Absorption costing vs variable discussion Flashcards
The managing director is correct in his interpretation of the results. Sales were 11 000 units higher in
the second six months , which translates to a 55% increase. He is however wrong in his estimates of
profit. Firstly he has ignored the fact that fixed costs do not change materially with an increase in production.
In addition, the company adopts an absorption costing system which makes the estimate of profits even
more difficult as changes in inventory levels also have an influence on profits. Increases in closing
inventory increase reported profits as a proportion of fixed overheads are capitalised to closing stock.
The sales of the product that the company manufactures, i.e. perfume, is likely to be cyclical in nature
which is evident by the higher sales in the second quarter. The sales of perfume is likely to spike during
December as this is a popular gift.
Based on the above, I would advise that a variable costing system be adopted for management reporting
purposes. In such a system profits are not affected by changes in inventory levels.
Variables costing systems would not encourage managers to increase production volumes merely to
increase profit and lends inself to C-V-P calculations which are useful for managerial decision making.
The difference between absorption and variable profit is ALWAYS only the increase or decrease in closing stock multiplied by the fixed overhead cost per unit!!!!!
