Chapter 7 - Variable and absorption costing Flashcards
- Identify what distinguishes variable costing from absorption costing
The two method differ in only one conceptual respect: whether fixed manufacturing costs (both direct and indirect) are ‘inventoriable’ costs
Variable costing is a method of stock costing in which all variable manufacturing costs are included as inventoriable costs. All fixed manufacturing costs are excluded from inventoriable costs; they are costs of the period in which they are incurred
Absorption costing is a method of stock costing in which all variable manufacturing costs and all fixed manufacturing costs are included as inventoriable costs.
- Explain how to construct income statements using absorption costing and variable costing
The variable-costing income statement differentiates between fixed and variable costs
It entails the determination of a ‘contribution margin’ which represents sales less variable costs (we refer to this type of income statement as the ‘contribution’ format). The distinction between variable and fixed costs is central to variable costing; the contribution format highlights this distinction. Hence, focussing more on the behaviour of costs.
The absorption-costing income statement calculates a ‘gross margin’ which represents sales less cost of goods sold. The distinction between manufacturing and non-manufacturing costs is central to absorption costing; the gross margin format highlights this distinction
The absorption-costing income statement classifies costs primarily by business function, such as manufacturing and marketing. In contrast, the variable-costing income statement features cost behaviour (variable or fixed) as the basis of classification.
- Explain differences in profit under absorption costing and variable costing
The production-volume variance, which relates to fixed manufacturing overhead, exists only under absorption costing and not under variable costing.
If the stock level increases during an accounting period, variable costing will generally report less operating profit than absorption costing; when the stock level decreases, variable costing will generally report more operating profit than absorption costing.
These differences in operating profit are due solely to moving fixed manufacturing costs into stock as stock increase and out of stock as they decrease.
Explain the effects on sales and production under variable and absorption costing
The period-to-period change in operating profit under variable costing is driven solely by changes in the unit level of sales, given a constant contribution margin per unit (unit sales less unit variable costs).
Under absorption costing, period-to-period change in operating profit is driven by variations in both the unit level of sales and the unit level of production.
Absorption costing enables a manager to increase operating profit in a specific period by increasing the production schedule, even if there is no customer demand for the additional production.
- Explain how absorption costing influences performance evaluation decisions
Undesirable stockbuilding
o Absorption costing enables managers to in the short run increase operating profit by increasing production. Such an increase can increase the costs of doing business without any attendant increase in sales
o A plant manager may switch production to those orders that absorb the highest amount of fixed manufacturing costs, irrespective of the customer demand for these products (called ‘cherry picking’ the production line)
o A plant manager may accept a particular order to increase production even though another plant in the same company is better suited to handle that order
o To meet increased production, a manager may defer maintenance beyond the current accounting period
7.8 What are four ways of reducing the negative aspects associated with using absorption costing to evaluate the performance of a plant manager?
o Changing the accounting system, for instance use variable costing or charge managers who tie up funds in stock
o Change the time period used to evaluate performance (decrease the incentive to take short-run actions that reduce long-term income)
o Careful budgeting and stock planning to reduce management’s freedom to build excess stock
o Including non-financial as well as financial variables in the measures used to evaluate performance
Closing stock in units this period ÷ closing stock in units last period
Sales in units this period ÷ closing stock in units this period
7.9 Which denominator-level concepts emphasise what a plant can supply?
Theoretical capacity (maximum or ideal capacity) is the denominator-level concept that is based on producing at full (peak) efficiency all the time. Does not allow for any plant maintenance or nay interruptions
Practical capacity is the denominator-level concept that reduces theoretical capacity by unavoidable operating interruptions e.g. shut down for holidays, maintenance.
Which denominator-level concepts emphasise what customers demand for products produced by a plant?
Normal utilisation is the denominator-level concept based on the level of capacity utilisation that satisfies average customer demand over several periods. Includes seasonal, cyclical or other trend factors.
Master-budget utilisation is the denominator-level concept based on the expected level of capacity utilisation for the next budget period (typically one year).
These two denominator levels can differ e.g. when an industry has cyclical periods of high or low demand or when management believes that the budgeted production for the coming period is unrepresentative of ‘long-term’ demand
7.10 Name one reason why many companies prefer the master-budget utilisation-level concept rather than the normal utilisation-level concept.
A major reason for choosing master-budget utilisation over normal is the difficulty of forecasting normal utilisation in many industries with long-run cyclical patterns. Similar problem when estimating normal demand
- Explain how the choice of denominator level affects reported operating profit and stock costs
The smaller the denominator level chosen, the higher the fixed manufacturing cost per output unit that is inventoriable
