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(C) Ghanendra Fago( M Phil, MBA) 1
Income Recognition and Reporting: Variable and
Absorption Costing
(C) Ghanendra Fago( M Phil, MBA) 2
Concept of Product Cost The cost of making a product is called product cost. It is also known as manufacturing cost. Product costs are taken for inventory valuation. So product costs are sometimes called inventory cost
as well. Inventorial costs are all costs of product that are
regarded as assets when they are incurred and then become costs of goods sold when the product is sold.
Product cost affects the value of inventory and the profit differs.
Raw material cost is an example of a product cost.
(C) Ghanendra Fago( M Phil, MBA) 3
The costs that are indifferent to the level of production are period cost.
Period costs do not change with the change in production volume.
Rather, these costs are incurred either for sales activity or with the passage of time
Period cost are not taken for inventory valuation. All period costs are deducted from the revenues of the
same period. Office and administrative and department costs, and
marketing department costs are good examples of period costs.
Period Cost
(C) Ghanendra Fago( M Phil, MBA) 4
Under Variable Costing Under Absorption Costing
Product Costs
Direct Material
Direct Labour
Variable Manufacturing Costs
Period Costs
Fixed manufacturing costs
General & administrative costs
Selling & distribution costs
Product Costs
Direct Material
Direct Labour
Variable Manufacturing Costs
Fixed manufacturing Costs
Period Costs
General & Administrative
Costs
Selling & Distribution Costs
(C) Ghanendra Fago( M Phil, MBA) 5
Product Costing
The process of determining cost of production. There two method of determining cost of product for accounting purposes: They are:
(a) Absorption costing and
(b) Variable costing
(C) Ghanendra Fago( M Phil, MBA) 6
Variable Costing It is also called marginal costing, direct costing,
Contribution margin format. Variable costing includes only variable production
costs in product costs. Fixed manufacturing overhead is treated as a period
cost and is charged against income each period. Cost of production is
Direct materials xxxxx
Direct labours xxxxx
Variable overheads xxxxx
Cost of goods manufactured xxxxxx.
(C) Ghanendra Fago( M Phil, MBA) 7
Absorption Costing Also called traditional costing, conventional costing, full
costing It treats all production costs as product costs, regardless of
whether they are variable or fixed. Under this costing, a portion of fixed manufacturing
overhead is allocated to each unit of product. Cost of production includes
Direct materials xxxxxDirect labours xxxxxVariable overheads xxxxxFixed manufacturing overhead xxxxxCost of goods manufactured xxxxx
(C) Ghanendra Fago( M Phil, MBA) 8
INCOME STATEMENT UNDFER VARIABLE COSTING
Particulars Details Amount
Sales revenue (Sales units SPPU)
Less: Variable cost of goods sold:
Direct material @ . . . production units
Direct labour @ . . . production units
Variable Overhead @ . . production units
Total variable manufacturing costs
Add: Opening stock @ . . .
Cost of goods available for sales
Less: Closing stock @ . . .
Variable cost of goods sold
Gross contribution margin
Less: Non-manufacturing variable costs @ . . Sales
Net contribution margin
Less: Fixed costs
Manufacturing
Non-manufacturing
Net Income before tax
(C) Ghanendra Fago( M Phil, MBA) 9
INCOME STATEMENT UNDFER VARIABLE COSTING
Particulars Details Amount
Sales revenue (Sales units SPPU)
Less: Variable cost of goods sold:
Direct material @ . . . production units
Direct labour @ . . . production units
Variable Overhead @ . . . production units
Total variable manufacturing costs
Add: Opening stock @ . . .
Cost of goods available for sales
Less: Closing stock @ . . .
Variable manufacturing cost of goods sold
Add: Non-manufacturing variable costs @ . . . Sales
Total variable costs of sales
Net Contribution margin
Less: Fixed manufacturing cost
Fixed non-manufacturing cost
Net Income before tax
(C) Ghanendra Fago( M Phil, MBA) 10
Absorption Costing Under Income Statement
Particulars Details Amount
Sales revenue (Sales units SPPU)
Less: Manufacturing cost of goods sold:
Direct materials @ . . . production units x
Direct labour @ . . . production units x
Variable overhead @ . . . production units x
Fixed manufacturing overhead @ . production units x
Cost of goods manufactured
Add: Opening stock @ . . . x
Cost of goods available for sale
Less: Closing stock @ . . . x
Cost of goods sold
Gross margin before adjustments xxxxx
Less: Under absorption of fixed manufacturing overhead
Add: Over absorption of fixed manufacturing overhead ()
Gross margin after adjustments
Less: Variable non manufacturing @ . . . X sales
Fixed non manufacturing costs xxxx
Net income before tax
(C) Ghanendra Fago( M Phil, MBA) 11
UNDER/OVER ABSORPTION OF FIXED MANUFACTURING OVERHEAD
Fixed manufacturing cost is considered as constant cost which is unaffected due
to change into production units.
The increase or decrease in production volume does not affect the total fixed cost.
Thus, fixed manufacturing overhead is allocated to product cost based on normal
level activities.
It is determined on the basis of normal capacity level of production.
The differences between normal capacity and actual production create over
absorption or under absorption of fixed manufacturing overhead.
Installed capacity - Maximum units that can be produced
Normal capacity - Average production level
Actual capacity - Actual production
Fixed overhead per unit = Fixed overhead/Normal capacity
Capacity Concepts
(C) Ghanendra Fago( M Phil, MBA) 12
Reconciliation Statement
Particulars Details Difference
Net profit as per variable costing xxxxxxx
Less: Net profit as per absorption costing xxxxxxx
DIFFERENCE IN PROFIT Xxxxxx
Opening stock in units xxxxxxx
Less: Closing stock in units xxxxxxx
Difference in stock xxxxxx
Fixed manufacturing cost per unit xxx
DIFFERENCE IN PROFIT(DIFF. STOCK X FIXED COST PER UNIT)
xxxxx
(C) Ghanendra Fago( M Phil, MBA) 13
Absorption Vs Variable Costing 1. Production Equals Sale
When production equals sales, inventories do not
change.
If inventories do not change, then there is no change in
the fixed manufacturing overhead costs in inventories
under absorption costing.
Therefore, under both costing methods all of the current
fixed manufacturing overhead will flow through to the
income statement as an expense.
In the case of absorption costing it will be part of cost of
goods sold. In the case of variable costing, it will be a
period expense.
(C) Ghanendra Fago( M Phil, MBA) 14
2. Production Exceeds Sales (Inventories Increase)
• When production exceeds sales, inventories grow.
• If inventories grow, then some of the current fixed
manufacturing overhead costs will be deferred in
inventories under absorption costing.
• Since all of the current fixed manufacturing overhead
costs are expensed under variable costing, the net
operating income reported under absorption costing
will be greater than the net operating income reported
under variable costing.
(C) Ghanendra Fago( M Phil, MBA) 15
Sales Exceed Production (Inventories Decrease) When sales exceed production, inventories shrink.
If inventories decrease, then some of the fixed
manufacturing overhead costs that had been deferred in
inventories in previous periods will be released to the
income statement as part of cost of goods sold as well as all
of the current fixed manufacturing overhead costs.
Since only the current fixed manufacturing overhead costs
are expensed under variable costing, the net operating
income reported under absorption costing will be less than
the net operating income reported under variable costing.
(C) Ghanendra Fago( M Phil, MBA) 16
Long-term Differences In Income Over an extended period of time, the cumulative net operating
income figures reported under absorption costing and variable costing will be about the same.
They will differ only by the amount of fixed manufacturing overhead cost in ending inventories under absorption costing.
Cumulative net operating income figures will be identical whenever ending inventories are reduced to zero
Changes In Production Volume Variable costing net operating income is not affected by
changes in production volume. On the other hand, absorption costing net operating income is
affected by changes in production volume. For any given level of sales, net operating income under
absorption costing will increase as the level of output increases and hence inventories increase.
(C) Ghanendra Fago( M Phil, MBA) 17
Use of Absorption Vs. Variable costing
Accountants and managers have been arguing for decades concerning the relative merits of absorption and variable costing. In practice, absorption costing is used far more than variable costing even for internal reports. The reasons for this are not entirely clear, although the perception that absorption costing is required for external reporting undoubtedly plays a key role.
Argument for absorption costing Advocates of absorption costing argue that all manufacturing
costs must be assigned to units of product so as to properly match costs with revenues.
They argue that fixed manufacturing overhead costs are essential to the production process and must be included when costing units of product, regardless of how the cost behaves.
(C) Ghanendra Fago( M Phil, MBA) 18
Argument for Variable Costing
Advocates of variable costing argue that fixed manufacturing
overhead costs are incurred in order to have the capacity to
produce. Moreover, they will be incurred regardless of whether
anything is actually produced. Since these costs are not caused
by any particular unit of product and are incurred to provide
capacity for a particular period, the matching principle would
dictate that fixed manufacturing overhead costs must be
expensed in the current period.
(C) Ghanendra Fago( M Phil, MBA) 19
Advantages of Variable CostingMore useful for CVP analysis. Variable costing statements provide
data that are immediately useful for CVP analysis since they
categorize costs on the basis of their behavior. In contrast, it is often
difficult to rework absorption costing data so that they can be used
in CVP analysis and in decisions.
Income is not affected by changes in production volume. Under
absorption costing, reported net operating income is affected by
changes in production since fixed costs are spread across more or
fewer units. This can distort income and may even result in income
moving in an opposite direction from sales. This does not occur
under variable costing.
(C) Ghanendra Fago( M Phil, MBA) 20
Avoids misunderstandings concerning unit product costs.
Absorption costing unit product costs can be easily misinterpreted as
variable costs since they are stated on a per unit basis. Such a
misperception can lead to serious errors in making decisions. Variable
costing avoids this problem since unit costs include only variable costs.
Fixed costs are more visible. The impact of fixed costs on profits is
emphasized because the total amount of such costs for the period
appears separately and is highlighted in the income statement rather
than being buried in cost of goods sold and ending inventory.
Understandability. Managers should find it easier to understand
variable costing reports because data are organized by behavior and
because variable costing is much closer to cash flow.
Facilitates in Control:. Variable costing ties in with cost control methods
such as flexible budgets.
(C) Ghanendra Fago( M Phil, MBA) 21
CASE 1: The Directorium Manufacturing Company produced: 80,000 units of new products during 1990 and sold 60,000 units at Rs. 50 each. The cost for 1990 were as follows: Direct materials Rs.200,000Direct labour Rs.160,000Variable Manufacturing Overhead Rs.320,000Fixed Manufacturing overhead Rs.440,000V. Selling/administrative expenses Rs.80,000F. Selling and administrative expensesRs. 280,000There was no ending work in process inventory.Required: a) Income statements for the year 1990 using (i) direct costing method (ii) Absorption costing methodb) Give the reasons for differences in reported net income or net loss in requirement a (i) and a (ii).
(C) Ghanendra Fago( M Phil, MBA) 22
Income Statement Under Contribution Margin ApproachParticulars Amount Amount
Sales revenue @ Rs.50 each Rs.3,000,000
Less: Variable manufacturing cost of goods sold:
Direct materials @ 2.5 each 200,000
Direct labour @ 2 each 160,000
Variable manufacturing overhead @ 4 each 320,000
Total variable manufacturing costs 680,000
Add: Opening stock @ 8.5 each Nil
Cost of goods available for sales 680,000
Less: Closing stock @ 8.5 each (20,000 units) 170,000 510,000
Gross contribution margin 2,490,000
Less: Variable selling and administrative 80,000
Net contribution margin 2,410,000
Less: Fixed costs:
Manufacturing 440,000
Selling and administrative 280,000 720,000
Net income 1,690,000
(C) Ghanendra Fago( M Phil, MBA) 23
Income Statement Under Absorption CostingParticulars Amount Amount
Sales revenue @ Rs.50 each Rs.3000,000
Less: Manufacturing cost of goods sold:
Direct materials @ 2.5 each 200,000
Direct labour @ 2 each 160,000
Variable manufacturing overhead @ 4 each 320,000
Fixed manufacturing overhead @ 5.5 each 440,000
Total manufacturing costs 11,20,000
Add: Opening stock @ 14 each Nil
1120,000
Less: Closing stock @ 14 each 280,000 840,000
Gross margin 21,60,000
Less: Non-manufacturing costs:
Variable selling and administrative expenses 80,000
Fixed selling and administrative expenses 280,000 360,000
Net income 1800,000
(C) Ghanendra Fago( M Phil, MBA) 24
Reconciliation Statement
Particulars Details Difference
Net profit as per variable costing 16,90,000
Less: Net profit as per absorption costing 18,00,000
Difference in profit 110,000
Opening stock in units 0
Less: Closing stock in units 20,000
Difference in stock 20,000
Fixed manufacturing cost per unit 5.5
Difference in profit (Diff. stock x fixed cost per unit) 110,000
(C) Ghanendra Fago( M Phil, MBA) 25
Assignment I
Even question numbers for EVEN ROLL NUMBERS
Uneven question numbers for UNEVEN ROLL NUMBERS
Submission Within one week from the date of completion of chapter