The document discusses the differences between absorption costing and variable costing methods. It provides examples of how profit would be calculated under each method for different production and sales volumes. It also examines how the two methods can result in different monthly and yearly profits depending on whether production equals, exceeds, or is less than sales in a given period. The document considers arguments for and against each costing method and how the appropriate choice depends on factors like typical fluctuations in production and sales volumes.
The document discusses the differences between absorption costing and variable costing methods. It provides examples of how profit would be calculated under each method for different production and sales volumes. It also examines how the two methods can result in different monthly and yearly profits depending on whether production equals, exceeds, or is less than sales in a given period. The document considers arguments for and against each costing method and how the appropriate choice depends on factors like typical fluctuations in production and sales volumes.
The document discusses the differences between absorption costing and variable costing methods. It provides examples of how profit would be calculated under each method for different production and sales volumes. It also examines how the two methods can result in different monthly and yearly profits depending on whether production equals, exceeds, or is less than sales in a given period. The document considers arguments for and against each costing method and how the appropriate choice depends on factors like typical fluctuations in production and sales volumes.
The document discusses the differences between absorption costing and variable costing methods. It provides examples of how profit would be calculated under each method for different production and sales volumes. It also examines how the two methods can result in different monthly and yearly profits depending on whether production equals, exceeds, or is less than sales in a given period. The document considers arguments for and against each costing method and how the appropriate choice depends on factors like typical fluctuations in production and sales volumes.
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Bohemia Industries
Discussion
Profit under alternative costing methods
Units Opening stock Manufactured during the period* Unit selling price Admin., Selling & Distribution cost (Fixed) How much is the profit under total costing & marginal costing if 10,000 units are sold? What if, 10,500 units are sold? What if 9,000 units are sold? * Fixed manufacturing cost is Rs.2,00,000.
Amount in INR
1,000
1,00,000
10,000
10,00,000 150 2,00,000
Impact of alternate costing
methods on profit measurement Production =Sales Production < Sales Production >Sales
Difference in profit
Cost of goods sold (absorption costing)
July (000s) August (000s)
3,000 3,300
Cost of goods sold (variable costing)
2,000 Fixed production costs incorporated in cost of goods sold 1,000
2,200 1,100
Fixed overhead volume variance
(10) 300 Fixed production costs included in absorption costing profit statement 990 1,400 Fixed production costs included in variable costing profit statement 1,200 1,200 Difference between absorption and variable costing fixed costs (210) 200 Reconciliation of difference between absorption and variable costing profits: Variable costing profit 200 500 Absorption costing profit 410 300 210 (200)
Cont. Large decline in opening and closing inventory valuations in August implies sales > production; so profits under absorption costing system will be lower Profit differences can also be derived in the changes in inventory valuations: 000s Decrease in inventory with absorption costing (6,300 5,700) 600 Decrease in inventory with variable costing (4,200 3,800) 400 Absorption costing additional fixed costs included in difference in opening and closing inventory (August) 200 Absorption costing profit for the 2 months (710,000) exceeds the variable costing profit (700,000) by 10,000. Combined July and August periods production volume > sales volume. This would have also have been true for July but not for August. If over the entire year production volume = sales volume then both systems will report the same profits, although profits will differ from month to month if monthly production and sales volumes differ.
Question Absorption2 costing
profit is a function of production and sales volumes whereas with variable costing profit is a function of sales volume. Thus the differences in profits in the case arises from production volume changes. If production and sales volumes differ significantly there are stronger arguments for the adoption of variable costing.
Cont. Vaughan: Variable costing would eliminate the need to undertake time-consuming allocations of fixed overheads. It may not be correct. It is likely that profits and inventory valuations need to be computed on an yearly basis (or even quarterly for interim financial statements) for external financial reporting. There may be a possibility that more simplistic approaches may be acceptable for external financial reporting such as apportioning the total manufacturing fixed overheads between inventories and cost of goods sold or using plant wide rates instead of departmental rates. However, it is possible that the external auditors may not accept such simplistic overhead allocations.
Blanket rate vs. Departmental rate
Department
Machine Hours
Labour Hours
Overhead (Rs.)
Machine hour Machine hour
required for required for Job A Job B Job A
Job B
Fabrication
12,000
8,000
1,50,000
30
20
Machining
15,000
7,000
1,80,000
40
60
Assembly
9,000
10,000
1,40,000
70
10
Finishing
8,000
4,000
90,000
10
60
5,60,000
150
150
44,000
Cont Vaughan: Variable costing is controlling fixed overheads.
preferable
for
It is not necessarily correct.
Adoption of an absorption costing system for profit measurement and inventory valuation does not preclude the separate reporting and control of fixed overheads.
Cont Vaughan: Absorption costing involves arbitrary allocations of fixed overheads that distorts product costs. Moving to ABC can help. Why absorption costing should be adopted for profit measurement and inventory valuation but productrelated decisions like product mix decisions, be based only on the assignment of relevant avoidable costs? Even some fixed costs change in the long run with change in product line and such costs should be incorporated in the product costs for decision-making.
Cont Director: Variable costing may result in business being undertaken at margins that exceeded variable costs but that may not provide a sufficient contribution to covering fixed costs or generating sufficient profit. Suggests a misunderstanding of marginal costing system if variable cost-plus pricing is used. Under pricing can be avoided by larger mark-ups over variable costs than that added to full cost.
Cont Director: Adopting variable costing system would result in two profit reporting systems (one for internal reporting and the other for external reporting) appears correct.
Profit differences between the two systems depend on inventory
changes
So it is wrong to assume that variable costing always results in
higher profits.
Question-3
No precise answer. Both the systems have some arguments in
favour and against.
If August is an abnormal month and substantial differences do not
normally tend to occur with monthly sales and production volumes in the remainder of the year then there are strong arguments for adopting an absorption costing system for monthly profit reporting and inventory valuation.
However, if there are significant mismatches between sales and
production, absorption costing would distort profit and variable costing would be better. However, the choice should also envisage which costs to be used for decision-making and control.
