Lecture 6 Flashcards
Absorption vs Variable costing
Absorption costing , Fixed overhead (FOH) is treated as a product cost,
While in Variable costing FOH is a period cost
What it means to be a period cost is that it is the same cost through out the year, WE DONT Attach it to the inventory we simply expense it immediately.
Problems with Absorption Costing :
1) Discourages work with positive contribution margin (CM) but negative gross margin
* Can lead to the Death Spiral
(Absorption costing encourages managers to focus on Gross Margin.
Gross Margin is Revenue minus COGS, where COGS includes allocated fixed costs
Variable costing encourages managers to focus on Contribution Margin
Contribution Margin is Revenue minus Variable Costs
Managers should focus on Contribution Margin when making decisions
)
2) Discourages the use of OH Drivers
In reality, the FOH was fixed, so those costs are still incurred. Huge writeoff at the end of the period.
Still paying for the machine.
Added cost of the DLH
Essentially,
Machine hours are really free (fixed cost -> pay the same whether or not we use them), but we act like they are expensive!
3) Encourages inventory build-up
4) Subject to denominator effects (what is it?)
Whats the Denominator Effects
PDR Denominators :
Budgeted Production: The amount we expect to produce next period – Bad Denominator!
Theoretical Capacity: The amount that could be produced under ideal, impossible-to-achieve conditions – Bad Denominator!
Practical Capacity: What we’d probably have if the market could support it. Allows for surge, buffer, mistakes, etc. – Good Denominator!
In our example, we could use 100 000 DLH if there was enough market demand. There wasn’t, but we’ll use the 100 000 DLH anyway.
Using something other than budgeted production as our denominator means we’re expecting a write-off!
Problems with Variable Costing
1) Easy to forget about FOH and not charge enough to cover the costs.
2)Encourages overuse of fixed (limited) resources
Ex: Mike sees that machine hours are free, so he and his employees start using the machine for everything! Pretty soon there is such a long line for the machine that Mike has to buy more machines.
3) Violates Financial Reporting Standards/ GAAP
Good of Both Absorption and Variable costing :
Absorption Costing:
Useful for long-run pricing decisions and recovering fixed costs
Costing system used for external reporting
Variable costing:
Closer to true cost behaviour
Useful for short-term decisions
No incentive to build up inventory
No denominator effects
Fixed MOH rate
Budgeted MOH / Budgeted production
Period cost vs product cost
Classification of Costs under Variable and Absorption Costing
Cost Types:
Direct Materials (DM)
Direct Labor (DL)
Manufacturing Overheads (MOH)
Variable MOH
Fixed MOH
Marketing & Selling Expenses
Cost Classification:
1. Direct Materials (DM)
Variable Costing: Product (Capitalized) Cost
Absorption Costing: Product (Capitalized) Cost
2. Direct Labor (DL)
Variable Costing: Product (Capitalized) Cost
Absorption Costing: Product (Capitalized) Cost
3. Manufacturing Overheads (MOH)
Variable MOH
Variable Costing: Product (Capitalized) Cost
Absorption Costing: Product (Capitalized) Cost
Fixed MOH
Variable Costing: Period (Revenue) Cost
Absorption Costing: Product (Capitalized) Cost
4. Marketing & Selling Expenses
Variable Costing: Period (Revenue) Cost
Absorption Costing: Period (Revenue) Cost
Summary of Key Points:
Direct Materials (DM) and Direct Labor (DL) are always treated as product (capitalized) costs under both variable and absorption costing methods.
Variable MOH is considered a product (capitalized) cost under both costing methods.
Fixed MOH is treated differently:
Under variable costing, fixed MOH is a period (revenue) cost and expensed in the period it is incurred.
Under absorption costing, fixed MOH is a product (capitalized) cost and included in the inventory cost until the product is sold.
Marketing & Selling Expenses are always treated as period (revenue) costs under both costing methods.
Marketing costs - revenue (period costs rather than product costs)
In summary, even though variable marketing and selling expenses fluctuate with sales volume, they are still period costs because they are related to sales activities, not production activities. Both variable and fixed M&S expenses are expensed as incurred, reflecting their role in generating revenue for the period rather than contributing to the creation of inventory.
Cost of Goods Available for Sale
for variaable :
Opening stock + Variable cost of goods manufactured
for Absorption :
Opening stock + Variable cost of goods manufactured + Fixed cost of goods manufactured
Variable Cost of Goods Sold:
Cost of goods available for sale - Closing stock
Contribution Margin:
Revenue - Total variable costs
The allocation of fixed Marketing & Selling (M&S) expenses
The allocation of fixed Marketing & Selling (M&S) expenses is based on revenue, it is a common approach in managerial accounting.
Breakdown of Fixed Manufacturing Costs:
Fixed manufacturing costs typically refer specifically to the fixed portion of manufacturing overhead costs (Fixed MOH)
Breakdown of Variable Manufacturing Costs:
In managerial accounting, variable manufacturing costs typically include the costs that vary directly with the level of production. These generally comprise:
Direct Materials (DM): Raw materials that are directly traceable to the product.
Direct Labor (DL): Wages for workers who are directly involved in manufacturing the product.
Variable Manufacturing Overhead (Var MOH): Indirect costs that vary with production volume, such as utilities for the production facility, indirect materials, and variable portions of maintenance costs.
CostofGoodsSold
CostofGoodsAvailableforSale−ClosingStock
