Income effects of alternative stock-costing methods
7.2 Yes, variable manufacturing costing is a more descriptive term than variable costing
The focus is on manufacturing costs only. Variable marketing and other variable non-manufacturing costs are treated as period costs when variable costing is used.
7.3 The main issue between variable costing and absorption costing is the proper timing of the release of fixed manufacturing costs as costs of the period:
a at the time of incurrence, or
b at the time the finished units to which the fixed overhead relates are sold.
Variable costing uses (a) and absorption costing uses (b).
any specific costing method. The example in the text of Chapter 7 makes a variable-cost/fixed-cost distinction. As illustrated, it can use variable costing, absorption costing or throughput costing.
A company that does not make a variable-cost/fixed-cost distinction cannot use variable costing or throughput costing. However, it is not forced to adopt absorption costing. For internal reporting, it could, for example, classify all costs as costs of the period in which they are incurred.
7.5 Variable costing does not view fixed costs as unimportant or irrelevant, but it maintains that the distinction between behaviours of different costs is crucial for certain decisions.
The planning and management of fixed costs is critical, irrespective of what stock-costing method is used.
7.6 Under absorption costing, heavy reductions of stock during the accounting period might combine with low production and a large production volume variance. This combination could result in lower operating profit even if the unit sales level rises.
7.7 Examples of dysfunctional decisions managers may make to increase reported operating profit are:
a Plant managers may switch production to those orders that absorb the highest amount of manufacturing overhead, irrespective of the demand by customers.
b Plant managers may accept a particular order to increase production even though another plant in the same company is better suited to handle that order.
c Plant managers may defer maintenance beyond the current period to free more time for production.
7.8 Approaches used to reduce the negative aspects associated with using absorption costing include:
a Changing the accounting system.
• Adopting either variable or throughput costing, both of which reduce the incentives of managers to build up stock.
• Adopting a stock-holding charge for managers who tie up funds in stock.
b Extending the time period used to evaluate performance. By evaluating performance over a longer time period (say, three to five years), the incentive to take short-run actions that reduce long-term profit is lessened.
c Including non-financial as well as financial variables in the measures used to evaluate performance.
7.9 The theoretical capacity and practical capacity denominator-level concepts emphasise what a plant can supply. The normal utilisation and master-budget utilisation concepts emphasise what customers demand for products produced by a plant.
7.10 Normal utilisation is the denominator-level concept based on the level of capacity utilisation that satisfies average customer demand over a period (say, two or three years), which includes seasonal, cyclical or other trend factors.
The numbers are simplified to ease calculations. This problem avoids standard costing and its complications.
1 a Variable-costing profit statements
Year 1 Year 2
Sales 1,000 units Sales 1,200 units Production 1,400 units Production 1,000 units Profit (€3 per unit)
Variable costs:
Opening stock
Variable cost of goods manufactured Cost of goods available for sale Closing stocka
Variable manufacturing cost of goods sold Variable marketing and admin. costs Variable costs:
Contribution margin Fixed costs
Fixed manufacturing costs Fixed marketing and admin. costs Fixed costs
a Unit stockable costs:
Year 1: €700 ÷ 1,400 = €0.50 per unit Year 2: €500 ÷ 1,000 = €0.50 per unit
Year 1 Year 2
Sales 1,000 units Sales 1,200 units Production 1,400 units Production 1,000 units Profit (€3 per unit)
Cost of goods sold:
Opening stock
Variable manufacturing costs Fixed manufacturing costsa Cost of goods available for sale Closing stockb
Cost of goods sold Gross margin
Marketing and administrative costs:
Variable marketing and admin. costs Fixed marketing and admin. costs Marketing and admin. costs Operating profit
a Fixed manufacturing costs:
Year 1: €700 ÷ 1,400 = €0.50 per unit Year 2: €700 ÷ 1,000 = €0.70 per unit b Unit stockable costs:
Year 1: €1,400 ÷ 1,400 = €1.00 per unit
a Absorption costing is more likely than variable costing to lead to stock build-ups. Under absorption costing, operating profit in a given accounting period is increased because some fixed manufacturing costs are accounted for as an asset (stock) instead of as a cost of the current period.
b Although variable costing will counteract undesirable stock build-ups, other measures can be used without abandoning absorption costing. Examples include budget targets and non-financial measures of performance such as maintaining specific stock levels, stock turnovers, delivery schedules and equipment maintenance schedules.
7.17 Variable and absorption costing, explaining operating profit differences. (30 min) 1 Key inputs for profit statement calculations are:
April May Opening stock
Production
Goods available for sale Units sold The unit fixed and total manufacturing costs per unit under absorption costing are:
April May (a) Fixed manufacturing costs
(b) Units produced
(c) = (a) ÷ (b) Unit fixed manufacturing costs (d) Unit variable manufacturing costs (e) = (c) + (d) Unit total manufacturing costs
€2,000,000 a Variable costing
April 2011 May 2011
Profitsa €8,400,000 €12,480,000
Variable costs
Opening stock € 0 €1,500,000
Variable cost of goods manufacturedb 5,000,000 4,000,000 Cost of goods available for sale 5,000,000 5,500,000
Closing stockc 1,500,000 300,000
Variable manufacturing cost of goods sold 3,500,000 5,200,000
Variable marketing costs 1,050,000 1,560,000
Total variable costs 4,500,000 6,760,000
Contribution margin 3,850,000 5,720,000
Fixed costs
Fixed manufacturing costs 2,000,000 2,000,000
Fixed marketing costs 600,000 600,000
Total fixed costs 2,600,000 2,600,000
Operating profit €1,250,000 €3,120,000
a €24,000 × 350; €24,000 × 520
b
April 2011 May 2011
Profita €8,400,000 €12,480,000
Cost of goods sold
Opening stock € 0 €2,100,000
Variable manufacturing costsb 5,000,000 4,000,000
Fixed manufacturing costsc 2,000,000 2,000,000
Cost of goods available for sale 7,000,000 8,100,000
Closing costsd 2,100,000 450,000
Cost of goods sold 4,900,000 7,650,000
Gross margin 3,500,000 4,830,000
Marketing costs
Variable marketing costse 1,050,000 1,560,000
Fixed marketing costs 600,000 600,000
Total marketing costs 1,650,000 2,160,000
Operating profit €1,850,000 €2,670,000
a €24,000 × 350; €24,000 × 520
b €10,000 × 500; €10,000 × 400
c €4,000 × 500; €5,000 × 400
d €14,000 × 150; €15,000 × 30
e €3,000 × 350; €3,000 × 520
2
(
Absorption costingoperating income) (
– Variable costingoperating income =)
Fixed manufacturing Fixed manufacturing
cost in – cost in
closing stock opening costs April:
€1,850,000 − €1,250,000 = (€4,000 × 150) − (€0)
€600,000 = €600,000
May:
€2,670,000 − €3,120,000 = (€5,000 × 30) − (€4,000 × 150) − €450,000 = €150,000 − €600,000
−€450,000 = −€450,000
The difference between absorption and variable costing is due solely to moving fixed manufacturing costs into stocks as stocks increase (as in April) and out of stocks as they decrease (as in May).
1 Key inputs for profit statement calculations are:
January February March Opening stock
Production
Goods available for sale Units sold The unit fixed and total manufacturing costs per unit under absorption costing are:
January February March (a) Fixed manufacturing costs
(b) Units produced
(c) = (a) ÷ (b) Unit fixed manufacturing costs (d) Unit variable manufacturing costs (e) = (c) + (d) Unit total manufacturing costs
DKr 400,000 7a Variable costing (in DKr)
January 2011 February 2011 March 2011
Profita 1,750,000 2,000,000 3,750,000
Variable costs
Opening stockb 0 270,000 270,000
Variable cost of goods
manufacturedc 900,000 720,000 1,125,000
Cost of goods available
for sale 900,000 990,000 1,395,000
Operating profit 160,000 260,000 960,000
a DKr 2,500 × 700; DKr 2,500 × 800; DKr 2,500 × 1,500
b DKr 900 × 0; DKr 900 × 300; DKr 900 × 300
c DKr 900 × 1,000; DKr 900 × 800; DKr 900 × 1,250
d DKr 900 × 300; DKr 900 × 300; DKr 900 × 50
January 2011 February 2011 March 2011
Profita 1,750,000 2,000,000 3,750,000
Cost of goods sold
Opening stockb 0 390,000 420,000
Variable manufacturing costsc 900,000 720,000 1,125,000 Fixed manufacturing costsd 400,000 400,000 400,000
Cost of goods available for sale 1,300,000 1,510,000 1,945,000
Closing stocke 390,000 420,000 61,000
Cost of goods sold 910,000 1,090,000 1,884,000
Gross margin 840,000 910,000 1,866,000
Marketing costs
Variable marketing costsf 420,000 480,000 900,000
Fixed marketing costs 140,000 140,000 140,000
Total marketing costs 560,000 620,000 1,040,000
Operating profit 280,000 290,000 826,000
a DKr 2,500 × 700; DKr 2,500 × 800; DKr 2,500 × 1,500
b DKr 900 × 0; DKr 1300 × 300; DKr 1,400 × 300
c DKr 900 × 1,000; DKr 900 × 800; DKr 900 × 1,250
d DKr 400 × 1,000; DKr 500 × 800; DKr 320 × 1,250
e DKr 1,300 × 300; DKr 1,400 × 300; DKr 1,220 × 50
f DKr 600 × 700; DKr 600 × 800; DKr 600 × 1,500
2
(
Absorption costing) (
Variable costing)
operating income – operating income =
stock closing in
cost manufacturing
Fixed −
cost Fixedin manufacturopeningstocking
January: DKr 280,000 − DKr 160,000 = DKr 120,000 − DKr 0 DKr 120,000 = DKr 120,000
February: DKr 290,000 − DKr 260,000 = DKr 150,000 − DKr 120,000 DKr 30,000 = DKr 30,000
March: DKr 826,000 − DKr 960,000 = DKr 16,000 − DKr 150,000
− DKr 134,000 = − DKr 134,000
1 The differences arise for several reasons:
a The theoretical and practical capacity concepts emphasise supply factors while normal utilisation and master-budget utilisation emphasise demand factors.
b The two separate six-month rates for the master-budget utilisation concept differ because of seasonal differences in budgeted production.
2
• Theoretical capacity – based on the production of output at maximum efficiency for 100% of the time.
• Practical capacity – reduces theoretical capacity for unavoidable operating interruptions such as scheduled maintenance time, shutdowns for holidays and other days and so on. For each of the three determinants of capacity at Montpazier, practical capacity is less than theoretical capacity:
Barrels
per year Capacity Theoretical capacity 3 The smaller the denominator, the higher the amount of overhead costs capitalised
for stock units. Thus, if the plant manager wishes to be able to ‘adjust’ plant operating profit by building up stock, master-budget utilisation or possibly normal utilisation would be preferred.
1 Solution Exhibit 7.17 reports the operating profit for each denominator-level
* €120,380,000 ÷ 2,600,000 = €46.30 per barrel
The output-level overhead variance for each denominator-level concept is:
a Theoretical capacity: €40,632,000 − (€7.99 × 2,600,000)
€40,632,000 − €20,774,000 = €19,858,000 U
b Practical capacity: €40,632,000 − (€12.00 × 2,600,000)
€40,632,000 − €31,200,000 = €9,432,000 U
c Normal utilisation: €40,632,000 − (€15.00 × 2,600,000)
€40,632,000 − €39,000,000 = €1,632,000 U Illustration of operating profit differences:
Practical − Theoretical: €13,848,000 − €13,046,000 = €802,000 Normal − Practical: €14,448,000 − €13,848,000 = €600,000 Normal − Theoretical: €14,448,000 − €13,046,000 = €1,402,000
The difference in operating profit across the three denominator-level concepts is due solely to differences in fixed manufacturing overhead included in the closing stock of 200,000 barrels:
Theoretical capacity: 200,000 × €7.99 = €1,598,000
}
€802,000 difference Practical capacity: 200,000 × €12.00 = €2,400,000}
€600,000 difference Normal capacity: 200,000 × €15.00 = €3,000,0002 Given the data in this question, the theoretical capacity concept reports the lowest operating profit and thus (other things being equal), the lowest tax bill for 2005.
Bières Ronsard benefits by having deductions as early as possible. The theoretical capacity denominator-level concept maximises the deductions for manufacturing costs.
c Restrict the ability of a company to use shorter write-off periods or more accelerated write-off periods for stock-related costs.
Solution Exhibit 7.21
Cost of goods sold:
Opening stock
Variable manufacturing costs,
€46.30 × 2,600,000
Fixed manufacturing overhead costs,
€7.99, €12, €15 × 2,600,000 Cost of goods available for sale Closing stock,
€54.29, €58.30, €61.30 × 200,000 Total cost of goods sold (at budgeted costs) Adjustment for variances Cost of goods sold
Gross margin
a. See the answer to requirement 1 for calculation.
7.22 Ginnungagap in 2007. (40 min)
This problem always generates active classroom discussion.
1 The treatment of fixed manufacturing overhead in absorption costing is affected primarily by what denominator level is selected as a base for allocating fixed manufacturing costs to units produced. In this case, is 10,000 tonnes per year, 20,000 tonnes or some other denominator level the most appropriate base?
We usually place the following possibilities on the board or overhead projector and then ask the students to indicate by vote how many used one denominator level rather than another. Incidentally, discussion tends to move more clearly if variable-costing profit statements are discussed first, because there is little disagreement as to calculations under variable costing.
a Variable-costing profit statements:
2006 2007 Together Profit (and contribution margin) €300,000 €300,000 €600,000
Fixed costs:
Manufacturing costs €280,000
Marketing and administrative cost 40,000 320,000 320,000 640,000 Operating profit €(20,000) €(20,000
) €(40,000)
The ambiguity about the 10,000- or 20,000-unit denominator level is intentional. IF YOU WISH, THE AMBIGUITY MAY BE AVOIDED BY GIVING THE STUDENTS A SPECIFIC DENOMINATOR LEVEL IN ADVANCE.
Alternative 1. Use 20,000 units as a denominator; fixed manufacturing overhead per unit is
€280,000 ÷ 20,000 = €14.
2006 2007 Together
Profit €300,000 €300,000 €600,000
Manufacturing costs @ €14 280,000 — 280,000
Deduct closing stock 140,000 — —
Cost of goods sold 140,000 140,000* 280,000 Underallocated manuf. overhead
− output level variance — 280,000 280,000 Marketing and administrative costs 40,000 40,000 80,000 Total costs 180,000 460,000 640,000 Operating profit €120,000 €(160,000) €(40,000)
* Stock carried forward from 2010 and sold in 2011.
Alternative 2. Use 10,000 units as a denominator; fixed manufacturing overhead per unit is
€280,000 ÷ 10,000 = €28.
2006 2007 Together
Profit €300,000 €300,000 €600,000
Manufacturing costs @ €28 560,000 — 560,000 Deduct closing stock 280,000 — — Cost of goods sold* 280,000 280,000 560,000
Underallocated manuf. overhead − output level variance
— 280,000 —
Overallocated manuf. overhead −
output level variance (280,000) — —
Marketing and administrative costs 40,000 40,000 80,000 Total costs 40,000 600,000 640,000 Operating profit €260,000 €(300,000) €(40,000)
*Stock carried forward from 2010 and sold in 2011.
Note that operating profit under variable costing follows sales and is not affected by stock changes.