Fixed and Variable Costs (Coursework Sample)

Variable and Fixed Costs
Name:
Course:
Professor:
Date Due:
Introduction
Fixed costs are firm’s expenses that are not related or dependent on the level of quantity of items or services produced by the company. They include overhead and other indirect expenses of operating a company. They tend to be seasonal or related to time such as remuneration salaries, security, administrative expenses or supplies or even monthly or quarterly rent payable. Fixed expenses or costs are used to control the prices of products or services to maximize profits to ensure appropriate returns and profitability the investment made. Variable costs are costs that vary in proportion to the activities of a company or business. For example direct labor and overheads or conversion cost as they are referred to. Also the prime cost is also a variable cost i.e. direct labor and direct material.
Explain the main differences between the absorption and contribution (behavioral, variable) income statements.
The contribution income statement involves only the variable costs in its calculations of the contribution and the cost of sales and transfers most of the values of the closing stock to later dates while the absorption income statement involves part of the fixed costs and the variable costs in its determination of the closing stock in its cost of sales. (Kieso, Weygandt & Warfield, 2007) Absorption costing apportions all the overheads to the individual products. In order to achieve this, the companies must directly apportion and allocate each service overhead to the major production department. All the direct labor/machine hourly rates are then calculated. All the costs are allocated to various individual departments and it’s assumed that the overhead costs relate directly and precisely to the level of production. The major problem with this concept is that the allocation or the apportionment of the costs is done arbitrary and may not give an accurate view of the activities which are responsible for the costs. A certain product or an activity may show a big loss just because the method used to allocate the costs have changed. Absorption costing is time consuming and requires a lot of concentration and energy to determine and implement an accurate basis of overall overhead allocation and eventual apportionment.
Will net income always be the same under the two approaches? If not, explain the difference.Comment specifically on why companies feel the need to create yet another income statement in a different format.
The net income between the contribution income statement and the absorption income statement can never be the same. The absorption income statement utilizes both the variable expenses and the fixed expenses when determining the closing stock while computing the cost of sales. The contribution income statement only utilizes the variable cost while calculating its contribution margin and the cost of sales and it completely ignores the fixed expenses. The need for companies to create another income statement comes in because of the calculation of the closing stock on rates that are similar to the current rates of the sales to give a true and fair view of the cost of sales.What information can the company gleam from this approach which is helpful as a tool in the decision making process.
The most important information from the above argument a company can utilize as a tool in decision making process is the valuation of closing stock and the way the different methods of absorption and contribution income statements affect the net income. The absorption income statement valuation of the closing stock utilizes most of the cost in the current income statement by also including the fixed costs together with the variable costs i.e. it’s very realistic while contribution income only uses the variable cost while determining the closing stock and it excludes the fixed costs.
Explain situations in which break-even analysis can be a useful tool. Provide a specific example.Breakeven analysis is the point where the total revenues of the product sales are equal to the total of all the costs associated with the sale of the product. In simple terms the profit is zero i.e. profit = 0. Breakeven analysis is a useful tool when it comes to planning and controlling the business operations. The breakeven point gives a true representation of the volume of the firm’s business. It shows whether the total revenue from a service or product has the capability to cover all the costs of the production of the product or service. It’s critical during the initial planning of a business as it shows the minimum number of units to be produced in order for the business to remain afloat. The resources the firm requires for its startup can then be calculated. When the business is planning its marketing strategy the amount of sales or the volume of sales the market can absorb or the size of market the company requires can be estimated from the breakeven analysis.
Absorption costing apportions all the overheads to the individual products. In order to achieve this, the companies must directly apportion and allocate each service overhead to the major production department. All the direct labor/machine hourly rates are then calculated. All the costs are allocated to various individual departments and it’s assumed that the overhead costs relate directly and precisely to the level of production. The major problem with this concept is that the allocation or the apportionment of the costs is done arbitrary and may not give an accurate view of the activities which are responsible for the costs. A certain product or an activity may show a big loss just because the method used to allocate the costs have changed. Absorption costing is time consuming and requires a lot of concentration and energy to determine and implement an accurate basis of overall overhead allocation and eventual apportionment. However, this process of allocation may interfere with the major causes for all of these costs. Traditional costing concepts separate and split costs between fixed and variable. The time scales that are relevant and applicable to most major projects make this method of costing unsuitable and redundant. Costs should be classified in terms of short or long run since most strategic decisions are meant to cover between three to five years during which period some costs turn and become variable.(Garrison, Noreen, Brewer, 2009)
Prepare a contribution margin (behavioral, variable) income statement for Herrestad Company, compare net operating profit from a contribution margin income statement with net income from an absorption income statement, and explain why this difference happens.
Absorption income statementFor the period ending Dec 31st 2011.Sales2000000cost of goods sold1600000GP400000Selling n adm exp180000Net income220000Contribution income statement Sales2000000Variable costlabor400000Material800000Variable cost o/h240000variable cost selling n adm80000Closing stock 200000cost of sales1720000Contribution280000Fixed man o/h200000Fixed selling100000Net loss-20000
The differences between the two income statements is that the absorption income statement has a positive net income of 220000 where as the contribution income statement has a Net loss of 20000. This has occurred because of the valuation of the cost of sales and the contribution margin.
Prepare a second version assuming the selling price per unit increases to $270 per unit.
Selling price increases to 270Absorption income statementFor the period ending Dec 31st 2011.Sales2160000cost of goods sold1600000GP560000Selling n adm exp180000Net income380000Contribution income statementSales2160000Variable costlabor400000Material800000Variable cost o/h240000variable cost selling n adm80000Closing stock 200000cost of sales1720000Contribution440000Fixed man o/h200000Fixed selling100000Net loss140000
Determine the number of units the company must sell to break even for the year?Compute break even assuming direct materials cost increase from $100 to $130, but all information remains the same.
Determination of the cost of sales and the contribution
Materials @ 100Materials @ 130Closing stock under absorption costing Variable cost + part of fixed costs.200000...