Group 4

Direct Materials

Direct Labor

Variable Manufacturing Overhead

Fixed Manufacturing Overhead

Variable Selling and Administrative Expenses

Fixed Selling and Administrative Expenses

VariableCosting

AbsorptionCosting

ProductCosts

PeriodCosts

ProductCosts

PeriodCosts

Source: Managerial Accounting /Garrison-Noreen-Brewer/McGraw-Hill International Edition

Variable costing income statements are easier to understand because net operating

income is only affected by changes in unit sales. Thisproduces net operating income figures that aremore consistent with managers’ expectations.

Variable costing income statements are easier to understand because net operating

income is only affected by changes in unit sales. Thisproduces net operating income figures that aremore consistent with managers’ expectations.

Source: Managerial Accounting /Garrison-Noreen-Brewer/McGraw-Hill International Edition

CVP Analysis, Decision Makingand Variable Costing Variable Costing harmonizes well with CVP

analysis because it essentially treats fixed manufacturing overhead as a period cost.

Treating fixed manufacturing overhead as a variable cost can:

• Lead to faulty pricing decisions and keep-or-drop decisions.

• Produce a higher net operating income compared to variable costing

Treating fixed manufacturing overhead as a variable cost can:

• Lead to faulty pricing decisions and keep-or-drop decisions.

• Produce a higher net operating income compared to variable costing

Source: Managerial Accounting /Garrison-Noreen-Brewer/McGraw-Hill International Edition

Advantages

Management findsit more useful.

Consistent withCVP analysis.

Net operating income is closer to

net cash flow.

Profit is not affected bychanges in inventories.

Consistent with standardcosts and flexible budgeting.

Impact of fixedcosts on profitsemphasized.

Easier to estimate profitabilityof products and segments.

Source: Managerial Accounting /Garrison-Noreen-Brewer/McGraw-Hill International Edition

DISADVANTAGES OF VARIABLE COSTING

DISADVANTAGES

Inconsistent with the Tax regulation and GAAP requirements

Inconsistent with how executives are evaluated by investors

understated inventory - lower net operating income

Overheads that are essential to producing a product do not form part of the product cost

Under Absorption Costing

To conform toTo conform toGAAP requirements,GAAP requirements,

absorption costing must be used forabsorption costing must be used forexternal financial reports in theexternal financial reports in the

United States. United States.

To conform toTo conform toGAAP requirements,GAAP requirements,

absorption costing must be used forabsorption costing must be used forexternal financial reports in theexternal financial reports in the

United States. United States.Under the Tax

Reform Act of 1986,absorption costing must be

used when filling out income tax returns.

Under the TaxReform Act of 1986,

absorption costing must beused when filling out income tax returns.Since top executives

are typically evaluated based on earnings reported to shareholders

in external reports, they may feel that decisions should be based on

absorption costing data.

Since top executivesare typically evaluated based on

earnings reported to shareholdersin external reports, they may feel that

decisions should be based on absorption costing data.

Source: Managerial Accounting /Garrison-Noreen-Brewer/McGraw-Hill International Edition

IFRS # 2 InventoriesInternational Accounting Standard (IAS) 2

Inventories...The cost of inventories shall comprise all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition

Sources : Wiley IFRS 2008 : Interpretation and Application of International Financial Reporting Standards - Barry J. Epstein, Eva K. Jermakowicz and IAS 2 Inventories

US Treasury Reg section 1.263A-1T

Also known as Uniform Capitalization (UNICAP)Itemizes the direct and indirect costs that must be

capitalized. Direct materials, direct labor, and certain types of overhead costs are required to be capitalized. In the regulations, overhead costs have typically been placed into three categories.

Under pre-1986 Act law, "category I" costs were capitalized; "category II" costs were expended; and "category III" costs were capitalized for tax purposes if they were capitalized for financial reporting purposes.

Under the new law, all category I and category III costs (except the costs of strikes and idle time) and certain types of category II costs must be capitalized.

UNICAP Summary

IRS.GOV - http://www.irs.gov/businesses/small/industries/article/0,,id=97675,00.html

Absorption CostingAdvantages DisadvantagesWidely accepted – method

used for external reporting

Recognises the importance of fixed costs in production

Stock is not undervalued – ensures that costs are fully recovered

Identifies the profitability of different products and services

Not useful for management to use to make decisions, planning and control

Portion of fixed cost is carried over to subsequent period as part of closing stock

Hard to distinguish between variable and fixed cost

Net profit varies with sales and stock values – variability of profit will cause confusion

Cost per unit changes from period to period due to existence of fixed overhead

Cost BehaviourAbsorption

CostingVariable Costing

Cost of Good Sold High Low

Ending Inventories High Low

Gross Margin Low High

Net Operating Income High Low

Normal Corporate Income Taxes

High Low

Minimum Corporate Income Tax Low High

Unit Cost High Low

Break Even Point Low High

Bridging the GAP for Labor CostsFixed Variable

Paid by result or per piece

X

Paid on daily / weekly or monthly without quota

X

Paid on daily / weekly or monthly, with overtime premiums , without quota

X X

Paid on daily / weekly or monthly - with quota

X

Paid on daily / weekly or monthly, with overtime premiums, with quota

X X

In a JIT inventory system . . .

Productiontends to equal

sales . . .

So, the difference between variable andabsorption income tends to be minimal or zero.

Source: Managerial Accounting /Garrison-Noreen-Brewer/McGraw-Hill International Edition

Source: Managerial Accounting /Garrison-Noreen-Brewer/McGraw-Hill International Edition

Impact on Lean ProductionThe difference in net operating income between

absorption and variable costing occur because of the changes in the number of units in the inventory. Under Lean Production, goods are produced to customers’ orders and the goal is to eliminate finished goods inventories entirely and reduce work-in-process almost entirely, thus, the differences in net operating income will be very minimal.

Just-in-time production

Questions?