Full (absorption) costing VS Variable (marginal) costing
Instead of gross profit, what term do we use in MC?
- AC includes ALL mfg costs (variable & fixed) in inventoriable costs; MC only includes variable mfg costs in inventoriable costs
- In MC, fixed mfg costs are charged directly to I/S as period costs. ∴ fixed costs are not capitalised under MC (but variable costs, yes). AC capitalises both variable and fixed costs.
- MC classifies costs by Behaviour: fixed vs variable
CONTRIBUTION
Formula for preparing I/S using MC
Revenue Less: Variable costs Mfg Non-mfg = CONTRIBUTION !!!
Less: fixed costs
Mfg
Non-mfg
= OPERATING PROFIT
Support for MC & argument against AC?
(MC is actually not allowed under IAS2)
AC can smooth out profit by deferring the fixed production overheads through high levels of production than needed.
- Avoids issue of arbitrary apportionment of fixed OH costs
- Only includes variable costs & Most costs are variable in the long run, ∴ relevant to users of financial statements (decision-making). MOST variable costs tend to be controllable.
- fixed costs are often uncontrollable
Often argued that apportionment of fixed overheads to individual units are carried out on a purely ARBITRARY basis, which is not very useful for decision making and can mislead.
How does management choose which costing method to use? (over/under-costing)
Cost of inventory matters (over-costing/under-costing). Profit can be different accordingly, Can lead to manipulation towards earnings.
Managers choose to under-cost for managerial commission based on profits.
Managers choose to over-cost for Government subsidies (if show low profits).
What is the meaning of under- & over-absorption?
Unrelated:
*Rmb that OAR has both fixed and variable cost elements!
Under-absorption: budgeted OAR absorbs too little cost to cost objects in the period
Over-absorption: budgeted OAR absorbs too much cost to cost objects in the period.
Production Volume Variance (PVV)
in Absorption costing
- Tells us whether actual production is above or below the predicted/budgeted volume
- Does not inform us about EFFICIENCY of production process
> (Actual - Budgeted volume) * fixed overhead rate - If budgeted volume > actual volume -> Unfavourable (U), lower actual gross profit
- If budgeted volume < actual volume -> Favourable (F), higher actual gross profit
Profit difference is caused by diff. valuations given to closing inventory.
When is Marginal costing-based profit higher than Absorption costing profit?
If opening inv > closing inv, MC based profit > AC
If opening inv < closing inv UNITS, MC based profit < AC
- Any inventory holding is higher for absorption costing because includes fixed costs
Undesirable effects for Full costing
Encourages operational inefficiencies
- enables a manager to increase operating profit by increasing production
- even if 0 customer demand; so classifying potential period cost to closing inventory
- Undesirable stock building (high closing inv, ie. high absorption of fixed costs into closing inv)
- > hence Capitalised rather than Expensed
4 ways to alleviate the undesirable effects of Full costing
- Change internal accounting systems to more integrated systems
- Revise performance evaluation of managers, ie. not necessarily focused on bottom line profit
- Redesign operating systems
- reduce waste
- don’t let stocks pile up, by acquiring resources only when needed
- move towards ‘Just-In-Time’ management (but risks in supply chain) - Companies can predict market demand more accurately using technology. Transaction records are stored and accessible by everyone; helps reduce Fraud & provide time-saving TRACEABLE procedure
3 limitations of Marginal costing
- In reality, difficult to distinguish between fixed and variable costs
- Sales staff may mistake marginal cost for total cost and sell at a low price; which will result in loss or low profits.
- Assumption that fixed costs are fixed forever is false. cost behaviour can change.
Differential cost
A change in cost when there are 2 diff. alternatives to choose from (important cost to bear in mind in decision making)
Opportunity cost
+ charge out rate for workers is important
FOREGONE POTENTIAL BENEFIT of an alternative, 2nd best alternative out of the ones we KNOW
> the value (in monetary terms) of being deprived of the next best opportunity in order to pursue the particular objective
- relevant to a particular decision if they differ between alternative courses of action
eg. loss of income the students experience by deciding to study for a degree at university instead of going straight into work - different options you consider should have the same RISK
- Never recorded in formal accounting records since they do NOT generate cash outlays
Sunk costs (past costs)
Actual costs/expenditure incurred in the past & CAN’T be recovered
- Irrelevant cost because they cannot be changed by any decision
Relevant costs
include opportunity costs + future outlay costs
Costs that relate to the business’ objectives and that will vary with the decision
- fixed costs are not relevant unless they will increase or decrease
AC vs MC - Explain reconciliation of income differences
Profit differences are caused by the different valuations given to the closing inventory in each period.
With absorption costing, an amount of fixed production overhead is included.
Inventory increased/decreased by __ units.
Under full costing, __ * £1 is inventoried.
Under variable costing, these costs are not inventoried; fixed mfg costs are treated as a period cost & charged to I/S.
Absorption costing operating profit – variable costing operating profit
= fixed manufacturing costs in closing inventory – fixed manufacturing costs in opening inventory
Cost
An amount of resources, usually measured in monetary terms,
/ (expense incurred)
sacrificed to achieve a particular objective
