Absorption Costing (AC) & Variable Costing (VC)

1. Absorption Costing (AC) &Variable Costing (VC) Differences between AC and VC Calculation of Product Cost under AC and VC VC and AC : A comparison of their impact on profit Arguments in support of VC Arguments in support of AC

2. Differences between AC and VC • Absorption Costing • Assign all manufacturing costs to products • Non manufacturing cost treated as period cost i.e excluded from inventory valuation • Allowed for external reporting • Variable costing • Only variable manufacturing costs are assigned to products and included in inventory valuation • Fixed manufacturing costs are not assigned to products • Only for internal reporting

3. Calculation of Product Cost • Under AC • Product Cost • Direct Material costs • Direct Labour costs • Variable Overhead Manufacturing costs • Allocated Fixed Manufacturing Overhead

4. Calculation of Product Cost • Under VC • Product Cost • Direct Material costs • Direct Labour costs • Variable Overhead Manufacturing costs

5. VC and AC : A comparison of their impact on profit • Production equals sales • AC profit equals VC profits • Production exceeds sales • AC profit greater than VC profit • Sales exceeds production • VC profit greater than AC profit

6. LO 2 INVENTORY VALUATION: Background

7. LO 2 ABSORPTION COSTING Value of ending inventory = 2,000 x RM 225 = RM 450,000

8. LO 2 VARIABLE COSTING Value of ending inventory = 2,000 x $ 200 = $ 400,000

9. LO 2 COMPARATIVE INCOME STATEMENTS Income lower under variable costing where fixed costs are expensed for period.

10. LO 2 ABSORPTION INCOME STATEMENT COGS = 8,000 x $ 225 = $ 1,800,000

11. LO 2 VARIABLE INCOME STATEMENT Variable costs: 8,000 x $200 Fixes costs: $250,000 + 100,000

12. LO 2 ABSORPTION VS. VARIABLE If more is sold than produced, variable costing income > absorption-costing income, opposite of Fairchild situation. Equal production & sales means equal income.

13. How do variable & absorption costing affect performance evaluation? Variable costing ensures that direct relationship between sales & income holds whereas absorption costing does not.

14. LO 2 EXPLANATION The difference between variable costing & absorption costing year to year is equal to the change in fixed overhead. Under absorption costing, fixed overhead is assigned to inventory produced. Under variable costing, fixed overhead is a period cost.

15. Some arguments in support of Variable Costing • VC provides more useful information for decision making • Separation of fixed cost and variable costs helps to provide relevant information about costs for making decisions • VC removes from profit the effect of inventory changes • Under VC, profit is a function of sales volume • Under AC, profit is a function of both sales and production (hence profit to decline when sales volume increase • Managers may deliberately alter inventory level to influence profit when AC is used

16. Some arguments in support of Variable Costing • VC avoids fixed overhead being capitalised in unsaleable stocks • When AC used, only portion of FO incurred during the period will be allocated as an expense in a period when sales demand decreases. • Remainder of FO will be included in valuation of surplus stock • Current period’s profit will be overstated

17. Some arguments in support of Absorption Costing • AC does not understate the importance of fixed costs • AC will not ensure that FC will be recovered if actual sales volume is less than the estimate used to calculate the FO rate • AC avoids fictitious losses being reported • Losses are unlikely to be reported in the periods when stocks are being built up • Fixed overhead will be deferred and included in the ending inventory valuation and will be recorded as expense only in the period in which the goods are sold

18. Some arguments in support of Absorption Costing • Fixed overhead are essential for production • Fixed manufacturing overhead are required for production of goods • Consistency with external reporting