Absorption and Variable costing Flashcards
what are absorption and variable costing two types of?
Ways that firms report profits
How does the choice of absorption or variable costing differ between financial and management accounting?
• Financial: must take full costing approach so uses absorption
• Management: Choice between either method depending on which is most appropriate
-variable for planning and decision making
-absorption better for pricing and stock valuation
• Argument over which is better &treatment of indirect items
What will potentially differ depending on which method you choose?
One or the other will produce different profits if production and revenue don’t match
What will be assigned to product costs and period costs for absorption costing?
Product: • Direct materials • Direct labour • Variable mfg. OH • Fixed mfg. OH Note: first 3 also done by variable costing Period: • Selling and admin costs
What will be assigned to product costs and period costs for variable costing?
Product: • Direct materials • Direct labour • Variable mfg. OH Period • Fixed mfg. OH i.e. keep as complete amount and right off at the end of the period • Selling and admin costs
Explain the process of absorption costing
- Costs split into manufacturing and non-manufacturing costs
- Manufacturing costs split into dir. material, dir. labour and MOHs
- these are assigned to WIP stock and then finished stock & once sold put in P&L
- Non-manufacturing costs straight to P&L
Explain the process of variable costing
- Costs split into manufacturing and non-manufacturing costs
- Manufacturing costs split into dir. material, dir. labour and MOHs
- MOHs then split into variable and fixed
- direct material/labour & VMOH assigned to WIP stock then finished goods then SOPL
- FMOH go straight into SOPL
What is the layout of the absorption P&L statement?
- Very similar to SOPL in annual report
- Revenue less cost of goods sold to get gross margin
- Less selling and admin expenses (variable and fixed)
- When production is greater than revenue ending stock carriers proportion of the fixed MOHs onto the next period
What is the calculation for the cost of good sold
• Beginning stock
Add COGM (units produced X per unit cost) to get goods available for sale
• minus closing stock (units left X per unit cost)
note: variable costing usually has lower per unit cost
What is the layout of the variable P&L statement?
- statement divided into variable expenses and fixed expenses
- Deducting variable expenses from revenue gives a contribution margin
- Fixed expenses then deducted to give net profit
- Net profit usually lower as all MOH costs have been deducted & not carried over to the next period
What accounting principles are used as the reasoning for variable costing?
- Objectivity-not dividing MOH costs which is more subjective
- Prudence- reflecting complete amount of MOH in a statement as those MOH likely to spend in that period
What accounting principles are used as the reasoning for absorption costing?
- Accruals/matching principle-including parts of MOH in each product in order to properly match cost to benefit
- Prudence-need to fully value stock and variable costing is undervaluing
- Argument that splitting costs into variable and fixed is subjective too as it requires discretion from accountants
What is reconciliation?
- Allows any
- Shows why there is a difference between the net profit in absorption vs variable statements
- Difference due to the stock not sold- so to reconcile MOH costs per unit should be multiplied by the stock leftover and added to the variable net profit
What may happen in different financial years?
The per-unit cost may change
How does the relationship between production and sales impact which P&L statement will have higher profits?
- When production>sales= Absorption profit>variable profit
* When production
What are the advantages of variable costing?
- Management finds it easy to understand
- Consistent with CVP analysis
- Net profit is closer to net cash flow
- Consistent with standard costs and flexible budgeting
- Easier to estimate profitability of products and segments
- Profit is not affected by changes in stock, only sales
- Impact of fixed costs on profits emphasised
What are the arguments against variable costing?
•Fixed production costs are incurred in the production of output- It is fair to charge all output with a share of these costs
• Charging only variable costs makes it difficult to assess if a product is profitable or not (IF)
• Product pricing can be a challenge (IF)
-(IF) =fixed manufacturing overhead are a high proportion of total costs
What is the impact of just-in-time (JIT) stock methods?
Production tends to equal sales in this method so, the difference between variable and absorption profit tends to disappear
What are the benefits of absorption?
• Good for multi-products to assess profitability if not all products are sold and on a item by item basis
What is ‘normal activity’?
Production average over the last 3 years
