L4 - Absorption and Variable Costing Flashcards
What is the difference between absorption and variable costs?
absorption costing would ration a proportion of the indirect fixed costs to say a long car journey e.g. car payment, insurance, Road tax
Variable costing classes these as period costs at the end of the period and doesn’t assign this to each separate car journey, and instead subtract the full about from the year
How does absorption costing systems allocate costs of the profit and loss account?
How does variable costing systems allocate costs of the profit and loss account?
What are the stages for compiling the income statement?
- Unit Product Cost computations
- Absorption costing will always be higher due to the spread of manufacturing costs
- Selling and administrative expenses are ALWAYS treated as period expenses and deducted from revenue
What are the arguments for the use of the absorption costing system?
- use the matching principle, so you match against the sales revenue the cost of generating that revenue –> thus you should include a proportion of the fixed costs to the stock they helped create –> properly match revenue and costs
- Depr
- Variable costing advocates argue prudence whereas those who use absorption costing using should fully value stock and the variable costing system is actually full prudent as it doesn’t take into account the fact some of the good made are not sold in that period but overhead are still accounted for –> Variable costing system underestimating the stock
- Also argue that splitting variable and fixed costs is not a clean-cut matter so management accounting will require a degree of subjectivity anyways
What are the arguments for the use of the variable costing system?
- Objectivity –> dividing and spreading overhead in a multi-product organisation requires subjective decisions, therefore they do not do this to be objective
- Overheads are are fixed costs and are not really the costs of any particular product
- Overheads are capacity costs and will be incurred if nothing is produced
- Prudent –> by using variable costing they are including the full overhead as it has been spent or likely to be spent in that period, so they are reflecting the complete amount of that period in
how can you reconcile the difference between absorption and variable profits?
- The difference will be in the stock not sold –> you will need to assign the fixed overhead to the stock
When will absorption and variable costing profit differ?
Production > Sales –> stock increases
- Absorption > Variable
Production < Sales –> stock decreases
- Absorption < Variable
Production = Sales = No change
- Absorption = Variable
If a Just-In-time stock system is used production tends to equal sales so both profits will be equal in this case
What are the advantages of the variable costing system?
- 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 od products and segments
- Profit is not affected by changes in stock
- Pact of fixed costs on profit emphasised
What are some arguments against the variable costing approach?
- Variable costing shows full payment for fixed-overhead expenses for the accounting period. Even if you don’t sell all the products you make, you must deduct the full cost of fixed overhead.
- This means you show less profit for the period because you show your complete overhead expense even when you haven’t sold all of your products. You show reduced income because of unsold products but full expenses for overhead
How would you choose a costing method?
Absorption costing appreciates the importance of fixed costs. Prices need to cover all costs •
Absorption costing is consistent with external reporting •For internal reporting purposes: • Variable costing should be used for planning and decision making • Absorption costing is better for pricing and stock valuation
What are the advantages of using an absorption costing system?
- GAAP Compliant
- One of the main advantages of choosing to use absorption costing is that it is GAAP compliant and required for reporting to the Internal Revenue Service (IRS).
- Accounts for All Production Costs
- Absorption costing takes into account all of the costs of production, not just the direct costs, as variable costing does.
- Absorption costing includes a company’s fixed costs of operation, such as salaries, facility rental, and utility bills.
- Having a more complete picture of cost per unit for a product line can be helpful to company management in evaluating profitability and determining prices for products.
- Tracks Profits More Accurately
- Absorption costing also provides a company with a more accurate picture of profitability than variable costing if all of its products aren’t sold during the same accounting period when they are manufactured.
- This can be especially important for a company that ramps up production well in advance of an anticipated seasonal increase in sales.
What are the disadvantages of using an absorption costing system?
- Can Skew Profit and Loss
- Absorption costing can cause a company’s profit level to appear better than it actually is during a given accounting period.
- This is because all fixed costs are not deducted from revenues unless all of the company’s manufactured products are sold.
- In addition to skewing a profit and loss statement, this can potentially mislead both company management and investors.
- Doesn’t Help Improve Operational Efficiency
- Absorption costing fails to provide as good an analysis of cost and volume as variable costing does.
- If fixed costs are an especially large part of total production costs, it is difficult to determine variations in costs that occur at different production levels.
- This makes it more difficult for management to make the best decisions for operational efficiency.
- Not Useful for Comparison of Product Lines
- Variable costing is more useful than absorption costing if a company wishes to compare the potential profitability of different product lines.
- It is easier to discern the differences in profits from producing one item over another by looking solely at the variable costs directly related to production.