© McGraw-Hill Education (UK) Limited 2013 COST REPORTING Chapter 5 1

© McGraw-Hill Education (UK) Limited 2013 Absorption costing means all production costs are absorbed into products. This means that the cost of production, or the cost of sales in financial accounting terms, will be measured according to absorption costing techniques and include a portion of fixed manufacturing overhead cost. In variable costing only variable manufacturing costs are included in product costs and fixed costs are treated as a period cost. The choice of method – absorption or variable costing – for reporting purposes will depend on the use of the information by managers, but you may have guessed that profit figures will vary depending on the method adopted. Absorption vs. variable costing 2

© McGraw-Hill Education (UK) Limited 2013 Some management accountants and management accounting textbooks use the term marginal costing in place of variable costing. The term marginal costing is more often used by economists, where marginal cost means the cost of one additional unit of output. Economists argue that fixed costs would increase as new productive equipment or resources may be required to increase output, that is, fixed costs are stepped. While this may be true, management accounting typically views costs as fixed within a relevant range of output, thus the marginal cost of one extra unit of output does not include any fixed costs. 3 Absorption vs. variable costing

© McGraw-Hill Education (UK) Limited 2013 Absorption costing defines full cost as: All variable manufacturing costs plus a portion of fixed manufacturing overhead. In other words: Fixed manufacturing overhead is treated as a product cost. 4 Absorption vs. variable costing

© McGraw-Hill Education (UK) Limited 2013 Variable costing The layout of this profit statement is slightly different from the one using absorption costing as It shows the contribution, which is calculated as sales less variables cost. Fixed costs are then deducted from contribution to derive a profit figure. You can also see that the meal preparation costs are calculated using variable cost per unit and inventory is valued similarly using variable unit cost. 5 Absorption vs. variable costing

© McGraw-Hill Education (UK) Limited 2013 This is because the cost of sales to the income statement does not vary, as the fixed manufacturing overhead expensed is the same using either method. When sales exceeds production, then more fixed manufacturing overhead is expensed under absorption costing, so the profit will be lower than variable costing. When the reverse occurs, production exceeds sales, more fixed manufacturing overhead is deferred to later periods, so the expensed overhead is less using absorption costing, thus yielding a higher profit than variable costing. 6 Absorption vs. variable costing

© McGraw-Hill Education (UK) Limited 2013 Management accounting was set out with a primary objective of assisting organizational decision-making. The profit statements are part of the decision- making tools used on a regular basis by managers. In order to make sound business decisions, managers need to have information presently to them in a clear, understandable format suitable to the decision purpose. 7 Absorption vs. variable costing

© McGraw-Hill Education (UK) Limited 2013 Choosing a costing method Absorption costing has a major advantage in that it meets the requirements of International Financial Reporting Standards. IAS 2 (Inventories), paragraph 12 states: ‘the cost of conversion of inventories include costs directly related to the units of production, such as direct labour. They also include a systematic allocation of fixed and variable production overheads that are incurred in converting materials into finished goods’. The requirements of IAS 2 implies that all external reporting must calculate production and inventory costs using absorption costing techniques. Thus all companies will use absorption costing at least once per year when preparing annual financial statements. However, as noted earlier absorption costing could lead to undesirable inventory building, particularly if managers are incentivized on the basis of profits. 8 Absorption vs. variable costing

© McGraw-Hill Education (UK) Limited 2013 Worked Example 5.1 Bottling plant capacity and utilization BM Bottling own a highly automated bottling plant and offer services to distillers, breweries and wine-makers. Their plant can bottle a maximum of 1,500,750 ml bottles per hour. The plant runs two 8-hour shifts and works 20 days each month. Fixed manufacturing overhead is £70,000 per month. Taking the above capacity, the maximum output level would be: 1,500 bottles × 8 hours × 20 days = 240,000 bottles This capacity level is referred to as the theoretical capacity. Assuming theoretical capacity, the overhead rate per 750 ml bottle would be £0.292 (£70,000/240,000). 9 Absorption vs. variable costing

© McGraw-Hill Education (UK) Limited 2013 In practice, the theoretical capacity level is not achieved due to reductions in output caused by equipment maintenance, downtime, and so on. The practical capacity of a plant takes such issues into account. Assuming 1.5 days per month is lost at the BM Bottling plant, then its practical capacity is now: 1,500 bottles × 8 hours × 18.5 days = 222,000 bottles 10 Absorption vs. variable costing

© McGraw-Hill Education (UK) Limited 2013 Variable costing offers a number of advantages for internal reporting purposes over absorption costing, as follows: 1. Variable costing techniques are more useful in reporting profitability of products, customers and business segments. This is due to the somewhat arbitrary nature of allocation fixed costs using absorption costing Techniques 2. The fixed costs are easily identifiable on variable costing profit Statements whereas absorption costing includes fixed costs in unit cost. Fixed costs are not relevant to many managerial decisions (see Chapter 13). 3. Using variable costing, managers see the actual unit costs which are controllable in the short term. Using absorption costing, a manager cannot easily separate the costs into fixed and variable components. Profit reporting 11

© McGraw-Hill Education (UK) Limited 2013 Variable costing does not affect profitability to the same extent as absorption costing when inventory levels are increased. Assuming sales price and variable costs remain constant, profit will increase or decrease in tandem with sales levels when variable costing is used. With absorption costing, for example, sale levels may remain static, but increasing Production (and thus inventory) levels will increase profits without any corresponding increase in sales. Arguably, the profit reported under variable costing is closer to the actual cash flows generated by business operations. This information may be particularly important if a business is experiencing tight cash flows. Variable costing profit statements may be more easily understood by junior managers and other employees. This may be particularly important in organizations where larger information systems distribute cost information to a broad audience. 12 Profit reporting

© McGraw-Hill Education (UK) Limited 2013 Nowadays, accounting and business information systems offer quite powerful information processing and analysis capabilities, particularly at the higher end of the market, and can provide cost information in multiple formats. For example, the Product Cost Controlling Information System (or CO-PC-IS) module of SAP (an enterprise resource planning system) can display product costs as fixed, variable or full.1 Thus, with systems like SAP, a business can produce profit statements using either variable or absorption costing in a few mouse clicks, so no addition effort is required once product costs are input to the system. 13 Profit reporting

© McGraw-Hill Education (UK) Limited 2013 Dugdale et al. (2006) reported that 68 per cent of companies they surveyed used variable costing profit statements. More recently, CIMA’s Annual Management Accounting survey (CIMA, 2009) reported that approximately 45 per cent of 439 respondent organizations used absorption costing as the main operational costing tool, with approximately 35 per cent using variable costing. The choice of method is thus mixed according to this research. Ultimately, the costing method used will depend on organizational context and the nature of decision making within the organization – for example, more frequent short-term decisions may imply more use of variable costing. Impact on managers 14

© McGraw-Hill Education (UK) Limited 2013 JIT environment One of the main goals of a JIT environment is to dramatically reduce, or even eliminate, materials inventory and work in progress. In such an environment with little or no inventory, the profits reported under variable and absorption costing will be very similar. This does not mean that product costs are the same, as absorption costing includes fixed manufacturing costs, but any difference in reported profits are likely to disappear as no inventory is allowed to build up. 15 Impact on managers

© McGraw-Hill Education (UK) Limited 2013 Lean organizations and throughput accounting A ‘lean’ approach can be applied in manufacturing or service organizations. Essentially, a lean approach eliminates all forms of waste in an organization and focuses on delivery the product or service as quickly and efficiently as possible. In lean manufacturing, there are three key underlying tenets (Cunningham and Fiume, 2003): 1. A pull-demand approach – producing the product as customers require rather than to inventory. 2. Flow production – production should flow as individual products/order rather than in batches. Product movements should be minimized and any wait times eliminated. 3. Takt (or cycle) time – the manufacturing process should be altered to match the cycle time required to meet customer demand. This typically means reducing the time. 16 Impact on managers

© McGraw-Hill Education (UK) Limited 2013 Throughput accounting Throughput accounting is based on the ideas of Goldratt (see Goldratt and Cox, 2004) which were first revealed in his book The Goal in Goldratt presented his theory of constraints, which is based on the concept that: For an organization to achieve its overriding goal, it must define the primary constraint which allows it to achieve or maximize that goal. 17 Impact on managers

© McGraw-Hill Education (UK) Limited 2013 The theory of constraints/ financial aspects 1. Totally variable costs – this means a cost which is incurred only when a product is produced. In practice, this often means only material costs. All overhead costs are not totally variable. 2. Throughput – this refers to revenue less totally variable costs. Thus, a contribution using throughput accounting is likely to be higher than in a traditional sense. 3. Operating expenses – this refers to all costs other than totally variable costs. Operating expenses are not distinguished into categories such as fixed or variable, or allocated to products in any way. In a way, operating expenses are similar to period costs, as they are costs which are more associated with the passage of time than with products. 4. Net profit – in throughput accounting, the net profit is simply throughput minus operating expenses. Arguably, a key advantage of throughput accounting is that is overcomes the problem of overhead cost allocation associated with both traditional absorption costing and activity-based costing 18 Impact on managers