Performance Management & Control

Lecture 5B:
Relevant Costs

Erfan Ovee Nomaan

 Topics for this presentation

• Example of Absorption and Marginal costing

• Profit comparisons (variable and absorption costing)
• Arguments in support of variable costing
• Arguments in support of absorption costing
• Choice between the two methods
Example
 Variable Costing Statement
(one of the many formats)

(Variable)

VC
Absorption Costing Statement
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.
(Drury, 2018)
 Profit comparisons (variable and absorption
costing)

• 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).

(Drury, 2018)
 Arguments in support of variable
costing

• Variable costing provides more useful information for

decision-making.
• From profit variable costing removes the effect of stock
changes.
• Variable costing avoids fixed overheads being capitalized
in unsaleable stocks.
 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.

(Drury, 2018)
 Choice between the two methods
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.

(Drury, 2018)
 Choice between the two methods

Debate only applies to internal reporting – SSAP 9 requires that absorption

costing is used for external reporting.
Debate only applies when historical cost accounting is used.

(Drury, 2018)
 Topics for next class

Decision Under Risk

 References

Drury, C. (2018). Management and cost accounting. 10th ed. Andover:

Cengage Learning