1. (C) Ghanendra Fago( M Phil, MBA)1 Income Recognition and Reporting: Variable and Absorption Costing

2. (C) Ghanendra Fago( M Phil, MBA) 2 Concept of Product Cost The cost of making a product is called product cost. It is also known as manufacturing cost. Product costs are taken for inventory valuation. So product costs are sometimes called inventory cost as well. Inventorial costs are all costs of product that are regarded as assets when they are incurred and then become costs of goods sold when the product is sold. Product cost affects the value of inventory and the profit differs. Raw material cost is an example of a product cost.

3. (C) Ghanendra Fago( M Phil, MBA) 3 The costs that are indifferent to the level of production are period cost. Period costs do not change with the change in production volume. Rather, these costs are incurred either for sales activity or with the passage of time Period cost are not taken for inventory valuation. All period costs are deducted from the revenues of the same period. Office and administrative and department costs, and marketing department costs are good examples of period costs. Period Cost

4. (C) Ghanendra Fago( M Phil, MBA) 4 Under Variable CostingUnder Absorption Costing Product Costs Direct Material Direct Labour Variable Manufacturing Costs Period Costs Fixed manufacturing costs General & administrative costs Selling & distribution costs Product Costs Direct Material Direct Labour Variable Manufacturing Costs Fixed manufacturing Costs Period Costs General & Administrative Costs Selling & Distribution Costs

5. (C) Ghanendra Fago( M Phil, MBA) 5 Product Costing The process of determining cost of production. There two method of determining cost of product for accounting purposes: They are: (a) Absorption costing and (b) Variable costing

6. (C) Ghanendra Fago( M Phil, MBA) 6 Variable Costing It is also called marginal costing, direct costing, Contribution margin format. Variable costing includes only variable production costs in product costs. Fixed manufacturing overhead is treated as a period cost and is charged against income each period. Cost of production is Direct materials xxxxx Direct labours xxxxx Variable overheadsxxxxx Cost of goods manufacturedxxxxxx.

7. (C) Ghanendra Fago( M Phil, MBA) 7 Absorption Costing Also called traditional costing, conventional costing, full costing It treats all production costs as product costs, regardless of whether they are variable or fixed. Under this costing, a portion of fixed manufacturing overhead is allocated to each unit of product. Cost of production includes Direct materials xxxxx Direct labours xxxxx Variable overheadsxxxxx Fixed manufacturing overhead xxxxx Cost of goods manufacturedxxxxx

8. (C) Ghanendra Fago( M Phil, MBA) 8 INCOME STATEMENT UNDFER VARIABLE COSTING ParticularsDetailsAmount Sales revenue (Sales units  SPPU)  Less: Variable cost of goods sold: Direct material @...  production units  Direct labour @...  production units  Variable Overhead @..  production units  Total variable manufacturing costs  Add: Opening stock @...  Cost of goods available for sales  Less: Closing stock @...  Variable cost of goods sold  Gross contribution margin  Less: Non-manufacturing variable costs @..  Sales  Net contribution margin  Less: Fixed costs Manufacturing  Non-manufacturing  Net Income before tax 

9. (C) Ghanendra Fago( M Phil, MBA) 9 INCOME STATEMENT UNDFER VARIABLE COSTING ParticularsDetailsAmount Sales revenue (Sales units  SPPU)  Less: Variable cost of goods sold: Direct material @...  production units  Direct labour @...  production units  Variable Overhead @...  production units  Total variable manufacturing costs  Add: Opening stock @...  Cost of goods available for sales  Less: Closing stock @...  Variable manufacturing cost of goods sold  Add: Non-manufacturing variable costs @...  Sales  Total variable costs of sales  Net Contribution margin  Less: Fixed manufacturing cost  Fixed non-manufacturing cost  Net Income before tax 

10. (C) Ghanendra Fago( M Phil, MBA) 10 Absorption Costing Under Income Statement ParticularsDetailsAmount Sales revenue (Sales units  SPPU)  Less: Manufacturing cost of goods sold: Direct materials @...  production unitsx  Direct labour @...  production unitsx  Variable overhead @...  production unitsx  Fixed manufacturing overhead @.  production unitsx  Cost of goods manufactured  Add: Opening stock @... x  Cost of goods available for sale  Less: Closing stock @... x  Cost of goods sold  Gross margin before adjustmentsxxxxx Less: Under absorption of fixed manufacturing overhead  Add: Over absorption of fixed manufacturing overhead (  )  Gross margin after adjustments  Less: Variable non manufacturing @... X sales  Fixed non manufacturing costs  xxxx Net income before tax 

11. (C) Ghanendra Fago( M Phil, MBA) 11 UNDER/OVER ABSORPTION OF FIXED MANUFACTURING OVERHEAD Fixed manufacturing cost is considered as constant cost which is unaffected due to change into production units. The increase or decrease in production volume does not affect the total fixed cost. Thus, fixed manufacturing overhead is allocated to product cost based on normal level activities. It is determined on the basis of normal capacity level of production. The differences between normal capacity and actual production create over absorption or under absorption of fixed manufacturing overhead. Installed capacity - Maximum units that can be produced Normal capacity- Average production level Actual capacity - Actual production Fixed overhead per unit = Fixed overhead/Normal capacity Capacity Concepts

12. (C) Ghanendra Fago( M Phil, MBA) 12 Reconciliation Statement ParticularsDetails Difference Net profit as per variable costingxxxxxxx Less: Net profit as per absorption costingxxxxxxx DIFFERENCE IN PROFITXxxxxx Opening stock in unitsxxxxxxx Less: Closing stock in unitsxxxxxxx Difference in stock xxxxxx Fixed manufacturing cost per unitxxx DIFFERENCE IN PROFIT (DIFF. STOCK X FIXED COST PER UNIT) xxxxx

13. (C) Ghanendra Fago( M Phil, MBA) 13 Absorption Vs Variable Costing 1. Production Equals Sale When production equals sales, inventories do not change. If inventories do not change, then there is no change in the fixed manufacturing overhead costs in inventories under absorption costing. Therefore, under both costing methods all of the current fixed manufacturing overhead will flow through to the income statement as an expense. In the case of absorption costing it will be part of cost of goods sold. In the case of variable costing, it will be a period expense.

14. (C) Ghanendra Fago( M Phil, MBA) 14 2. Production Exceeds Sales (Inventories Increase) When production exceeds sales, inventories grow. If inventories grow, then some of the current fixed manufacturing overhead costs will be deferred in inventories under absorption costing. Since all of the current fixed manufacturing overhead costs are expensed under variable costing, the net operating income reported under absorption costing will be greater than the net operating income reported under variable costing.

15. (C) Ghanendra Fago( M Phil, MBA) 15 Sales Exceed Production (Inventories Decrease) When sales exceed production, inventories shrink. If inventories decrease, then some of the fixed manufacturing overhead costs that had been deferred in inventories in previous periods will be released to the income statement as part of cost of goods sold as well as all of the current fixed manufacturing overhead costs. Since only the current fixed manufacturing overhead costs are expensed under variable costing, the net operating income reported under absorption costing will be less than the net operating income reported under variable costing.

16. (C) Ghanendra Fago( M Phil, MBA) 16 Long-term Differences In Income Over an extended period of time, the cumulative net operating income figures reported under absorption costing and variable costing will be about the same. They will differ only by the amount of fixed manufacturing overhead cost in ending inventories under absorption costing. Cumulative net operating income figures will be identical whenever ending inventories are reduced to zero Changes In Production Volume Variable costing net operating income is not affected by changes in production volume. On the other hand, absorption costing net operating income is affected by changes in production volume. For any given level of sales, net operating income under absorption costing will increase as the level of output increases and hence inventories increase.

17. (C) Ghanendra Fago( M Phil, MBA) 17 Use of Absorption Vs. Variable costing Accountants and managers have been arguing for decades concerning the relative merits of absorption and variable costing. In practice, absorption costing is used far more than variable costing even for internal reports. The reasons for this are not entirely clear, although the perception that absorption costing is required for external reporting undoubtedly plays a key role. Argument for absorption costing Advocates of absorption costing argue that all manufacturing costs must be assigned to units of product so as to properly match costs with revenues. They argue that fixed manufacturing overhead costs are essential to the production process and must be included when costing units of product, regardless of how the cost behaves.

18. (C) Ghanendra Fago( M Phil, MBA) 18 Argument for Variable Costing Advocates of variable costing argue that fixed manufacturing overhead costs are incurred in order to have the capacity to produce. Moreover, they will be incurred regardless of whether anything is actually produced. Since these costs are not caused by any particular unit of product and are incurred to provide capacity for a particular period, the matching principle would dictate that fixed manufacturing overhead costs must be expensed in the current period.

19. (C) Ghanendra Fago( M Phil, MBA) 19 Advantages of Variable Costing More useful for CVP analysis. Variable costing statements provide data that are immediately useful for CVP analysis since they categorize costs on the basis of their behavior. In contrast, it is often difficult to rework absorption costing data so that they can be used in CVP analysis and in decisions. Income is not affected by changes in production volume. Under absorption costing, reported net operating income is affected by changes in production since fixed costs are spread across more or fewer units. This can distort income and may even result in income moving in an opposite direction from sales. This does not occur under variable costing.

20. (C) Ghanendra Fago( M Phil, MBA) 20 Avoids misunderstandings concerning unit product costs. Absorption costing unit product costs can be easily misinterpreted as variable costs since they are stated on a per unit basis. Such a misperception can lead to serious errors in making decisions. Variable costing avoids this problem since unit costs include only variable costs. Fixed costs are more visible. The impact of fixed costs on profits is emphasized because the total amount of such costs for the period appears separately and is highlighted in the income statement rather than being buried in cost of goods sold and ending inventory. Understandability. Managers should find it easier to understand variable costing reports because data are organized by behavior and because variable costing is much closer to cash flow. Facilitates in Control:. Variable costing ties in with cost control methods such as flexible budgets.

21. (C) Ghanendra Fago( M Phil, MBA) 21 CASE 1: The Directorium Manufacturing Company produced: 80,000 units of new products during 1990 and sold 60,000 units at Rs. 50 each. The cost for 1990 were as follows: Direct materials Rs.200,000 Direct labour Rs.160,000 Variable Manufacturing Overhead Rs.320,000 Fixed Manufacturing overheadRs.440,000 V. Selling/administrative expenses Rs.80,000 F. Selling and administrative expensesRs. 280,000 There was no ending work in process inventory. Required: a) Income statements for the year 1990 using (i) direct costing method (ii) Absorption costing method b) Give the reasons for differences in reported net income or net loss in requirement a (i) and a (ii).

22. (C) Ghanendra Fago( M Phil, MBA) 22 Income Statement Under Contribution Margin Approach ParticularsAmount Sales revenue @ Rs.50 eachRs.3,000,000 Less: Variable manufacturing cost of goods sold: Direct materials @ 2.5 each200,000 Direct labour @ 2 each160,000 Variable manufacturing overhead @ 4 each320,000 Total variable manufacturing costs680,000 Add: Opening stock @ 8.5 eachNil Cost of goods available for sales680,000 Less: Closing stock @ 8.5 each (20,000 units)170,000510,000 Gross contribution margin2,490,000 Less: Variable selling and administrative80,000 Net contribution margin2,410,000 Less: Fixed costs: Manufacturing440,000 Selling and administrative280,000720,000 Net income1,690,000

23. (C) Ghanendra Fago( M Phil, MBA) 23 Income Statement Under Absorption Costing ParticularsAmount Sales revenue @ Rs.50 eachRs.3000,000 Less: Manufacturing cost of goods sold: Direct materials @ 2.5 each200,000 Direct labour @ 2 each160,000 Variable manufacturing overhead @ 4 each320,000 Fixed manufacturing overhead @ 5.5 each440,000 Total manufacturing costs11,20,000 Add: Opening stock @ 14 eachNil 1120,000 Less: Closing stock @ 14 each280,000840,000 Gross margin21,60,000 Less: Non-manufacturing costs: Variable selling and administrative expenses80,000 Fixed selling and administrative expenses280,000360,000 Net income1800,000

24. (C) Ghanendra Fago( M Phil, MBA) 24 Reconciliation Statement ParticularsDetails Differenc e Net profit as per variable costing16,90,000 Less: Net profit as per absorption costing18,00,000 Difference in profit110,000 Opening stock in units0 Less: Closing stock in units20,000 Difference in stock 20,000 Fixed manufacturing cost per unit5.5 Difference in profit (Diff. stock x fixed cost per unit)110,000

25. (C) Ghanendra Fago( M Phil, MBA) 25 Assignment I Even question numbers for EVEN ROLL NUMBERS Uneven question numbers for UNEVEN ROLL NUMBERS Submission Within one week from the date of completion of chapter