How Do You Increase Net Operating Income Without Increasing Sales Under Absorption Costing?

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Absorption costing is a cost accounting method that allocates the costs for direct materials, direct labor and overhead to products. Generally accepted accounting principles prefer this method for reporting product costs. Companies looking to increase their operating profit need to reduce these costs in the absence of higher sales. In reality, lowering costs or increasing sales are the only two ways to improve a company's profitability. Cost accounting can provide a plethora of information for reducing production costs.

  • Discuss the budget with production supervisors. Request input on how the company can reduce production costs.

  • Create a budget for all production costs. Review historical production periods to determine the normal expenditures to produce goods.

  • Compare actual production costs against budgeted costs. Look for unfavorable variances where the department spent more money for producing goods.

  • Identify the specific reasons for the cost overruns. These should be direct materials, labor or manufacturing overhead.

  • Correct the cost overruns by finding cheaper resources. Another option is to update production processes that produce less waste or increase the production output of employees.

  • Change cost accounting methods. A review of the current cost accounting system may result in activity-based costing providing more accurate --- and lower --- allocated production costs than standard costing.

Tips & Warnings

  • Cost accounting methods are highly customizable. Companies typically have the freedom to change or alter allocation methods to ensure the best possible internal reporting process. Any activity or change that lowers productions costs may be a plausible way to improve operating profit margins.

References

  • "Cost Management: Strategies for Business Decisions"; Ronald Hilton, et al.; 2006
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