Part 1 Study Unit 3.1 – 3.3

1. Part 1 Study Unit 3.1 – 3.3 Cost Allocation Techniques Adrien Dubourg, CMA

2. Absorption versus Variable Costing • You need to be able to answer the following: • Under absorption costing, which cost are considered product cost? Which costs are considered period cost? • In the variable costing, which costs are considered product cost? Which costs are considered period cost? • What income statement format is appropriate for variable cost? • When is income of the variable costing higher than income and absorption costing? • What format can be used to calculate the difference between income under variable costing and income and absorption costing? • What managerial behavior does variable costs were render ineffective?

3. 3.1 Absorption and Variable Costing TheoryOverview Product cost consist of all the costs incurred the production of a product: direct materials, direct labor, and manufacturing overhead. The process to classified all these costs as part of product costs is referred to as absorption costing (or full costing). Absorption costing is the cost accumulation method required by generally accepted accounting principles (GAAP) for external reporting, and by regulatory body such as the Internal Revenue Service. continued

4. 3.1 Absorption and Variable Costing TheoryOverview The main reason is that absorption costing satisfies the matching principle, which states that expenses should be matched with revenues they generate. Based on the matching principle, our product cost flow through raw materials inventory, work in process inventory, and finished goods inventory until the goods are sold.

5. 3.1 Absorption and Variable Costing TheoryOverview One thing you have to ask yourself is, if inventory unit costs combined variable cost (typically direct materials, direct labor, and overhead) with fixed cost (typically overhead), how can managers make sound decisions? One way is to use variable costing (or direct costing) in which only variable product costs are accumulated in the inventory accounts. In variable costing, fixed manufacturing overhead is treated as a period expense rather than product cost, meaning it is expensed in the period in which it is incurred.

6. 3.1 Absorption and Variable Costing TheoryOverview The main advantage other variable costing method is that income cannot be manipulated by management action, whereas management can manipulated income when using absorption method.

7. Absorption Costing Sales - Product Costs (incl. fixed and variable) = Gross Margin - Total S, G & A (fixed and Variable)

8. Variable Costing Sales - Product Cost (only variable cost) = Contribution Margin (portion available to cover fixed costs • Fixed Costs (both mfg. and S, G & A) • Under variable costing, fixed overhead is considered a cost of maintaining capacity, not a cost of producing a product. • Contribution margin will tell you if you are covering at least the direct product costs

9. 3.1 Absorption and Variable Costing Theory See comparison shown on page 92

10. 3.1 Absorption and Variable Costing Theory • Impact on Operating Income • Produced = Sold = no difference in income • Produced > Sold > income • When production exceeds sales, fewer fixed cost are expensed under the absorption basis, and operating income always increases. • A production manager can thus increase absorption-based operating income by increasing production, whether there is any customer demand for the additional product or not. • This practice, called producing for inventory, can be effectively discouraged by using variable costing for performance reporting and consequent bonus calculation.

11. 3.1 Absorption and Variable Costing Theory • Produced < Sold < income • Variable costing will show a higher income in periods when inventories decline because absorption method forces the subtraction of all of the current fixed costs, plus some fixed costs incurred (and capitalized) in prior periods. • Most importantly, in using variable costing, profits always move in the same direction as sales volume. Profits reported on absorption costing behave erratically and sometimes move in the opposite direction from sales trends

12. 3.1 Absorption and Variable Costing Theory

13. SU 3.1 Question 1

14. SU 3.1 Question 1 Answer Correct Answer: C Absorption (full) costing considers all manufacturing costs to be inventoriable as product costs. These costs include variable and fixed manufacturing costs, whether direct or indirect. The alternative to absorption is known as variable (direct) costing. Incorrect Answers: A: Variable (direct) costing does not inventory fixed overhead. B: Variable (direct) costing does not inventory fixed overhead. D: Conversion costs include direct labor and overhead but not direct materials.

15. SU 3.1 Question 2

16. SU 3.1 Question 2 Answer Correct Answer: C Because the production manager wishes to maximize her bonus for the coming year, the action she must take will necessarily have most of its effect in the short run. The action she should take to achieve this goal is to defer costs under her control until the following period. Incorrect Answers: A: The perverse incentive to “produce for inventory” only works under absorption costing. B: The production manager has no control over advertising and marketing costs. D: Activity-based costing and activity-based management require time, effort, and resources in the short run and only show benefits over the long run.

17. 3.2 Absorption and Variable Costing - Calculations

18. 3.2 Absorption and Variable Costing - Calculations See extended example on page 94

19. Variable Costing Practical Exercise

20. Variable Costing Practical Exercise Solutions

21. 3.1 Absorption and Variable Costing Theorycontinued • Other benefits of variable costing: • Variable costing is better suited for management's needs which requires a knowledge of cost behavior under various operating conditions. For planning and control, management is more concerned with treating fixed and variable costs separately than with calculating full cost. • Full costs are usually dubious value because they contain arbitrary allocation of fixed cost. • The production manager cannot manipulate income levels over overproducing. continued

22. 3.1 Absorption and Variable Costing Theory • The cost data for profit planning and decision-making are readily available from accounting records and statements under variable costing. For example cost profit relationships and the effects of changes in sales volume on that income can easily be computed from income statement prepared under the variable costing concept, but not from the conventional absorption costing income statement based on the same data. • Absorption cost income statements may show decreases in profits from sales and rising and increases in profits from sales or decreasing, which may be confusing to management. • A favorable margin in the variable costing justifies a higher production level. • Variable costing is also preferred over absorption costing for studies of relative profitability of products, territories, and other segments of a business. A concentrate on the contribution of each segment makes to the recovery of fixed costs that will not be altered by decisions to make and sell. continued

23. 3.1 Absorption and Variable Costing Theory Inventory changes have no effect on the breakeven computation. Disinvestment decisions are facilitated because were their product or department is recouping its variable cost can be determined. If the variable costs are being covered operating a department at apparent loss may be profitable. Cost figures are guided by the sales figures. Under variable costing cost of goods sold very directly with sales volume, and the influence of production of gross profit is avoided. There will costing also eliminates a possible difficulties have explain over and under applied factory overhead to higher management.

24. SU 3.2 Question 1 Question 1 - CMA1 Study Unit 3: Cost Allocation Techniques A manufacturing company employs variable costing for internal reporting and analysis purposes. However, it converts its records to absorption costing for external reporting. The Accounting Department always reconciles the two operating income figures to assure that no errors have occurred in the conversion. The fixed manufacturing overhead cost per unit was based on the planned level of production of 480,000 units. Financial data for the year are presented below:

25. SU 3.2 Question 1 Answer (continued)

26. SU 3.2 Question 1 (continued)

27. SU 3.2 Question 1 Answer Correct Answer: B The difference between variable costing and absorption costing is that the former treats fixed manufacturing overhead as a period cost. The latter method treats it as a product cost. Given that sales exceeded production, both methods expense all fixed manufacturing overhead incurred during the year. However, 10,000 units (510,000 sales – 500,000 production) manufactured in a prior period were also sold. These units presumably were recorded at $10 under variable costing and $16 under absorption costing. Consequently, absorption costing operating income is $60,000 (10,000 units × $6) less than that under variable costing. Incorrect Answers: A: The amount of $57,600 equals 10,000 units times $5.76 per unit (total budgeted fixed manufacturing overhead ÷ 500,000 units). C: The amount of $90,000 is the difference between planned sales (495,000 units) and actual sales (510,000 units), times the fixed manufacturing overhead per unit ($6). D: The amount of $120,000 is the volume variance under absorption costing.

28. SU 3.2 Question 2 Question 2 - CMA1 Study Unit 3: Cost Allocation Techniques Pontotoc Industries manufactures a product that is used as a subcomponent by other manufacturers. It has the following price and cost structure:

30. SU 3.2 Question 2 Answer Correct Answer: B Contribution margin is the excess of sales over variable costs. Sales will be at $300 per unit. Variable costs are $100, consisting of $40 of direct materials, $30 of direct labor, $24 of variable overhead, and $6 of variable selling costs. Thus, the contribution margin will be $200 per unit ($300 – $100). Incorrect Answers: A: Excluding variable selling costs results in $206. C: Including fixed manufacturing overhead results in $140. D: This amount is the operating margin.

31. 3.3 Joint Product and By-Product • Joint processing and the split off point • Joint (common) cost are those costs incurred up to the point where products become separately identifiable, called the split off point. They can include direct materials direct labor and manufacturing overhead, and must be allocated to the individual joint products. • Separable cost and be identified with a particular joint product and allocated to a specific unit of output.

32. 3.3 Joint Product and By-Product • Since joint cost cannot be traced to individual products, they must be allocated. There essentially four methods of doing so: • Physical-measure-based approach • Market-based approach • Sales value at split off method • Estimated net realizable value method • Constant gross margin percentage NRV method

33. 3.3 Joint Product and By-Product See examples on page 98 - 100

34. 3.3 Joint Product and By-Product • By-products - Are products of relatively small total value that are produced simultaneously from a common manufacturing process with products of greater value and quantity. • If additional processing and selling cost exceed the selling price they should be scrapped. • If they can be processed further at a gain than the question becomes are the byproduct material, and if so they should be capitalized in a separate inventory account, which essentially reduces the cost of goods sold. • If the byproducts are immaterial after further processing their not recognize until the time of sale.

35. SU 3.3 Question 1

36. SU 3.3 Question 1 Answer Correct Answer: A Joint products are created from processing a common input. Joint costs are incurred prior to the split-off point and cannot be identified with a particular joint product. As a result, joint costs are irrelevant to the timing of sale. However, separable costs incurred after the split-off point are relevant because, if incremental revenues exceed the separable costs, products should be processed further, not sold at the split-off point. Incorrect Answers: B: Joint costs have no effect on the decision as to when to sell a product. C: Sales salaries for the production period do not affect the decision. D: Purchase costs are joint costs.

37. SU 3.3 Question 2

38. SU 3.3 Question 2 Answer Correct Answer: D Joint products must be valued for external financial reporting purposes based on the full (absorption) cost of the product. Any common costs attributable to the joint production process must therefore be allocated on a systematic and rational basis. Incorrect Answers: A: The selling price of a by-product is determined by market forces outside the manufacturer’s control, not by the manufacturer’s cost structure.  B: The decision to discontinue a joint product is based on the incremental profit from that product, not the allocation of common costs.  C: A variance between budgeted and actual costs is scrutinized regardless of the method of allocating common costs.