A. C Ezej~lue A. !1~ Okoye

ACCOUNTANCY: Management Companion

PAitetl6y: cp,of )I. C. <Ezejefue fDepartment of }l.ccountaru:y rfacufty of CJ3usiness }l.dininistmtion }1.6ia State Vnivemty, V rut u, .}16ia State, :Nigeria.

& (J) r. )f.CE. Ok,oye V epartmcnt of jl.ccounting, rfacufty of :Management Scieru;es 'University of rBenin, CJ3enin City, C£do State, 'Jfigeria.

<Pu6lislietf 6y: :NI(JF/1{!)'8{ JICCO'V1fl1!Nq .JfSSOCJ)flJJO'.N (!N.Jf.ft) 2004.

. ·'·

All Rights Reserved Nigerian. Accounting Association (NAA) 2004.

ISBN: 978-32941-5-6

CONSULTING EDITORS:

Prof. B. Akpa (Former National President NAA) Department of Accounting, Benue State University, Mak.urd~ Nigeria.

Prof. A.A. Okwoli (Former National Vice President NAA) Department o.f Accounting, University of Jos,

Jos, Nigeria.

Prof. Wilson E. Herbert General Manager, Nigerian Education Bank, Abuja, Nigeria.

Dr. M.A. Matnoma (Current National President NAA)

Department of Accounting, Ahmadu Bello University, Zwia, Nigeria.

Nigerian Ac Association advancement improving ac exchange of i<1

Membe to Accountin1 and Polyteclui in Accounting.

Nigenru Nigerian Aci following obje~

• (a) Proll

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(c)

(d)

sectJ lnsd Boru To scho Spot and AsS(J has pub1

This book Ac~ the Book of Re findings carrj Association. TI Nigerian Aco Nigerian Gov~ Financial am

. ru• accounting, decision-m~

The Editoi A

. . J sSOClation W11

rights for the~ book a succes

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CHAPTER TEN

PREFERENCE FOR VARIABLE COSTING UE IN THE VALUATION OF INVENTORY

ON GENERAL PURPOSE FINANCIAL .- STATEMENTS

PAT DONWA AND SYLVESTER ER!AB!E*

reporting on fina ncial statements, a is required to value inventory by the absorption

technique. Financial statements that include valued at variable cost only may be subject to n by external auditors, if the valuation differs from what it would be under absorption costing

. Because of these uncertainties variable costing (i.e . direc t costing) is often confined to purposes of

reporting only . Variable costing claims theoretical support for it being

the valua lion of inven tory by virtue of the generally accounting concept that period costs should be

in the profit a nd loss account of the period in th~y are incurred as against the a bsorption costing

which claims th a t inventory value should carry with it part of the period costs to future accounting

Using absorption costing technique, the part of the cost (i.e. fixed cost) embedded in inventory is not an

from the view point of 'Accounting Theory', since it have future service potential (i. e . revenue producing

, in the sense that fixed costs incurred during one · period h ave no bearing on re-incurring the same fixed cost in subsequent periods. A cost is viewed as

if it can be shown that it has futu re service

ontl.~rll't'.l'f (' l' l:'rtullle arc /.('Cfurers of ..lccmmllllg. ( !,u,·ersily t~{Bcnin, Hc111 11 C 'ity.

174

potentia l as generally viewed in accountin g theory. international Accounting Sta nda rd Com mittee Fra mework for the Preparation a nd Presentation of Sta tem ents ( 19 89, F19) defi n ed a n asse t as "a controlled by the en terprise a s a result of past · from which future economic benefits a re expected to the enterprise". Th is buttresses the basic principle a sset is only an asset if it is a source of future benefit'. (Lewis & Pen d rill: 1981, 73).

CONTROVERSY ON THE USE OF THE TERMS 'V COSTING', 'MARGINAL COSTING' AND 'DIRECT COST:

Though, the terms 'direct cos ting', 'm arginal a nd 'varia ble costing' is used intercha n geably, there been some disagreement on these terms, each being place of the other to reflect the sam e m eaning.

Although direct costing has earned th e m a ny accountants a n d businessmen, pa rticula rly the industry, the status of the m ethod as to accepta nce sti ll remains doubtful. As p ointed out by a nd Howa rd ( 19 82), controversy h as a ri sen no t only usefulness of "margina l costing" but even what the m eans. Horngren (1982) has a rgu ed tha t m ore terms would be va ria ble or m a rgina l costing since approach includes a n inventory that h a s not only el of direct m aterials and direct la bour but a lso indirect manufacturing costs. Batty ( 19 7 8 ,282) s tates "the m a in rea son for u se of 'direct costing' seem s to be is a description of long standing".

In their contributions to the d eba te ; Dru ry (1 Horngren et a l ( 1994) h ave argued tha t n either directs nor marginal costs are quite the same as va riable Direct costs a re those costs that can be specifically · with a product (i .e. those costs th a t are easily tracea the products) . They are d irect materials, direct la bour direct exp enses. However, in som e situa6ons direct 1 may not vaJY in the short run with changes in outpu t. use the term 'direct costing' as meaning the same a s

175

it specifically includes a non-variable item in the (i.e. direct labour) is n ot at all appropriate .

(1992) went further to a rgue that using the term costing" is 9-lso inappropriate. Economists use the

describe the cost of producing one additional unit. an application of this definition may lead to fixed · g included in a situation where the production of

al unit will result in a n increase in fixed costs, for the appointment of an a dditional supervisor, or an in capacity due to the purchase of additional

This differs from the accountants' definition of costing.

accountants use the term 'm a rgina l cost' to variable cost' (Lucey: 1986, 171). This implies

cost per unit of product or service . To the t, ma rginal cost is particula rly appropriate for

run decisions in a particular firm. While to the it is used as an explanation of the cost behaviour

in general (Lucey: 1986, 172). As margina l cost may be interpreted in different ways

tants and economists, it is better not to use the referring to stock valu a tion (Drury : 1992, 188 -

m th e a bove explanation, it is clea r that the use of "variable cos ting" is more appropriate; hence it is

adopted in this paper.

COSTING AND ABSORPTION COSTING Variable costing adopts a system in which all direct

ble manufacturing overhead costs a re allocated to ts. Va r iable costing is an approach to product

that relies h eavily upon cost behaviour analysis and 'bution approach to incom e determination - an in which only variable manufacturing costs are

ted and attached to products . Put differently, it is of inventory costing in which a ll direct g costs and variable m a nufacturing overhead included as inventoria ble costs, fixed

176

manufacturing overhead costs are excluded from inventoriable costs and are costs of the period in which are incurred .

Proponents of varia ble costing are of the view fixed manufacturing costs are incurred on tim e basis not d epend on the units produced. In other words m a nufacturing costs expire with the passage of regardless of production activity and that these incurred for the benefits of operations during a given of time. This benefit is unchanged by the actual operations during the period a nd the benefits expire end of the period . For example, the fixed overhead costs rent a nd supervisory salaries will still be irrespective of whether any actual production takes

On the other hand, absorption costing sometimes referred to as full costing, views product consisting of both the variable and fixed costs of In other words, it refers to a system in m a nufacturing costs both fixed and variable a re cu1ucaLc

products. Advocates of this m ethod rest their argument

principles that the fixed costs are assigned to the because each unit benefits from the capacity prov fixed costs. The time period in their view is purely in to the operation of the business . It is furthe r a rgued since revenu e is derived from the sale of the p p roduction costs regardless fixed or variable matched with revenue in the period of sale.

The primary difference between the two m in the treatm ent of fixed m a nufacturing cost. A costing includes fixed m anufacturing cost as pa rt of of goods sold and part of closing stock. Marginal the other h a nd does not treat fixed manufacturing cos t a s part of product cost. It treats it as a period consequently no fixed overhead cost is included closing stock for the period. All the fixed man costs of the period are charged against profit and account as expenses.

177

. . ney rs recerve

their relatic with in the 1

they relate. , the earned ted tha t rev , must be rna and loss accc

technique ' ced by charg t of the per

which a re a J

a fun ction c that the fixed ~ cost of pro tes productio1 level of produc In theory, var ss as a cons of time. Whe. d expire with st be m atche

only source of

general terms, absorption costing emphasises the between production costs and all other costs. On

hand, variable costing emphasises the distinction fixed and variable costs . Each values inventory

costing justified · ble costing is accepted as being proper, right and

by the accrual concept, which is one of the accepted accounting concepts. The accrual concept

in SSAP 2 as follows : 'revenues and cost are (i.e. recognised as they are earn.ed or incurred, not

is received or paid) , match ed with one another so their relationship can be justifiably assumed, and

in the profit and loss account of the period to they relate . This implies that for any accounting the earned revenue and a ll the incurred costs that .. . -· .. .

that revenue provided they both relate to the must be m a tched with one another and shown in the

loss account. This concept justifies the variable technique \Vhich conforms to the accrual concept

by charging period costs against profit and loss of the period to which they relate as only those

which are a function of output should be deferred as costs and matched against future revenue.

tes of variable costing contend that fixed g overhead is incurred to provide the capacity These fixed costs a re incurred every year and

a function of production volume (i. e . output). They t the fixed portion of-manufacturing overhead is not

f1 cost of production but only a standby cost which production and which must be incurred regardless I of production or sa les .

theory, variable costing views the fixed cost of a . as a constant quantity that is _incurred during a

of time. When the time period expires, the fixed costs expire with it . Accordingly, the whole of the fixed be match ed with the revenue of the period, as this

only source of revenue from which the fixed costs can

178

.. ,1 •

be recovered. The next accounting period will incur its fixed overhead . Therefore, it is regarded a s irrational to in the inventory account any portion of the previous fixed costs. Moreover, fixed costs are the result of a kind of management decision hence it is re accord a different accounting treatment to th.e fixed variable portions of manufacturing overhead.

Variable costing is also justified on the basis of termed 'Contribution Theory'. Sales revenue is consist of two parts:

(1) A reimbursement of total variable costs, and (2) The remainder of the sales revenue, which con

to the coverage of fixed costs and profits.

Applying this to the measurement of income; accords with economists' concept of the margin, clearly demonstrates that profit does not accrue on a basis. No profit regardless of price ·is realised until costs are fully recovered .

THEORY ACCEPTANCE. From the foregoing explanation of variable

there is ample evidence to accept variable costing as a generally accepted method of accounting. · But a s regards theory acceptance as given by the Accounting Association (1977) concluded that a universally accepted basic accounting theory does not as at this time. Instead, a multiplicity of theories has and continues to be proposed. The Basic Accounting of the American Accounting Association ( 1966), also that there is no generally accepted accounting justify accounting standard. It follows that a generally accepted accounting principles does not exist

This suggests that those efforts by various formulate a unified theory .in accounting is · may not yield the desired result . But what exists financial accounting literature is a collection of

179

be

Some tin in dete some ca where 1

profit j jluctuati (CICA: 1

can d

recognizes

Where} howet are subject tc kept in balar these (period) that as they C<

of production ( the effect of n in the period L

which it shoul expenses m a properly relate

tants who ac financial st

f

ariable •sting g. · But r the

that

can be arrayed over the difference m user­t specifications (AAA: 1977, 1-2).

PRONOUNCEMENTS ON THE ACCEPTABILITY uu.~D.LI!:J COSTING

have been official pronouncements on the of variable costing. For instance, the committee

ting and Auditing Research of the Canadian of Chartered Accountants (CICA) states:

Sometimes- certain costs are excluded in determining inventory values... in some cases; fixed overhead is excluded where its inclusion would distort the profit for the year by reason of fluctuating volume of production. (CICA: 1950, 2).

can deduce from the above statement an of acceptability of variable costing. Also, the

of Chartered Accountants in England and Wales recognizes the accepta bility of variable costing. It

Where, however, the levels (of production or sales) subject to materials fluctuation and are not

in balance, it may be decided to exclude these (period) expenses from stock on the ground that as they could be incun-ed whatever the levels of production or sales, their inclusion in stock has the effect of relieving the profit and loss account in the period w hen they are incun-ed of expenses which it should fairly bear and of charging these expenses in a later period to which they do not properly relate. (I(;AEW: 1960, 3)

Underdown (1982, 525-533) states ts who advocate the· use of absorption costing for

financia l s tatements deprive investors of a useful

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analytical device and make the task results more difficult".

McGregor ( 1961, 269) notes th at: "In a rriving at cost of work in progress it was u n desira ble to indulge what is no better than guesswork: and a la rge part of absorption cost m ethod appeared to the learned judge involve the 'wildest' guesswork".

Zimmerman ( 1995,482) opines that "Absorption systems can distort reported profit s as -production change, crea ting for managers to over produ ce a nd create larger inventories ."

Wright ( 1962) reports that upwards of 40% company that use variable cos t ing (i.e. direct co internally also use the method in externa l fi statements. Moreover, among the remaining companies use variable costing, there is a strong preferen ce for reports, which agree with interna l financia l statements.

ACCOUNTING THEORY'S VIEW ON THE INCLUSION FIXED COST IN INVENTORY VALUATION.

The fundamental issue h ere is to a scertain fixed costs added to inventory fa lls with in the definition asset as generally viewed in accoun tifig theory . Ace theory has a comprehensive definition of a ssets. International Accounting Standard Committee framework for the Preparation and Presentation of S ta tements (1989,Fl9) defined a n asset a s 'a re controlled by the enterprise as a result of pa st events from which future economic ben efits are expected to the enterprise. It should be noted th a t the key elements control (not ownership), future economic benefits and need to be a ble to identify a past transaction or event gave rise to the a sset. A m ajor element of these elements is that a cost is viewed as a n a s se t if it shown that it has future economic ben efits t h a t a re if it be shown that it h a s revenue-producing powers , or will be beneficial in some ways to operations in periods . One would say that a s set s h ave fu ture e

181

le, h as argu tes t better

If this l

two mE

variabl< reqwre1 future l costs . rncurrec cas e oj since U future _ op eratic

a cturing co

cri te r ion n ting per

Fixed r n test fo r

during or rring the s

No p art be carr ied

costs don

to the extent that they save costs in the fu ture. This the costs obviation concept and advocates of

costing h ave used it to argue th a t varia ble costing is to absorption costing. Wetnight (1958:84), for has argued that variable costing m eets the future

better than absorption costing in the following

If this test of futu re benefit is applied to the two metl]ods of costing it can be seen that variable costing most closely meets the requirements. In the first p lace there is a fu ture benefit from the incurrence of variable costs. The·se costs will not need to be incurred in a future period. However, in the case of fixed costs, no future benefit exists since these costs will be incurred during the future period no matter what the level of operations.

a variable costing viewpoint, variable­ring costs satisfies the futu re benefit of cost

criterion since inventory produced but unsold in ting period relieves subsequent periods of further Fixed m anufacturing overheads fai ls the cost test for fu ture benefits since the fixed costs

during one accounting period have no bearing on the same kind of fixed costs in subsequent

No part of the fixed production costs of one year be carried forward as an asset to the following year costs do not result in future cost avoidance .

OF VARIABLE COSTING TECHNIQUE N COSTING TECHNIQUE.

nwa (1992,292) identified the following as of varia ble costing technique;

fixed cosls from the produ ct cost, it preparation of responsibility-based

182

income statement for production managers, enabling them to act upon variances and disc under their control.

2. Under variable costing, end of year production cannot be used to manipulate profit. Under a costing, it is possible to produce m ore units be sold for the sole aim of charging greater part fixed cost to closing stock , there by increasing profit. Such practice is n ot possible under costing since all the fixed costs are cha rged to and loss account irrespective of the number of sold.

3. Since profit is normally recognized a t the time and not at the time of production, the marginal costing moves with level of sales and is a better measure of index of changes in the fortunes.

4. It eliminates the need to allocate, a pportion absorb fixed overhead costs into product.

5. Varia ble costing technique of contribution. margin the following: (i) It assists in determining the product profita (ii) It assists in price fixing especially when the

working below capacity. (iii) It assesses the effect of a change in volume

miX.

However, in addition to the above, our variable costing information enables both investors to plan and make economic decisions. This supported by Lucey ( 1986, 176) who opines, "The marginal costing principles (i.e . variable costing) in

183

m

m or e v2 d in va statemj

ue, w h ich:

"'ater ~easing

under h.arged umber

making 1s universal and 1s of considerable

lSSUe at stake is as to whether variable costing should be u-sed in the valua tion of inventory in

to absorption costing technique on external statemen ts.

earlier explanations, it is clear that valuation of using the absorption costin g technique has its

Carrying forward an expired part of fixed to subsequent accounting period h as a tendency of the profit for the year by reason of fluctuating

of production . accounting theory's view point, including part of fixed cost in the valu e of inventory using the

costing technique is wrong because that expired portion embedded in the value of the inventory is

t since it does not have fu ture economic benefits ,of the fact that it does not have the capacity to save

the future , moreso, it does not h ave any bearing on the sam e fixed costs in subsequent periods.

conclusion summarily, is that since variable technique can a id both managem ent and investors in more valua ble economic decisions , it should be

in valuing inventory for externa l reporting on statements in preference to absorption costing , which is being currently a dopted.

184

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M. H. (1 977): Basic Boston: Houghton

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and Finance, Plymount: Macdonald & Evans Ltd.

Canadian Institute of Chartered Accountants 1950: Meaning of the Term Cost as used in Valuation", Bulletin, No. 5 , Committee and Auditing Research, p. 2.

Chartered Institute of Management Accountants, Terminology of Management and Accountancy, Great Britain: ICMA.

Drury, Colin ( 1992): Management and Cost Accounting, Edition, London: Chapman and Hall Ltd.

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185

of C (1960) : Progress Principle

Framewo financial Standard Departm

~hton

c.

M.W.E. & · Underdown, ( 1982): Accounting Theory Practice, London: Pitman Books Ltd.

Nils, H. (1 9_78): "Where We Are in.Accounting: A of Statement on Accounting Theory and Theory

, The Accounting Review, July, pp. 71.7-

, Eldon S . and Van Breda, M. (2001): Accounting

( 1982): Costing Accounting: A Emphasis, 51h Edition, Englewood Cliff, New

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Charles, T., Foster G. and Data r Strikant, (1994): t Accounting: A Managerial Emphasis, 81h Edition,

d Cliff, New Jersey: Prentice-Hall nal Inc.

in England and Wales "Treatment of Stock-in-Trade a nd Work-in-

in Financial Accounts", Accounting s, No. 22.

Accounting Sta ndard Committee ( 1989): rlc for the preparation and presentation of statements, London: International Accounting

rd Committee Framework Publications nt.

Richard and Pendrill David , ( 1996): Advance Financial nting, 5 111 Edition, London: Pitman Publishing.

Terry (1986): ACCA combined study and Revision al Costing, London : DP Publications Ltd .

186

McGragor, G. (1961): "Accountan cy in the Lords" , Tax Journal, July- Augus t , P: 269.

Omolehinwa, Eddy ( 1991): Coping .with Cost Ikej a : Puma rk Nigeria Limited.

Pea snell, K. V. ( 1987): "Statemen t of Accounting Theory Accepta nce", Accounting and Research, London: Institu te of Chartered Ace in England and Wales, Summer, p. 217-225.

Wetnight, R. B. (1958) : "Direct Costing Passes Benefit Test", National As sociation of Bulletin, p . 84.

Wright, W. (1962): Direct Standard Cos ts for and Control, New York: McGraw-Hill.

Zeff, S .A. (1973): Financial Accounting Theory I: Controversies, 2 nd Edition, New York: McGraw-Hill

Zimmerman, Jerold, L. (1 995): Accounting for Making and Control 2 nd Edition Bos ton: Irwin/ Hill.

187