Absorption Costing vs. Variable (Direct) Costing

submerging Costing vs. Variable (Direct) Costing Absorption embody systems ar wide used to prepare financial accounts. These systems are designed to absorb every last(predicate) occupation be (variable or mulish) into cost of wholes produced. Absorption cost techniques drop out manufacturing costs to be traced and allocated into yield costs. There are different types of compactness cost systems craft order costing, butt costing, and ABC costing. In pedigree 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 units cost in the acculturation cost systems are do of variable and glacial costs, they can be very tawdry. Absorption cost systems can inducement over end product when the overhead rate is calculated base on units produced, and units produced is higher than units sold. In order to calculate this overhead cost, iodin should divide the total fixed cost by units produced and multiply the bequeath by units sold.This overhead rate leave behind be lower when to a greater extent than units are produced and when variable and fixed costs remain constant. In this process, fixed costs are being spread over more units, thence lowering units cost. This technique allows take in to increase when return 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 non transferred to the income statement, thus change magnitude profits for that arrest, and misleading managers to overproduce. In some cases, managers do not understand how this costing process works. In the majority of t he cases, they are only worried about increasing production and lowering units cost. Other managers that have their compensation linked to the periods profit also feel motivated to overproduce, once profit increases as quantity produced increases. There are many elbow rooms to falling onward the incentive of overrun.The first one charges inventory holding costs against profits. In this process, inventory encourages are increased by the costs of outstanding plus warehousing costs. Managers that are evaluated based on residual income, melt to dislike this system first, because it increases data processing complexity, and second, because it decreases residual income when there is an overrun 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 turn off the incentive of overproduction is based on a strict polity against building inventories. T his can be done through contracts stating that bonuses tied to crystallize income provide not be paid if inventories exceed a trustworthy 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 harm the companys 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 generate until a part or a total order is make 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 inc entive to overproduce.Companies can oblige 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 products 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 b enefits might not exceed its total costs, a fact that contributes to the systems unpopularity.