Variable and Absorption Costing - Lecture Notes PDF

NATURE AND CLASSIFICATION OF COSTS VARIABLE AND ABSORPTION COSTING NATURE AND CLASSIFICATION OF COSTS Product Costs: Also referred to as manufacturing costs / production costs / factory costs. Initially treated as an asset and allocated to the inventory account in the st...

NATURE AND CLASSIFICATION OF COSTS VARIABLE AND ABSORPTION COSTING NATURE AND CLASSIFICATION OF COSTS Product Costs: Also referred to as manufacturing costs / production costs / factory costs. Initially treated as an asset and allocated to the inventory account in the statement of financial position. Once the goods have been sold the costs are then transferred to the statement of comprehensive income. Therefore: Product costs are only treated as an expense when the product is sold (matching principle). These costs basically comprise: ∙ Direct Materials: The material that becomes an identifiable component of the finished product. For example: The denim used to make the jeans. ∙ Direct Labour: The amount of wages earned by workers that actually worked on the product. ∙ Manufacturing Overheads: All other production related costs. Manufacturing overheads include indirect materials, indirect labour and other manufacturing costs. Indirect Material Indirect Labour Other Manufacturing Costs Those materials that Salaries and wages These include costs cannot be identified with of employees who such as factory rent, any one product because do not actually insurance on factory they are work on the building and used for all products product, but assist equipment, rather than a specific in the depreciation on product. For example: manufacturing machinery, repairs and machine oil. process. For maintenance of factory Indirect material also example: factory equipment, electricity includes small insignificant cleaners, used in the items where it is not cost supervisors and production process. effective to trace the cost employees who to individual products. oversee For automated example: zips, buttons machines. & cotton thread. Direct costs: Costs that can be easily traced to a particular cost object (product). Indirect costs: Costs that cannot be easily traced to a particular cost object (product) either because the cost is incurred for the benefit of all products manufactured rather than one specific product or because it is not cost effective to trace the cost of such items to each product. These costs are treated as manufacturing overheads and must be allocated to a cost object (product). PRIME COST = Direct material + Direct labour CONVERSION COST = Direct labour + Manufacturing overheads Period Costs (non-manufacturing costs): These are costs that are not included in inventory valuation and are expensed in the statement of comprehensive income in the period they are incurred. These costs are generally divided into 2 categories: ∙ Marketing costs (selling and distribution costs) include costs relating to selling and delivery. These costs begin at the point where manufacturing costs end. For example: advertising, sales commission, sales salaries and shipping. ∙ Administrative costs include costs incurred in directing and controlling the organisation. For example: compensation of executives, general accounting costs, secretarial costs, etc. COST BEHAVIOUR Cost behaviour refers to how a cost reacts to changes in the level of business activity. Fixed costs: Fixed costs remain constant in total, regardless of the change in output, within a relevant range. The relevant range is the normal operating range of the organisation, within which the cost behaviour is known. NB!! It is recommended that you work with fixed costs in total. Variable costs: Total variable costs change in direct proportion with output, while the cost per unit remains constant. NB!! It is recommended that you work with variable costs per unit. Step-fixed or semi-fixed costs remain fixed within specified activity levels but increase or decrease by a constant amount when output levels shift substantially. An example of a step fixed cost would be the need to buy new production machinery to increase production output to another level. If each production machine costs R25 000 and each machine can only produce 10 000 units, the cost behaviour will be as follows: 0 - 10 000 units R25 000 10 001 – 20 000 units R50 000 20 001 – 30 000 units R75 000 Semi-variable costs: Semi-variable or mixed costs contain both fixed and variable costs. For calculation and decision making purposes semi-variable costs must always be split into their fixed and variable components. COST ESTIMATION The following methods can be used to split semi-variable costs into their fixed and variable components: ∙ High-low method ∙ Scatter diagram method ∙ Least squares method ∙ Inspection of the accounts ∙ Engineering methods Example: The following information was obtained from the books of Siberian Limited for the 6 months ended 31 December 20X3: Month Number of Total overhead units cost manufactured July 14 000 R183 000 August 30 000 R375 000 September 25 000 R315 000 October 18 000 R231 000 November 34 000 R423 000 December 37 000 R383 000 Using the high – low method calculate the variable cost per unit and the fixed cost in total. Number of Total units overhead cost High 34 000 R423 000 Low (14 000) (R183 000) 20 000 R240 000 The variable cost per unit is R12 (R240 000 / 20 000) The total fixed cost is: Total overhead cost R423 000 R183 000 Variable cost R408 000 (R12 x 34 000) R168 000 (R12 x 14 000) Total fixed cost R15 000 R15 000 LEARNING CURVES As a specific task is repeated, workers become more familiar with the work so less labour time is required for the production of each unit. As labour efficiency increases the labour cost per unit will decline. This process continues for some time and a regular rate of decline in the cost per unit can be established at the outset. This rate of decline can then be used in predicting future labour costs. Every time production volume is doubled the cumulative time decreases to a fixed percentage (depending on what the learning curve is). Example: You are told that it took 10 hours to make the first unit and a learning curve of 70% exists. From this you can calculate the following: Number of units Cumulative labour hours 1 10 2 14 (10 x 2 x 70%) 4 19.6 (14 x 2 x 70%) 8 27.4 (19.6 x 2 x 70%) 16 38.4 (27.4 x 2 x 70%) 32 53.8 (38.4 x 2 x 70%) The above table will give us the total production time for specific quantities only (i.e. for units where production volume is doubled). How would we estimate the time to make 10 or 20 units? Average time per unit = Time for 1st unit x Number of units b log 0.7 as the learning curve us Where b = log 0.7 / log 2 = 70%. log 2 will not change. -0.515 Prove that the formula works by calculating the time to make 4 units and agreeing it to the table: Total time to make 4 units = 10 hours x 4 -0.515 = 4.9 x 4 units = 19.6 hours Therefore total time to make 10 units = 10 hours x 10 -0.515 = 3.05 x 10 units = 30.5 hours Therefore total time to make 20 units = 10 hours x 20 -0.515 = 2.14 x 20 units = 42.8 hours Estimating incremental hours: Incremental hours cannot be obtained from the formula. What if I’ve made and sold 4 units and I want to estimate the time for the next 6 units: Total time for 10 units 30.5 hours Less: Time for 4 units (19.6 hours) Time for next 6 units 10.9 hours What if I’ve made and sold 10 units and I want to determine the time for the next 10 units: Total time for 20 units 42.8 hours Less: Time for 10 units (30.5 hours) Time for next 10 units 12.3 hours VARIABLE AND ABSORPTION COSTING VARIABLE COSTING ∙ Also referred to as direct / marginal costing. ∙ Used for management accounts and decision making purposes. ∙ Only variable production costs are included in the cost of inventory. ∙ Actual fixed production overheads are written off as period costs in the year in which they are incurred. Arguments in support of variable costing: ∙ Provides more useful information for decision making. ∙ Profits are not distorted by fixed costs allocated to products (carried forward in closing inventory). ∙ It is easier to determine the effect of volume changes on profit. ∙ Avoids fixed costs being capitalised to unsaleable goods. ABSORPTION COSTING ∙ Used for external reporting purposes – compliance with IAS 2. ∙ Variable and fixed production costs are included in the cost of inventory. Arguments in support of absorption costing: ∙ Does not understate the importance of fixed costs. ∙ Avoids fictitious losses being reported. ∙ Fixed overheads are essential for production. ∙ Consistency with external reporting (IAS 2). IAS 2 – INVENTORIES (ABSORPTION COSTING) Measured at the lower of cost and net realizable value (selling price less estimated costs of completion and costs to sell). When inventories are sold, the carrying amount of those inventories shall be recognised as an expense in the period in which the related revenue is recognised. The cost of inventories includes: ∙ Costs of purchase, including non-recoverable taxes, transport and handling ∙ Other costs to bring inventory into its present condition and location ∙ Net of trade volume rebates ∙ Costs of conversion The costs of conversion of inventories include costs directly related to the units of production, such as direct labour. They also include a systematic allocation of fixed and variable production overheads that are incurred in converting materials into finished goods. The allocation of fixed production overheads to the costs of conversion is based on normal capacity. Normal capacity is the production expected to be achieved on average over a number of periods or seasons under normal circumstances (the actual level of production may be used if it approximates normal capacity) taking into account the loss of capacity resulting from planned maintenance. Variable production overheads are allocated to each unit of production on the basis of the actual use of the production facilities. The amount of fixed overhead allocated to each unit of production is not increased as a consequence of low production. Unallocated overheads are recognised as an expense in the period in which they are incurred. In periods of abnormally high production the amount of fixed overhead allocated to each unit of production is decreased so that inventories are not measured above cost. The cost of inventories excludes: ∙ Abnormal waste ∙ Storage costs (unless necessary for the production process) ∙ Admin overheads not related to production ∙ Selling costs Bases of inventory valuation: The following methods can be used for inventory valuation: ∙ First-In-First-Out (FIFO): The FIFO formula assumes that the items of inventory that were purchased or produced first are sold first. Consequently the items remaining in inventory at the end of the period are those most recently purchased or produced. ∙ Weighted average: The cost of each item is determined from the weighted average of the cost of similar items at the beginning of a period and the cost of similar items purchased or produced during the period. Example: On 1 January 20X4 there were 3 000 units in opening inventory which cost R4 each. During the month an additional 10 000 units were produced at R6 each and 9 000 units were sold. The value of closing inventory at 31 January 20X4: Closing inventory = 3 000 + 10 000 – 9 000 = 4 000 units FIRST-IN-FIRST-OUT (FIFO): = Current production costs Current production units = (10 000 x R6) / 10 000 = R6 x 4 000 units = R24 000 WEIGHTED AVERAGE: = (Opening inventory + current production costs) (Opening inventory + current production units) = [(3 000 X R4) + (10 000 x R6)] / [3 000 + 10 000] = R5.54 x 4 000 units = R22 160 ∙ Standard cost: The standard cost method may be used for convenience if the results approximate cost. Standard costs take into account normal levels of materials and supplies, labour, efficiency and capacity utilisation. They are regularly reviewed and, if necessary, revised in the light of current conditions. ∙ Specific identification: The cost of inventories of items that are not ordinarily interchangeable and goods or services produced and segregated for specific projects shall be assigned by using specific identification of their individual costs. © CA Campus 11 FOR USE BY CA CAMPUS STUDENTS ONLY Example: Actual information for the 20X3 financial year: Opening inventory (variable costing) R44 000 (4 000 units) Opening inventory (absorption costing) R64 800 (4 000 units) Units manufactured 32 000 units Sales R800 000 (34 000 units) Material cost R5 per unit Other variable production costs R6 per unit Sales commission R1.2 per unit Fixed production costs R150 000 Fixed selling and administration costs R140 000 Budgeted information for the 20X3 financial year: Normal capacity 30 000 units Fixed production costs R156 000 Inventory is valued according to the First-In-First-Out method. REQUIRED (a) Prepare the actual Statement of Comprehensive Income for the 20X3 financial year using: i. Variable costing ii. Absorption costing (b) Reconcile the net income according to the two methods. (c) Assume that the high level of production is considered to be materially different from the budget. What should the value of inventories be in terms of IAS 2? © CA Campus 12 FOR USE BY CA CAMPUS STUDENTS ONLY SUGGESTED SOLUTION (a)(i) Actual Statement of Comprehensive Income: Variable Costing Sales R5 x 32 000 R800 000 Less: Cost of sales R6 x 32 000 (R374 000) Opening inventory (C1) Material R1.2 x 34 000 R44 000 Other variable production R160 000 costs Closing inventory R192 000 Sales commission (R22 000) Contribution (R40 800) Fixed production costs Fixed selling and administration R385 200 costs Net income (R150 000) (R140 000) R95 200 Calculations: C1: Closing inventory: 4 000 + 32 000 – 34 000 = 2 000 units FIFO = Current production costs Current production units = (R160 000 + R192 000) / 32 000 = R11 x 2 000 units = R22 000 (a)(ii) Actual Statement of Comprehensive Income: Absorption Costing Sales R5 x 32 000 R800 000 Less: Cost of sales R6 x 32 000 (R550 800) Opening inventory (C1) Material (C2) R64 800 Other variable production (C1) R160 000 costs Fixed production costs (C1) R192 000 Closing inventory R166 400 Expenditure variance R1.2 x 34 000 (R32 400) Volume variance R6 000 Gross profit R10 400 Sales commission Fixed selling and administration R265 600 costs Net income (R40 800) (R140 000) R84 800 Calculations: C1: Fixed production costs: The allocation of fixed production overheads to the costs of conversion is based on normal capacity. STEP 1: Allocation rate = Budgeted overhead / normal capacity = R156 000 / 30 000 units = R5.20 per unit Why do we use budgeted data? The actual manufacturing overhead is only available after the last transaction for the year has been entered. Information on product costs is required more quickly if it is to be used for monthly profit calculations, inventory valuations or as a basis for setting selling prices. Can’t this timing problem be overcome by calculating rates on a more frequent basis (i.e. monthly)? The problem with this is that as activity varies from month to month (due to holiday periods / seasonal fluctuations) there will be large fluctuations in activity rates. These fluctuating rates are not representative of typical, normal production conditions. NB!! The allocation rate should always be a rate per unit. If you calculate a rate per hour it must first be converted into a rate per unit before you calculate the absorbed overhead in Step 2. STEP 2: Absorbed overhead = Allocation rate x actual production = R5.20 x 32 000 = R166 400 STEP 3: Expenditure variance = Actual overhead – Budgeted overhead = R150 000 – R156 000 = R6 000 Favourable STEP 4: Volume variance = Budgeted overhead – Absorbed overhead = R156 000 – R166 400 = R10 400 Favourable OR = (Actual units – Budgeted units) x Allocation rate = (32 000 – 30 000) x R5.20 = R10 400 Favourable NB: Over/under recovery = expenditure variance + volume variance. C2: Closing inventory: 4 000 + 32 000 – 34 000 = 2 000 units FIFO = Current production costs Current production units = (R160 000 + R192 000 + R166 400) / 32 000 = R16.20 x 2 000 units = R34 200 (b) Reconciliation: Absorption costing profit R84 800 Add: Difference in opening inventory R20 800 (R64 800 – R44 000) OR (4 000 x R5.20) Less: Difference in closing inventory (R10 400) (R32 400 – R22 000) OR (2 000 x R5.20) Variable costing profit R95 200 (c) In periods of abnormally high production the amount of fixed overhead allocated to each unit of production is decreased so that inventories are not measured above cost (IAS 2). STEP 1: Recalculate the overhead recovery rate based on actual production: R156 000 / 32 000 = R4.875 per unit (the old rate was R5.20 per unit). STEP 2: Calculate the difference between the old and new rate: R5.20 – R4.875 = R0.325 STEP 3: Write down units in closing inventory: 2 000 units x R0.325 per unit = R650 Dr Cost of sales 650 Cr Inventory 650 Value of closing inventory: R32 400 – R650 = R31 750 Impact on cost of sales: R550 800 + R650 = R551 450 Proof: R64 800 + R160 000 + R192 000 + R166 400 – R31 750 = R551 450