Group 4
Direct Materials
Direct Labor
Variable Manufacturing Overhead
Fixed Manufacturing Overhead
Variable Selling and Administrative Expenses
Fixed Selling and Administrative Expenses
VariableCosting
AbsorptionCosting
ProductCosts
PeriodCosts
ProductCosts
PeriodCosts
Source: Managerial Accounting /Garrison-Noreen-Brewer/McGraw-Hill International Edition
Variable costing income statements are easier to understand because net operating
income is only affected by changes in unit sales. Thisproduces net operating income figures that aremore consistent with managers’ expectations.
Variable costing income statements are easier to understand because net operating
income is only affected by changes in unit sales. Thisproduces net operating income figures that aremore consistent with managers’ expectations.
Source: Managerial Accounting /Garrison-Noreen-Brewer/McGraw-Hill International Edition
CVP Analysis, Decision Makingand Variable Costing Variable Costing harmonizes well with CVP
analysis because it essentially treats fixed manufacturing overhead as a period cost.
Treating fixed manufacturing overhead as a variable cost can:
• Lead to faulty pricing decisions and keep-or-drop decisions.
• Produce a higher net operating income compared to variable costing
Treating fixed manufacturing overhead as a variable cost can:
• Lead to faulty pricing decisions and keep-or-drop decisions.
• Produce a higher net operating income compared to variable costing
Source: Managerial Accounting /Garrison-Noreen-Brewer/McGraw-Hill International Edition
Advantages
Management findsit more useful.
Consistent withCVP analysis.
Net operating income is closer to
net cash flow.
Profit is not affected bychanges in inventories.
Consistent with standardcosts and flexible budgeting.
Impact of fixedcosts on profitsemphasized.
Easier to estimate profitabilityof products and segments.
Source: Managerial Accounting /Garrison-Noreen-Brewer/McGraw-Hill International Edition
DISADVANTAGES OF VARIABLE COSTING
DISADVANTAGES
Inconsistent with the Tax regulation and GAAP requirements
Inconsistent with how executives are evaluated by investors
understated inventory - lower net operating income
Overheads that are essential to producing a product do not form part of the product cost
Under Absorption Costing
To conform toTo conform toGAAP requirements,GAAP requirements,
absorption costing must be used forabsorption costing must be used forexternal financial reports in theexternal financial reports in the
United States. United States.
To conform toTo conform toGAAP requirements,GAAP requirements,
absorption costing must be used forabsorption costing must be used forexternal financial reports in theexternal financial reports in the
United States. United States.Under the Tax
Reform Act of 1986,absorption costing must be
used when filling out income tax returns.
Under the TaxReform Act of 1986,
absorption costing must beused when filling out income tax returns.Since top executives
are typically evaluated based on earnings reported to shareholders
in external reports, they may feel that decisions should be based on
absorption costing data.
Since top executivesare typically evaluated based on
earnings reported to shareholdersin external reports, they may feel that
decisions should be based on absorption costing data.
Source: Managerial Accounting /Garrison-Noreen-Brewer/McGraw-Hill International Edition
IFRS # 2 InventoriesInternational Accounting Standard (IAS) 2
Inventories...The cost of inventories shall comprise all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition
Sources : Wiley IFRS 2008 : Interpretation and Application of International Financial Reporting Standards - Barry J. Epstein, Eva K. Jermakowicz and IAS 2 Inventories
US Treasury Reg section 1.263A-1T
Also known as Uniform Capitalization (UNICAP)Itemizes the direct and indirect costs that must be
capitalized. Direct materials, direct labor, and certain types of overhead costs are required to be capitalized. In the regulations, overhead costs have typically been placed into three categories.
Under pre-1986 Act law, "category I" costs were capitalized; "category II" costs were expended; and "category III" costs were capitalized for tax purposes if they were capitalized for financial reporting purposes.
Under the new law, all category I and category III costs (except the costs of strikes and idle time) and certain types of category II costs must be capitalized.
UNICAP Summary
IRS.GOV - http://www.irs.gov/businesses/small/industries/article/0,,id=97675,00.html
Absorption CostingAdvantages DisadvantagesWidely accepted – method
used for external reporting
Recognises the importance of fixed costs in production
Stock is not undervalued – ensures that costs are fully recovered
Identifies the profitability of different products and services
Not useful for management to use to make decisions, planning and control
Portion of fixed cost is carried over to subsequent period as part of closing stock
Hard to distinguish between variable and fixed cost
Net profit varies with sales and stock values – variability of profit will cause confusion
Cost per unit changes from period to period due to existence of fixed overhead
Cost BehaviourAbsorption
CostingVariable Costing
Cost of Good Sold High Low
Ending Inventories High Low
Gross Margin Low High
Net Operating Income High Low
Normal Corporate Income Taxes
High Low
Minimum Corporate Income Tax Low High
Unit Cost High Low
Break Even Point Low High
Bridging the GAP for Labor CostsFixed Variable
Paid by result or per piece
X
Paid on daily / weekly or monthly without quota
X
Paid on daily / weekly or monthly, with overtime premiums , without quota
X X
Paid on daily / weekly or monthly - with quota
X
Paid on daily / weekly or monthly, with overtime premiums, with quota
X X
In a JIT inventory system . . .
Productiontends to equal
sales . . .
So, the difference between variable andabsorption income tends to be minimal or zero.
Source: Managerial Accounting /Garrison-Noreen-Brewer/McGraw-Hill International Edition
Source: Managerial Accounting /Garrison-Noreen-Brewer/McGraw-Hill International Edition
Impact on Lean ProductionThe difference in net operating income between
absorption and variable costing occur because of the changes in the number of units in the inventory. Under Lean Production, goods are produced to customers’ orders and the goal is to eliminate finished goods inventories entirely and reduce work-in-process almost entirely, thus, the differences in net operating income will be very minimal.
Just-in-time production
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