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When planning production, short-term decisions should be made using variable costing and long-term decisions should be made using absorption costing. Production is limited by capacity, so the products with the highest contribution margin per unit should be produced as long as there is a demand for the products. The highest income is generated when a company produces and sells the products with the highest contribution margin per unit. That said, in the short term, variable costing is appropriate. Income reporting under variable costing is not affected by production level changes since all fixed production costs are expensed in the year they are incurred. Companies will increase income by selling more units, rather than by producing excess inventory.
In the long run, capacity can be expanded by purchasing a new facility or adding to the current facility. The long run is an extended period of time during which production and costs are variable. Since expanding capacity will impact both fixed and variable costs, absorption costing is more appropriate than variable costing. Under absorption costing, income can be increased by producing more and disregarding whether the remaining units can be sold or not.
Over the long run, sales prices need to be high enough to cover all costs, including variable costs and fixed costs, while providing an acceptable amount of profit. In this case, absorption cost information is useful because it shows the full costs that sales must exceed for the company to be profitable. A three-step process is used to determine product selling prices.
Target markup is the amount by which the product cost needs to be increased to determine the selling price. Management will look at the prices that have been charged in the past or the industry averages in order to determine the target markup. They need to make sure that the markup is high enough to be able to pay for selling and administrative expenses since they are not included in the product cost. Similar to the target markup, the target selling price is the amount that the company must sell its product for in order to cover the absorption cost and the target markup per unit.
EXAMPLE
Under absorption costing, Bradley Company has a unit product cost of $28. The company’s management needs to determine a target markup on the $28 unit cost. Let’s assume that the company targets a 50% markup of the absorption cost, resulting in a target markup of $14 ($28 x 50%). The last step is to determine the target selling price by adding the absorption cost per unit and the target markup, giving us a target selling price of $42. Similar to the target markup, the target selling price is the amount that the company must sell its product for in order to cover the absorption cost and the target markup per unit.Now that we looked at setting prices in the long run, let’s look at setting prices in the short run. The short run is a short time period during which companies can change prices by adjusting production levels. In the short run, variable costing is the most appropriate method in most cases. If a company has extra capacity and has an opportunity to accept a customer order at a lower sales price, the order should be accepted as long as the sales price is more than the variable costs. In this case, the fixed costs won’t matter because they would be incurred regardless of whether the order is accepted or not. Variable costing would be appropriate here since the fixed costs are irrelevant.
When setting prices, calculating the target selling price is important. However, managers must also consider the competition and customer preferences. In order to remain competitive, in most instances, a company will need to have a selling price that is the same as or lower than their competitors so that they can attract customers. They also have to consider what customers are willing to pay for the product. If the company is selling products for higher prices than its competitors, customers will more likely purchase the product at a lower price if both products offer the same benefit to the customer.
Managers are typically responsible for the company’s controllable costs. Controllable costs are expenses that a manager can influence by their decisions. If a manager can determine or impact a specific expense that is incurred, that expense is controllable. On the other hand, an uncontrollable cost is an expense that a manager does not have an influence or control over. Some examples of uncontrollable costs include insurance expenses or depreciation expenses. These costs are predetermined and cannot be altered by management during the accounting period.
In the general sense, managers are able to control both variable costs and fixed costs in the production process. Variable costs such as direct materials, direct labor, and variable manufacturing overhead are controlled by a production supervisor since they can negotiate prices with suppliers, reduce the amount of overtime used, and the utilities that are used to run production.
While production supervisors are able to manage variable costs, fixed costs that are related to production capacity are often controlled by upper management because they make many of the long-term decisions for the company such as changes in factory size, renegotiating a lease, or adding new machines to the production process. These fixed costs are often controlled by the company’s owners and upper management because they will have a long-term impact on the company’s overall financial state.
EXAMPLE
Bradley Company signed a three-year lease for their manufacturing facility. The rent expense is fixed over the three years. After the three-year term, the company has the option to buy a building, rent a different building, or renew its current lease. These fixed costs are controllable because upper management has options related to the facility that they use to manufacture their products.When variable costing is used, the contribution margin income statement is useful for controlling costs as it reports variable and fixed costs separately. This allows managers to distinguish between the two costs and make appropriate decisions that will impact variable and/or fixed costs. Since absorption costing does not separate variable and fixed costs, it is less effective in evaluating cost control at different levels of management.
In a service company, a manager can analyze the company’s financial data into different business segments that will allow them to determine which segment is more profitable. A business segment is an identifiable part of a company that has financial data available. Businesses might be segmented by geography (domestic or global), customer types (residential or commercial), or salespersons (eastern sales territory and western sales territory).
EXAMPLE
Push & Pull is a towing company that provides services within city limits and outside city limits. The city limits are shorter routes and take less time while the routes outside the city are longer and take more time. In addition, within city limits, there are busier streets which cause more accidents, increasing the number of tows that are within city limits. The towing jobs that are outside city limits use more in gas and drivers wages than the towing jobs that are within city limits, therefore, they have higher variable costs.Source: THIS TUTORIAL HAS BEEN ADAPTED FROM “ACCOUNTING PRINCIPLES: A BUSINESS PERSPECTIVE” BY hermanson, edwards, and maher. ACCESS FOR FREE AT www.solr.bccampus.ca. LICENSE: CREATIVE COMMONS ATTRIBUTION 3.0 UNPORTED.
