Question

Application of full costing is widely used by managers as an operational tool. However, it may not always be the optimal method. Define and support 2 specific situations where you believe this is not the case, supporting your position with objective information. Provide a 4-5 paragraph initial response to the question and at least one follow-up posting of 2-3 paragraphs.

Answer 1

Answer:

Please check the explanation below.

Explanation:

Full costing is also known as absorption costing. Under the full costing method, all the costs of production (whether fixed or variable) are included in the product cost and are therefore, allocated to each unit produced during the period. Selling and administrative expenses (whether fixed or variable) are treated as period costs under this method.

A major disadvantage of the full costing method is that it results in higher profit if the volume of production exceeds the volume of sales during the relevant period. It is so because some portion of the fixed cost will get included in the ending inventory. This method, can therefore, be used by managers to inflate profits by showing an increase in production.

Full costing method is generally method for external reporting purposes. For decision making and internal reporting purposes, managers prefer to use variable costing method. Under, variable costing method, fixed expenses (all type) are treated as period costs and are not included in the product costs. Only the variable costs of production are included in producting costs. This method relies on the premise of "Contribution" margin which is commonly used as the basis for decision making in various complex situations/scenarios.

Full costing method will not preferably be used in the following 2 situations:

1) decisions relating to special orders

2) where a make or buy decision is required to be made

In both the above cases, we will have to consider only the relevant costs (which are generally variable in nature) in order to make a decision. For instance, a company operating at 70% of the capacity can accept a special order if the price offered by the customer exceeds the variable cost of producing those units. It is so because the fixed manufacturing costs will have to be incurred by the company irrespective of the fact whether it accepts or rejects the special order.