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Introductory Management Accounting Variable Costing Vs Absorption Costing

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Title: Introductory Management Accounting Variable Costing Vs Absorption Costing


1
Introductory Management Accounting Variable
Costing Vs Absorption Costing
  • Topic 7- Ch. 7 (Appendix) L/S

2
Learning Objectives
  • Prepare a profit and loss statement using either
    variable or absorption costing
  • Reconcile the differences between variable and
    absorption costing
  • Describe how changes in sales and/or production
    levels affect net income under absorption and
    variable costing

3
Review
  • Costing systems
  • Measuring costs
  • Manufacturing overheads

4
Costing Systems
  • Major sources of variation in conventional
    costing systems stem from
  • The way costs are measured
  • The focus of the costing system
  • The method used to allocate manufacturing
    overhead to products
  • The cost included in product (or service) costs
  • Different costs for different purposes

5
Measuring costs
  • Actual costing
  • Actual costs assigned to products
  • Normal costing
  • Actual direct material labour and predetermined
    overhead
  • Standard costing
  • Budgeted direct materials direct labour cost
    and predetermined overhead rate

6
Costing Systems
  • Job costing
  • Costs are assigned to individual jobs
  • Process costing
  • Costs are traced to processes/departments and
    averaged across units produced
  • Hybrid costing
  • Combinations of two or more costing systems

7
Allocating Manufacturing Overheads
  • The number of overhead rates
  • Plant wide manufacturing overhead rate
  • Departmental overhead rates
  • The measure of cost driver volume
  • Budget volume
  • Normal volume
  • Theoretical capacity
  • Practical capacity

8
Selecting which costs to include
  • External reporting purposes
  • Product costs must include a share of fixed
    manufacturing overhead costs, and no
    non-manufacturing costs
  • Management decision-making purposes
  • A product cost may exclude fixed manufacturing
    overhead (variable costing) /or
  • Include non-manufacturing costs

9
Variable Costing and Absorption Costing
  • Variable Costing- only variable manufacturing
    costs assigned to products
  • Direct materials, direct labour and variable
    manufacturing overhead
  • Absorption costing- all manufacturing costs are
    assigned to products
  • Direct materials, direct labour, variable and
    fixed manufacturing overhead

10
Calculating profit under variable costing
  • Contribution (margin) statement- highlights the
    variable and fixed costs of the business
  • Total contribution margin (CM) Total sales
    revenue less total variable costs
  • Variable cost of goods sold- total direct
    materials, direct labour and variable overhead
    assigned to units sold.

11
Calculating profit under absorption costing
  • Profit statement separates manufacturing from
    non-manufacturing costs
  • Use of gross margin
  • Consistent with external reporting requirements

12
Absorption costing illustrated
  • Manufacturing costs become either COGS or
    Inventory

DM
DL
Fixed O/Heads
Variable O/Heads
WIP
Inventory
B/Sheet
PL
COGS
13
Variable costing illustrated
  • Only variable manufacturing costs assigned to
    products

DM
DL
Fixed O/Heads
Variable O/Heads
WIP
Inventory
B/Sheet
PL
COGS
14
Absorption and Variable Costing
  • Berry Co. produces a single product with the
    following information available

15
Absorption and Variable Costing
  • Unit product cost is determined as follows

Selling and administrative expenses are always
treated as period expenses (not product costs).
16
Absorption Costing Income Statements
  • Berry Co. had no beginning inventory, produced
    25,000 units and sold 20,000 units this year.

17
Variable Costing Income Statements
  • Variable costing by Berry Co.

18
What has happened?
  • Why has absorption costing a profit of 120,000
    which is 30,000 higher than the 90,000 reported
    under variable costing?

19
Was it magic?
  • The basic information was the identical for both
    methods of calculating profit

20
No! Nothing magical!
  • The 30,000 had been released as a period cost
    under variable costing (income statement).
  • The 30,000 was hiding in the absorption
    costing valuation of ending inventory (balance
    sheet)

21
Comparing Absorption and Variable Costing-
Comparison
  • Lets compare the methods.

22
Reconciling Income Under Absorption Variable
Costing
  • We can reconcile the difference between
    absorption and variable net income as follows

Fixed mfg. overhead 150,000 Units
produced 25,000
6.00 per unit

23
Extending the Example
Lets look at the second year of operations for
Berry Company.
24
Berry Co. Year 2
  • In its second year of operations, Berry Co.
    started with an inventory of 5,000 units,
    produced 25,000 units and sold 30,000 units.

25
Berry Co. Year 2
  • Unit product cost is determined as follows

There has been no change in Berrys cost
structure.
26
Berry Co. Year 2
Now lets look at Berrys income
statement assuming absorption costing is used.
27
Berry Co. Year 2
28
Berry Co. Year 2
Next, well look at Berrys income
statement assuming variable costing is used.
29
Berry Co. Year 2
30
What has happened? Why has absorption
costing a profit of 230,000 which is 30,000
lower than the 260,000 reported under variable
costing?
31
Summary
In the first period, production (25,000
units) was greater than sales (20,000).
32
Summary
In the second period, production (25,000
units) was less than sales (30,000).
33
Summary
For the two-year period, total absorption income
and total variable income are the same.
34
Comparison of Absorption Variable Costing
This was the case in the first period when
production of 25,000 units was greater than
sales of 20,000 units.
35
Comparison of Absorption Variable Costing
Inventory increased from zero to 5,000 units and
absorption income (120,000) was greater than
variable income (90,000).
36
Comparison of Absorption Variable Costing
In the second period sales of 30,000 units were
greater than production of 25,000units.
37
Comparison of Absorption Variable Costing
Inventory decreased from 5,000units to zero, and
absorption income 230,000 was less than variable
income 260,000.
38
Comparison of Absorption Variable Costing
For the two-year period, units produced equals
units sold, so total absorption income equals
total variable income.
39
Reconciling profit under variable and absorption
costing
  • When inventory increases or decreases during the
    period
  • Difference in fixed overhead expensed under
    absorption and variable costing equals the change
    in inventory multiplied by the predetermined
    overhead rate per unit
  • Over the long term, differences in profits
    between the two methods will diminish

40
Variable or absorption costing?
  • Valuing inventory
  • Only absorption costing is allowed for external
    reporting purposes
  • Providing relevant cost information
  • Variable costing- useful for short-term decisions
  • Absorption costing- useful for long-term decisions

41
Variable costing
  • Profit information from variable costing
  • Classification of fixed and variable costs
    simplifies predictions of the effects of changes
    in sales on profit
  • Link between sales performance and profit
    performance is easily understandable
  • Highlights the impact of fixed costs on profits
    by isolating them

42
Absorption costing
  • Profit information from absorption costing
  • No direct relationship between sales and profit
    so
  • Provides a poor basis for planning and control
  • May encourage managers to increase inventories to
    drive profits up
  • Meets the requirements for external reporting

43
Evaluation of Variable Costing
Consistent with CVP analysis.
Management finds it easy to understand.
Emphasises contribution in short-run pricing
decisions.
Advantages
Profit for period not affected by changes in
fixed mfg. overhead.
Impact of fixed costs on profits emphasised.
44
Evaluation of Absorption Costing
Fixed manufacturing overhead is treated the same
as the other product costs, direct material and
direct labour.
Consistent with long-run pricing decisions that
must cover full cost.
Advantages
External reporting and income tax law require
absorption costing.
45
Absorption and variable costing compared
  • Absorption

    Variable

    Costing Costing

46
Lecture example
  • See the Worksheet
  • Quality Packaging P/L produces a range of
    packaging products. The companys Drum plant
    produces and sell a high-quality stainless steel
    drum for packaging. The Drum plant uses normal
    absorption costing and sells its drums at cost
    plus 25 mark-up.

47
Lecture example
  • Additional information
  • FG inventory- start 10,000 units
  • FG inventory end 15,000 units
  • Sales revenue 5,062,500
  • Sales units 135,000 units
  • Applied fixed M/OH 700,000
  • Selling Admin. Costs
  • Fixed 200,000
  • Variable 270,000

48
Lecture example
  • Reconstruct the profit statement using
  • Absorption costing
  • Variable costing
  • Reconcile the difference between the two profits
  • (Based on Problem 7.40 L/S text 2nd ed.)
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