the Argument

The criticism of variable costing is valid when analyzing the full financial health of a company because it does not account for a significant portion of total costs in businesses where fixed costs are high, potentially leading decision-makers astray if they rely solely on this cost method.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Fixed Costs
Fixed costs are expenses that stay the same whether a company produces a single unit or thousands of units. Unlike variable costs that fluctuate with production volume, fixed costs do not change.
Some common examples include:
  • Rent for office or manufacturing facilities
  • Salaries of permanent employees who are not paid hourly
  • Depreciation on machinery and equipment
These costs are crucial because they represent a financial commitment a company needs to uphold no matter how much it produces.
In manufacturing, fixed costs have gained importance, especially as companies invest in automation and technology. A high proportion of fixed costs can lead companies to produce more to reduce the per-unit cost of products, affecting overall business strategy.
Manufacturing Costs
Manufacturing costs encompass all expenses related to producing a product. This includes both variable and fixed costs.
Understanding manufacturing costs is vital for setting the correct selling price, budgeting, and evaluating the efficiency of the production process.
  • Variable Costs: These are costs that change with production volume, such as materials and direct labor. The more you produce, the more you spend on these costs.
  • Fixed Costs: Even if production stops, these costs remain, such as rent and salaries.
Companies must balance their manufacturing costs to remain profitable. By fully understanding these costs, businesses can make more informed decisions, such as determining the optimal level of production and identifying potential areas for cost reduction.
Cost Accounting
Cost accounting is a method used to understand and control a company鈥檚 cost structure. It goes beyond traditional accounting by focusing specifically on costs associated with producing goods or services.
Variable costing, part of cost accounting, includes only the costs that change with the level of production in product costs. While this method can be useful for short-term decision-making, it often overlooks the role of fixed costs.
Fixed costs are crucial to understanding the larger financial picture as they can be significant in industries with high machinery investments.
Accurate cost accounting helps a company:
  • Ensure pricing strategies cover all costs
  • Plan budgets accurately by considering both fixed and variable costs
  • Monitor and optimize production efficiency
By capturing a comprehensive view of both variable and fixed costs, cost accounting provides a clearer picture of a company鈥檚 financial health and guides business strategy effectively.

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Most popular questions from this chapter

Match each of the following items with one or more of the denominator-level capacity concepts by putting the appropriate letter(s) by each item: a. Theoretical capacity b. Practical capacity c. Normal capacity utilization d. Master-budget capacity utilization 1\. Measures the denominator level in terms of what a plant can supply 2\. Is based on producing at full efficiency all the time 3\. Represents the expected level of capacity utilization for the next budget period 4\. Measures the denominator level in terms of demand for the output of the plant 5\. Takes into account seasonal, cyclical, and trend factors 6\. Should be used for performance evaluation in the current year 7\. Represents an ideal benchmark 8\. Highlights the cost of capacity acquired but not used 9\. Should be used for long-term pricing purposes 10\. Hides the cost of capacity acquired but not used 11\. If used as the denominator-level concept, would avoid the restatement of unit costs when expected demand levels change

Critics of absorption costing have increasingly emphasized its potential for leading to undesirable incentives for managers. Give an example.

The Mavis Company uses an absorption-costing system based on standard costs. Total variable manufacturing cost, including direct material cost, is \(\$ 3\) per unit; the standard production rate is 10 units per machine-hour. Total budgeted and actual fixed manufacturing overhead costs are \(\$ 420,000\). Fixed manufacturing overhead is allocated at \(\$ 7\) per machine-hour \((\$ 420,000 \div\) 60,000 machine-hours of denominator level). Selling price is \(\$ 5\) per unit. Variable operating (nonmanufacturing) cost, which is driven by units sold, is \(\$ 1\) per unit. Fixed operating (nonmanufacturing) costs are \(\$ 120,000\). Beginning inventory in 2012 is 30,000 units; ending inventory is 40,000 units. Sales in 2012 are 540,000 units. The same standard unit costs persisted throughout 2011 and 2012 . For simplicity, assume that there are no price, spending, or efficiency variances. 1\. Prepare an income statement for 2012 assuming that the production-volume variance is written off at year-end as an adjustment to cost of goods sold. 2\. The president has heard about variable costing. She asks you to recast the 2012 statement as it would appear under variable costing. 3\. Explain the difference in operating income as calculated in requirements 1 and 2. 4\. Graph how fixed manufacturing overhead is accounted for under absorption costing. That is, there will be two lines: one for the budgeted fixed manufacturing overhead (which is equal to the actual fixed manufacturing overhead in this case) and one for the fixed manufacturing overhead allocated. Show how the production-volume variance might be indicated in the graph. 5\. Critics have claimed that a widely used accounting system has led to undesirable buildups of inventory levels. (a) Is variable costing or absorption costing more likely to lead to such buildups? Why? (b) What can be done to counteract undesirable inventory buildups?

Will the financial statements of a company always differ when different choices at the start of the accounting period are made regarding the denominator-level capacity concept?

Mile-High Foods, Inc., was formed in March 2011 to provide prepackaged snack boxes for a new low cost regional airline beginning on April 1. The company has just leased warehouse space central to the two airports to store materials. To move packaged materials from the warehouses to the airports, where final assembly will take place, Mile-High must choose whether to lease a delivery truck and pay a full-time driver at a fixed cost of \(\$ 5,000\) per month, or pay a delivery service a rate equivalent to \(\$ 0.40\) per box. This cost will be included in either fixed manufacturing overhead or variable manufacturing overhead, depending on which option is chosen. The company is hoping for rapid growth, as sales forecasts for the new airline are promising. However, it is essential that MileHigh managers carefully control costs in order to be compliant with their sales contract and remain profitable. Ron Spencer, the company's president, is trying to determine whether to use absorption, variable, or throughput costing to evaluate the performance of company managers. For absorption costing, he intends to use the practical- capacity level of the facility, which is 20,000 boxes per month. Production- volume variances will be written off to cost of goods sold. Costs for the three months are expected to remain unchanged. The costs and revenues for April, May, and June are expected to be as follows: Sales revenue \(\$ 6.00\) per box Direct material cost \(\$ 1.20\) per box Direct manufacturing labor cost \(\$ 0.35\) per box Variable manufacturing overhead cost \(\$ 0.15\) per box Variable delivery cost (if this option is chosen) \(\$ 0.40\) per box Fixed delivery cost (if this option is chosen) \(\$ 5,000\) per month Fixed manufacturing overhead costs \(\$ 15,000\) per month Fixed administrative costs \(\$ 28,000\) per month Projected production and sales for each month follow. High production in May is the result of an anticipated surge in June employee vacations. 1\. Compute operating income for April, May, and June under absorption costing, assuming that Mile-High opts to use a. the leased truck and salaried driver. b. the variable delivery service. 2\. Compute operating income for April, May, and June under variable costing, assuming that Mile-High opts to use a. the leased truck and salaried driver. b. the variable delivery service. 3\. Compute operating income for April, May, and June under throughput costing, assuming that MileHigh opts to use a. the leased truck and salaried driver. b. the variable delivery service. 4\. Should Mile-High choose absorption, variable, or throughput costing for evaluating the performance of managers? Why? What advantages and disadvantages might there be in adopting throughput costing? 5\. Should Mile-High opt for the leased truck and salaried driver or the variable delivery service? Explain briefly.
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