Pros and cons of absorption costing

Discussion Board Postings.

The three methods used to allocate joint cost are Physical Measures of Output, Relative Sales Value, and Net Realizable value. Physical measures of output reflect some quantifiable physical characteristics of the joint products (Schneider, 2012). Physical Measures of Output method has two potential disadvantages. One disadvantage is having the possibility of having different units of measure. A second limitation is that physical measures may be unrelated to the profitability of the joint products (Schneider, 2012). The advantage of using this method is that it gives flexibility. The physical-measure method is often used when "output prices are highly volatile or unpredictable, significant processing occurs between the split-off point and the first sales opportunity, or the market does not set product prices" (Hilton et al, 2003).

The relative sales value (RSV) approach allocates joint costs in proportion to the joint products' total sales values at the split-off point. (Schneider, 2012). A potential problem with the RSV approach is that sales prices at the split-off point may not be readily available (Schneider, 2012). Even after one of the products may be complete after the split-off, the availability to sell the product may not exist at the present time. This will cause profits to be delayed until the product has been developed into something useful.

The net realizable value (NRV) method uses approximations of sales values at the split-off point. NRV is the total sales revenue of the product in its final form less any separable costs (Schenider,2012). This is the process that I would recommend because it is as close as you can get to actual value when estimating profits and/or losses. The NRV method "allocates joint costs to joint products on the basis of relative NRV - final sales value minus separable costs - of total production of the joint products during the accounting period" (Horngren et al, 2006, p. 572).

2.

· Physical Measures of Output allocate costs of products that have some measurable physical components of the joint product (Schneider, 2012). One advantage to physical measures of output is that it is fairly simple to use; however outputs may have different units of measure (Schneider). An example provided in our text was that of petroleum that produces gasoline, a liquid measured by gallons, and paraffin, a solid measured by pounds (Schneider).

· Relative Sales Value (RSV), allocates joint costs as they relate to the joint products’ total sales value at the split-off point (Schneider, 2012, 8.1). A disadvantage with this method is that at the split-off point sales prices may not be available or the product may not even have a market (Schneider).

· Net Realizable Value (NRV), uses total sales revenue minus any separable costs, such as processing costs, selling costs, and disposal costs (Schneider, 2012). At times there are products with a NRV that is negative, when this occurs allocation costs should not be applied to that product (Schneider).

Although the first two methods seem relatively simple to use, I would recommend the NRV method. This method can be approximated by using total revenues minus the separable costs (Schneider, 2012). Plus, NRV also gives you the additional advantage of estimating the byproduct and scrap value of the main product (Schneider).

3.

Variable costing (also known as direct costing) is an approach to product costing that assigns only variable manufacturing costs (direct materials, direct labor, and variable factory overhead) to items produced (Schneider, 2012). Absorption costing (also known as full costing), the method typically used for external income statement reporting, allocates all manufacturing costs (variable and fixed) to products (Schneider, 2012).

After reviewing each costing methods I chose to explore the Absorption Costing method. I am in favor of using this method instead of the variable costing method. My decision was not based on which method would lead to larger profits. Deciding between variable costing and absorption costing has an impact on inventory values and profits because of the variation in the treatment of fixed factory overhead. Although the profit can differ between the two costing methods, profit under variable costing is not always higher or lower than absorption costing (Schneider,2012). Companies have to prepare financial statements each year. The absorption costing methods already allocates the cost as needed to prepare the statements. Another benefit to using this method is that you are not dealing with variables that change each quarter or year. By absorbing all of the cost, you eliminate the hassle of trying allocate cost to the correct overhead for unexpected expenses. Each cost has its benefits and disadvantages. I think that the type of organization you have and the product you produce should be the determining factor on which method you choose.

4.

The costing approach I selected was that of absorption costing. My first reasoning is based on the argument for the long-term value of absorption costing, mangers may prefer short-term due to their focus on short-term situations, which is more conducive with variable costing, however eventually a company’s main focus should be that of a long-term (Schneider, 2012). My second reasoning is based on the additional argument that even though with the absorption costing some mistakes may be made in the short-term, the situation will eventually correct itself in the long-term. Also, the argument of an unethical manager could be discovered with a skilled supervisor (Schneider).

Finally, I believe the most important reason for the absorption costing approach is that it is required by the Internal Revenue Service (Schneider, 2012). If a manager using the variable costing approach internally, then switches to the absorption costing approach for the external requirements (IRS), this could cause unnecessary confusion, not to mention that it may have the appearance of some type of unethical behavior, such as hiding something (Schneider).