Management and Cost Accounting, 6

th
edition, ISBN 1-84480-028-8
2004 Colin Drury
MANAGEMENT
AND COST
ACCOUNTING
SIXTH EDITION

COLIN DRURY
Management and Cost Accounting, 6
th
edition, ISBN 1-84480-028-8
2004 Colin Drury
2000 Colin Drury
Part Two:
Cost accumulation for inventory valuation and profit
measurement

Chapter Seven:
Income effects of alternative cost accumulation systems
Management and Cost Accounting, 6
th
edition, ISBN 1-84480-028-8
2004 Colin Drury
7.1a
2000 Colin Drury
Absorption and variable costing

1. Absorption costing (also known as full costing) traces all manufacturing
costs to products and treats non-manufacturing overheads as a period
cost.

2. Variable costing (also known as direct or marginal costing) traces all
variable costs to products and treats fixed manufacturing overheads
and non-manufacturing overheads as a period cost.

3. Therefore,variable and absorption costing differ in the treatment of fixed
manufacturing costs.
Management and Cost Accounting, 6
th
edition, ISBN 1-84480-028-8
2004 Colin Drury
7.1b
2000 Colin Drury
Management and Cost Accounting, 6
th
edition, ISBN 1-84480-028-8
2004 Colin Drury
7.2
2000 Colin Drury
Management and Cost Accounting, 6
th
edition, ISBN 1-84480-028-8
2004 Colin Drury
7.3
2000 Colin Drury
Variable costing statements
Management and Cost Accounting, 6
th
edition, ISBN 1-84480-028-8
2004 Colin Drury
7.4
2000 Colin Drury
Absorption costing statements
Management and Cost Accounting, 6
th
edition, ISBN 1-84480-028-8
2004 Colin Drury
7.5a
2000 Colin Drury
Profit comparisons (variable and absorption costing)

Profits are the same for both methods when production equals sales
(no changes in stock levels)in periods 1 and 4.

Where production exceeds sales (increasing stock levels) the
absorption costing system produces higher profits in periods 2 and 5.

Where sales exceed production (declining stock levels)the variable
costing system produces higher profits in periods 3 and 6.

With an absorption costing system profits can decline when sales
volume increases and costs remain unchanged (e.g.period 6).
Management and Cost Accounting, 6
th
edition, ISBN 1-84480-028-8
2004 Colin Drury
7.5b
2000 Colin Drury
Some arguments in support of variable costing

Variable costing provides more useful information for decision-making.

Variable costing removes from profit the effect of stock changes.

Variable costing avoids fixed overheads being capitalized in unsaleable
stocks.

Some arguments in support of absorption costing

Absorption Costing does not understate the importance of fixed costs.

Absorption costing avoids fictitious losses being reported (e.g stocks
accumulated for seasonal sales).

Absorption costing is theoretically superior to variable costing.(Note cost
obviation concept favours variable costing,whereas revenue production
concept favours absorption costing.)
Management and Cost Accounting, 6
th
edition, ISBN 1-84480-028-8
2004 Colin Drury
7.6
2000 Colin Drury
Conclusion

1. Choice depends on the circumstances.

Volatile sales and changing stock levels favour variable costing for
internal monthly or quarterly profit measurement.

Seasonal sales where stocks are built up in advance favours
absorption costing.

2. Debate only applies to internal reporting SSAP 9 requires that
absorption costing is used for external reporting.

3. Debate only applies when historical cost accounting is used.

Management and Cost Accounting, 6
th
edition, ISBN 1-84480-028-8
2004 Colin Drury
7.7a
2000 Colin Drury
Alternative denominator level measures

Absorption costing systems require the computation of estimated fixed
overhead rates.

The fixed overhead rate will be significantly influenced by the choice of the
denominator level.
Management and Cost Accounting, 6
th
edition, ISBN 1-84480-028-8
2004 Colin Drury
7.7b
2000 Colin Drury
Example
Annual budgeted fixed overheads for a machine cost centre 192 000
The cost centre operates 3 shifts of 8 hours for 5 days per week for 50 weeks
(6 000 hours)

Practical operating capacity to allow for preventative maintenance 5 000 hours
Requirements based on average sales demand for next 3 years is 4 800 hours
Budgeted usage for the coming year 4 000 hours

Four different denominator levels can be used

1. Theoretical maximum capacity of 6 000 hours = 32 per hour (192 000/6 000
hours)
2. Practical capacity of 5 000 hours = 38.40 per hour (192 000/5 000 hours)
3. Normal average long-run activity of 4 800 hours = 40 per hour
(192 000/4 800 hours)
4. Budgeted activity of 4 000 hours = 48 per hour (192 000/ 4 000 hours)
Management and Cost Accounting, 6
th
edition, ISBN 1-84480-028-8
2004 Colin Drury
7.8a
2000 Colin Drury
Assuming actual activity and spending is the same as budget the annual costs will
be allocated as follows:
Allocated to Volume variance Total
products cost of unused ()
capacity)
Practical 153 600 38 400 192 000
capacity (4 000 hrs
38.40) (1 000 hrs 38.40)

Normal 160 000 32 000 192 000
activity (4 000 hrs
40) (800 hrs 40)

Budgeted 192 000 Nil 192 000
activity (4 000 hrs 48)
Management and Cost Accounting, 6
th
edition, ISBN 1-84480-028-8
2004 Colin Drury
7.8b
2000 Colin Drury
The choice of an appropriate activity level can have a significant effect on the
inventory valuation and profit computation.
Assuming 90%of output is sold and no openings inventories the above costs will
be allocated as follows:

Allocated to Allocated to
cost of sales inventories Total

Practical capacity 176 640 15 360 192 000
Normal activity 176 000 16 000 192 000
Budgeted activity 172 800 19 200 192 000

For many organizations the allocation of costs between cost of sales and
inventories is not an issue.

Note the theoretical disadvantages of using budgeted activity.