ACCT312

Week 2

Cost

management

systems

1

Variable

costing Absorption

costing

2

Cos measurement

systems

Process Job

Variable Absorption

Actual

Normal

Standard

Variable Absorption

Actual

Standard

Actual

Normal

Standard

Actual

Standard

Normal Normal

3

TOTAL COSTS

Manufacturing Non Manufacturing

Variable

Direct Costs

D. Materials

D. Labour

Sub-

contracts

Indirect Costs

Electricity

Indirect

materials

Variable Sales

and

Distribution

Commissions

Fuel

Variable

Admin

Telecommuni-

cations

Stationery

Fixed

Fixed Indirect

Costs

Rent

Depreciation

Supervisory

salaries

Security

Fixed Sales

and

Distribution

Rent

Depreciation

Salaries

Advertising

Fixed Admin

Rent

Depreciation

Salaries

Absorption Costing (Period Costs) 4

Absorption and variable costing

1. Absorption costing (also known as full costing)

traces/allocates variable and fixed manufacturing costs

to products and treats non-manufacturing overheads as

a period cost.

2. Variable costing (also known as marginal costing)

traces/allocates variable manufacturing costs to

products and treats fixed manufacturing overheads and

non-manufacturing overheads as a period cost.

3. Therefore variable and absorption costing differ only in

the treatment of fixed manufacturing overheads.

5

Absorption and variable costing

6

Costing Comparison

• Variable costing is a method of inventory costing in

which only variable manufacturing costs are included

as inventoriable costs

• Absorption costing is a method of inventory costing

in which all variable manufacturing costs and all

fixed manufacturing costs are included as

inventoriable costs

• Throughput Costing is a modified variable costing –

only Direct Materials are capitalized; all other costs

are expensed

7

Differences in Income

• Operating Income will differ between Absorption and

Variable Costing

• The amount of the difference represents the amount

of Fixed Product Costs capitalized as Inventory under

Absorption costing, and expensed as a period costs

under Variable Costing

8

Comparative Income Effects

Variable Costing Absorption Costing

Are fixed product

costs inventoried?

No

Yes

Is there a

production-volume-

variance?

No

Yes

9

Profit comparisons

• Profits are the same for both methods when production equals

sales (and there are no changes in stock levels)

• Where production exceeds sales (increasing stock levels) the

absorption costing system produces higher profits

• Where sales exceed production (declining stock levels) the

variable costing system produces higher profits

10

Comparative Income Effects

Variable Costing Absorption Costing

How do changes in

unit inventory affect

operating income

if…?

Production = Sales Equal Equal

Production > Sales Lower Higher

Production < Sales Higher Lower

11

Comparative Income Effects

Variable Costing Absorption Costing

What are the

effects on cost-

volume-profit (for a

given level of fixed

costs and a given

contribution margin

per unit?

Driven by:

unit level

of sales

Driven by:

1. Unit level of

sales

2. Unit level of

production

3. Chosen

denominator

level

12

Cos measurement

systems

Both Process

and job costing Variable

Absorption

Actual Normal

Standard

Actual

Standard

Normal

13

Variable and absorption costing, explaining operating-income

differences

Nascar Motors assembles and sells motor vehicles and uses

standard costing. Actual data relating to April and May 2008 are:

Exercise 9-16

14

The selling price per vehicle is $24,000.

The budgeted level of production used to calculate

the budgeted fixed manufacturing cost is for 500

units per period (month).

So, what is the fixed manufacturing rate per unit?

$2,000,000/500= $4,000

There are no price, efficiency, or spending variances.

Any production-volume variance is written off to cost

of goods sold in the month in which it occurs.

The following information is available:

15

1. Prepare April and May 2008 income

statements for Nascar Motors under:

(a) variable costing

(b) absorption costing

16

(a) variable costing

17

(b) absorption costing

18

2. Prepare a numerical reconciliation and explanation of

the difference between operating income for each month

under variable costing and absorption costing.

The difference between absorption and variable costing is due solely to

moving fixed manufacturing costs into inventories as inventories increase (as

in April) and out of inventories as they decrease (as in May).

19

Extreme Variable Costing:

Throughput Costing

• Throughput costing (super-variable costing) is a

method of inventory costing in which only direct

material costs are included as inventory costs. All

other product costs are treated as operating expenses

20

Throughput Costing Illustrated

21

Exercise 9-18

Variable and absorption costing, explaining operating-

income differences

BigScreen Corporation manufactures and sells 50-inch

television sets and uses standard costing.

The selling price per unit is $2,500.

The budgeted level of production used to calculate the

budgeted fixed manufacturing cost per unit is 1,000

units.

There are no price, efficiency, or spending variances.

Any production-volume variance is written off to cost

of goods sold in the month in which it occurs.

22

Actual data relating to January, February, and

March of 2009 are:

23

Prepare income statements for BigScreen in

January, February, and March of 2009 under

(a) variable costing and

(b) considering the changes in beginning and

ending inventories calculate expected income

under absorption costing (no income statement

is required)

24

(a) variable costing

25

(b) considering the changes in beginning and endi

ng inventories, calculate expected income under a

bsorption costing (no income statement is require

Income under absorption costing =Income under variable costing +(net change (+-) in inventories × fixed manufacturing overhead rate

January: $160,000+ (300 -0)× $400) = $280,000

February: $260,000 +(300 - 300) × $400 = $260,000

March: $960,000 +(50-300)× $400 =$860,000

26

Costing Systems Compared

27

Comparison of Alternative Inventory

Costing Systems

• Variable Direct Manufacturing Cost for both methods

Actual Costing Normal Costing Standard Costing

Actual Prices

X

Actual Quantity

of inputs used

Actual Prices

X

Actual Quantity

of inputs used

Standard prices

X

Standard Quantity

of inputs allowed

for actual output

achieved

28

Comparison of Alternative Inventory

Costing Systems

• Variable Indirect Manufacturing Cost for both methods

Actual Costing Normal Costing Standard Costing

Actual variable

indirect rates

X

Actual quantity of

cost-allocation

bases used

Budgeted variable

indirect rates

X

Actual quantity of

cost-allocation

bases used

Standard variable

indirect rates

X

Standard quantity of

cost-allocation

bases allowed for

actual output

achieved

29

Comparison of Alternative Inventory

Costing Systems

• Fixed Direct Manufacturing Cost only for absorption costing

• Not very common (usually all fixed costs are considered

as indirect

Actual Costing Normal Costing Standard Costing

Actual prices

X

Actual quantity

of inputs used

Actual prices

X

Actual quantity

of inputs used

Standard prices

X

Standard quantity

of inputs allowed

for actual output

achieved

30

Comparison of Alternative Inventory

Costing Systems

• Fixed Indirect Manufacturing Cost only for absorption

costing

Actual Costing Normal Costing Standard Costing

Actual fixed

indirect rates

X

Actual quantity

of cost-allocation

bases used

Budgeted fixed

indirect rates

X

Actual quantity

of cost-allocation

bases used

Standard fixed

indirect rates

X

Standard quantity

of cost-allocation

bases allowed for

actual output

achieved

31

Comparison of Alternative Inventory

Costing Systems

• Except actual costing, there could be over or under

applied when using overhead rates

32

Performance Issues and Absorption

Costing

• Managers may seek to manipulate income by producing too many units

• Production beyond demand will increase the amount of inventory on hand

• This will result in more fixed costs being capitalized as inventory

• That will leave a smaller amount of fixed costs to be expensed during the period

• Profit increases, and potentially so does a manger’s bonus

33

Inventories and Costing Methods

• One way to prevent the unnecessary buildup of

inventory for bonus purposes is to base manager’s

bonuses on profit calculated using Variable Costing

• Drawback: complicated system of producing two

inventory figures – one for external reporting and the

other for bonus calculations

34

Other Manipulation Schemes Beyond

Simple Overproduction

• Deciding to manufacture products that absorb the

highest amount of fixed costs, regardless of demand

(“cherry-picking”)

• Accepting an order to increase production, even

though another plant in the same firm is better suited

to handle that order

• Deferring maintenance

35

Management Countermeasures for Fixed

Cost Manipulation Schemes

• Careful budgeting and inventory planning

• Incorporate an internal carrying charge for inventory

• Change (lengthen) the period used to evaluate performance (e.g. 3 years or more)

• Include nonfinancial as well as financial variables in the measures to evaluate performance

36

Exercise 9-21

Absorption and variable costing

Osawa, Inc., planned and actually manufactured 200,000 units of

its single product in 2009, its first year of operation.

Variable manufacturing cost was $20 per unit produced.

Variable operating (non-manufacturing) cost was $10 per unit

sold.

Planned and actual fixed manufacturing costs were $600,000.

Planned and actual fixed operating (non-manufacturing) costs

totaled $400,000.

Osawa sold 120,000 units of product at $40 per unit.

37

1. Osawa’s 2009 operating income using

absorption costing is:

(a) $440,000

(b) $200,000

(c) $600,000

(d) $840,000

(e) none of these

38

Answer: (a)

39

2. Osawa’s 2009 operating income using

variable costing is:

(a) $800,000

(b) $440,000

(c) $200,000

(d) $600,000

(e) none of these

40

Answer: (c)

41

Which method?

• Some arguments in support of variable costing

– Variable costing provides more useful information for decision-

making

– Variable costing removes from profit the effect of stock

changes

– Variable costing avoids fixed overheads being capitalized in

unsaleable stocks

• Some arguments in support of absorption costing

– Absorption Costing does not understate the importance of fixed

costs

– Revenue Production Concept favours absorption costing

– Consistency with external reporting

42