Part 1
Study Unit 2
Cost Allocation Techniques
Absorption versus Variable Costing
• You need to be able to answer the following:
– Under absorption costing, which cost are considered product
cost? Which costs are considered period cost?
– In the variable costing, which costs are considered product cost?
Which costs are considered period cost?
– What income statement format is appropriate for variable cost?
– When is income of the variable costing higher than income and
absorption costing?
– What format can be used to calculate the difference between
income under variable costing and income and absorption
costing?
– What managerial behavior does variable costs were render
ineffective?
3.1 Absorption and Variable Costing Theory
Overview
Product cost consist of all the costs incurred the production of a
product: direct materials, direct labor, and manufacturing
overhead.
The process to classified all these costs as part of product costs is
referred to as absorption costing (or full costing).
Absorption costing is the cost accumulation method required by
generally accepted accounting principles (GAAP) for external
reporting, and by regulatory body such as the Internal Revenue
Service.
continued
3.1 Absorption and Variable Costing Theory
Overview
The main reason is that absorption costing
satisfies the matching principle, which states
that expenses should be matched with revenues
they generate.
Based on the matching principle, our product
cost flow through raw materials inventory, work
in process inventory, and finished goods
inventory until the goods are sold.
3.1 Absorption and Variable Costing Theory
Overview
One thing you have to ask yourself is, if inventory unit
costs combined variable cost (typically direct materials,
direct labor, and overhead) with fixed cost (typically
overhead), how can managers make sound decisions?
One way is to use variable costing (or direct costing) in
which only variable product costs are accumulated in the
inventory accounts.
In variable costing, fixed manufacturing overhead is
treated as a period expense rather than product cost,
meaning it is expensed in the period in which it is
incurred.
3.1 Absorption and Variable Costing Theory
Overview
The main advantage other variable costing
method is that income cannot be manipulated
by management action, whereas management
can manipulated income when using absorption
method.
Absorption Costing
Sales
- Product Costs (incl. fixed and variable)
= Gross Margin
- Total S, G & A (fixed and Variable)
Variable Costing
Sales
- Product Cost (only variable cost)
= Contribution Margin (portion available to cover fixed
costs
- Fixed Costs (both mfg. and S, G & A)
- Under variable costing, fixed overhead is considered a
cost of maintaining capacity, not a cost of producing a
product.
- Contribution margin will tell you if you are covering at
least the direct product costs
3.1 Absorption and Variable Costing Theory
• See comparison shown on page 92
3.1 Absorption and Variable Costing Theory
• Impact on Operating Income
– Produced = Sold = no difference in income
– Produced > Sold > income
• When production exceeds sales, fewer fixed cost are expensed
under the absorption basis, and operating income always
increases.
• A production manager can thus increase absorption-based
operating income by increasing production, whether there is any
customer demand for the additional product or not.
• This practice, called producing for inventory, can be effectively
discouraged by using variable costing for performance reporting
and consequent bonus calculation.
3.1 Absorption and Variable Costing Theory
– Produced < Sold < income
• Variable costing will show a higher income in periods when
inventories decline because absorption method forces the
subtraction of all of the current fixed costs, plus some fixed
costs incurred (and capitalized) in prior periods.
• Most importantly, in using variable costing, profits always
move in the same direction as sales volume. Profits
reported on absorption costing behave erratically and
sometimes move in the opposite direction from sales
trends
3.1 Absorption and Variable Costing Theory
SU 3.1 Question 1
Question 1 - CMA1 Study Unit 3:
Cost Allocation Techniques
Which method of inventory costing
treats direct manufacturing costs and
manufacturing overhead costs, both
variable and fixed, as inventoriable
costs?
A.
Direct costing.
B.
Variable costing.
C.
Absorption costing.
D.
Conversion costing.
SU 3.1 Question 1 Answer
Correct Answer: C
Absorption (full) costing considers all manufacturing costs to be inventoriable
as product costs. These costs include variable and fixed manufacturing costs,
whether direct or indirect. The alternative to absorption is known as variable
(direct) costing.
Incorrect Answers:
A: Variable (direct) costing does not inventory fixed overhead.
B: Variable (direct) costing does not inventory fixed overhead.
D: Conversion costs include direct labor and overhead but not direct
materials.
SU 3.1 Question 2
Question 2 - CMA1 Study Unit 3: Cost
Allocation Techniques
Huntington Corporation pays bonuses to its
managers based on operating income, as
calculated under variable costing. It is now 2
months before year end, and earnings have
been depressed for some time. Which one
of the following actions should Wanda
Richards, production manager, definitely
implement if she desires to maximize her
bonus for this year?
A.
B.
C.
D.
Step up production so that more
manufacturing costs are deferred into
inventory.
Cut $2.3 million of advertising and marketing
costs.
Postpone $1.8 million of discretionary
equipment maintenance until next year.
Implement, with the aid of the controller, an
activity-based costing and activity-based
management system.
SU 3.1 Question 2 Answer
Correct Answer: C
Because the production manager wishes to maximize her bonus for the coming year,
the action she must take will necessarily have most of its effect in the short run. The
action she should take to achieve this goal is to defer costs under her control until the
following period.
Incorrect Answers:
A: The perverse incentive to “produce for inventory” only works under absorption
costing.
B: The production manager has no control over advertising and marketing costs.
D: Activity-based costing and activity-based management require time, effort, and
resources in the short run and only show benefits over the long run.
3.2 Absorption and Variable Costing - Calculations
3.2 Absorption and Variable Costing - Calculations
• See extended example on page 94
Variable Costing Practical Exercise
Variable Costing Practical Exercise Solutions
3.1 Absorption and Variable Costing Theory
continued
• Other benefits of variable costing:
– Variable costing is better suited for management's needs
which requires a knowledge of cost behavior under various
operating conditions. For planning and control,
management is more concerned with treating fixed and
variable costs separately than with calculating full cost.
– Full costs are usually dubious value because they contain
arbitrary allocation of fixed cost.
– The production manager cannot manipulate income levels
over overproducing.
continued
3.1 Absorption and Variable Costing Theory
–
–
–
–
The cost data for profit planning and decision-making are readily available from
accounting records and statements under variable costing. For example cost
profit relationships and the effects of changes in sales volume on that income
can easily be computed from income statement prepared under the variable
costing concept, but not from the conventional absorption costing income
statement based on the same data.
Absorption cost income statements may show decreases in profits from sales
and rising and increases in profits from sales or decreasing, which may be
confusing to management.
A favorable margin in the variable costing justifies a higher production level.
Variable costing is also preferred over absorption costing for studies of relative
profitability of products, territories, and other segments of a business. A
concentrate on the contribution of each segment makes to the recovery of
fixed costs that will not be altered by decisions to make and sell.
continued
3.1 Absorption and Variable Costing Theory
• Inventory changes have no effect on the breakeven computation.
• Disinvestment decisions are facilitated because were their product
or department is recouping its variable cost can be determined. If
the variable costs are being covered operating a department at
apparent loss may be profitable.
• Cost figures are guided by the sales figures. Under variable costing
cost of goods sold very directly with sales volume, and the influence
of production of gross profit is avoided.
• There will costing also eliminates a possible difficulties have explain
over and under applied factory overhead to higher management.
SU 3.2 Question 1
• Question 1 - CMA1 Study Unit 3: Cost Allocation
Techniques
• A manufacturing company employs variable costing for
internal reporting and analysis purposes. However, it
converts its records to absorption costing for external
reporting. The Accounting Department always
reconciles the two operating income figures to assure
that no errors have occurred in the conversion. The
fixed manufacturing overhead cost per unit was based
on the planned level of production of 480,000 units.
Financial data for the year are presented below:
SU 3.2 Question 1 Answer (continued)
Budget
Actual
Sales (in units)
495,000
510,000
Production (in units)
480,000
500,000
Variable
Absorption
Costing
Costing
Variable costs
$10.00
$10.00
Fixed manufacturing overhead
0
6
Total unit manufacturing costs
$10.00
$16.00
SU 3.2 Question 1 (continued)
The difference between the
operating income calculated under
the variable costing method and the
operating income calculated under
the absorption costing method would
be
A.
$57,600
B.
$60,000
C.
$90,000
D.
$120,000
SU 3.2 Question 1 Answer
Correct Answer: B
The difference between variable costing and absorption costing is that the former
treats fixed manufacturing overhead as a period cost. The latter method treats it as a
product cost. Given that sales exceeded production, both methods expense all fixed
manufacturing overhead incurred during the year. However, 10,000 units (510,000
sales – 500,000 production) manufactured in a prior period were also sold. These units
presumably were recorded at $10 under variable costing and $16 under absorption
costing. Consequently, absorption costing operating income is $60,000 (10,000 units ×
$6) less than that under variable costing.
Incorrect Answers:
A: The amount of $57,600 equals 10,000 units times $5.76 per unit (total budgeted
fixed manufacturing overhead ÷ 500,000 units).
C: The amount of $90,000 is the difference between planned sales (495,000 units)
and actual sales (510,000 units), times the fixed manufacturing overhead per unit ($6).
D: The amount of $120,000 is the volume variance under absorption costing.
SU 3.2 Question 2
Question 2 - CMA1 Study Unit 3: Cost Allocation Techniques
Pontotoc Industries manufactures a product that is used as a subcomponent by
other manufacturers. It has the following price and cost structure:
Selling price
$300
Costs
Direct materials
$40
Direct labor
30
Variable manufacturing overhead
24
Fixed manufacturing overhead
60
Variable selling
6
Fixed selling and administrative
20
Operating margin
-180
$120
What will the contribution margin
per unit be if the company sells
10,000 units?
A.
$206
B.
$200
C.
$140
D.
$120
SU 3.2 Question 2 Answer
Correct Answer: B
Contribution margin is the excess of sales over variable costs. Sales will be at
$300 per unit. Variable costs are $100, consisting of $40 of direct materials,
$30 of direct labor, $24 of variable overhead, and $6 of variable selling costs.
Thus, the contribution margin will be $200 per unit ($300 – $100).
Incorrect Answers:
A: Excluding variable selling costs results in $206.
C: Including fixed manufacturing overhead results in $140.
D: This amount is the operating margin.
3.3 Joint Product and By-Product
• Joint processing and the split off point
– Joint (common) cost are those costs incurred up
to the point where products become separately
identifiable, called the split off point. They can
include direct materials direct labor and
manufacturing overhead, and must be allocated
to the individual joint products.
– Separable cost and be identified with a particular
joint product and allocated to a specific unit of
output.
3.3 Joint Product and By-Product
• Since joint cost cannot be traced to individual
products, they must be allocated. There
essentially four methods of doing so:
1. Physical-measure-based approach
2. Market-based approach
1. Sales value at split off method
2. Estimated net realizable value method
3. Constant gross margin percentage NRV method
3.3 Joint Product and By-Product
• See examples on page 98 - 100
3.3 Joint Product and By-Product
• By-products - Are products of relatively small total
value that are produced simultaneously from a
common manufacturing process with products of
greater value and quantity.
– If additional processing and selling cost exceed the selling
price they should be scrapped.
– If they can be processed further at a gain than the
question becomes are the byproduct material, and if so
they should be capitalized in a separate inventory account,
which essentially reduces the cost of goods sold.
– If the byproducts are immaterial after further processing
their not recognize until the time of sale.
SU 3.3 Question 1
Question 1 - CMA1 Study Unit 3: Cost
Allocation Techniques
In joint-product costing and analysis,
which one of the following costs is
relevant when deciding the point at which
a product should be sold to maximize
profits?
A.
B.
C.
D.
Separable costs after the split-off point.
Joint costs to the split-off point.
Sales salaries for the period when the units
were produced.
Purchase costs of the materials required for
the joint products.
SU 3.3 Question 1 Answer
Correct Answer: A
Joint products are created from processing a common input. Joint costs are
incurred prior to the split-off point and cannot be identified with a particular
joint product. As a result, joint costs are irrelevant to the timing of sale.
However, separable costs incurred after the split-off point are relevant
because, if incremental revenues exceed the separable costs, products should
be processed further, not sold at the split-off point.
Incorrect Answers:
B: Joint costs have no effect on the decision as to when to sell a product.
C: Sales salaries for the production period do not affect the decision.
D: Purchase costs are joint costs.
SU 3.3 Question 2
Question 2 - CMA1 Study Unit 3:
Cost Allocation Techniques
The primary purpose for allocating
common costs to joint products is to
determine
A.
The selling price of a by-product.
B.
Whether one of the joint products
should be discontinued.
C.
The variance between budgeted and
actual common costs.
D.
The inventory cost of joint products for
financial reporting.
SU 3.3 Question 2 Answer
Correct Answer: D
Joint products must be valued for external financial reporting purposes based on the
full (absorption) cost of the product. Any common costs attributable to the joint
production process must therefore be allocated on a systematic and rational basis.
Incorrect Answers:
A: The selling price of a by-product is determined by market forces outside the
manufacturer’s control, not by the manufacturer’s cost structure.
B: The decision to discontinue a joint product is based on the incremental profit
from that product, not the allocation of common costs.
C: A variance between budgeted and actual costs is scrutinized regardless of the
method of allocating common costs.