(C) Ghanendra Fago( M Phil, MBA)1 Income Recognition and Reporting: Variable and Absorption Costing.

(C) Ghanendra Fago( M Phil, MBA) 1

Income Recognition and Reporting: Variable and

Absorption Costing


Concept of Product Cost The cost of making a product is called product cost. It is also known as manufacturing cost. Product costs are taken for inventory valuation. So product costs are sometimes called inventory cost

as well. Inventorial costs are all costs of product that are

regarded as assets when they are incurred and then become costs of goods sold when the product is sold.

Product cost affects the value of inventory and the profit differs.

Raw material cost is an example of a product cost.


The costs that are indifferent to the level of production are period cost.

Period costs do not change with the change in production volume.

Rather, these costs are incurred either for sales activity or with the passage of time

Period cost are not taken for inventory valuation. All period costs are deducted from the revenues of the

same period. Office and administrative and department costs, and

marketing department costs are good examples of period costs.

Period Cost


Under Variable Costing Under Absorption Costing

Product Costs

Direct Material

Direct Labour

Variable Manufacturing Costs

Period Costs

Fixed manufacturing costs

General & administrative costs

Selling & distribution costs

Product Costs

Direct Material

Direct Labour

Variable Manufacturing Costs

Fixed manufacturing Costs

Period Costs

General & Administrative

Costs

Selling & Distribution Costs


Product Costing

The process of determining cost of production. There two method of determining cost of product for accounting purposes: They are:

(a) Absorption costing and

(b) Variable costing


Variable Costing It is also called marginal costing, direct costing,

Contribution margin format. Variable costing includes only variable production

costs in product costs. Fixed manufacturing overhead is treated as a period

cost and is charged against income each period. Cost of production is

Direct materials xxxxx

Direct labours xxxxx

Variable overheads xxxxx

Cost of goods manufactured xxxxxx.


Absorption Costing Also called traditional costing, conventional costing, full

costing It treats all production costs as product costs, regardless of

whether they are variable or fixed. Under this costing, a portion of fixed manufacturing

overhead is allocated to each unit of product. Cost of production includes

Direct materials xxxxxDirect labours xxxxxVariable overheads xxxxxFixed manufacturing overhead xxxxxCost of goods manufactured xxxxx


INCOME STATEMENT UNDFER VARIABLE COSTING

Particulars Details Amount

Sales revenue (Sales units SPPU)

Less: Variable cost of goods sold:

Direct material @ . . . production units

Direct labour @ . . . production units

Variable Overhead @ . . production units

Total variable manufacturing costs

Add: Opening stock @ . . .

Cost of goods available for sales

Less: Closing stock @ . . .

Variable cost of goods sold

Gross contribution margin

Less: Non-manufacturing variable costs @ . . Sales

Net contribution margin

Less: Fixed costs

Manufacturing

Non-manufacturing

Net Income before tax


INCOME STATEMENT UNDFER VARIABLE COSTING



Less: Variable cost of goods sold:

Direct material @ . . . production units

Direct labour @ . . . production units

Variable Overhead @ . . . production units

Total variable manufacturing costs

Add: Opening stock @ . . .

Cost of goods available for sales

Less: Closing stock @ . . .

Variable manufacturing cost of goods sold

Add: Non-manufacturing variable costs @ . . . Sales

Total variable costs of sales

Net Contribution margin

Less: Fixed manufacturing cost

Fixed non-manufacturing cost

Net Income before tax


Absorption Costing Under Income Statement



Less: Manufacturing cost of goods sold:

Direct materials @ . . . production units x

Direct labour @ . . . production units x

Variable overhead @ . . . production units x

Fixed manufacturing overhead @ . production units x

Cost of goods manufactured

Add: Opening stock @ . . . x

Cost of goods available for sale

Less: Closing stock @ . . . x

Cost of goods sold

Gross margin before adjustments xxxxx

Less: Under absorption of fixed manufacturing overhead

Add: Over absorption of fixed manufacturing overhead ()

Gross margin after adjustments

Less: Variable non manufacturing @ . . . X sales

Fixed non manufacturing costs xxxx

Net income before tax


UNDER/OVER ABSORPTION OF FIXED MANUFACTURING OVERHEAD

Fixed manufacturing cost is considered as constant cost which is unaffected due

to change into production units.

The increase or decrease in production volume does not affect the total fixed cost.

Thus, fixed manufacturing overhead is allocated to product cost based on normal

level activities.

It is determined on the basis of normal capacity level of production.

The differences between normal capacity and actual production create over

absorption or under absorption of fixed manufacturing overhead.

Installed capacity - Maximum units that can be produced

Normal capacity - Average production level

Actual capacity - Actual production

Fixed overhead per unit = Fixed overhead/Normal capacity

Capacity Concepts


Reconciliation Statement

Particulars Details Difference

Net profit as per variable costing xxxxxxx

Less: Net profit as per absorption costing xxxxxxx

DIFFERENCE IN PROFIT Xxxxxx

Opening stock in units xxxxxxx

Less: Closing stock in units xxxxxxx

Difference in stock xxxxxx

Fixed manufacturing cost per unit xxx

DIFFERENCE IN PROFIT(DIFF. STOCK X FIXED COST PER UNIT)

xxxxx


Absorption Vs Variable Costing 1. Production Equals Sale

When production equals sales, inventories do not

change.

If inventories do not change, then there is no change in

the fixed manufacturing overhead costs in inventories

under absorption costing.

Therefore, under both costing methods all of the current

fixed manufacturing overhead will flow through to the

income statement as an expense.

In the case of absorption costing it will be part of cost of

goods sold. In the case of variable costing, it will be a

period expense.


2. Production Exceeds Sales (Inventories Increase)

• When production exceeds sales, inventories grow.

• If inventories grow, then some of the current fixed

manufacturing overhead costs will be deferred in

inventories under absorption costing.

• Since all of the current fixed manufacturing overhead

costs are expensed under variable costing, the net

operating income reported under absorption costing

will be greater than the net operating income reported

under variable costing.


Sales Exceed Production (Inventories Decrease) When sales exceed production, inventories shrink.

If inventories decrease, then some of the fixed

manufacturing overhead costs that had been deferred in

inventories in previous periods will be released to the

income statement as part of cost of goods sold as well as all

of the current fixed manufacturing overhead costs.

Since only the current fixed manufacturing overhead costs

are expensed under variable costing, the net operating

income reported under absorption costing will be less than

the net operating income reported under variable costing.


Long-term Differences In Income Over an extended period of time, the cumulative net operating

income figures reported under absorption costing and variable costing will be about the same.

They will differ only by the amount of fixed manufacturing overhead cost in ending inventories under absorption costing.

Cumulative net operating income figures will be identical whenever ending inventories are reduced to zero

Changes In Production Volume Variable costing net operating income is not affected by

changes in production volume. On the other hand, absorption costing net operating income is

affected by changes in production volume. For any given level of sales, net operating income under

absorption costing will increase as the level of output increases and hence inventories increase.


Use of Absorption Vs. Variable costing

Accountants and managers have been arguing for decades concerning the relative merits of absorption and variable costing. In practice, absorption costing is used far more than variable costing even for internal reports. The reasons for this are not entirely clear, although the perception that absorption costing is required for external reporting undoubtedly plays a key role.

Argument for absorption costing Advocates of absorption costing argue that all manufacturing

costs must be assigned to units of product so as to properly match costs with revenues.

They argue that fixed manufacturing overhead costs are essential to the production process and must be included when costing units of product, regardless of how the cost behaves.


Argument for Variable Costing

Advocates of variable costing argue that fixed manufacturing

overhead costs are incurred in order to have the capacity to

produce. Moreover, they will be incurred regardless of whether

anything is actually produced. Since these costs are not caused

by any particular unit of product and are incurred to provide

capacity for a particular period, the matching principle would

dictate that fixed manufacturing overhead costs must be

expensed in the current period.


Advantages of Variable CostingMore useful for CVP analysis. Variable costing statements provide

data that are immediately useful for CVP analysis since they

categorize costs on the basis of their behavior. In contrast, it is often

difficult to rework absorption costing data so that they can be used

in CVP analysis and in decisions.

Income is not affected by changes in production volume. Under

absorption costing, reported net operating income is affected by

changes in production since fixed costs are spread across more or

fewer units. This can distort income and may even result in income

moving in an opposite direction from sales. This does not occur

under variable costing.


Avoids misunderstandings concerning unit product costs.

Absorption costing unit product costs can be easily misinterpreted as

variable costs since they are stated on a per unit basis. Such a

misperception can lead to serious errors in making decisions. Variable

costing avoids this problem since unit costs include only variable costs.

Fixed costs are more visible. The impact of fixed costs on profits is

emphasized because the total amount of such costs for the period

appears separately and is highlighted in the income statement rather

than being buried in cost of goods sold and ending inventory.

Understandability. Managers should find it easier to understand

variable costing reports because data are organized by behavior and

because variable costing is much closer to cash flow.

Facilitates in Control:. Variable costing ties in with cost control methods

such as flexible budgets.


CASE 1: The Directorium Manufacturing Company produced: 80,000 units of new products during 1990 and sold 60,000 units at Rs. 50 each. The cost for 1990 were as follows: Direct materials Rs.200,000Direct labour Rs.160,000Variable Manufacturing Overhead Rs.320,000Fixed Manufacturing overhead Rs.440,000V. Selling/administrative expenses Rs.80,000F. Selling and administrative expensesRs. 280,000There was no ending work in process inventory.Required: a) Income statements for the year 1990 using (i) direct costing method (ii) Absorption costing methodb) Give the reasons for differences in reported net income or net loss in requirement a (i) and a (ii).


Income Statement Under Contribution Margin ApproachParticulars Amount Amount

Sales revenue @ Rs.50 each Rs.3,000,000

Less: Variable manufacturing cost of goods sold:

Direct materials @ 2.5 each 200,000

Direct labour @ 2 each 160,000

Variable manufacturing overhead @ 4 each 320,000

Total variable manufacturing costs 680,000

Add: Opening stock @ 8.5 each Nil

Cost of goods available for sales 680,000

Less: Closing stock @ 8.5 each (20,000 units) 170,000 510,000

Gross contribution margin 2,490,000

Less: Variable selling and administrative 80,000

Net contribution margin 2,410,000

Less: Fixed costs:

Manufacturing 440,000

Selling and administrative 280,000 720,000

Net income 1,690,000


Income Statement Under Absorption CostingParticulars Amount Amount

Sales revenue @ Rs.50 each Rs.3000,000

Less: Manufacturing cost of goods sold:

Direct materials @ 2.5 each 200,000

Direct labour @ 2 each 160,000

Variable manufacturing overhead @ 4 each 320,000

Fixed manufacturing overhead @ 5.5 each 440,000

Total manufacturing costs 11,20,000

Add: Opening stock @ 14 each Nil

1120,000

Less: Closing stock @ 14 each 280,000 840,000

Gross margin 21,60,000

Less: Non-manufacturing costs:

Variable selling and administrative expenses 80,000

Fixed selling and administrative expenses 280,000 360,000

Net income 1800,000


Reconciliation Statement

Particulars Details Difference

Net profit as per variable costing 16,90,000

Less: Net profit as per absorption costing 18,00,000

Difference in profit 110,000

Opening stock in units 0

Less: Closing stock in units 20,000

Difference in stock 20,000

Fixed manufacturing cost per unit 5.5

Difference in profit (Diff. stock x fixed cost per unit) 110,000


Assignment I

Even question numbers for EVEN ROLL NUMBERS

Uneven question numbers for UNEVEN ROLL NUMBERS

Submission Within one week from the date of completion of chapter

(C) Ghanendra Fago( M Phil, MBA)1 Income Recognition and Reporting: Variable and Absorption Costing.

Documents

Transcript of (C) Ghanendra Fago( M Phil, MBA)1 Income Recognition and Reporting: Variable and Absorption Costing.