The difference between concepts of Absorption costing and Variable Costing - Essay Example

? MANAGEMENT ACCOUNTING PART To understand the different concepts of Absorption costing and Variable Costing, it is essential to know and understand about the various types of costs that are a part of the total costing process. Such concepts comprise of: Operating Gearing Operational gearing is the total impact of fixed costs that is laid on the link between the sales and the profit incurred. Operational gearing is increased when the fixed costs are augmented. To understand the concept better, a simple example is described underneath:   Company X Company Y Sales 2,000,000 2,000,000 Variable Costs 7,00,000 800,000 Fixed Costs 200,000 100,000 Operating profit 11,00,000 11,00,000 The above example states that both the organizations are at a point of equal sales and costs, thus similar operating profit. Now if the organizational sales are increased by almost fifty percent then the changes made would feature as:   Company X Company Y Sales 3,000,000 3,000,000 Variable Costs 1,050,000 1,200,000 Fixed Costs 200,000 100,000 Operating profit 1,75,0000 1,70,0000 The above figures reveal that the organizations with an increased operational gearing X earns a higher operating profit in comparison to organization Y. Operational gearing in another words, is the total effect on the operating profit earned. It reveals the extent to which the costs of an organization are fixed. They also reflect upon the link between the sales revenue and the operating profits earned. The company who attains an increased fixed cost will ultimately have an increased operational gearing, but in cases where the organization incurs no operational gearing then operating profit would increase on the basis of increase in the sales value. Direct and Indirect Costs Direct Costs Direct costs are those costs that can be easily associated with a specific identity that may be a product or a service. Cost incurred for purchase of material, labor costs earned to produce the final product etc; all are a part of direct cost as they can be easily linked with per unit cost of a product (Gazely M A & Lambert M, 2006). Such costs vary with the nature of a business, for instance if a company manufactures electronic gadget like microprocessor and an expert production manager is hired for the job then his salary would be considered as a direct cost or if an individual runs a car washing business which is imparting of service, then the wages paid to the people hired for the job will be taken to be a direct cost. Direct costs are most of the time taken to be as variable costs. Variable costs increase proportionately with the increase in the quantity of production, thus they are also considered to be direct costs in nature. But in case when the manager or person acquired to monitor the production process is paid a regular amount of salary every month or for a particular period of time irrespective of the volume of production then it is called a fixed cost. Direct Materials and Direct Labor The different types of direct costs consist of direct materials and direct labor. Direct materials are directly identified with the particular product (Seal W, Garrison H R & Noreen W E, 2006). For instance, to manufacture product like furniture, direct material required for it would be wood, varnish, polish etc. When charging expenses to federally sponsored agreements, Virginia Commonwealth University (VCU) faculty and staff must be aware of the appropriateness of the charges.  OMB Circular A-21 provides the criteria for direct charging costs to federally sponsored programs.  The basic principle is that costs directly charged to a sponsored project must be allocable, allowable, reasonable and necessary, and treated consistently. A cost to be called as a direct cost must result in a direct gain from an activity and also it should be directly allocable to the specific project or task taken into consideration (Hilton W R, Robert J. Swieringa J R & Turner J M, 1988). On the whole direct costs must be: Allocable: if the costs can be bifurcated into various heads such as material and labor, expense then it can be considered as direct costs. Allowable: all costs which are legal and permitted to be treated as direct cost in accordance with the nature of the product can be taken as direct costs. Reasonable and Important for production: such costs must be necessary for production of goods or delivery of services Treated uniformly throughout the Process: The direct costs must be recorded consistently throughout the entire production process, without making any changes in accounting process whatsoever. INDIRECT COSTS Indirect costs are those costs which have a total influence on the working affairs of the organization. They can’t be linked directly to one single product or associated with per unit cost of the product. For instance cost of advertising, depreciation, accounting etc can be treated as indirect costs. They are usually termed as overhead costs which are perpetual in nature but are generally not accounted and allocated in an appropriate manner by many organizations (Alderson J M & Betker L B, 1996).. Indirect costs can be further classified into fixed or variable costs. Fixed costs are incurred regularly for a specific time period irrespective with the quantity of production or usage while variable cost depend on the volume of production and decrease or increase proportionately. Indirect Materials and Indirect Labor Indirect materials aid in the production process but certainly can’t be linked with direct per unit production cost such as tools, cleaning aids etc. Labor costs, similarly help in the production of goods and services but can be associated with one single product or unit (Lucey T, 2003). For instance, salary of a supervisor is paid for the complete production process for a specific period such as monthly or weekly, no matter how many goods are produced. Indirect costs are incurred for a joint purpose and most of the time linked with facilities and administrative costs. It may be noted further that to ascertain whether a cost must be treated as a direct cost or an indirect cost, purely depends upon the objective or nature of cost involved. For instance, if the motive behind the cost is to determine the running of the business, then all the costs related to it are termed to be as direct costs. FIXED AND VARIABLE COSTS Fixed Costs: are those which are incurred from a long term investment and can be recovered only by exhausting them in regard to the production of goods and delivery of services. Assets like machinery, land , building, plant, furniture etc are a part of fixed as there do not vary on a day to basis and they are purchased keeping in view the returns from a long term perspective. They remain constant and are unaffected by changes in the level of production. There exist an indirect relationship between volume of production and the cost per unit of the product (Khan & Jain , 2006). However, it may be noted, that fixed costs tend to change from period to period for instance salaries etc may change due to changes in pay rates etc or compensation packages etc. Variable Costs: or engineered costs are such costs that change in accordance with the changes in the immediate environment. Labor costs etc on the other hand are greatly affected by the production levels etc and change quite frequently. The prime costs that consist of direct material, direct labor and direct expenses total are termed as variable costs as they vary in respect to the level of production (Johnson, P, 1999). Such costs bear an unambiguous relationship with the desired measure of activity and also features an optimum cause and effect relationship between the input and output capacities. Unit Product Costs Direct Materials ? 11 $11 Direct Labor 6 6 Variable Manufacturing Overhead 3 3 Fixed manufacturing overhead (? 120000 / 10000 units) 12 (?120000/6000 units) 20 Absorption costing unit product cost ? 32 ? 40 Sales (8000 units @ 50 per unit) ?400000 ?400000 Cost of goods sold (8000 units @ 32 per unit) (2000 units @ ?32 per unit) + (6000 units @ 40 per unit) 256000 304000 Gross margin 144000 96000 Selling and administrative expenses (8000@4 + 70000) 102000 102000 Net Operating Income ?42000 ? (6000) 2. A in Variable Costing, only manufacturing costs are taken into consideration: Year 1 Year 2 Direct Materials ? 11 ?11 Direct Labor 6 6 Variable manufacturing Overhead 3 3 Variable Costing Unit Product Cost ? 20 ? 20 Variable Income Statement Sales (8000 @ ? 50 per unit) ? 4000000 ? 4000000 Variable Expenses: Variable Cost of Goods Sold (8000 units * ? 20 per unit) ? 160000 ? 160000 Variable Selling & Administrative Expenses (8000 @ 4) 32000 32000 Contribution Margin 208000 208000 Fixed Expenses: Fixed Manufacturing Overhead 120000 120000 Fixed selling & administrative Expenses 70000 70000 Net Operating Income ? 18000 ? 18000 2. The computer data information as revealed in the question is given below: There are two products A and B for which actual and budgeted data is given including information such as: Product A Product B Actual Budget Actual Budget Sales volume 29000 27500 10500 8500 Revenue (?000s) 720 690 430 300 Variable cost of sales (?000s) 280 270 170 127 Contribution (?000s) 440 420 260 173 Fixed Costs: ?310,000 2 C. The Reconciliation of the Variable and Absorption Costing Net Operating Incomes: The net operating incomes calculated through the Variable costing method and the absorption costing method can be reconciled by ascertaining the total fixed manufacturing overhead which was deferred or released during the financial period in terms of inventories used. However, many researchers in the past have analyzed the possible reasons for variances that arise between AC and VC income that may be due to differences in the value of closing stock or other expenses (Black, T. and Gray, P. K. (1995). Variable Costing net Operating Income ? 18,000 ? 18,000 + Fixed Manufacturing Overhead costs deferred Under absorption costing (2000 @ 12 per unit) 24000 Less: Fixed manufacturing Overhead Costs released From inventory under absorption costing (2000 @ 12 per unit) (24000) Absorption Costing net Operating Income (Loss) ? 42,000 ? (6,000) PART II Mathematical Calculations to be presented in the Report After analyzing the information revealed in the statements of Product A and Product B, some data can be calculated which can serve to be important for making future decisions and highlighting the current performance level of the organization. Such calculations will include the following deductions. Break-even Point = Fixed Cost/P/V Ratio P/V ratio = Contribution/Sales * 100 Product A = 440000/720000 * 100 = 61.1% Product B = 260000/430000 * 100 = 60.4 % Break Even Sales Product A = 310000/ 61.1 % = ?508196.72 Product B = 310000/ 60.4% = ?516666.67 Margin of Safety = Actual Sales – Break Even Sales Product A = 720000 - 508196.72 = ?211803.28 Product B = 430000 - 516666.67 = ? (86666.67) Margin of Safety as % of sales = MOS/Total Sales * 100 Product A = 211803.28/ 720000 * 100 = 29.4% Product B = (86666.67)/ 430000 * 100 = Negative Actual Profit = Contribution – Fixed Cost Product A = 440000 – 310000 = ?130000 Product B = 260000 – 310000 = ? (50000) Budgeted Profit = Contribution – Fixed Cost Product A = 420000 – 310000 = ?130000 Product B = 173000 – 310000 = ? (110000) Total Sales Margin Variance = Actual Profit – Budgeted Profit Product A = 130000 – 130000 = 0 Product B = (50000) – (110000) = ?10000 SIGNIFICANCE OF DATA CALCULATED ABOVE P/V Ratio is an important consideration in ascertaining the performance levels as it reveals the total contribution rate per product that is product A and product B as in this case, as a percentage of the total sales or the turnover. In simpler words, it is the relationship between the contribution and the total sales of the organization. The P/V ratio actually indicates the financial soundness of the organizations product line. Dexter has two products A and B for which the ratios calculated are to 61.1 % and 60.4 %. Keeping all the other conditions constant, the performance of the product is quite commendable. P/V ratio is indicating that Dexter is earning profit at a reasonable pace, however further improvements could be made by adopting features such as increasing the selling price if appropriate In terms of competitive scenario, by further reducing the marginal cost borne by the firm by making effective utilization of men, material and resources. Break Even Sales of the company reveals the level of operations of the firm where its total revenue would equalize its total costs. In other terms it is an indicator of the firm’s performance during the initial or preliminary phases of market penetration. In simple terms it is a no loss and no profit situation (Li A, Krapfel, R. & LaBahn D, 1995). As per the data analyzed and calculated, Dexter has already attained its break even sales for products A but is in process to attain it for product B; hence it has perfect opportunity in future to enhance its production, operations, efficiency etc on the product line B. The data clearly reveals that Dexter has to improve its demand for product B so that sales can be increased. Appropriate profit margins and selling price has to be fixed so that the product gains enough market shares to attain its break even sales and thereby profits in future (Solomons D, 1968). Margin of Safety on the other hand refers to the total amount of sales that are in surplus in regard to the break even volume. In other terms, it marks the difference between the sales at a given point of production level and at break even point. However, it becomes essential for any organization to have a reasonable margin of safety for products in order to run the operations of an organization in the most profitable manner, however in the figures calculated above, one can see that Product A has considerable safety margins with almost 29% of sales, but Product B reveals disappointing figures. Dexter has to adopt effective means to improve the margin of safety for product B so that its high fixed overheads can be reduced greatly. Improved MOS could certainly add to the strength of the product line and organizational stability in the market as well (Atrill P & McLaney E, 1994). For product B, the organization can increase its sales volume or the selling price; reduce its fixed costs and variable cost as well. Dexter has to make efforts for keeping the break even point to the minimum extent possible and raising the actual sales to the maximum level. Profit earned by the two product lines can also help in making important decisions regarding the future strategy of the product lines, as seen product A’s actual profit and budgeted profit figures are similar which means the product is in tandem with the projected sales figures including the other costs and expenditure estimates as well. However, there lies a significant difference in the actual and budgeted profit figures of product B. product B is actually incurring losses instead of profit as it has still not reached its break even sales. Efforts have to be put in to convert these losses into profit figures as early as possible to remain in the league. The actions that can be taken for the same include creation of product demand by appropriate advertising and targeting the appropriate market segment. An increase in the selling price of product B can further increase the amount of contribution and ultimately the profits. At the same time, the decrease in the variable cost per unit can also improve the current statistics of the organization and can further facilitate in increasing the overall P/V ratio. Total Sales Margin Variance also affect the business of the firm in terms of changes in revenue, deviation or variances can also be caused due to the differences in sales volume budgeted and actually realized along with the sales prices (Kishore M R, 2006). The organization needs to keep proper check on the pricing of the product so that the wide gap between the budgeted and actual figures can be reduced and bridged. On the whole it can be said that the performance of Dexter in terms of Product A and Product B is marginally fair and needs efforts for increasing its pace for future growth and development. Product A though successful in terms of equalizing its budgeted and actual profit figures, yet can prove to be a major competitive strength for the organization in coming times. The pace at which the product can be spread in the market can be triggered looking at the promising aspects of the product line and its competitive figures. Proper budgetary control system needs to be adopted by the organizational system so reduce the existing differences and economize on the managerial time and efficiency levels. The limited resources of the firm must be utilized in the most optimal manner and look forward to achieve the long term goals and objectives of the company. After the analysis of the product line, all the areas of inefficiency have been identified and need to be worked upon. People are to be made responsible for cost and revenue, in other words the areas of responsibility are to be demarcated. The company’s performance can be summed up by describing the three major questions, those are: 1. What is the total amount of net profit that the company has earned in the financial year? 2. Does the budgeted sales volume and the revenue of the company are in tandem with the actual sales or not? 3. What is the total Return of Investment that the organization has earned in the recent past? The net profit earned by an organizational actually determines its real financial position. This is the point where decisions can be taken for future expansions and growth is possible. Thus the performance level of an organization depends upon the profitability levels during a particular time period. The increased sales do not guarantee profits, hence it has to be ascertained what actually needs to be focused upon so that actual sales and profits can be kept in tandem. The budget is a controlling tool. It helps the organization to track its planned course of action and detect deviations wherever visible and also take necessary corrective actions to avoid them in future. The performance of the company depends upon the extent to which the company deviates from its budgeted plan, the lesser the deviation the better the performance. The organization needs to apply constant control and monitoring for keeping track of the standards laid and the actual results derived. And lastly return on investment reveals whether the investments made by the company are correct, feasible and practical in terms of market changes and external environment (Chadwick L, 1998). If the returns are promising, certainly the performance level of the company would be marked high else poor. Dexter so far has earned an above average performance but not completely satisfying. BIBLIOGRAPHY Chadwick L. (1998). “ Management Accounting”. 2nd Edition. Published by Cengage Learning EMEA. Available at http://books.google.com/books?id=htlHYBEBpq8C&dq=Management+Accounting&source=gbs_navlinks_s Kishore, M, R. (2006). “Cost & Management Accounting”. 4th Edition. Published by Taxman: India Johnson, P.( 1999) . “History of Finance”. Published by Cambridge: Cambridge University Press Atrill P & McLaney E. (1994). “Management Accounting: An Active Learning Approach”. Published by Wiley-Blackwell. Available at http://books.google.com/books?id=0ZD7rOWiYZEC&dq=management+accounting&source=gbs_navlinks_s Khan & Jain . (2006). “Management Accounting”. 4th Edition. Published by Tata McGraw-Hill Education. Available at http://books.google.com/books?id=Es37CPpEItwC&dq=management+accounting&source=gbs_navlinks_s Lucey T. (2003). “Management accounting”. 5th Edition. Published by Cengage Learning, EMEA. Available at http://books.google.com/books?id=EU66QH3p0a8C&dq=management+accounting&source=gbs_navlinks_s Gazely M A & Lambert M. (2006). “Management Accounting”. Published by SAGE. Available at http://books.google.com/books?id=j4PFeaGo8BwC&printsec=frontcover&dq=MANAGEMENT+ACCOUNTING&cd=7#v=onepage&q&f=false Seal W, Garrison H R & Noreen W E. (2006). “Management Accounting”. 2nd Edition. Published by McGraw-Hill. Solomons D. (1968). “Breakeven Analysis under Absorption Costing”. The Accounting Review Vol. 43, No. 3 (Jul., 1968), pp. 447-452 Hilton W R, Robert J. Swieringa J R & Turner J M. (1988). “Product Pricing, Accounting Costs and Use of Product-Costing Systems”. The Accounting Review Vol. 63, No. 2 (Apr., 1988), pp. 195-218 Li A, Krapfel, R. & LaBahn D. (1995) “Product Innovativeness and Entry Strategy: Impact on Cycle Time and Break-even Time”. Journal of Product Innovation Management, 12. Pp 54–69. Black, T. and Gray, P. K. (1995). “The Effect of the Production Volume Variance on Absorption Costing Income”. Accounting & Finance, 35, pp 133–142. Alderson J M & Betker L B. (1996). “Liquidation Costs and Accounting Data”. Financial Management Vol. 25, No. 2 (Summer, 1996), pp. 25-36 Read More