Variable Costing versus Absorption Costing within The Irish Defence Forces





Variable Costing versus Absorption Costing within The Irish Defence Forces

Forward, although the Defence Forces is a non profit/sales organisation it does maintain strict budget control measures and strives to minimise loss and waste of funds. The national expenditure on Defence is low in comparison to other government departments. This means that cost control and monitoring are crucial to the efficient running of the organisation. The objective of cost analysis for the forces is the same as any profit orientated business, to keep losses to a minimum, costs to a reasonable level and raise productivity, Thus constantly improving the operational ability of the Defence Forces and in particular The Army Corps of Engineers.

the use of Variable Costing in the Army Corps of Engineers

This report has been prepared following an examination of the present costing system employed within the Corps of Engineers of the Defence Forces. Currently the organisation uses absorption costing, and there is some concern that the operational expenditure could be and estimated losses could be accurately represented by using variable costing. This assignment will examine the difference between absorption costing and variable costing, list the main arguments put forward in support of both methods and explain the impact on expenditure of using absorption costing as oppose to variable costing.

Absorption costing refers to a system in which all the fixed production overheads are allocated to products. Product costs then comprise, direct materials, direct labour, direct expenses, variable production overhead and an allocation of fixed production overheads. Variable costing maybe described as marginal costing or direct costing and refers to a system in which only variable production costs are assigned to products. Product costs comprise direct materials, direct labour, direct expenses and variable production overheads. Fixed production overheads are considered to be period costs and are not charged to products.

The existing system of absorption costing had the following arguments for it.

o Absorption costing does not understate the importance of fixed costs. The allocation of fixed operational costs to operations or missions recognises that sufficient revenue must be generated to cover fixed costs in the long run.
o Absorption costing avoids fictitious losses being reported. Absorption costing defers fixed overheads by including them in the stock evaluation. These fixed overheads are only recorded as an expense when operations or jobs are carried out by the Corps. This in contrast to a variable costing system which includes fixed overheads in the period in which they are incurred and if the sales are lower than the operation or job output may result in fictitious losses.
o Absorption costing is in theory superior to variable costing. Theory suggests that the fixed operational costs are just as much expended in the execution of jobs and missions as variable operational costs and consequently all costs expended in the operation should be charged to the job or mission completed.
o Absorption costing is based on the revenue production concept. This concept assumes that any cost essential in the completion of a job or operation of the Corps that may reasonably be expected to be used represents a cost of obtaining revenue in benefit to the operation of the Defence Forces. Hence these costs should be deferred and included in the stock valuation so that they may be matched with the revenue in calculating profit for the period of usage.
The arguments in support of marginal costing are as follows.

o Marginal costing provides more useful information for decision making. Marginal costing separates variable and fixed operational costs. It facilitates projection of future costs and revenues for different activity levels and the use of relevant cost decision making techniques. Relevant costs are required for a variety of short term decisions e.g. whether to carry out a job internally from the Corps resources or to contract it out.
o Marginal costing removes the effect of stock changes on the Corps productivity and efficiency. Where stock levels are likely to fluctuate significantly, figures for the production may be distorted when they are calculated on an absorption basis, since the stock changes will considerably affect the amount of fixed operation overhead charged to an accounting period. This is not the case with the marginal costing as fixed operational overheads are not