Variable Costing System
A Decision Making Tool for Management:
Learning Objectives:
1. Explain how variable costing differs from absorption costing and compute unit product costs under each method
2. Prepare income statements using variable and absorption costing.
3. Reconcile variable and absorption costing net operating income and explain why two amounts differ.
4. Understand the advantages and disadvantages of both variable and absorption costing.
Two general approaches are used for valuing inventories and cost of goods sold (http://www.accountingformanagement.com/cost_of_goods_sold_definition.htm). One approach is called variable costing and other is called absorption costing. Absorption costing is generally used for external financial reports and variable costing is preferred by managers for internal decision making and must be used when an income statement (http://www.accountingformanagement.com/income_statement_definition.htm) is prepared in the contribution margin (http://www.accountingformanagement.com/contribution_margin_definition.htm) format. Ordinarily these two costing systems produce different figures for net operating income (http://www.accountingformanagement.com/net_operating_income.htm) and difference can be quite large. The reason of this difference is well explained on the following pages.
Variable Costing Versus Absorption Costing:
Absorption Costing or Full Costing System:
Learning Objectives:
1. Define and explain variable and absorption costing.
2. Explain the difference between variable and absorption costing and calculate unit product cost under each method.
Definition and explanation:
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 (http://www.accountingformanagement.com/direct_material_definition.htm), direct labor (http://www.accountingformanagement.com/direct_labor_definition.htm) 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 (http://www.accountingformanagement.com/product_costs_and_period_costs.htm), it is frequently referred to as full costing method.
Variable, Direct or Marginal Costing:
Definition and explanation:
Variable costing is a costing system under which those costs of production that vary with output are treated as product costs (http://www.accountingformanagement.com/product_costs_and_period_costs.htm). This would usually include direct materials (http://www.accountingformanagement.com/direct_material_definition.htm), direct labor (http://www.accountingformanagement.com/direct_labor_definition.htm) and variable portion of manufacturing overhead. Fixed manufacturing cost is not treated as a product costs (http://www.accountingformanagement.com/product_costs_and_period_costs.htm) under variable costing. Rather, fixed manufacturing cost is treated as a period cost (http://www.accountingformanagement.com/product_costs_and_period_costs.htm) and, like selling and administrative expenses, it is charged off in its entirety against revenue each period. Consequently the cost of a unit of product in inventory or cost of goods sold (http://www.accountingformanagement.com/cost_of_goods_sold_definition.htm) under this method does not contain any fixed overhead cost. Variable costing is some time referred to as direct costing or marginal costing. To complete this summary comparison of absorption and variable costing, we need to consider briefly the handling of selling and administrative expenses. These expenses are never treated as product costs (http://www.accountingformanagement.com/product_costs_and_period_costs.htm), 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 (http://www.accountingformanagement.com/product_costs_and_period_costs.htm) and deducted from revenues as incurred.
The concepts explained so for are illustrated below
Cost classifications--Absorption versus variable costing
|
Absorption
Costing
|
| Variable Costing
|
Product cost
| Direct materials
Direct Labor
Variable Manufacturing overhead
| Product cost
|
Fixed manufacturing overhead
| Period cost
|
Period cost
| Variable selling and administrative expenses
|
Fixed selling and administrative expenses
|
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.
Number of units produced
| $6,000
| | Variable costs per unit:
| Direct materials
| $2
| Direct labor
| $4
| Variable manufacturing overhead
| $1
| Variable selling and Administrative expenses
| $3
| | Fixed costs per year:
| Fixed manufacturing overhead
| $30,000
| Fixed selling and administrative expenses
| $10,000
|
[/t][/t][/t][/t][/t][/t] |
Required:
1. Compute the unit product cost under absorption costing method.
2. Compute the unit product cost under variable / marginal costing method.
| Unit product Cost
Absorption Costing Method
| Direct materials
| $2
| Direct labor
| $4
| Variable manufacturing overhead
| $1
|
| --------
| Total variable production cost
| $7
| Fixed manufacturing overhead
| $5
|
| --------
| Unit product cost
| $12
|
| =====
| | Unit product Cost
Variable Costing Method
| Direct materials
| $2
| Direct labor
| $4
| Variable manufacturing overhead
| $1
|
| --------
| Unit product cost
| $7
|
| =====
| | (The $30,000 fixed manufacturing overhead will be charged off in total against income as a period expense along with selling and administrative expenses)
|
[/t][/t][/t][/t][/t][/t] |
Under the absorption costing, notice that all production costs, variable and fixed, are included when determining the unit product cost. Thus if the company sells a unit of product and absorption costing is being used, then $12 (consisting of $7 variable cost and $5 fixed cost) will be deducted on the income statement (http://www.accountingformanagement.com/income_statement_definition.htm) as cost of goods sold (http://www.accountingformanagement.com/cost_of_goods_sold_definition.htm). Similarly, any unsold units will be carried as inventory on the balance sheet at $12 each.
Under variable costing, notice that all variable costs of production are included in product costs. Thus if the company sells a unit of product, only $7 will be deducted as cost of goods sold (http://www.accountingformanagement.com/cost_of_goods_sold_definition.htm), and unsold units will be carried in the balance sheet inventory account at only $7.
Income Comparison of Variable and Absorption Costing:
Learning Objectives:
1. Prepare income statements using variable costing and absorption costing.
2. Why net operating income usually different under variable and absorption costing methods?
The income statements prepared under absorption costing (http://www.accountingformanagement.com/absorption_costing_definition.htm) and variable costing (http://www.accountingformanagement.com/variable_costing_definition.htm) usually produce different n (http://www.accountingformanagement.com/net_operating_income.htm)et operating income (http://www.accountingformanagement.com/net_operating_income.htm) figures. This difference can be quite large. Here we will explain the basic reason of this difference in income. The explanation for this difference needs two separate income statements one under absorption costing (http://www.accountingformanagement.com/absorption_costing_definition.htm) and other under variable costing (http://www.accountingformanagement.com/variable_costing_definition.htm). We will prepare two income statements that will produce different income figures and then explain the reasons of difference. Consider the following example:
Example:
Following data relates to a manufacturing company:
Number of units produced each year
| 60,000
| | | Variable cost per unit:
| $2
| Direct materials
| $4
| Direct labor
| $1
| Variable Manufacturing Overhead
| $3
| Variable selling and Administrative expenses
|
|
|
| Fixed costs per year:
| $30,000
| Fixed manufacturing overhead
| $10,000
| Fixed selling and administrative expenses
|
|
|
| Units in beginning inventory
| 0
| Units produced
| 6,000
| Units Sold
| 5,000
| Units in ending inventory
| 1,000
| Selling price per unit
| $20
| | | Selling and administrative expenses:
| | Variable per unit
| $3
| Fixed per year
| $10,000
|
[/t][/t][/t][/t][/t][/t] |
Required:
1. Prepare income statements using:
a. Absorption costing system
b. Variable costing system
2. Prepare a reconciliation schedule
| Absorption Costing Income Statement
| Sales (5,000 units×$20 per unit)
| $100,000
|
| ----------
| Less cost of goods sold:
| | Beginning inventory
| $0
| Add Cost of goods manufactured (6,000 units×$12per unit)
| $72,000
|
| ----------
| Goods avail able for sale
| $72,000
| Less ending inventory
| $12,000
|
| ----------
| Cost of goods sold
| $60,000
|
| ----------
| Gross Margin ($100,000 – $60,000)
| $40,000
| | ----------
| Less selling and administrative expenses
| | Variable selling and administrative expenses (5,000 × 3)
| $15,000
| Fixed selling and administrative expenses
| $10,000
|
| ---------
|
| $25,000
|
| ----------
| Net operating income ($40,000 – $25,000)
| $15,000
|
| ========
|
|
| | Variable Costing Income Statement
| Sales ($5,000units×$20 per unit)
| $100,000
| Less variable expenses:
| | Variable cost of goods sold:
|
| Beginning inventory
| $0
| Add variable manufacturing costs (1,000 units×$7 per unit)
| $42,000
|
| -----------
| Goods available for sale
| $42,000
| Less ending inventory (1,000 units×$7 per unit)
| $7,000
|
| ---------
| Variable cost of goods sold
| $35,000
| variable selling and administrative expenses
(5,000 units × $3 per unit)
| $15,000
| | ---------
| | 50,000
| | ----------
| Contribution margin ($100,000 − $50,000)
| 50,000
| | ----------
| Less fixed expenses:
| | Fixed manufacturing overhead
| $30,000
| Fixed selling and administrative expenses
| $10,000
| | ---------
| | $40,000
| | ---------
| Net operating Income ($50,000 − $40,000)
| $10,000
| | =======
| | |
[/t][/t][/t][/t][/t][/t] |
The income statements prepared above have different net operating income (http://www.accountingformanagement.com/net_operating_income.htm) figures. Now we will explain why net operating income (http://www.accountingformanagement.com/net_operating_income.htm) is different under both the costing systems.
Explanation:
Several points can be noted from the income statements prepared above:
Under absorption costing (http://www.accountingformanagement.com/absorption_costing_definition.htm) if inventories increase then some of the fixed manufacturing costs of the current period will not appear on the income statement as part of cost of goods sold (http://www.accountingformanagement.com/cost_of_goods_sold_definition.htm). Instead, these costs are deferred to a future period and are carried on the balance sheet as part of the inventory account. Such a deferral of cost is known as fixed manufacturing overhead deferred in inventory (http://www.accountingformanagement.com/fixed_manufacturing_overhead_deferred_definition.htm). The process involved can be explained by referring to income statements prepared above. During the current period 6,000 units have been produced but only 5,000 units have been sold leaving 1,000 unsold units in the ending inventory. Under the absorption costing system each unit produced was assigned $5 in fixed overhead cost. Therefore each unit going into inventory at the end of the period has $5 in fixed manufactured overhead cost attached to it, or a total of $5,000 for 1,000 units (1,000 × $5). This fixed manufacturing overhead cost of the current period deferred in inventory to the next period, when hopefully these units will be taken out of inventory and sold. This deferral of $5,000 of fixed manufacturing overhead costs can be clearly seen by analyzing the ending inventory under the absorption costing method:
Variable manufacturing costs (1000units × $7 per unit)
| $7,000
| Fixed manufacturing overhead costs (1,000 × $5 per unit)
| $5,000
|
| ---------
| Total ending inventory value
| $12,000
|
| =======
|
[/t][/t][/t][/t][/t][/t] |
In summary, under absorption costing, of the $30,000 in fixed manufacturing overhead costs incurred during the period, only $25,000 (5,000 $ per unit) has been included in the cost of goods sold. The remaining $5000 (1000 units not sold $5 per unit) has been deferred in inventory to the next period.
Under variable costing method the entire $30,000 in fixed manufacturing overhead costs has been treated as an expense of the current period (see the bottom portion of the variable costing income statement).
The ending inventory figure under the variable costing method is $5,000 lower than it is under the absorption costing method. The reason is that under variable costing, Only the variable manufacturing costs are assigned to units of product and therefore included in the inventory:
Variable manufacturing costs (1000units × $7 per unit)
| $7,000
|
[/t][/t][/t][/t][/t][/t] |
The $5,000 difference in ending inventories explains the difference in net operating income reported between the two costing methods. Net operating is $5,000 higher under absorption costing since, as explained above, $5,000 of fixed manufacturing overhead cost has been deferred in inventory to the next period under that costing method. Hopefully, when the units relating to this $5,000 fixed cost will be sold in the next period the cost attached to these units will be included in the cost of goods sold of the next period. This is called fixed manufacturing overhead cost released from inventory (http://www.accountingformanagement.com/fixed_manaufacturing_overhead_released_definition.htm).
The absorption costing system makes no distinction between fixed and variable costs; therefore, it is not well suited for CVP computations, which are important for good planning and control. To generate data for cost volume profit (CVP) analysis (http://www.accountingformanagement.com/cost_volume_profit_analysis.htm), it would be necessary to spend considerable time reworking and reclassifying costs on the absorption statement.
The variable costing approach to costing units of product works very well with the contribution approach to the income statement, since both concepts are based on the idea of classifying costs by behavior. The variable costing data could be immediately used in cost volume profit (CVP) calculations (http://www.accountingformanagement.com/cost_volume_profit.htm).
Advantages and Disadvantages of Absorption Costing System:
Learning Objectives:
1. What are the advantages and disadvantages of using absorption or full costing method?
Advantages of Absorption Costing:
It recognizes the importance of fixed costs in production;
This method is accepted by Inland Revenue as stock is not undervalued;
This method is always used to prepare financial accounts;
When production remains constant but sales fluctuate absorption costing will show less fluctuation in net profit and
Unlike marginal costing where fixed costs are agreed to change into variable cost, it is cost into the stock value hence distorting stock valuation.
Disadvantages of Absorption Costing:
As absorption costing emphasized on total cost namely both variable and fixed, it is not so useful for management to use to make decision, planning and control;
as the manager’s emphasis is on total cost, the cost volume profit relationship is ignored. The manager needs to use his intuition to make the decision.
Advantages of Variable or Direct or Marginal Costing System:
Learning Objectives:
1. What are the advantages of variable costing system?
2. Why absorption costing continues to be used almost exclusively for external reporting purposes?
V (http://www.accountingformanagement.com/variable_costing_definition.htm)ariable costing (http://www.accountingformanagement.com/variable_costing_definition.htm) has the following main advantages:
1. The data that are required for cost volume profit (CVP) analysis (http://www.accountingformanagement.com/cost_volume_profit.htm) can be taken directly from a variable costing (http://www.accountingformanagement.com/variable_costing_definition.htm) format income statement. These data are not available on a conventional income statement based on absorption costing (http://www.accountingformanagement.com/absorption_costing_definition.htm).
2. Under variable costing, the profit for a period is not affected by changes in inventories. Other things remaining the same (i.e. selling prices, costs, sales mix, etc.), profits move in the same direction as sales when variable costing is in use.
3. Managers often assume that unit product costs are variable costs. This is a problem under absorption costing, since unit product costs are a combination of both fixed and variable costs. Under variable costing, unit product costs do not contain fixed costs (http://www.accountingformanagement.com/fixed_cost_definition.htm).
4. 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 (http://www.accountingformanagement.com/variable_cost_definition.htm) and are buried in cost of goods sold and in ending inventories.
5. Variable costing data make it easier to estimate the profitability of products, customers, and other segments (http://www.accountingformanagement.com/segment_definition.htm) of the business. With absorption costing, profitability is obscured by arbitrary allocations of fixed costs.
6. Variable costing ties in with cost control methods such as standard costs and flexible budgets.
7. Variable costing net operating income (http://www.accountingformanagement.com/net_operating_income.htm) is closer to net cash flow than absorption costing net operating income. This is particularly important for companies having cash flow problems.
With all of these advantages one might wonder why absorption costing (http://www.accountingformanagement.com/absorption_costing_definition.htm) 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 (http://www.accountingformanagement.com/absorption_costing_definition.htm) is also attractive to many accountants because they believe it better matches costs with revenues. Advocates of absorption costing (http://www.accountingformanagement.com/absorption_costing_definition.htm) 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 (http://www.accountingformanagement.com/fixed_cost_definition.htm) of depreciation, taxes, insurance, supervisory, salaries, and so on, are just as essential to manufacturing products as are the variable costs (http://www.accountingformanagement.com/variable_cost_definition.htm). Advocates of v (http://www.accountingformanagement.com/variable_costing_definition.htm)ariable costing (http://www.accountingformanagement.com/variable_costing_definition.htm) argue that fixed manufacturing costs are not really the costs of any particular unit of product. These costs are incurred to have the capacity to make products during a particular period and will be incurred even if nothing is made during the period. Moreover, whether a unit is made or not, the fixed manufacturing cost will be exactly the same. Therefore, v (http://www.accountingformanagement.com/variable_costing_definition.htm)ariable costing (http://www.accountingformanagement.com/variable_costing_definition.htm) advocates argue that fixed manufacturing costs are not part of the costs of producing a particular unit of product and thus the matching principle dictates that fixed manufacturing costs should be charged to the current period. At any rate, absorption costing (http://www.accountingformanagement.com/absorption_costing_definition.htm) is the generally accepted method for preparing mandatory external financial reports and income tax returns. Probably because of the cost and possible confusion of maintaining two separate costing systems-one for external reporting and one for internal reporting-most companies use absorption costing (http://www.accountingformanagement.com/absorption_costing_definition.htm) for both external and internal reports.
Limitations of Variable Costing--GAAP and External Reports:
Learning Objectives:
1. What are the limitations of variable costing?
2. Is variable costing acceptable for external reports?
3. Do financial statements prepared under variable costing system conform to generally accepted accounting principles (GAAP)?
Practically speaking, absorption costing (http://www.accountingformanagement.com/absorption_costing_definition.htm) is required for external reports in United States and almost all over the world. A company that attempts to use variable costing (http://www.accountingformanagement.com/variable_costing_definition.htm) (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) (http://www.accountingformanagement.com/generally_accepted_accounting_principles_gaap.htm). Tax laws almost all over the world require the usage of a form of absorption costing (http://www.accountingformanagement.com/absorption_costing_definition.htm) for filling out income tax forms.
Even if a company must use absorption costing for its external reports, a manager can use variable costing (http://www.accountingformanagement.com/variable_costing_definition.htm) statements for internal reports. No particular accounting problems are created by using both costing methods--the variable costing method for internal reports and the absorption costing method for external reports. The adjustment from variable costing net operating income to absorption costing net operating income (http://www.accountingformanagement.com/net_operating_income.htm) is a simple one that can be easily made at year-end.
Top executives are typically evaluated based on the earnings reported to shareholders on the external financial reports. This creates a problem for top executives who might otherwise favor using variable costing for internal reports. They may feel that since they are evaluated based on absorption costing reports, decisions should also be based on absorption costing data.
Absorption Costing Around the World:
Absorption costing is norm around the world for external financial reports. After the fall of communism, accounting methods were changed in Russia to bring them into closer agreement with accounting methods used in the west. One result was the adoption of absorption costing
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Variable/Direct/Marginal and Absorption Costing Discussion Questions and Answers:
Questions:
1. Differentiate between direct costs and direct costing. See answer (http://www.accountingformanagement.com/variable_costing_questions_answers.htm#Direct%20costs%20are%20direct%20materials).
2. Distinguish between period costs and product costs. See answer (http://www.accountingformanagement.com/variable_costing_questions_answers.htm#Period%20costs%20are%20costs)
3. Why does the direct costing or variable costing theorist exclude fixed manufacturing costs from inventories? See answer (http://www.accountingformanagement.com/variable_costing_questions_answers.htm#Fixed%20manufacturing%20costs)
4. In the process of determining a proper sales price, what kind of cost figures are likely to be most helpful? See answer (http://www.accountingformanagement.com/variable_costing_questions_answers.htm#There%20is%20no%20way)
5. Why is it said that an income statement prepared by the direct costing procedure is more helpful to management than an income statement prepared by the absorption costing method? See answer (http://www.accountingformanagement.com/variable_costing_questions_answers.htm#An%20income%20statement%20prepared)
6. Why should the chart of accounts be expanded when direct costing is used? See answer (http://www.accountingformanagement.com/variable_costing_questions_answers.htm#Under%20a%20direct%20costing%20plan)
7. A manufacturing concern follows the practice of charging the cost of direct materials and direct labor to work in process but charges off all indirect costs (factory overhead) directly to income summary. State the effects of this procedure on the concern's financial statements and comment on the acceptability of the procedure for use in preparing financial statements. See answer (http://www.accountingformanagement.com/variable_costing_questions_answers.htm#The%20cost%20to%20manufacture%20usually)
8. Has the Internal Revenue Service approved direct costing for tax purposes? See answer (http://www.accountingformanagement.com/variable_costing_questions_answers.htm#The%20Internal%20Revenue%20Service)
9. A speaker remarked that even though direct costing has attractive merits, there are certain items that should be concerned before converting the present system. What hidden dangers or disadvantages are present in direct costing? See answer (http://www.accountingformanagement.com/variable_costing_questions_answers.htm#The%20hidden%20dangers%20or%20disadvantages)
10. List the arguments for and against the use of direct costing. See answer (http://www.accountingformanagement.com/variable_costing_questions_answers.htm#Arguments%20for%20the%20use)
11. Select the answer which best completes the statement: See answer (http://www.accountingformanagement.com/variable_costing_questions_answers.htm#%28a%29%203;)
| (a)
| The term meaning that all manufacturing costs (direct and indirect, fixed and variable) which contribute to the production of the product and traced to output and inventories is: (1) job order costing; (2) process costing; (3) absorption costing; (4) direct costing.
|
| (b)
| The term that is most descriptive of the type of cost accounting often called direct costing is (1) out of pocket costing; (2) variable costing; (3) relevant costing; (4) prime costing.
|
| (c)
| Costs treated as product costs under direct costing are: (1) prime costs only; (2) variable production costs only; (3) all variable costs; (4) all variable and fixed manufacturing costs.
|
| (d)
| The basic assumptions made in direct costing with respect to fixed costs is that fixed cost is: (1) controllable cost; (2) a product cost; (3) an irrelevant cost; (4) a period cost
|
| (e)
| Operating income computed using direct costing would generally exceed operating income computed using absorption costing if: (1) units sold exceed units produced; (2) units sold are less than units produced; (3) units sold equal units produced; (4) the unit fixed cost is zero
|
| (f)
| A company has operating income of $50,000; using direct costing for a given period. Beginning and ending inventories for that period were 13,000 units and 18,000 units, respectively. If the fixed factory overhead application rate is $2 per unit, the operating income using absorption costing is: (1) $40,000; (2) $50,000; (3) $60,000; (4) not determinable from the information given.
|
| (g)
| Absorption costing differs from direct costing in the: (1) fact that standard costs can be used with absorption costing but not with direct costing; (2) kinds of activities for which each can be used to report ; (3) amounts of costs assigned to individual units of product; (4) amount of fixed costs that will be incurred.
|
| (h)
| When a firm uses direct costing: (1) the cost of a unit of product changes because of changes in the number of units manufactured; (2) profits fluctuate with sales; (3) an idle capacity variance is calculated by a direct costing system; (4) product cost include variable administrative costs.
|
| (i)
| Operating income under absorption costing can be reconciled to operating income determined under direct costing by computing the difference between: (1) inventoried fixed costs in the beginning and ending inventories and any deferred over or under applied fixed factory overhead; (2) inventoried discretionary costs in the beginning and ending inventories; (3) gross profit (absorption costing method) and contribution margin (direct costing method); (4) sales as recorded under the direct costing method and sales as recorded under the absorption costing method.
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| (j)
| Under the direct costing concept, unit product cost would most likely be increased by: (1) a decrease in the remaining useful life of factory machinery depreciated by the units of production method; (2) a decrease in the number of units produced; (3) an increase in the remaining useful life of factory machinery depreciated by the sum of the years digits method; (4) an increase in the commission paid to salespersons for each units sold.
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| (k)
| When using direct costing information, the contribution margin discloses the excess of: (1) revenue over fixed cost; (2) projected revenue over the break even point; (3) revenue over variable cost; (4) variable cost over fixed cost.
See answers (http://www.accountingformanagement.com/variable_costing_questions_answers.htm#%28a%29%203;)
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Answers:
1. Direct costs are direct materials, direct labor, and other costs directly assignable to a product. Direct costing or variable costing is a procedure by which only prime costs plus variable factory overhead are assignable to a product or inventory; all fixed costs are considered period costs.
2. Period costs are costs charged against the income of the current period. In direct costing, the fixed factory overhead as well as selling and administrative expenses are treated as period costs. Expenses that apply to the production of goods are called product costs. Variable manufacturing costs are typical product costs in direct costing and are charged against income when the units to which they relate are sold.
3. Fixed manufacturing costs are the expenses of maintaining capacity; such expenses occur with the passage of time and not with the utilization of the facilities.
4. There is no way to prove that one type of cost figure is going to be more helpful than another in the determination of the sales price. The sales price must exceed all costs of every kind before a profit is realized, but this does not mean that some sales of a single product or sales of products could not be made at a price which recovers at least the variable costs or makes a contribution to the recovery of fixed expenses. The absorption or conventional cost approach to pricing looks at the long run total cost recovery. The marginal costing or direct costing approach looks at the short run profit contribution aspect of immediate sales. It seems probable that direct costing is more appropriate in making short run decisions with regard to production schedules and pricing products offered for sales, provided the total cost recovery in the long run is kept in mind.
5. An income statement prepared by the direct costing method presents cost of goods sold figures with variable costs only. These variable costs, based on the number of units sold, facilitate computing a contribution margin figure. Thus the direct costing income statement is preferred by the management because it follows management's decision making processes more closely that the statement based on absorption costing.
6. Under a direct costing plan, all variable expenses are channeled into the fixed category at the time the expenses are incurred. This procedure means that the chart of accounts has to be expanded to take care of the new accounts needed.
7. The cost to manufacture usually includes the sum of direct materials, direct labor, and applicable indirect factory costs. Consequently, by omitting indirect factory costs from work in process (WIP) the concern is understanding inventory accounts in comparison with concerns which follow the usual practice. At any particular time, then, its financial position (balance sheet) is incorrectly stated because: (a) work in process and finished goods are understated; (b) current assets are understated and so is the net working capital--and therefore the current ratio (http://www.accountingformanagement.com/current_ratio.htm) is understated; (c) total assets are under stated; (d) stockholder's equity is understated--particularly the retained earnings amount.
Of at least equal importance is the effect on the recorded results of operations. Unless the sum of the work in process and finished goods accounts happens to be the same at each balance sheet date, costs and revenue will not be matched in the usual manner, resulting in a corresponding distortion of reported income. Thus, if these inventories at the end of the year exceed the corresponding totals at the beginning of the year, Profits will be understated; if these inventories are below those at the beginning of the year, profits will be overstated.
It is not accepted accounting practice to omit all factory overhead from inventories. While the costs of idle facilities, excessive spoilage, and certain other variances and usual items may be treated as period costs, the usual indirect costs are considered assignable to the production of the period. These indirect factory costs are ordinarily not as easily assignable to products as are the direct cost; but at the time they are incurred, they are recoverable from future revenues. Therefore, they should be added to the direct costs and flow through inventories.
8. The Internal Revenue Service (IRS) does not permit the use of direct costing for tax purposes because it does not clearly reflect income.
9. The hidden dangers or disadvantages present in direct costing are:
(a) A change to direct costing will prohibit a comparison with the company's accounting information for any prior year unless past periods are changed to a direct costing basis.
(b) A seasonal business which produces for six months and sells its entire production in the next six months would show a sizeable loss for the first six months and a sizeable profit for the last six months.
(c) Those who use direct costing figures must understand the difference between conventional gross profit on sales and contribution to fixed costs and profits and realize the limitations of the contribution theory.
(d) In planning price and sales policies, the full cost to develop, produce, and market a product must be known. Using direct costs and looking at marginal contributions only would certainly be fallacious when new extensive use of existing expensive equipment or expansion of facilities.
(e) Direct costing might bring unsatisfactory management action when sales outrun production and inventories are being drawn on. Under these conditions, direct cost profits are higher than under absorption costing. The opposite is true when sales lag behind production.
(f) When used as the sole vehicle for the management decisions, direct costing can lead to a disregard for the need to recover fixed costs.
10. Arguments for the use of direct costing include the following:
(a) For profit planning purposes, management requires cost volume profit relationship data which are more readily available from direct cost statement than from absorption costing.
(b) Since fixed factory overhead is absorbed as a period cost, increasing or reducing production and differences in the number of units produced versus the number sold do not affect the per unit production cost.
(c) Direct costing reports are more easily understood by management because the statements follow management's decision making process more closely than do absorption costing statements.
(d) Reporting the total fixed cost for the period in the income statement directs management's attention to the relationship of this cost to profits.
(e) The elimination of allocated joint fixed cost permits a more objective appraisal of income contributions according to products, sales areas, kinds of customers, etc. Cost volume relationships (http://www.accountingformanagement.com/cost_volume_profit.htm) are highlighted.
(f) The similarity of the underlying concepts of direct costing, flexible budgets, break even analysis (http://www.accountingformanagement.com/Break_even_analysis.htm), and standard costs facilitates the adoption and use of these methods for reporting, cost control and financial planning.
(g) Direct costing provides a means of costing inventory that is similar to management's concept of inventory cost as the current out of pocket expenditures necessary to produce or replace the inventory.
(i) The computation of product costs is simpler and more reliable under direct costing because a basis of allocating the fixed cost, which involves estimates and personal judgment, is eliminated.
(j) A "true and proper" profit results from direct costing because only variable costs should be identified with production. Fixed costs occur with the passage of time.
Arguments against the use of direct costing include the following:
(a) Separation of costs into fixed and variable costs might be difficult, especially when such costs are semi variable in nature. Moreover, all costs--including fixed costs--are variable at some level of production and in the long run.
(b) Long-range pricing of products and other long range policy decisions require a knowledge of complete manufacturing cost which would require additional separate computations to allocate fixed overhead.
(c) The pricing of inventories by the direct costing method is not acceptable for income tax computation purposes.
(d) Direct costing has not been recognized as conforming with generally accepted accounting principles (GAAP) (http://www.accountingformanagement.com/generally_accepted_accounting_principles_gaap.htm) applied in the preparation of financial statements for stockholders and general public.
(e) Profits determined by direct costing are not "true and proper" because of the exclusion of fixed production costs which are a part of total production costs. and inventory. Production would not be possible without plant facilities, equipment, etc. To disregard these fixed costs violates the general principle of matching costs with revenues.
(f) The elimination of fixed costs from inventory results in a lower figure and consequent reduction of reported working capital for financial analysis purposes. The decrease in working capital may also weaken the borrowing position.
11. (a) 3; (b) 2; (c) 2; (d) 4; (e) 1; (f) 3*; (g) 3; (h) 2; (i) 1; (j) 1 (k) 3
*Operating income under direct costing + Cost deferred in inventory
$50,000 + $10,000
$60,000
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