Determining the cost of goods sold is an important part of analyzing profitability. In a manufacturing environment, there can be a lot of variables involved in producing the final product. This article looks at the two most common cost accounting methods for determining the cost of finished goods. This article also looks at how costing methods are applied to the company’s profitability.
Manufacturing Accounting - Absorption Costing Method
Absorption costing is a method of determining what the actual costs are associated with producing the final product. Virtually all costs and expenses associated with a finished manufactured product are figured into determining the unit cost with the absorption method. There can be many factors involved to determine the actual cost to produce a single product The following is a list of some of the cost considerations used.
- Direct Materials Cost is the actual cost of all materials that are used in the production of a finished product
- Direct Labor Cost is the expense of the actual internal wages associated with the production of a finished product.
- Variable Manufacturing Cost fluctuates with output. Examples may include equipment depreciation, utilities, outside labor, plant or equipment maintenance and material handling.
- Variable Sales Costs are associated with the expense of sales. Salespersons commissions and advertising are examples of variable sales costs.
- Fixed Manufacturing Overhead costs remain the same regardless of manufacturing output. Salaries paid to plant managers, rent on the facilities and insurance are some examples.
- Fixed Selling Costs are expenses that do not fluctuate that are associated with the sale of the final product. Examples may include sales managers and administration salaries.
Manufacturing Accounting – Variable Costing Method
Unlike absorption costing, which considers all manufacturing costs for inventory value, the variable costing method does not consider fixed costs associated with producing the final product. Only materials, labor and variable manufacturing overhead costs and expenses associated with a finished manufactured product are figured into determining the unit cost. Fixed expenses are not figured into the finished product cost with the variable costing method.
Profitability Factors - Absorption Costing vs. Variable Costing
Using absorption versus variable costing for the finished product will have different effects on gross profit as reported on the income statement. Since fixed expenses aren’t figured into the cost of goods with the variable method, the inventory value will be less than using the absorption method. Since the inventory value is less, a higher gross profit will be realized when the products are sold using the variable costing method.
Variable costing may not be acceptable for external reporting of the income statement for income tax purposes. A CPA or tax professional should be consulted before implementing the variable costing method. Inventory costing methods will also have an affect on asset valuation as reported on the balance sheet.
James Clausen - Clausen received a Bachelors Degree in Business Administration in Automotive Management and Marketing at Northwood University, graduating ...
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