INCOME EFFECTS OF ALTERNATIVE COST ACCUMULATION SYSTEMS

LEARNING OBJECTIVES

After studying this chapter, you should be able to:

 explain the differences between an absorption costing and a variable costing

system;
 prepare profit statements based on a variable costing and absorption costing
system;
 explain the difference in profits between variable and absorption costing profit
calculations;
 explain the arguments for and against variable and absorption costing;

SUMMARY
The following items relate to the learning objectives listed at the beginning of the
chapter.

Explain the differences between an absorption costing and a variable costing

system.

 With an absorption costing system, fixed manufacturing overheads are allocated to

the products and these are included in the inventory valuations.

 With a variable costing system, only variable manufacturing costs are assigned to
the product; fixed manufacturing costs are regarded as period costs and written
off as a lump sum to the profit and loss account.

 Both variable and absorption costing systems treat non-manufacturing overheads

as period costs.

Prepare profit statements based on a variable costing and absorption costing

system.

 With a variable costing system, manufacturing fixed costs are added to the
variable manufacturing cost of sales to determine total manufacturing costs to be
deducted from sales revenues.

Prepared By Senior Hannington - 0789538704

CPA Paper 7 – Cost & Management Accounting – March 2021 Sitting
 Manufacturing fixed costs are assigned to products with an absorption costing
system. Therefore, manufacturing cost of sales is valued at full cost
(manufacturing variable costs plus manufacturing fixed costs).

 With an absorption costing system, fixed manufacturing costs are unitized by

dividing the total manufacturing costs by estimated output.

 If actual output differs from estimated output an under- or over-recovery of

overheads arises. This is recorded as a period cost adjustment in the current
accounting period.

Explain the difference in profits between variable and absorption costing profit
calculations.
 When production exceeds sales, absorption costing systems report higher profits.

 Variable costing systems yield higher profits when sales exceed production.

 Nevertheless, total profits over the life of the business will be the same for both
systems. Differences arise merely in the profits attributed to each accounting
period.

The arguments that have been made supporting absorption costing include:

 absorption costing does not understate the importance of fixed costs;

 absorption costing avoids the possibility of fictitious losses being reported;

 fixed manufacturing overheads are essential to production and therefore should be

incorporated in the product costs; and

 internal profit measurement should be consistent with absorption costing profit

measurement that is used for external reporting requirements.

Prepared By Senior Hannington - 0789538704

CPA Paper 7 – Cost & Management Accounting – March 2021 Sitting
MARGINAL COSTING OR ABSORPTION COSTING?

Strength of Marginal costing in costing

 Simple to operate.
 No apportionments which are frequently on arbitrary basis, of fixed costs to
products or departments. Many fixed costs are indivisible by their nature, e.g.
managing director’s salary.
 Under or over absorption of overheads is almost entirely avoided. The usual reason
for under/over absorption is the inclusion of fixed costs into overhead absorption
rates and the level of activity being different to that planned.
 The technique provides useful data for managerial decision making.
 The technique is flexible in the sense that it can be used along with other
techniques such as budgetary control and standard costing.

Weaknesses of Marginal costing

 If used for setting prices of products the resulting profit may not cover the fixed
costs of the company.
 It is not always easy to separate fixed costs from variable costs.
 It is not acceptable for external reporting due to the fact that it understates
closing stock of work in progress and finished goods values.
 The information provided by the system can be used in the short run.
 It is not appropriate to exclude fixed manufacturing costs from production costs.
 The variable cost per unit remains constant only in the short run but not in the
long run.

Strengths of Total Absorption costing

 The technique is supported by tax authorities because it gives the true and correct
profits of the company.
 IAS 2 Inventory requires that costs must be matched against revenues that are
derived from a particular period.
 Fixed costs are incurred so that production takes place therefore should be taken
into consideration when valuing the cost of a production and stock.
 The calculation of marginal cost and the concentration upon contribution may lead
to the firm setting prices which are below the total cost although producing some
contribution. etc.

Arguments of Absorption Costing

 Absorption costing depends on a number of estimates and assumptions while

calculating full cost of a product or a service.

Prepared By Senior Hannington - 0789538704

CPA Paper 7 – Cost & Management Accounting – March 2021 Sitting
 The treatment of under or over absorption of fixed costs can at times give a
misleading picture of the profit.
 Absorption costing is not favourable for decision making since it does not make a
distinction between fixed and variable costs. Fixed costs do not influence the
decision but variable costs influence because they do change.
 It increases the company’s tax liability due to the fact that it uses full costs; the
value of closing stock is at times higher than that of marginal costing. This results
into an increase in the company’s profits therefore higher taxes.

Prepared By Senior Hannington - 0789538704

CPA Paper 7 – Cost & Management Accounting – March 2021 Sitting