Semester 1 Week 4 PP (Income Effects of Alternative Cost accumulation systems) Flashcards
Absorption or Full Costing System?
Approach, so far: Allocate ALL manufacturing costs to products, and value unsold inventories at their TOTAL cost of manufacturing.
Non-manufacturing costs were not allocated to products but were charged directly to the profit statement and excluded from inventory valuation.
In absorption costing, fixed production costs are absorbed into the cost of units and are carried forward in inventory to be charged against sales for the next period. Inventory values using absorption costing are therefore greater than those calculated using marginal costing.
Variable/Marginal or Direct Costing?
Under this system only variable manufacturing costs are assigned to products and included in the inventory valuation.
Fixed manufacturing costs are Not allocated to the product but are considered as period costs and charged directly to the profit statement.
With both systems, non-manufacturing costs are treated as period costs.
Difference: lies in whether or not manufacturing fixed overhead should be regarded as a period costs or a product cost.
In marginal costing, fixed production costs are treated as period costs and are written off as they are incurred.
Marginal Costing vs Absorption Costing, which is which?
What are the principles of marginal costing?
Marginal cost is the variable cost of one unit of product or service.
It usually consists of the following
1. Direct Materials.
2. Direct Labour.
3. Variable Production Overheads.
Marginal Cost of Sales = Marginal Cost of Production (material and labour) Adjusted for Inventory Movements (changes) Plus the Variable Selling Costs (sales commission etc…)
Contribution = Sales Value – Marginal Cost of Sales
Contribution is of fundamental importance in marginal costing, and the term “contribution” is really short for “contribution towards covering fixed overheads and making a profit”.
Principles:
Period fixed costs are the same, for any volume of sales and production (within the “relevant range” of activity). Therefore, by selling an extra item of product or service the following will happen:
Revenue will increase by the sales value of item sold
Costs will increase by the variable cost per unit.
Profit will increase by the amount of contribution earned from the extra item.
(b) Similarly, if the volume of sales fall by one item, the profit will vary by the amount of contribution earned from the item.
(c) Profit measurement should therefore be based on an analysis of total contribution. Since fixed costs relate to a period of time, and do not change with increases or decreases in sales volume, it is misleading to charge units of sale with a share of fixed cost.
Absorption costing is therefore misleading, and it is more appropriate to deduct fixed costs from total contribution for the period to derive a profit figure.
(d) When a unit of product is made, the extra costs incurred in its manufacture are the variable production costs.
Fixed costs are unaffected, and no extra fixed costs are incurred when output is increased.
It is therefore argued that the valuation of closing inventories should be at variable production costs (direct materials, direct labour, direct expenses [if any] and variable production overhead) because these are the only costs properly attributable to the product.
Variable Cost of Sales = Value of Opening Inventory + Variable Production Cost – Value of Closing Inventory at Marginal Cost
Production – Sales = Changes in Inventory. Therefore, the difference in profits is due to changes in inventory levels during the period.
Reconciling profits
Reported profit figures using MC or AC will differ if there is any change in the level of inventories in the period.
If production is equal to sales, there will be no difference in calculated profits using the costing methods.
The difference in profits reported under the two costing systems is due to different inventory valuation methods used.
If inventory levels increase between the beginning and end of period, AC will report the higher profit. This is because some of the fixed production overhead incurred during the period will be carried forward in closing inventory (which reduces cost of sales) to be set against sales revenue in the following period instead of being written off in full against profit in the period concerned.
If inventory levels decrease, AC will report the lower profit because fixed production overhead which had been carried forward in opening inventory is released and is also included in cost of sales.
Advice: for the reconciliation always start from marginal profit, so that the adjustment for overheads will have the sign of the change in inventory, like above.
Example on Income Effects: AC vs MC
What are some arguments in support of variable costing?
Simple to Operate:
Variable Costing provides more useful information for decision making:
Unlike absorption costing, it highlights the separation of fixed and variable costs, which in turn, helps to provide relevant info about cost for making various short-term decisions (produce internally or purchase, product mix, etc).
Size of contribution provides management useful information about expected profits.
Variable costing removes from profit the effect of inventory changes:
Under/over absorption is avoided.
With VC profit is a function of sales, where with AC profit is a function of both sales and volume.
Hence, with AC it is possible for possible for profit to decline when sales volume increase.
MC more appropriate at frequent intervals and when inventory levels fluctuate.
MC is less susceptible than AC to profit manipulation (deliberately deferring fixed overheads allocation by unnecessarily increasing inventory over successive periods).
Variable costing avoids fixed overheads being capitalized in unsaleable inventories:
With No apportionment of fixed costs and fixed costs = period costs unchanged at all output levels, the closing inventory is more realistically valued at variable cost per unit.
Decrease of sales demand->Surplus inventories. With an absorption system closing inventories will be valued at full manufacturing cost. However, if these surplus inventories cannot be disposed of, the (overstated) profit calculation will be misleading, since fixed overheads will have to be deferred to later accounting periods.
What are some arguments in support of Absorption costing?
Absorption costing does not understate the importance of fixed costs:
Some people argue that decisions based on a VC costing system may concentrate only on sales revenue and variable costs and ignore the fact that fixed costs must be met in the long run.
However, this argument implicitly assumes that such managers are not very bright!
Using VC costing for inv valuation and profit measurement still enables full cost information to be extracted for pricing decisions.
Absorption costing avoids fictitious losses being reported:
Absorption costing provides more logical profit calculation in cases when inventories are being build up, due to the business model of the firm.
In such a case, fixed costs are recorded as an expense only in the period in which the goods are sold.
In contrast, when inventory is being build up, MC will report losses during out-of-season periods and large profits in the high season periods.
Fixed profits are essential for production:
The proponents of AC argue that the production of goods is not possible if fixed manufacturing costs are not incurred.
Consequently, it is “fair” to share fixed production overheads between units of production and in the inventory valuation.
Consistency with External Reporting:
Top management may prefer their internal profit reporting systems to be consistent with the external financial accounting absorption costing systems (IAS 2 principles) so that they will be congruent with the measures used by financial markets to appraise overall company performance.
