1. Management and Cost Accounting, 6 th edition, ISBN 1-84480-028-8 © 2004 Colin Drury MANAGEMENT AND COST ACCOUNTING SIXTH EDITION COLIN DRURY

2. Management and Cost Accounting, 6 th edition, ISBN 1-84480-028-8 © 2004 Colin Drury © 2000 Colin Drury Part Two: Cost accumulation for inventory valuation and profit measurement Chapter Seven: Income effects of alternative cost accumulation systems

3. Management and Cost Accounting, 6 th edition, ISBN 1-84480-028-8 © 2004 Colin Drury 7.1a © 2000 Colin Drury Absorption and variable costing 1.Absorption costing (also known as full costing) traces all manufacturing costs to products and treats non-manufacturing overheads as a period cost. 2.Variable costing (also known as direct or marginal costing) traces all variable costs to products and treats fixed manufacturing overheads and non-manufacturing overheads as a period cost. 3.Therefore,variable and absorption costing differ in the treatment of fixed manufacturing costs.

4. Management and Cost Accounting, 6 th edition, ISBN 1-84480-028-8 © 2004 Colin Drury 7.1b © 2000 Colin Drury

5. Management and Cost Accounting, 6 th edition, ISBN 1-84480-028-8 © 2004 Colin Drury 7.2 © 2000 Colin Drury

6. Management and Cost Accounting, 6 th edition, ISBN 1-84480-028-8 © 2004 Colin Drury 7.3 © 2000 Colin Drury Variable costing statements

7. Management and Cost Accounting, 6 th edition, ISBN 1-84480-028-8 © 2004 Colin Drury 7.4 © 2000 Colin Drury Absorption costing statements

8. Management and Cost Accounting, 6 th edition, ISBN 1-84480-028-8 © 2004 Colin Drury 7.5a © 2000 Colin Drury Profit comparisons (variable and absorption costing) Profits are the same for both methods when production equals sales (no changes in stock levels)in periods 1 and 4. Where production exceeds sales (increasing stock levels) the absorption costing system produces higher profits in periods 2 and 5. Where sales exceed production (declining stock levels)the variable costing system produces higher profits in periods 3 and 6. With an absorption costing system profits can decline when sales volume increases and costs remain unchanged (e.g.period 6).

9. Management and Cost Accounting, 6 th edition, ISBN 1-84480-028-8 © 2004 Colin Drury 7.5b © 2000 Colin Drury Some arguments in support of variable costing Variable costing provides more useful information for decision-making. Variable costing removes from profit the effect of stock changes. Variable costing avoids fixed overheads being capitalized in unsaleable stocks. Some arguments in support of absorption costing Absorption Costing does not understate the importance of fixed costs. Absorption costing avoids fictitious losses being reported (e.g stocks accumulated for seasonal sales). Absorption costing is theoretically superior to variable costing.(Note cost obviation concept favours variable costing,whereas revenue production concept favours absorption costing.)

10. Management and Cost Accounting, 6 th edition, ISBN 1-84480-028-8 © 2004 Colin Drury 7.6 © 2000 Colin Drury Conclusion 1.Choice depends on the circumstances. Volatile sales and changing stock levels favour variable costing for internal monthly or quarterly profit measurement. Seasonal sales where stocks are built up in advance favours absorption costing. 2.Debate only applies to internal reporting – SSAP 9 requires that absorption costing is used for external reporting. 3.Debate only applies when historical cost accounting is used.

11. Management and Cost Accounting, 6 th edition, ISBN 1-84480-028-8 © 2004 Colin Drury 7.7a © 2000 Colin Drury Alternative denominator level measures Absorption costing systems require the computation of estimated fixed overhead rates. The fixed overhead rate will be significantly influenced by the choice of the denominator level.

12. Management and Cost Accounting, 6 th edition, ISBN 1-84480-028-8 © 2004 Colin Drury 7.7b © 2000 Colin Drury Example Annual budgeted fixed overheads for a machine cost centre £192 000 The cost centre operates 3 shifts of 8 hours for 5 days per week for 50 weeks (6 000 hours) Practical operating capacity to allow for preventative maintenance 5 000 hours Requirements based on average sales demand for next 3 years is 4 800 hours Budgeted usage for the coming year 4 000 hours Four different denominator levels can be used 1. Theoretical maximum capacity of 6 000 hours = £32 per hour (£192 000/6 000 hours) 2. Practical capacity of 5 000 hours = £38.40 per hour (£192 000/5 000 hours) 3. Normal average long-run activity of 4 800 hours = £40 per hour (£192 000/4 800 hours) 4. Budgeted activity of 4 000 hours = £48 per hour (£192 000/ 4 000 hours)

13. Management and Cost Accounting, 6 th edition, ISBN 1-84480-028-8 © 2004 Colin Drury 7.8a © 2000 Colin Drury Assuming actual activity and spending is the same as budget the annual costs will be allocated as follows: Allocated to Volume variance Total products cost of unused (£) capacity) Practical £153 600 £38 400 192 000 capacity (4 000 hrs × £38.40)(1 000 hrs × £38.40) Normal £160 000 £32 000 192 000 activity (4 000 hrs × £40)(800 hrs ×£40) Budgeted £192 000 Nil 192 000 activity (4 000 hrs × £48)

14. Management and Cost Accounting, 6 th edition, ISBN 1-84480-028-8 © 2004 Colin Drury 7.8b © 2000 Colin Drury The choice of an appropriate activity level can have a significant effect on the inventory valuation and profit computation. Assuming 90%of output is sold and no openings inventories the above costs will be allocated as follows: Allocated to cost of sales inventories Total £ £ £ Practical capacity 176 640 15 360 192 000 Normal activity 176 000 16 000 192 000 Budgeted activity 172 800 19 200 192 000 For many organizations the allocation of costs between cost of sales and inventories is not an issue. Note the theoretical disadvantages of using budgeted activity.