Chapter 6. Variable and Absorption Costing

Credibility standard:

1. Communicate information fairly and objectively. 2. Disclose all relevant information that could reasonably be expected to influence an intended users understanding of the reports, analyses, or recommendations.

In Super-variable costing direct labor is treated as a fixed cost for at least three reasons:

1. Many companies have a commitment to guarantee workers a minimum number of paid hours. 2. Treating direct labor as variable suggests they are expendable and replaceable like materials rather than unique, difficult to replace assets. 3. Cost savings from terminating or laying off employees during short-term business downturns may be swamped by the costs of finding and training suitable replacements when business conditions improve and by lowered employee morale. Since employee lay offs can devastate morale, managers can be extremely reluctant to lay off employees.

Integrity standard

1. Mitigate actual conflicts of interest...Advise all parties of any potential conflicts. (The controller may benefit in some way.) 2. Refrain from engaging in any activity that would prejudice carrying out their duties ethically. 3. Abstain from engaging in or supporting any activity that might discredit the profession

Key Differences of Variable Costing

FMO is a period cost FMO is related to capacity to produce Profit is a function of sales only Less representative inventory valuation of a profitable product Recognizes cost by cost behavior and highlights contribution margin Often supported by internal reporting and short-term decision making

Key Differences of Absorption Costing

FMO is a product cost FMO is necessary to produce units of output Profit is a function of production and sales More representative inventory valuation of a profitable product Recognizes costs by business function and highlights gross margin The only method permitted for US GAAP & IRS (required for external parties

Product < Sales. Absorption and Variable Relation between production and sales

Inventory decreases Absorption < Variable

Absorption and Variable Relation between production and sales Product > Sales

Inventory increases Absorption > Variable

Absorption and Variable Relation between production and sales Product = Sales

No Change Absorption = Variable

Segment

is a part or activity of an organization about which managers would like cost, revenue, and/or profit data. For example: an individual store, a sales territory, a service center.

Super-variable costing (or Throughput costing)

is a variation of variable costing in which direct labor and manufacturing overhead costs are considered fixed.

Variable costing

only these manufacturing costs that vary with output are treated as product cost (direct materials, direct labor, variable portion of manufacturing overhead). Referred to as direct costing or marginal costing.

Absorption Costing

treats all manufacturing costs as product costs, regardless of whether they are variable or fixed (direct materials, direct labor, fixed and variable manufacturing overhead). Includes all manufacturing costs and referred as the full cost method.

Segment Margin

which is computed by subtracting the traceable fixed costs of a segment from its contribution margin, is the best gauge of the long-run profitability of a segment. Also, need a cash flow analysis to identify avoidable costs.

Advantages of Variable Costing and the Contribution Approach

• Clear and easy to understand • Enables Cost-Volume-Profit (CVP) analysis. CVP analysis requires that we break costs down into their variable and fixed components. • Net operating income is closer to net cash flow. • Consistent with standard costs and flexible budgeting. • Easier to estimate profitability of products and segments. • Profit is not affected by changes in inventories. • Impact of fixed costs on profits emphasized.

Traceable fixed costs

◦ incurred because the segment exists ◦ would disappear over time if the segment itself disappeared

Common fixed costs

◦ not incurred because a segment exists and are not traceable in whole or part to any one segment ◦ support the operations of more than one segment (e.g., arise from overall company operations) and are not reduced if a segment is eliminated