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AC 515 by MSF
AC - DC
Alternative Approaches Used for Product Costing
 Absorption Costing/Full Costing/ Conventional or Traditional Costing/Normal Costing
 Direct Costing/Variable Costing/Marginal Costing

DISTINCTIONS BETWEEN

PRODUCT COST PERIOD COST

1. Are those costs involved in the purchase or 1. Are those costs that are matched against revenues
manufacture of goods. on a time period basis.
2. At the point of sale, the costs are released from
inventory and treated as expenses (typically called 2. Does not form part of the cost of inventory.
CGS) & matched against sales.
3. It diminishes current income by that portion 3. It diminishes income for the current period by its full
identified with sold units only, the balance of which is amount.
deferred to the next accounting period as part of EI.
In short term decisions, period costs are not relevant.

Differences between AC and DC:

1. Cost Segregation - DC segregates all costs (manufacturing, selling & administrative) into fixed and variable items. This
segregation is seldom found in AC.
2. Inventories - In AC, inventories include both VFO & FFO. Due to the treatment of FFO, cost of inventory under DC
is less than the cost of inventory under AC.
3. FFO treatment -Under DC, FFO is a period cost while in AC, FFO is a product cost.
4. Net Income -Net Income under DC may differ from Net Income under AC because of variations between production
& sales volume. Over an extended period of time, the NI reported by the 2 costing methods will tend
to be the same. The reason is that over the long run, sales cannot continuously exceed production,
nor can production continuously exceed sales. The shorter the time period, the more that the NI will
tend to differ.

The essential difference between AC & DC centers on TIMING (that is, when to recognize FFO as an expense) or the proper timing of
the release of FMC as costs of the period:
a) At the time of incurrence (under DC); or
b) At the time the finished units to which the fixed overhead relates are sold (under AC).

The term DC is a misnomer for variable costing for 2 reasons:

1. Variable costing does not include all direct costs as product costs. Only variable direct manufacturing costs are included. Any fixed
direct manufacturing costs, & any direct nonmanufacturing costs, (either variable or fixed) are excluded from product costs.
2. Variable costing includes as product costs not only direct manufacturing costs but also some indirect costs (variable indirect
manufacturing costs).

Including or excluding FC from inventories & from CGS causes GP to differ form gross CM. Gross CM (Sales less VMC) is
considerably greater than GP. In the TOC (Theory of Constraints) approach, DL is generally considered a FC for the following reasons:
1. Even though DL workers may be paid on an hourly basis, many companies have a commitment (sometimes enforced in labor
contracts or by law) to guarantee workers a minimum number of paid hours;
2. In TOC companies, DL is not usually the constraint (it’s either machine constraint or policy constraint);
3. TOC emphasizes continuous improvement to maintain competitiveness. Without the committed & enthusiastic
employees, sustained continuous improvement is virtually impossible. Managers involved in TOC are extremely reluctant
to lay off employees.

TOC companies believe that DL is much more like a committed FC than variable cost. Hence, in the modified form of Variable Costing
used in TOC companies, DL is not included as part of product costs.
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EFFECT ON NET INCOME

Relation between Production & Relation between

Sales for the Period Effect on Inventories ACNI and VACNI
No change in inventories
If P = S
FFO expensed under AC is equal to the ACNI = VACNI
FFO expensed under DC
Inventory increases;

Net income is higher under AC since FFO is

If P > S deferred in inventory under AC as ACNI > VACNI
inventories increase.
Inventory decreases;

If P < S Net income is lower under AC since FFO is

released from inventory under AC as ACNI < VACNI
inventories decrease.
As service or merchandising companies have no fixed manufacturing costs, these companies do not make choices between AC and
DC.
EFFECT OF CHANGES IN PRODUCTION ON NET INCOME

 Net Income under DC is not affected by changes in production. Using DC, reported NI moves in the same direction as Sales.
 Net Income under AC is affected by changes in production.
a. NI will increase as production increases & decrease as production decreases. As inventories grow, FFO is
deferred in inventories but as inventories shrink, FFO is released to the income statement.
b. These changes in NI are a major drawback of AC since a company can increase its reported NI by simply increasing
production.

Fluctuations in NI can be due to changes in inventories rather than to changes in sales.

Arguments for the Use of DC:

1. DC reports are simpler & easier to understand.
2. Data needed for breakeven & CVP analysis are readily available.
3. Eliminates the problem involved in allocating fixed costs.
4. DC is more compatible with the standard cost accounting system.
5. DC reports provide useful info. for pricing decisions & other decision making problems encountered by management.

Advocates of DC argue that FFO are incurred in order to have the capacity to produce output in a given period. These costs ar e
incurred whether or not the capacity is actually used to make the output. The costs have no future service potential since incurring
them in the current period does not remove the necessity to incur them in future periods. Thus, FFO should be charged against the
period & not included in product costs. It is not possible to compute a BEP under AC unless an assumption is made that inventory
levels will not change.

Arguments Against DC:

1. Difficulty in segregating the fixed & variable components of a mixed cost.
2. Violates the matching principle since DC excludes FFO from product costs & charges the same to period costs regardless
of production & sales.
3. With DC, inventory costs & other related accounts such as working capital, current ratio, & acid test ratio are understated because of
the exclusion of FFO in its product costs.

Advocates of AC believe that all manufacturing costs whether fixed or variable are essential to the production process & should not be
ignored when determining product costs. AC is the generally accepted method for external reporting & for preparing ITRs. DC is
usually limited to internal use in a company. Most managers would prefer AC because their performance in any given reporting period,
at least in the short run, is influenced by how much production is scheduled near the end of a period.
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When companies employ JIT, problems with NI under AC are either eliminated or become insignificant. The erratic movement of NI
under AC & the difference in NI between AC & DC arise because of changing inventory level. Under JIT, goods are produced strictly to
customers’ orders, so inventories are largely eliminated. There is little opportunity for FFO to be shifted between periods under AC.
Thus, NI will be essentially the same whether AC or DC is used, & the erratic movement in NI under AC will be largely eliminated.
Inasmuch as DC is used in short-range planning, it encourages a short-sighted approach to profit planning.

Approaches used to reduce the negative aspects associated with using AC include:
1. Change the accounting system
 Adopt either variable or throughput costing, both of which reduce the incentives of managers to build for inventory.
 Adopt an inventory holding charges for managers who tie up funds in inventory.
2. Extend the time period used to evaluate performance. By evaluating performance over a longer time period (like 3 to 5 years), the
incentive to take short-run actions that reduce long-term income is lessened.
3. Include non-financial as well as financial variables in the measures used to evaluate performance.

Capacity Levels a company can use to compute the budgeted Fixed OH rate:
1. The theoretical capacity & practical capacity denominator-level concepts emphasize what a plant can supply.
2. The normal utilization & master budget utilization concepts emphasize what customers demand for products produced by a plant.

Theoretical capacity is 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,
shutdowns for holidays and other days, and so on.

The smaller the denominator, the higher is the overhead costs capitalized for inventory units. Thus, if the plant manager wishes to be
able to adjust plant operating income by building inventory, master budget utilization or possibly normal utilization would be preferred.

Under a cost-based pricing system, the choice of a master budget level denominator will lead to high prices when demand is low (more
FC allocated to the individual product level), further eroding demand; conversely it will lead to low prices when demand is high, forgoing
profits. This has been referred to as the downward demand spiral, which is the continuing reduction in demand that occurs when the
prices of competitors are not met and demand drops, resulting in even higher unit costs & even more reluctance to meet the prices of
competitors.

A costing methodology that focuses on capacity utilization is called throughput accounting. It assumes that there is always one
bottleneck operation in a production process that commands the speed with which products or services can be completed. This
operation becomes the defining issue in determining what products should be manufactured first, since this in turn results in differing
levels of profitability.

Throughput Costing puts greater emphasis on sales as the source of OI than either absorption or variable costing. It is not based on
standard costing nor ABC. Throughput costing puts a penalty on producing without a corresponding sale in the same period. Costs
other than DM that are variable with respect to production are expensed to that period, whereas under variable costing they would be
capitalized as product costs. A manager using throughput costing cannot increase OI by building for inventory as is possible with AC.

Sales – Cost of Raw Materials = Throughput Contribution – Other Manufacturing Costs & Operating Expenses = NI

CONVERSION OF ABSORPTION COSTING TO DIRECT COSTING

1. Upon conversion:
a) Determine the FFO per unit of the base period & deduct this from the unit cost of beginning inventory.
b) Compute the FFO per unit for the current period and deduct it from the unit cost of ending inventory.
c) Determine the fixed portion of Operating Expenses.
2. If the income statement to be converted to DC includes variances due to inclusion of factory overhead based on normal
capacity, they should be treated as adjustments to factory overhead with the spending variance generally identified with
VFO, the volume variance with the FFO. V V = BASH – SHASOR ICV = BAAH - AHSOR
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Group Assignment (Use Microsoft Excel)

Group 1 – Answer Problem # 3

Group 2 - Answer Problem # 4
Group 3 - Answer Problem # 5
Group 4 - Answer Problem # 6
Group 5 - Answer Problem # 7

1. The following data were taken from the records of HERSHE INC.:
Beginning Ending
Finished goods inventory 1,100 units 2,200 units
Cost data per unit:
Direct material P 20 P 20
Direct labor 25 25
Manufacturing overhead:
Variable 15 15
Fixed 12 10
P 72 P 70
==== ====
Selling price per unit is P100. Yearly production is 10,000 units.
Selling and administrative expenses: Variable P 80,000
Fixed 90,000

REQUIRED: Determine the income under both costing methods & reconcile the resulting profit.

2. Kitkat Corp. developed the following standard unit costs:

Materials ……………………………………………………………………………………6.00
Labor ………………………………………………………………………………………...4.25
Variable overhead ……………………………………………………………………… 4.80
Fixed overhead …………………………………………………………………………… 1.55
Variable marketing expenses …………………………………………………………….1.50
Fixed administrative expenses ………………………………………………………… 4.50
Total ……………………………………………………………………………………P22.60

The selling price is estimated at P 30, & standard production is 9,000 units. Last year, production was 9,000 units, of which 1,500 units
were in inventory at the end of the year. This year, production is 7,700 units; 7,000 units were sold at standard price. There are no
work in process or materials inventories.

REQUIRED:
a. Prepare an income statement for the current year, using absorption costing and direct costing. (Round all computations to the
nearest peso and round P.50 up. Any over- or underapplied factory overhead should be closed to CGS.

b. Compute and reconcile the difference in operating income under the two methods.

3. The president of Toblerone, Inc. has been reviewing the income statements of the two most recent months. She is puzzled because
sales rose and profits fell in March, and she asks you, the controller, to explain.
February March
Sales (P30 per case) P 540,000 P 660,000
Standard cost of sales 270,000 330,000
Standard gross profit P 270,000 P330,000
Volume variance 40,000 (50,000)
Selling and administrative expenses (150,000) (150,000)
Income P160,000 P130,000
======== ========
The standard fixed cost per case is P10, based on normal capacity of 20,000 cases per month.
REQUIRED: 1) Determine production in each month. 2) Prepare the income statement using variable costing.
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4. Pro-Pinoy Products presents the following data from absorption costing income statements for the last two years:
19A 19B
Sales ................................................................................................................... P2,000,000 P2,500,000
Cost of goods sold (at standard) ......................................................................... 800,000 950,000
Over- or underapplied overhead .......................................................................... 25,000 (25,000)
Marketing and general expense .......................................................................... 500,000 550,000
Operating income ................................................................................................ 675,000 1,050,000

REQUIRED: Prepare the direct costing income statements for each year, assuming that there were no changes in capacity
between years and that the unit variable costs are constant. (Hint: Use the high- and low-points method to
determine the fixed & variable portions of each cost element.)

5. Pasta Corp. manufactures a variety of products. The ff. data pertain to the company’s operations over the last 2 years;
Variable Costing Net Operating Income, last year …………………P 82,700
Variable Costing Net Operating Income, this year ………………… 87,800
Increase in ending inventory last year ……………………………… 900
Decrease in ending inventory this year …………………………….. 3,100
Fixed manufacturing overhead cost per unit 2
REQUIRED: a) Determine the absorption costing net operating income last year.
b) Determine the absorption costing net operating income this year.

6. Cadbury Co. uses a standard cost system in accounting for its only product which it sells @ P22 per unit. The std.UC is:
Direct materials..................................................................................... P 4
Direct labor.......................................................................................... 6
Variable factory overhead.................................................................... 2
Fixed factory overhead (based on normal capacity of 60,000 units).................. 3
P 15
====
All variances are closed to CGS. On October 1, there were 10,000 units on hand. During October, 50,000 units were produced and
45,000 were sold. Costs incurred during October were:
Direct materials...................... P 198,000 Fixed factory overhead......................... 186,000
Direct labor.......................... 305,000 Variable marketing and administrative 50,000
Variable factory overhead........ 103,000 Fixed marketing and administrative 74,000
REQUIRED: (1) Explain whether the company uses direct or absorption costing.
(2) Prepare an income statement for October, using direct costing.
(3) Compute the operating income for October if absorption costing is used. (CGAAC adapted)

7. K Corp.developed the ff. standard unit costs @ 100% of its normal production capacity, which is 50,000 units per year:
Direct materials…....................P 3
Direct labor............................... 3
Variable factory overhead........ 2
Fixed factory overhead…......... 3
P 11
====
The selling price of each unit of product is P20. Variable commercial expenses are P1 per unit sold and fixed commercial
expenses total P 150,000 for the period. During the year, 49,000 units were produced & 52,000 units were sold. There are no work
in process beginning or ending inventories, & finished goods inventory is maintained at standard cost, which has not changed from
the preceding year. For the current year, there is a net favorable variable cost variance of P1,000.
REQUIRED: (1) Prepare an income statement on the absorption costing basis.
(2) Prepare an income statement on the direct costing basis.
(3) Compute and reconcile the difference in operating income for the current year under AC & DC.