A REPORT ON

COMPARATIVE ANALYSIS OF THE EFFECT IN PRODUCTION

ON NET OPERATING INCOME DUE TO USE OF VARIABLE
AND ABSORPTION COSTING: A CASE STUDY ON SQUARE
PHARMACEUTICALS LTD.

PATUAKHALI SCIENCE AND TECHNOLOGY UNIVERSITY

Group-1 (Warrior)
 COMPARATIVE ANALYSIS OF EFFECTS IN PRODUCTION ON NET
OPERATING INCOME DUE TO USE OF VARIABLE AND ABSORPTION
COSTING: A CASE STUDY ON SQUARE PHARMACEUTICALS LTD.

Prepared For:
M. Takibur Rahman
Lecturer
Department of Accounting and Information System
Faculty of Business Administration and Management

Prepared By:
Group: 01(Warrior)
Level- 3, Semester- II
Faculty of Business Administration and Management

Sl. No. Name of the students Position Roll No. Reg. No.
01 Md. Kamruzzaman Group Leader 01 00660
02 Shuvradeb Barai Asst. Group leader 09 00668
03 Abu Zafour Member 21 00680
04 Sahana Parveen Member 07 00666
05 Nazmul Alam Siddiqui Member 25 00565

Management Accounting
Course Code: AIS 325
Date of Submission: November 22, 2008

PATUAKHALI SCIENCE AND TECHNOLOGY UNIVERSITY

Group-1 (Warrior)
Date: November 22, 2008

To
M. Takibur Rahman
Lecturer
Department of Accounting and Information System
Faculty of Business Administration and Management

Subject: Letter of Transmittal

Dear Sir,

Here is the report on “Comparative Analysis of Effects in Production on Net

Operating Income Due to Use of Variable and Absorption Costing: ‘A Case Study
on Square Pharmaceuticals Ltd.’ you asked us to prepare this report as a course
requirement of Management Accounting.

This report focuses on the Management Accounting. We are proud of making this
report. We have tried our level best to make the report informative and fruitful. For
any classification we will be available and looking for such term paper in coming
days. We will be happy to get such type of report further.

Sincerely Yours

Md. Kamruzzaman
(Group Leader)
Group: 01(Warrior)
Level-3, Semester-2
Faculty of Business Administration and Management

Group-1 (Warrior)
 A cknowledgment

At first we desire to express our deepest sense of gratitude of almighty Allah.

With profound regard we gratefully acknowledge our respected course teacher

M. Takibur Rahman, Lecturer, Department of Accounting and Information System,
Faculty of Business Administration and Management for his generous help and
day to day suggestion during the survey.

We like to give thanks especially to our friends & many individuals, for their
enthusiastic encouragements and helps during the preparation of this report and for
their assistance in typing and proofreading this manuscript.

Table of Contents
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Introduction
► Introduction 01
► Origin of the report 02
► Purpose of the report 02
► Limitations and scope of the report 03
► Methodology of the Report 04

Overview of Square Pharmaceuticals Limited

► Overview of Square group 05
► Corporate information 06
► About Square Pharmaceuticals Limited 07
► Mission, Vision and Objectives 08
►Square quality policy 08
►Chronology since inception 09
Description
► Overview of variable costing and absorption costing 10
► Cost classifications 11
► Comparison between variable costing and absorption costing 12
► The matching principles 13
► Advantages of variable costing 14
► Impact of JIT 17
► Format under differences under two methods 18
► Rules regarding absorption costing versus variable costing 20

Problems and Suggesting Actions

► Analysis of absorption costing and variable costing 21
► Summary result at a glance 28
► Overall comments 29
Conclusions 30
References 31

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 E xecutive Summary

This report is an assigned job as a partial fulfillment of course requirement by

honorable Course teacher M. Takibur Rahman Lecturer, Department of Accounting
& Information System, Faculty of Business Administration and Management,
Patuakhali Science and Technology University. It is the optimum aggregated
outcome of 5 pupils’ about “Comparative Analysis of Effects in Production on Net
Operating Income Due to Use of Variable and Absorption Costing: ‘A Case Study
on Square Pharmaceuticals Ltd.’. The view of this report is to find out the effects
of variable and absorption costing in production on the net operating in come of a
company (Square Pharmaceuticals Ltd.). Now its make a great position in the
market of Bangladesh. Variable costing and absorption costing are significant
elements of a company for the determination of the cost of production, it is also
important to know ‘what are the effects of variable and absorption costing on the
net operating income of a company.

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 i ntroduction

Management accounting is undergoing a renaissance in response to technological

changes, globalization, growing risk management concerns. In these challenging
times management accountants help ‘steady of the sleep’ by acting as their
organizations interprets, sage advisors, and ethical keepers of the numbers.
Management accountants are qualified to help their fellow managers achieve good
business results because they have earned an advanced certification that addresses
all important aspects of accounting inside organizations. For the internal decision
making of a company variable costing method is too much significant. Another
costing method is absorption costing; this costing method is known as full costing
method. This costing method is used for external purpose. It is logical that
producing more units would have no impact on profits unless the units are sold. As
we will discover in this report, absorption costing—the most widely used method
of determining products costs—can artificially increase profits by increasing the
quantity of units produced.

Origin of the report

We are lucky to say that our honorable course teacher M. Takibur Rahman
Lecturer, Department of Accounting and Information System, of Faculty of
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Business Administration and Management. Assigned us a report on ‘Comparative
Analysis of Effects in Production on Net Operating Income Due to Use of Variable
and Absorption Costing: ‘A Case Study on Square Pharmaceuticals Ltd.’. This
report is prepared on the basis of surveying the Square Pharmaceuticals Limited.

Purpose of the Report

As a business expectative of future, we should have to gather experience
beside our survey. We should not concern our lesion only in classroom but to
implement it in practical life that will help us in our future life .A clear
objective help in preparation of well decorated report in which other take the
right type of decision .So, we identifying objectives is very much important.
Our purpose of preparing this report is:

 To know about the absorption costing and variable costing

 To explain the difference between absorption (full) costing and variable
costing.
 To prepare an income statement using variable costing and absorption
(full) costing.

 To discuss the effect in production on net operating income due to use of

absorption (full) costing and variable costing.

 To explain the impact of JIT (just-in-time) on the difference between full

and variable costing income.

 To discuss the benefits of variable costing for internal reporting purposes.

 To discuss the benefits of variable costing for internal reporting purposes.

 To understand the advantages and disadvantages of both variable and

absorption costing.

Limitations & Scope of the Report

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As a student of faculty of Business Administration and Management, 6th semester,
this is our initiative for making a report on ‘Comparative Analysis of Effects in
Production on Net Operating Income Due to Use of Variable and Absorption
Costing: ‘A Case Study on Square Pharmaceuticals Ltd.’ by meeting a survey.
Beside this we have faced the following hindrances in preparing this report:

► Lack of knowledge and experience

► Short of time
► Lack of computer facilities
► Lack of sufficient privileges
► Lack of communication facilities

The survey report focuses on ‘Comparative Analysis of Effects in Production on

Net Operating Income Due to Use of Variable and Absorption Costing: ‘A Case
Study on Square Pharmaceuticals Ltd.’. The survey may not be more comparable
or more valid. Moreover, the report is emphasized on the primary data such as
interview of the manager of Square Pharmaceuticals Limited, as well as secondary
data such as annual report of Square Pharmaceuticals Limited.

M ethodology of the Report

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This report is based on both primary and secondary data. Initially, the work is
started with data those were available at Company’s Annual Report and company’s
news letter. Moreover, it becomes helpful to gather some more information from
the website of the company.

Later on, the work progressed through some depth interviews of good range
professionals trying to heat some expected area of the study. After that, an
effective questionnaire is designed to collect likely data from the target group of
people.

Then we analyze those data from many angles, in different aspect and present the
information in different segment according to their category, in compact way. We
highlight different important things, which we found during our survey. After
doing all of those we submit the report to the proper authority.

OVERVIEW OF SQUARE GROUP

Square Pharmaceuticals Ltd is the flagship company of Square Group. In stark

contrast to its present stature, Square had a rather humble beginning. In 1958, the
Company started out as a small scale pharmaceutical venture at Pabna, a small
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town in Northern Bangladesh. It was a partnership effort of four young and
enterprising men under the leadership of the Chairman, Mr. Samson H
Chowdhury, whose determination and passion saw it through the turmoil of the
early days.

In 1964, the Company was turned into a Private Limited Company. After the
independence of Bangladesh, 1975 was quite a significant year for Square as it
established a technical collaboration with Janssen Pharmaceuticals of Belgium; a
subsidiary of Johnson & Johnson, USA. In its relentless quest for higher
technology, Square signed a technological collaboration agreement with F.
Hoffman-La Roche & Co. Ltd in 1982.

1985 was another historical year for Square as the Company gained the market
leadership for the first time in Bangladesh pharmaceuticals market and since then
it has been maintaining its position as the leading pharmaceutical Company of the
country. In 1987, Square became the first Bangladeshi company to export its
product abroad.

The Company stepped into a new era when it was transformed into a Public
Limited Company in 1991 and subsequently it was publicly listed at both the stock
exchanges in the year 1995. Square Pharmaceutical Ltd has been successfully
retaining its market leader position in Bangladesh for the last consecutive 22 years
and its current market share is approximately 16%.

CORPORATE INFORMATION

Corporate Focus:-
Our vision, our mission and our objectives are to emphasize on the quality of
product, process and services leading to growth of the company imbibed with
good governance.
Corporate Governance:-
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Top Management: Board of Directors

As per provisions of the Article of Association, Board of Directors holds periodic

meetings to resolve issue of policies and strategies, recording minutes/decisions
for implementation by the Executive Management.

Executive Management

The Executive Management is headed by the Managing Director, the Chief

Executive Officer (CEO) who has been delegated necessary and adequate
authority by the Board of Directors. The Executive Management operates through
further delegations of authority at every echelon of the line management.

The Executive Management is responsible for preparation of segment plans/sub-

segment plans for every profit centers with budgetary targets for every item of
goods & services and are held accountable for deficiencies with appreciation for
exceptional performance. These operations are carried out by the Executive
Management through series of committees, sub-committees, ad-hock committees,
standing committees assisting the line management.

ABOUT SQUARE PHARMACEUTICALS LIMITED

SQUARE today symbolizes a name – a state of mind. But its journey to the
growth and prosperity has been no bed of roses. From the inception in 1958, it has
today burgeoned into one of the top line conglomerates in Bangladesh. Square
Pharmaceuticals Ltd., the flagship company, is holding the strong leadership
position in the pharmaceutical industry of Bangladesh since 1985 and is now on its
way to becoming a high performance global player.

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SQUARE Pharmaceuticals Limited is the largest pharmaceutical company in
Bangladesh and it has been continuously in the 1st position among all national and
multinational companies since 1985. It was established in 1958 and converted into
a public limited company in 1991. The sales turnover of SPL was more than Taka
7.5 Billion (US$ 107.91 million) with about 16.92% market share (April 2006–
March 2007) having a growth rate of about 23.17%.

SQUARE Pharmaceuticals Limited has extended her range of services towards the
highway of global market. She pioneered exports of medicines from Bangladesh in
1987 and has been exporting antibiotics and other pharmaceutical products. This
extension in business and services has manifested the credibility of Square
Pharmaceuticals Limited.

VISION, MISSION, AND OBJECTIVES

We view business as a means to the material and social wellbeing of the investors,
employees and the society at large, leading to accretion of wealth through financial
and moral gains as a part of the process of the human civilization.

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Our Mission is to produce and provide quality & innovative healthcare relief
for people, maintain stringently ethical standard in business operation also
ensuring benefit to the shareholders, stakeholders and the society at large.

Our objectives are to conduct transparent business operation based on market

mechanism within the legal & social frame work with aims to attain the mission
reflected by our vision.

SQUARE's Quality Policy

SQUARE is committed to ensure better life through quality medicine. Ensure strict
compliance with WHO standards and local regulatory norms in every phase of
sourcing & procuring quality materials, manufacturing, quality assurance and
delivery of medicines.
Ensure all activities through documented Quality Management System (QMS)
complying International Standard requirements of ISO 9001 through continuously
developing Human Resources by regular training and participation.
SQUARE is committed to undertake appropriate review, evaluation and
performance measurement of processes, business activities and Quality
Management System for continual improvement to ensure highest standard,
customer satisfaction, developing human resources and company's growth.

CHRONOLOGY SINCE INCEPTION

1958 : Debut of Square Pharma as a Partnership Firm.
1964 : Converted into a Private Limited Company.
1974 : Technical Collaboration with Janssen Pharmaceutica, Belgium, a
subsidiary of Johnson and Johnson International, USA.
1982 : Licensing Agreement signed with F. Hoffmann-La Roche Ltd.,
Switzerland.

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 1985 : Achieved first position in the Pharmaceutical Market of Bangladesh
among all national and multinational companies.
1987 : Pioneer in pharmaceutical export from Bangladesh.
1991 : Converted in to a Public Limited Company
1994 : Initial Public Offering of Square Pharmaceutical Shares.
1995 : Chemical Division of Square Pharmaceuticals Ltd. starts production of
pharmaceutical bulk products (API).
1997 : Won the National Export trophy for exporting pharmaceuticals.
1998 : Agro-chemicals & Veterinary Products Division of Square Pharma
starts its operation.
2001 : US FDA/UK MCA standard new Pharmaceutical factory goes into
operation built under the supervision of Bovis Lend Lease, UK.
2004 : Signing of agreement with ROVIPHARM, Vietnam to manufacture and
market SQUARE products under license in Vietnam.
Secured the top position for the best published accounts and report for
2003 in the manufacturing category for transparency and excellence in
corporate reporting.
2005 : New State-of- the-Art Square Cephlosporins Ltd. goes into operation;
built under the supervision of TELSTAR S.A. of Spain as per US FDA/
UK MHRA requirements.
2007 : Square Pharmaceuticals Ltd., Dhaka Unit gets the UK MHRA
approval.

Overview of Variable and Absorption Costing

At least two methods can be used in manufacturing companies to value units of
product for accounting purposes— absorption costing and variable costing. These
methods differ only in how they treat fixed manufacturing overhead costs.

Variable Costing

Variable costing includes only variable production costs in product costs. Direct
materials, direct labor and variable manufacturing overhead costs would ordinarily
be included in product costs under variable costing. Fixed manufacturing overhead
is not treated as a product cost under this method. Rather, fixed manufacturing
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overhead is treated as a period cost and is charged against income each period.
This costing system is used for the internal purpose. So, variable costing
considered the following—

 Under variable costing, no fixed overhead is assigned to inventory

 Fixed overhead is a period expense which enters the income statement as a
line item every period regardless of the number of units sold
 Variable costing excludes fixed manufacturing overhead from inventoriable
costs.

Absorption Costing

Absorption costing treats all production costs as product costs, regardless of

whether they are variable or fixed. Under absorption costing, a portion of fixed
manufacturing overhead is allocated to each unit of product. Absorption costing is
treated as full cost and this costing system is used for the external purpose. So,
variable costing considered the following—

 Under absorption costing, fixed overhead is assigned to units of inventory

and shows up in the income statement as part of the cost of goods sold
(COGS) when the units are sold
 When units are produced and not sold, fixed overhead stays in finished
goods inventory
 Absorption costing includes fixed manufacturing overhead in inventoriable
costs.

Cost Classifications
Cost Classifications—Absorption costing versus Variable Costing
Under absorption costing and variable costing, cost can be classified into two
ways,
1. Product cost, and
2. Period cost

The cost categories under this two cost classification in case of absorption costing
and variable costing are shown in the following figure—

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 Figure: Cost classifications

From the above figure we see that under absorption costing method, all
manufacturing costs, variable and fixed, are included when determining the unit
product cost. Direct materials, direct labor, variable manufacturing overhead, fixed
manufacturing overhead costs are included for determining the product costs under
absorption costing, and variable selling and administrative expenses and fixed
selling and administration expenses are included for determining the period costs.

Under the variable costing method, only the variable manufacturing costs are
included in product costs and fixed manufacturing overhead, variable and fixed
selling and administrative expenses are included for determining the period costs.

Comparison between Absorption Costing and

Variable Costing
When comparing absorption costing and variable costing income statements, a
number of points should be noted:

1. Deferral of fixed manufacturing costs under absorption costing

Under absorption costing, if inventories increase then a portion of the fixed
manufacturing overhead costs of the current period is deferred to future periods
in the inventory account. When the units are later taken out of inventory and
sold, the deferred fixed costs flow through to the income statement as part of
cost of goods sold.

2. Differences in inventories under the two methods

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 The ending inventory figures under the variable costing and absorption costing
methods are different. Under variable costing, only the variable manufacturing
costs are included in inventory. Under absorption costing, both variable and
fixed manufacturing costs are included in inventory.

3. Suitability for CVP analysis

An absorption costing income statement is not well suited for providing data for
CVP computations since it makes no distinction between fixed and variable
costs. In contrast, the variable costing method classifies costs by behavior and is
very useful in setting-up CVP computations.

Extended Comparison of Income Data

The comparative income statement’s effects under the variable costing and
absorption costing are as follows—

1. Production equals sales (no change in inventories)

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.

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.

3. 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

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 costing will be less than the net operating income reported under variable
costing.

Relation Between Production Effects on Relation Between Absorption and

and Sales for the Period Inventories Variable Costing Net Operating Income
Production = Sales No change Absorption costing NOI = Variable
costing NOI
Production > Sales Increase Absorption costing NOI > Variable
costing NOI
Production < Sales Decrease Absorption costing NOI < Variable
costing NOI
Figure: Comparative income effects— Absorption Costing and Variable Costing

4. 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.

5. 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.

The Matching Principles

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. The argument for using
absorption costing in external reports seems to be based on the matching principle.
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1. 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.

2. 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.

Advantages of Variable Costing and the Contribution Approach

There are a number of advantages to using variable costing (and the contribution
approach) in internal reports and analysis.

1. 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.

2. 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.

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3. 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.

4. 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.

5. 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.

6. Control is facilitated
Variable costing ties in with cost control methods such as flexible budgets.

7. Incremental analysis is more straight-forward

Variable cost corresponds closely with the current out-of-pocket expenditure
necessary to produce and sell products and services and can therefore be used
more readily in incremental analysis than absorption costing data. And since
variable costing net operating income is closer to net cash flow than absorption
costing net operating income, it is likely to be more useful to companies that
have cash flow problems.

However, variable costing is not generally accepted by auditors for external

financial reports and is not permitted by the IRS in the United States and by tax
authorities in many other countries for income tax calculations. There is some
question about whether variable costing is actually prohibited in the United
States by official pronouncements and some companies do use some form of
variable costing in their external reports, but absorption costing must be
considered the most generally accepted practice.

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 Impact of (just in time) JIT
Impact of JIT Inventory Methods
When companies use JIT methods for controlling their operations, the distortions
of income that can occur under absorption costing largely (or completely)
disappear.
1. The cause of distortions in net operating income
Erratic movements in net operating income under absorption costing and the
differences in net operating income between absorption and variable costing can
be traced to changing levels of inventory. When inventory levels are constant or
negligible, absorption costing and variable costing methods yield the essentially
same net operating income.

2. The JIT solution

Under an ideally functioning JIT system, goods are produced strictly to
customers’ orders. Finished goods inventories almost disappear and work in
process inventories are kept to a minimum. With little or no inventories, fixed
manufacturing overhead costs cannot be shifted between periods under
absorption costing. As a result, both variable and absorption costing will show
essentially the same net operating income figure, and the net operating income
under absorption costing will move in the same direction as movements in sales.
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Absorption Costing (External reporting) and Income Taxes

Absorption costing is required for external reporting for a company. A company

that attempts to use variable costing on its external financial reports runs the risk
that its auditors may not accept the financial statements as conforming to generally
accepted accounting principles (GAAP). Tax law on this issue is cleat cut. A
company must use absorption costing for its external reports; a manager can also
use variable costing income statements for internal reports. No particular
accounting problems are created by using both costing methods- the variable
costing method for internal reports and the absorption costing method for external
reports. Top executives are typically evaluated based on the earnings reported to
shareholders on the company’s external financial reports.

Format Differences Under Two Methods

Format (Technical) Differences

 Absorption costing makes a primary classification of costs according to

manufacturing and non–manufacturing functions, emphasizing the gross
margin (that is, Sales – COGS) available to cover all fixed and variable
selling and administrative expenses.
 Direct costing makes a primary classification of costs into variable and
fixed categories, emphasizing the contribution margin (that is, sales –
variable costs) available to cover all fixed costs.

Report Formats

The formats for profit reporting under direct costing and absorption costing are
different.

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The figures under the two approaches will not always be the same.

Interpretation of the Difference

The difference between the two income measurement approaches is essentially the
difference in the timing of the charge to expense for fixed factory overhead cost. In
the absorption costing method, fixed factory overhead is first charged to inventory;
thus, it is not charged to expense until the period in which the inventory is sold and
included in cost of goods sold (an expense). In contrast, in the variable costing
method, fixed factory overhead is charged to expense immediately, and only
variable manufacturing costs are included in product inventories. Therefore, if
inventories increase during a period (i.e., production exceeds sales), the variable
costing method will generally report less operating income than will the absorption
costing method; when inventories decrease, the opposite effect will take place.

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 Rules Regarding Absorption Costing Versus Variable
Costing
Rules about unit sales and production under the two costing methods are as
follows:

If sales are variable and production constant

a. When production is equal to sales, then absorption costing and variable costing
will give the same amount of net income.

b. When production is greater than sales, then Net Income under absorption
costing will be greater than net income under variable costing because a portion
of the fixed costs was deferred to other years under the absorption method.

c. When production is less than sales, then Net Income under absorption costing
will be less than net income under variable costing because a portion of the
fixed costs that were deferred from previous years will be absorbed into this
year’s cost of goods sold.

d. The value of inventory will be greater under the absorption method because of
the deferred costs; however the total unit count will be the same for each
accounting method.

e. Over the long-term, net income will be equal under both methods.

If sales are constant and production is variable then

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a. Net income under variable costing is not influenced by the fluctuations in sales
(given a constant production) because none of the fixed manufacturing costs are
deferred.

b. Net income under absorption costing is influenced by the fluctuations in sales

(given a constant production) because a portion of the fixed manufacturing costs
are deferred and may be used each year to increase costs.

Calculation of Product and Period cost of

SQUARE PHARMACEUTICALS LTD.
Calculation of product and period cost of SQUARE PHARMACEUTICALS LTD.
by using both Absorption Costing and Variable Costing Methods for the 2007 are
shown in the following two tables:

Calculation of Product Cost under Absorption Costing and Variable Costing:

Particulars Total (TK.) Per Unit Cost (TK.)

Production in units 3,076,850,000 Absorption Costing Variable Costing

Direct Material note-1 3,569,146,00 1.16 1.16

Variable Manufacturing Overhead 0 0.07 0.07
Fixed Manufacturing Overhead note-2 215,379,500 0.17
Total 523,064,500 1.40 1.23
4,307,590,00
0

Calculation of Period Cost under Absorption Costing and Variable Costing:

Particulars Total (TK.) Per Unit Cost (TK.)

Sales in units 3,076,620,000 Absorption Costing Variable Costing

Fixed Manufacturing Overhead note-2 523,064,000 ----- 0.17

Variable selling and distribution
expenses 399,960,600 0.13 0.13
Fixed selling and distribution
expenses 615,324,000 0.20 0.20
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 Variable administrative expenses 92,298,600 0.03 0.03
Fixed administrative expenses 307,662,000 0.10 0.10
Total 1,938,309,200 0.46 0.63

Note-1
Direct material includes the raw materials, packaging materials, and purchase of
finished goods.
Note-2
Fixed manufacturing includes the salaries, allowances and wages, factory
employee’s fees lunch, rental expenses, depreciation and others.
SQUARE PHARMACEUTICALS LTD.
Absorption Costing Income Statement
For the Year Ended 31 March 2007

Particulars Amounts (TK.) Amounts (TK.)

Sales (3,076,620,000 units) note-1 7,691,550,000
Less Cost of Goods Sold:
Beginning inventory note-2 258,696,200
Add cost of goods manufactured note-3 4,307,590,000
Goods available for sale 4,566,286,200
Less ending inventory note-4 259,018,200 4,307,268,000
Gross Margin 3,384,282,000
Less Selling and Administration Expenses
Variable selling and distribution
expenses 399,960,600
Fixed selling and distribution expenses 615,324,000
Variable administrative expenses 92,298,600
Fixed administrative expenses 307,662,000 1,415,245,200
Net Operating Income 1,969,036,800

Note-1

Sales during the year is 3,760,620,000 units and selling price per unit is tk. 2.50
Note-2

Beginning inventory in the year is 184,783,000 units

Note-3

Group-1 (Warrior)
Production during the year is 3,076,850,000 units
Note-4

Ending inventory is 185,013,000 units

Product cost per unit is tk. 1.40.

SQUARE PHARMACEUTICALS LTD.

Variable Costing Income Statement
For the Year Ended 31 March 2007

Particulars Amounts (TK.) Amounts (TK.)

Sales (3,076,620,000 units) 7,691,550,000
Less Variable Expenses:
Variable Cost of Goods Sold:
Beginning inventory 227,283,090
Add cost of goods manufactured 3,784,525,500
Goods available for sale 4,011,808,590
Less ending inventory 227,565,990
Total 3,784,242,600
Variable selling and distribution expenses 399,960,600
Variable administrative expenses 92,298,600 4,276,501,800
Contribution Margin (CM) 3,415,048,200

Less Fixed Expenses:

Fixed manufacturing overhead 523,064,000
Fixed selling and distribution expenses 615,324,000
Fixed administrative expenses 307,662,000 1,446,050,000
Net Operating Income 1,968,998,200

Group-1 (Warrior)
In 2007 opening inventory is 184,783,000 units and ending inventory is
185,013,000 units. Here we see that inventories are increased (185,013,000 –
184,783,000) = 230,000 units during the year, as a result net operating income is
increased under the absorption costing method than the variable costing method.
The net operating income under absorption costing method is tk. 1,969,036,800
and variable costing method’s net operating income is tk. 1,968,998,200.

Calculation of Product and Period cost of

SQUARE PHARMACEUTICALS LTD.
Calculation of product and period cost of SQUARE PHARMACEUTICALS LTD.
by using both Absorption Costing and Variable Costing Methods for the 2006 are
shown in the following two tables:

Calculation of Product Cost under Absorption Costing and Variable Costing:

Particulars Total (TK.) Per Unit Cost (TK.)

Production in units 2,779,500,000 Absorption Costing Variable Costing

Direct Material note-1 3,224,220,00 1.16 1.16

Variable Manufacturing Overhead 0 0.07 0.07
Fixed Manufacturing Overhead note-2 194,565,000 0.1881865
Total 523,064,500 1.4181865 1.23
3,941,849,50
0

Calculation of Period Cost under Absorption Costing and Variable Costing:

Particulars Total (TK.) Per Unit Cost (TK.)

Sales in units 2,768,567,000 Absorption Costing Variable Costing

Fixed Manufacturing Overhead note-2 523,064,000 ----- 0.1889295

Variable selling and distribution
expenses 359,913,710 0.13 0.13
Fixed selling and distribution
expenses 615,324,000 0.2222536 0.2222536
Group-1 (Warrior)
 Variable administrative expenses 83,057,010 0.03 0.03
Fixed administrative expenses 307,662,000 0.1111268 0.1111268
Total 1,938,309,200 0.4933804 0.6823099

Note-1
Direct material includes the raw materials, packaging materials, and purchase of
finished goods.
Note-2
Fixed manufacturing includes the salaries, allowances and wages, factory
employee’s fees lunch, rental expenses, depreciation and others.
SQUARE PHARMACEUTICALS LTD.
Absorption Costing Income Statement
For the Year Ended 31 March 2006

Particulars Amounts (TK.) Amounts (TK.)

Sales (2,768,567,000 units) note-1 6,921,417,500
Less Cost of Goods Sold:
Beginning inventory note-2 246,551,723
Add cost of goods manufactured note-3 3,941,849,377
Goods available for sale 4,188,401,100
Less ending inventory note-4 262,056,756 3,926,344,344
Gross Margin 2,995,073,156
Less Selling and Administrative Expenses
Variable selling and distribution
expenses 359,913,710
Fixed selling and distribution expenses 615,324,000
Variable administrative expenses 83,057,010
Fixed administrative expenses 307,662,000 1,365,956,720
Net Operating Income 1,629,116,436

Note-1

Sales during the year is 2,768,567,000 units and selling price per unit is tk. 2.50
Note-2

Beginning inventory in the year is 173,850,000 units

Note-3
Group-1 (Warrior)
Production during the year is 2,779,500,000 units
Note-4

Ending inventory is 184,783,000 units

Product cost per unit is tk. 1.4181865.

SQUARE PHARMACEUTICALS LTD.

Variable Costing Income Statement
For the Year Ended 31 March 2006

Particulars Amounts (TK.) Amounts (TK.)

Sales (2,768,567,000 units) 6,921,417,500
Less Variable Expenses:
Variable Cost of Goods Sold:
Beginning inventory 213,835,500
Add cost of goods manufactured 3,418,785,000
Goods available for sale 3,632,620,500
Less ending inventory 227,283,090
Total 3,405,337,410
Variable selling and distribution expenses 359,913,710
Variable administrative expenses 83,057,010 3,848,308,130
Contribution Margin (CM) 3,073,109,370

Less Fixed Expenses:

Fixed manufacturing overhead 523,064,000
Fixed selling and distribution expenses 615,324,000
Fixed administrative expenses 307,662,000 1,446,050,000
Net Operating Income 1,627,059,370

Group-1 (Warrior)
In 2006 opening inventory is 173,850,000 units and ending inventory is
184,783,000 units. Here we see that inventories are increased (184,783,000 –
173,850,000) = 10,933,000 units during the year, as a result net operating income
is increased under the absorption costing method than the variable costing method.
The net operating income under absorption costing method is tk. 1,629,116,436
and variable costing method’s net operating income is tk. 1,627,059,370.

Reconciliation of Net Operating Income

The reconciliation of the variable costing and absorption net operating income are
shown in the following figure—

Particulars Amount (TK.) Amount (TK.)

Year 2007 2006
Variable costing net operating income 1,968,998,200 1,627,059,370
Add fixed manufacturing overhead costs
deferred in inventory under absorption
costing 31,452,210 31,413,110

Deduct fixed manufacturing overhead costs

released from inventory under absorption 31,413,110 29,356,500
costing
1,969,037,300 1,629,115,980
Absorption costing net operating income note-1

Note-1

Absorption costing income statement show that the Net operating Income of
SQUARE PHARMACEUTICALS LTD. for the year 2007 is tk. 1,969,036,800 but
in reconciliation it shows that the company’s Net Operating income is
1,969,037,300. This difference is tk. (1,969,037,300 — 1,969,036,800) =500 and
in 2006 absorption costing Net Operating Income is tk. 1,629,116,436 but in
reconciliation we see that this is tk. 1,629,116,436. Difference is tk.
(1,629,116,436—1,629,115,980) = 456. These differences occurred due to the
fractions in different figure.

Group-1 (Warrior)
 Summary Result at a Glance
The total result of our calculation for the comparison of net effect on net operating
income under both methods Absorption Costing and Variable Costing are shown in
the following:

Particulars Year-2007 Year-2006

Costing method Absorption Variable Absorption Variable
Product cost 1.40 1.23 1.4181865 1.23
Period cost 0.46 0.63 0.4933804 0.6823099
Net operating income 1,969,036,800 1,968,998,200 1,629,116,436 1,627,059,370
Effects
Inventories Increased during the year Increased during the year
Absorption costing net Absorption costing net
Net operating income operating income > Variable operating income > Variable
costing net operating income costing net operating income
Net operating income 1,969,036,800>1,968,998,200 1,629,116,436>1,627,059,370

Group-1 (Warrior)
Overall Comments
From the calculations of net operating income of variable costing and absorption
costing of Square Pharmaceuticals Limited we see that, in 2006 their net operating
income under absorption costing is tk. 1,629,116,436 and under variable costing net
operating income is tk. 1,627,059,370. Here a question arise that why this
difference is occurred. This difference is occurred due to use of different
accounting method. We know that if inventory increase during the year then the
net operating income is increased under absorption costing than that of viable
costing net operating income statement. Because when inventory increase then
fixed manufacturing overhead cost of these ending inventories is deferred to the
next period, as a result total cost during the year is decreased. Here fixed
manufacturing overhead cost is treated as product cost, but in case of variable
costing method fixed manufacturing overhead cost is treated as period cost. So
total manufacturing overhead cost is charged in the period regardless their sales
volume. As a result net operating income under this method is lower than that of
absorption costing method. In 2006 opening inventory is 173,850,000 units and
ending inventory is 184,783,000 units. Here we see that inventories are increased
(184,783,000 – 173,850,000) = 10,933,000 units during the year, as a result net
operating income is increased under the absorption costing method than the
variable costing method.

In the same way in 2007 opening inventory is 184,783,000 units and ending
inventory is 185,013,000 units. Here we see that inventories are increased
(185,013,000 – 184,783,000) = 230,000 units during the year, as a result net
operating income is increased under the absorption costing method than that of the
variable costing method. The net operating income under absorption costing
method is tk. 1,969,036,800 and variable costing method’s net operating income is
tk. 1,968,998,200.

Group-1 (Warrior)
 CONCLUSION

Two general approaches are used in manufacturing companies for costing products
for the purpose of valuing inventories and cost of goods sold. Absorption costing
is generally used for external financial reports. The other approach, called variable
costing, is preferred by some managers for internal decision making and must be
used when an income statement is prepared in the contribution format. Ordinarily,
absorption costing and variable costing produces different figures for net operating
income, and the difference can be quite large. In addition to showing how these
two methods differ, we will consider the arguments for and against each costing
method and we will show how management decisions can be affected by the
costing method chosen.

Group-1 (Warrior)
 BIBLIOGRAPHY
H. Garrison Ray, W. Noreen Eric, and C. Brewer Peter, Managerial Accounting,
12th Edition, McGraw-Hill, pp 276-292.

Annual report of Square Pharmaceuticals Limited, 2007-2008.

Roychowdhury, S. (2006). Management of earnings through the manipulation of

real activities that affect cash flow from operations. Working Paper. MIT Sloan
School of Management.

Kinney, M. and W. Wempe (2005). JIT Adoption: Theeffects of LIFO reserves and
financial reporting and tax incentives. Contemporary Accounting Research 21(3),
603-638.

Jiambalvo, J, E. Noreen and T. Shevlin (2007). Incremental information content of

the change in percent of production added to inventory. Contemporary Accounting
Research, 14(1), 69-97.

Group-1 (Warrior)