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How important is it to trace costs appropriately? Explain.

As you are beginning to think about the importance of tracing costs appropriately, please consider the differences between variable costing and absorption costing. What implications does each of these have on such things as financial reporting of profit and pricing your products for the marketplace?

You may also want to think about the issues involved with traceable costs as discussed in our text or in articles that you may find online.

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It's crucial to follow costs just as they are to maintain reliable financial reports, help people make informed decisions, and ensure pricing strategies represent the actual business costs. Good cost tracing allows you to home in on direct and indirect costs linked to what you produce. That way, you can be assured that each product or service bears its fair share of costs. It also opens the door for using cost information in various ways, especially when moving between the two primary cost accounting methods, variable and absorption costing.

Under variable costing, the only costs that are charged against income to arrive at the amount of the net operating income are the variable costs. Every cost that does not behave as a variable must be covered in the period incurred. This is beneficial for internal decision-making because it clarifies which costs of producing a product vary with the production level and which costs are fixed and should be expensed as incurred. Also, because this method is not in conformity with generally accepted accounting principles, it provides no appearance of being a basis for external reporting, which is beneficial for internal management when using the method because it eliminates any incentive for an external appearance to be good.

Conversely, absorption costing is preferred for determining the cost of goods sold because it is more comprehensive. It includes both variable and fixed manufacturing costs. Fixed costs do not vary with production levels. Generally Accepted Accounting Principles (GAAP) dictate that external financial statements must use this method. Auditors always point out in lecture notes that public corporations must follow GAAP. Therefore, they use absorption costing for external reporting. But this method has funny consequences. For example, under it, costs capitalized in inventory directly inflate net income when inventories increase. Thus, using absorption costing can cre-ate a false impression of greater profitability.

These pricing strategies derive from how costs are assigned to products, and they have significant effects on the kinds of prices that are charged. The incremental cost information from variable costing is more helpful in setting prices in competitive markets. Managers can use the information to understand how much more it will cost to produce a certain number of units. In contrast, absorption costing may permit or may even encourage overpricing. This is particularly true if it is assumed that all fixed costs have been spread across a certain number of units and that no price is charged, which might encourage the manager to produce more units.

Product profitability can also be critically affected by traceable costs. Direct costs, such as labor and materials, are easy to follow to a product, whereas indirect costs, like facility expenses, often require allocation methods that seem almost alchemical. If too many costs are alchemized to a product, the risk is that product profitability will appear to be distorted. Conversely, we risk overestimating product profitability if too few costs are allocated to a product.