Slide 1

COSTING METHODS

OBJECTIVE OF STUDYCOSTING METHODS: DIRECT COSTING ABSORPTION COSTING ACTIVITY BASED COSTING STANDARD COSTING

DIRECT COSTING\ MARGINAL COSTING\VARIABLE COSTINGOn the basis of behavior, cost can be classified as Fixed cost and variable cost. Fixed cost remain constant in aggregate amount and do not vary with the increase or decrease in production up to a given level of output.Aggregate Variable cost varies to increase or decrease in level of output and remain constant per unit of output. Thus, fixed overheads leads to different cost per unit at different level of output. on account of this , a special technique is used called Direct costing or Marginal Costing which excludes fixed overheads entirely from the cost of production and gives us same cost per unit up to a particular level of output

Direct costing is a costing system under which those costs of production that vary with output are treated as product costs. This would usually include direct materials, direct labor and variable portion of manufacturing overhead. Fixed manufacturing cost is not treated as a product costs under variable costing. Rather, fixed manufacturing cost is treated as a period cost and, like selling and administrative expenses, it is charged off in its entirety against revenue each period. The cost of a unit of product in inventory or cost of goods sold under this method does not contain any fixed overhead cost. Variable costing is some time referred to as direct costing or marginal costing.

Advantages of Variable or Direct or Marginal Costing System:

The data that are required for cost volume profit (CVP) analysis can be taken directly from a variable costing format income statement. These data are not available on a conventional income statement based on absorption costing. The valuation of closing stock under direct costing is done at marginal cost and thus prevents the illogical carry forward of fixed costs of one period to next period as part of value of stock There is no problem of computing fixed overhead recovery rates and their over or under recovery as fixed overheads are charged against contribution.Sales- variable cost = Contribution. It establishes that profit is function of sale and not of production as profit depends on sales volume and not on production volume. It facilitates control over variable cost by avoiding apportionment and allocation of fixed costs

The impact of fixed costs on profits is emphasized under the variable costing and contribution approach. The total amount of fixed costs appears explicitly on the income statement. Under absorption, the fixed costs are mingled together with the variable costs and are buried in cost of goods sold and in ending inventories.Variable costing ties in with cost control methods such as standard costs and flexible budgets. It is very useful tool for profit planning.It is valuable technique in decision making It provides the management with useful technique like BE analysis, P.V ratio etcIt helps management in cost control by concentrating on variable cost as fixed cost is uncontrollable in short run.

DISADVANTAGE OF DIRECT COSTING:

Absorption costing is required for external reports in United States and almost all over the world. A company that attempts to use variable costing (also called direct costing and marginal costing) on its external financial reports runs the risk that its auditors may not accepts the financial statements as conforming to generally accepted accounting principles (GAAP). Tax laws almost all over the world require the usage of a form of absorption costing for filling out income tax forms. The separation of expense as fixed and variable present technical difficulties. With development of technology, fixed expenses have increases and their impact on production is much more than variable cost. Ignoring fixed expenses makes costing system less effective.

It cannot be successfully applied in cost plus contract unless a high percentage over marginal cost is charged from contractee to cover fixed cost and profit.

Further Discussion on Direct CostingA direct cost is a cost that is directly associated with changes in production volume. This usually restricts the definition of direct costs to direct materials and direct labor (and a strong case can be made forNOTusing direct labor, since this costs tends to be present even when production volumes vary). For example, the materials used to create a product are a direct cost, whereas the machine used to convert the materials into a finished product is not a direct cost, because it is still going to be sitting on the factory floor, irrespective of any changes in production volume.

Further Discussion on Direct CostingBy focusing solely on the direct cost of a product or activity, a cost accountant can provide valuable information to management regarding prospective changes in costs that will arise as a result of some management action. For example, if a change to a more efficient type of processing equipment is contemplated, then the direct cost of a product may be lowered if this will result in less material usage. This may also result in less direct labor cost if the machine takes over some tasks previously performed by employees - this will cut direct costs, but may increase overhead costs if the cost of the machine is higher than that of the machine that it is replacing.

Further Discussion on Direct CostingYet another example is when a customer wants the lowest possible price for a product, and the company has some free capacity available for producing what the customer needs; the use of direct costing will reveal the lowest possible cost that must be covered by the price charged to the customer in order to break even. Direct costing can also be used to determine which customers are the most profitable, by subtracting the direct cost of their purchases from the prices paid, which yields the amount they are contributing toward the company's coverage of overhead costs and profit.

Further Discussion on Direct CostingAnother very good use for direct costing is to include the concept in the budgeting system, where it is used to change budgeted variable costs to match the actual sales volumes achieved; this approach achieves a much closer match between the budgeted and actual cost of goods sold, because the budget now flexes with the actual volume level experienced. For all of these reasons, direct costing is a highly recommended costing system.

Further Discussion on Direct CostingHowever, there are a number of situations in which direct costing shouldnotbe used, and in which it will yield incorrect information. Its single largest problem is that it completely ignores all indirect costs, which make up the bulk of all costs incurred by today's companies. This is a real problem when dealing with long-term costing and pricing decisions, since direct costing will likely yield results that do not achieve long-term profitability.

Further Discussion on Direct CostingFor example, a direct costing system may calculate a minimum product price of $10.00 for a widget that is indeed higher than all direct costs, but which is lower than the additional overhead costs that are associated with the product line. If the company continues to use the $10.00 price for all product sales for well into the future, then the company will experience losses because overhead costs are not being covered by the price. The best way to address this problem is to build strict boundaries around the circumstances where incremental prices derived from a direct costing system are used.

Further Discussion on Direct CostingAnother problem with direct costing is that it assumes a steady level of unit costs for the incremental costing and pricing decisions for which it is most often used. For example, a company receives an offer from a customer to buy 5,000 units of Product ABC at a fixed price. The cost accounting staff may determine that the proposed price will indeed yield a profit, based on the direct cost per unit, and so recommends that the deal be approved..

Further Discussion on Direct CostingHowever, because the staff has only focused on direct costs, it has missed the fact that the company is operating at near full-capacity levels, and that to process the entire 5,000-unit order will require the addition of some costly machinery, the acquisition of which will make the proposed deal a very expensive one indeed. To avoid this problem, anyone using a direct costing system must have access to company capacity information, and should coordinate with the production scheduling staff to ensure that capacity levels will permit their incremental pricing and costing scenarios to be achieved

Further Discussion on Direct CostingDirect costing cannot be used for inventory valuation, because it is disallowed by GAAP. The reason for this is that, under a direct costing system, all costs besides direct costs are charged to the current period. There is no provision for capitalizing overhead costs and associating them with inventory that will be sold off in future periods. This results in an imbalance between the reported level of profitability in each period and the amount of production that occurred.

Further Discussion on Direct CostingFor example, a manufacturer of Christmas ornaments with a direct costing system may sell all of its output in one month of the year, but be forced to recognize all of its non-direct production costs in every month of the year, which will result in reported losses for eleven months of the year. Under GAAP, these non-direct costs would be capitalized into inventory and recognized only when the inventory is sold, thereby more closely matching reported revenues and expenses. Given the wide disparity between the reported results, it is no surprise that GAAP bans the use of direct costing for inventory valuation.

Absorption costing is a costing system which treats all costs of production as product costs, regardless weather they are variable or fixed.The cost of a unit of product under absorption costing method consists of direct materials, direct labor and both variable and fixed overhead.Absorption costing allocates a portion of fixed manufacturing overhead cost to each unit of product, along with the variable manufacturing cost.Because absorption costing includes all costs of production as product costs it is frequently referred to as full costing method. ABSORPTION COSTING\full costing methodwe need to consider briefly the handling of selling and administrative expenses. These expenses are never treated as product costs, regardless of the costing method in use. Thus under either absorption or variable costing, both variable and fixed selling and administrative expenses are always treated as period costs and deducted from revenues as incurred

ADVANTAGES OF ABSORPTION COSTING SYSTEM:Recognizes the importance of including fixed manufacturing cost in product cost determination and framing a suitable pricing policy.Show correct profit calculations in case where production is done to have sales in future( e.g seasonal sales) as compared to variable costingHelps to conform with accrual and matching concept which require matching cost with revenue for particular period. Recognized by various bodies as FASB( USA), ASC(UK), ASB(India) for purpose of preparing external reports and valuation of inventory. Avoids separation of cost into fixed and variable elements which cannot be done easily and accurately Discloses inefficient or efficient utilization of production resources by indicating under-absorption or over-absorption of overheads.Helps to calculate gross profit and net profit separately in income statement.

DISADVANTAGES OF ABSORPTION COSTING SYSTEM:

Difficulty in comparison and control of cost.- An increase in volume of output result in decrease in unit cost and decrease in volume of output result in increases in unit cost. Not helpful in managerial decision- selection of suitable product mix, weather to buy or manufacture, choice of alternatives etc. Cost vitiated because of fixed cost included in inventory valuation.- As closing stock is valued at cost of product ion. Fixed cost inclusion in cost not justified Apportionment of fixed overheads by arbitrary method Not helpful for preparation of flexible budgets.

COST CLASSIFICATIONS--ABSORPTION VERSUS VARIABLE COSTINGPRODUCT COSTPERIOD COSTPERIOD COSTPRODUCT COSTDIRECT MATERIALDIRECT LABORVARIABLE MANUFACTURING OVERHEADSFIXED MANUFACTURING OVERHEADSVARIABLE SELLING AND ADMINISTRATIVE EXPENSESVARIABLE SELLING AND ADMINISTRATIVE EXPENSESABSORPTION COSTINGDIRECT COSTING

Number of units produced6,000Variable costs per unit:Direct materials$2Direct labor$4Variable manufacturing overhead$1Variable selling and Administrative expenses$3Fixed costs per year:Fixed manufacturing overhead$30,000Fixed selling and administrative expenses$10,000

UNIT COST COMPUTATION/CALCULATION:To illustrate the computation/calculation of unit product costs under both absorption and variable costing consider the following example.Example:A small company that produces a single product has the following cost structure.

ANSWER:

Unit product CostAbsorption Costing MethodDirect materials$2Direct labor$4Variable manufacturing overhead$1--------Total variable production cost$7Fixed manufacturing overhead$5--------Unit product cost$12=====Unit product CostVariable Costing MethodDirect materials$2Direct labor$4Variable manufacturing overhead$1--------Unit product cost$7=====

why absorption costing continues to be used almost exclusively for external reporting purposes and why it is predominant choice for internal reports as well.

This is partly due to tradition, but absorption costing is also attractive to many accountants because they believe it better matches costs with revenues. Advocates of absorption costing argue that all manufacturing costs must be assigned to products in order to properly match the costs of producing units of product with the revenues from the units when they are sold. The fixed costs of depreciation, taxes, insurance, supervisory, salaries, and so on, are just as essential to manufacturing products as are the variable costs

THANK YOU