Term Paper

On
Importance of Variable Costing for External Reporting

1
 Chapter One
Introduction

1.1 Background of the Study

Cost information is extremely important for managers of any given crop,
regardless of the productive activity involved. In rural properties, information is
essential for decision making, as prices in the marketplace are influenced
by supply and demand, and not by individual producers. Cost control
becomes an instrument of revenue information and, despite technological
advances, farm managers often lack the necessary tools for decision making.

1.2 Origin of the Study

To complete MBA program term paper is an important task under National
University. This term paper issued to the faculty of accounting of Kabi Nazrul
College, Dhaka for the partial fulfillment of MBA program. When I had got this
topic I had been revealed previous researches, relevant books, journals and
liberal work on this topic. Then the term paper completed as per the guideline
that was issued by our instructor.

1.3 Rationale of the Study

Managers use variable costing to determine which products to offer and which
products to discontinue. Rather than discontinuing a product based on negligible
profits, a manager can use variable costing to determine the overall costs of
keeping a unit in production. For example, if a company offers four products
and decides to discontinue two, the two remaining products have to absorb
higher overhead expenses. Variable costing illustrates the impact that
discontinuing a product has on all costs related to production. When considering

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variable costing, managers logically see that keeping a particular unit in
production helps absorb fixed costs and maintain overall profitability.

1.4 Objectives of the Study

The objectives of the term paper are given below:
To learn variable costing and its implementation
To learn about how the variable costing helps to external reporting
To learn the importance and loopholes of variable costing

1.5 Methodology of the Study

The present study based on analytical method. Relevant literature review that
are from books, journals and previous research works. Basically, I have
collected data to complete this term paper from secondary data sources. GAAP
research and journals has been followed to complete this term paper.

1.6 Limitations of the Study

The limitations of the term paper are given below:
Lack of enough data collection
Lack of previous research work
Time limitation

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 Chapter Two
Literature Review

Cost Control

Variable costing systems simplify the estimation of product and customer

profitability. Rather than analyzing data hidden by costs that would exist
whether a unit is produced or not, variable costing allows managers to analyze
data based on the actual cost of production. Understanding the actual cost of
each unit allows managers to reduce variances between actual and budgeted
amounts, which often means controlled costs and higher revenues for the
organization.

Accuracy

Most organizations do not produce or sell the same number of units each period.
Because sales fluctuate, managers could make poor decisions based on obscured
data, unless they use the most appropriate costing system. Variable costing helps
managers with irregular sales patterns more accurately determine the cost of
production during a given period. If sales patterns are comparable each year --
for example, sales increase during the winter months and decrease during the
summer months -- managers can use variable costing data to approximate future
costs of production.

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 Chapter Three

Product Cost and Decision Making

3.1 Product Costs

Accountants prepare product costs to serve two purposes: Decision making by

managers, and external reporting. Decision making product costs approximate
the marginal costs economists discuss, i.e., the unit costs includes the amount
that total company costs increase when an additional unit is produced.

Product costs for external reporting in contrast include a portion of company

costs that do not vary with units produced. These product costs include material
costs, labor costs, and overhead costs.

3.2 Product Costs for Decision Making

In many manufacturing companies labor costs remain constant over wide ranges
of output, so managers can consider labor a fixed cost for many short-term
output decisions. In addition, most overhead costs change only when managers
decide to restructure the company, so these costs do not change as output
fluctuates from day to day. The only costs that definitely does go up and down
with production is the material cost.

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3.3 Estimating Material Cost for Products

If a company has a reliable bill of materials, the accountant can simply take the
total material cost from it as an estimate of product cost. The following example
illustrates a bill of materials for a paint sprayer. As this example shows, the bill
of materials lists all the materials and purchased components that make up the
product, their quantities, and the unit cost for each one. The summation of the
material cost for each piece gives the total material cost for the finished product.
Accountants usually refer to this cost as the unit variable cost.

The accountant will estimate the unit production cost for the paint sprayer at
Tk.310 because this equals the materials cost for the product.

Bill of Materials for a Paint Sprayer

Unit Extended
Description Quantity
Cost Cost
Head casting 1 Tk.54.23 Tk.54.23
Block casting 1 81.25
Head bolts 6 81.25 0.72
Head gasket 1 0.12 0.15
Bushings 4 0.15 3.40
Piston casting 1 0.85 35.00
Piston connection 1 35.00 5.14
assy. 1 5.14 45.32
Crankshaft 1 45.32 24.13
Base casting 5 24.13 0.40
Gaskets 1 0.08 5.64
Check valve 1 5.64 12.45
assembly 1 12.45 15.14
Intake valve 1 15.14 1.25
assembly 1 1.25 3.24
Output valve 1 3.24 1.13

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 assembly
Hose--18 inches
Hose--five feet
1.13
Metal frame 2 3.70
1.85
Wheels 1 3.25
3.25
Mounting 1 12.45
12.45
platform 1 0.75
0.75
Label set 1 1.26
1.26
Packing materials

Packing box
Total material cost Tk.310.00

To estimate the increase in company cost from producing another 100 paint
sprayers, the accountant merely multiplies the unit cost of Tk.310 by the 100
units to arrive at a total cost increase of Tk.31,000. If the accountant or manager
expects any of the materials costs to change because of this order, he or she can
just incorporate the new materials cost into the bill of materials to compute a
new unit cost.

3.4 Product Costs for External Reporting

Many cases while studying in MBA program this presenting me with product
costs that have been developed for external reporting. These costs do not
approximate marginal costs, so I have to modify the product costs to arrive at
the values as per need. First, consider how an accountant develops the unit cost
used for external reporting.

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3.4.1 Developing a Unit Cost for External Reporting
Labor Cost

Assume an accountant wants to develop a unit cost for external reporting for the
paint sprayer illustrated above. First, the accountant must estimate the amount
of labor cost for the product. A product routing shows every step a product goes
through in the manufacturing process, and these routings usually include labor
times for each step. So the accountant can use these labor times from the routing
to estimate the labor time required to make the product.

Assume in this case the total labor time equals 10 hours to make the paint
sprayer. Next the accountant reviews payroll records to estimate the labor cost
per hour and finds workers usually make Tk.12 per hour; in addition, the
company pays a variety of fringe benefits that amount to 30% of the hourly
wage. Total company cost for an hour of labor, then, equals Tk.15.60 (Tk.12 +
(30% x Tk.12). The total labor cost for a paint sprayer for external reporting
then equals Tk.156 (10 hours x Tk.15.60).

Overhead Cost

Overhead cost consists of numerous types of expenses ranging from

depreciation and taxes to various kinds of supplies. Because it is such a
miscellaneous collection of costs, accountants spread this total lump of costs
across products made to assign a portion of overhead costs to each unit
produced.

In companies that run their cost systems primarily to generate unit costs for
external reporting, accountants must estimate the total annual overhead at the
start of the year. Usually they divide this total estimated overhead by the
estimated number of labor hours the company will use during the year. The

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resulting value is called an overhead rate per labor hour, and accountants
multiply this rate by the number of labor hours in a product to assign overhead
cost to the product. Remember, accountants perform this calculation only
because financial reporting rules require them to do so. This has no relevance
for decision making.

Assume in the paint spraying example that accountants estimated at the start of
the year that total overhead would equal Tk.820,000 and that the company
would use 100,000 labor hours. This provides an overhead rate of Tk.8.20 per
labor hour. Putting the material, labor and overhead costs together provides a
unit cost for external reporting of Tk.548. This Tk.548 value appears in the
balance sheet and income statement issued to creditors, investors and taxing
authorities.

Materials (from bill of materials) Tk.310

Labor cost (10 hours @ Tk.15.60) 156
Overhead cost (Tk.8.20 per labor hour) 82
Total unit cost for external reporting Tk.548
However, this product cost has no relevance for management decision
making.
Peeling Back Costs to Develop Decision Making Product Costs

Since the product cost developed for external reporting is not suitable for
decision making, you must peel off some of the costs to create a product cost
you can use for decision making. Most of the cases you will encounter in your
MBA studies will include product cost designed for external reporting instead of
for decision making. Consequently you must peel off the irrelevant costs to get
at a number you can use.

To do this, just reverse the process used above to generate a unit cost for
external reporting. Follow these steps:

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 1. Discard the overhead cost per unit
2. Carefully examine the information to see if labor is really variable.
Remove it if it appears it really is a fixed cost.

Consider the following example. This product cost is typical of those found in
many cases used in MBA programs.

Cost Component Steel Bushing Plastic Bushing

Material Tk. 6.50 Tk. 1.25
Direct Labor 21.40 12.60
Overhead*
42.80 25.20
Departmental
32.10 18.90
Administrative
Total costs Tk.102.80 Tk.57.95

*Overhead is allocated to products on the basis of direct labor dollars.

In this case the information indicates that the company multiplied the direct
labor costs by some factor to arrive at the overhead cost allocated to each
product. A review of the data indicates that Departmental overhead is applied at
200% of direct labor cost and that Administrative overhead is applied at 150%
of direct labor cost.

For decision analysis you should ignore the overhead costs. It is clear that
managers have given no thought to how overhead behaves relative to product
output because they just apply a factor to labor cost. Consequently, you should
use only the material and labor cost for decision analysis. This means you
should use a unit cost of Tk.27.90 for the steel bushing instead of the Tk.102.40
and that you should use a unit cost of Tk.13.85 instead of Tk.57.95 for the
plastic bushing.

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Generally speaking, the smaller the proportion of the product cost devoted to
labor, the more likely the labor cost is fixed and should be eliminated from the
unit cost.

3.5 Evaluating Product Profitability

Product profitability consists of two things:

1. The difference between unit variable cost and the selling price, and
2. Product velocity

Revenue minus variable costs equals contribution margin, or some accountants

just call it margin. Product velocity refers to how many units per time period a
company can sell. Multiplying velocity by unit margin gives the total margin a
product can generate in a given time period.

Given a choice, managers will usually choose the product that can generate the
most margin per time period. So when choosing which product to push,
managers always look at product velocity as well as unit margin. Consider the
following example.

Account Product A Product B Product C

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 Revenue 125 350 420
Variable costs 75 200 220
Margin 50 150 200
Margin percentage 40% 43% 48%

Velocity
Units per week 500 100 50

Total margin 25,000 15,000 10,000

Although Product C has the highest margin percentage, it generates the lowest
total margin per week of the three products. However, Product A with the lowest
margin percentage generates the highest weekly margin.

Always remember to consider product velocity when looking at product

profitability so you do not overlook the real profit potential for a product.

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 Chapter Four
Inventory An Absorbing Problem

4.1 Effectiveness of Variable Costing to External Reporting

This Chapter of the term paper presents a lot of great methods developed over
the years by merchants and manufacturers to manage inventory and inventory
costs. There are significant costs associated with having too much or too little
inventory in the organization to support its business. The JIT concept suggests
that inventory is kept in an organization in order to minimize the risks of poor
inventory management. In other words, as described in the Inventory Chapter,
having a lot of inventory can serve as a buffer that protects the organization
against problems that would otherwise occur when suppliers dont deliver
inventory on time, or when inventory being manufactured turns out to have less-
than-acceptable quality, or when customers demand to purchase more inventory
than the organization expected. However, since all of these problems are
symptomatic of a poorly-run organization, the JIT concept begins by reducing
or removing inventory in order to force the organization to deal explicitly with
unsatisfactory suppliers, low-quality manufacturing processes, or uncertain
sales and marketing methods. Further, by reducing or removing inventory,
organizations are able to avoid the explicit management costs, as well as the
implicit financial holding costs, of keeping a lot of inventory in the system.
Today, most managers would argue that it is important to reduce inventory
levels in an organization whenever possible. Therefore, good management
accounting should report on all costs of inventory in the organization, and
support the effort to intelligently reduce or remove inventory levels. However,
an interesting fact of financial accounting systems can make this difficult to
accomplish.

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 U.S. Generally Accepted Accounting Principles (GAAP) requires that
inventory be carried on the balance sheet, and expensed on the income
statement, at its full cost. This means that all of the product costs of inventory
(direct materials, direct labor, and manufacturing overhead) need to be included
in the Inventory asset on the balance sheet, and in the Cost of Goods Sold
expense on the income statement. This seems sensible, but it can lead to some
strange information about inventory and expenses when production volumes
and sales volumes are different from each other (in other words, when inventory
levels start increasing or decreasing). For example, lets consider a company
well call Mason Tool Company. Well assume that Mason builds hammers, and
that it has a production facility that normally manufacturers 100,000 hammers
each year. Further, well assume that Masons variable production costs (that is,
the costs of direct materials, direct labor, and variable manufacturing overhead)
are Tk.6.50 per hammer, and well assume that fixed production costs (in other
words, the fixed manufacturing overhead costs) are Tk.400,000. So, the total
production costs for each hammer is Tk.10.50, as computed below.
Variable production costs per hammer Tk. 6.50
Fixed production costs per hammer 4.00 (= Tk.400,000
100,000 hammers)
Total production costs per hammer Tk.10.50

Actually, the Tk.10.50 cost per hammer is only accurate if Mason does in fact
produce 100,000 hammers each year. What if Mason only produces 80,000
hammers? In that case, the total production costs per hammer would be
Tk.11.50, as you can see below.

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 Variable production costs per hammer Tk. 6.50
Fixed production costs per hammer 5.00 (= Tk.400,000
80,000 hammers)
Total production costs per hammer Tk.11.50
To complete the example, the production costs per hammer would be Tk.9 if the
Mason employees work hard and produce 160,000 hammers.
Variable production costs per hammer Tk. 6.50
Fixed production costs per hammer 2.50 (= Tk.400,000
160,000 hammers)
Total production costs per hammer Tk. 9.00

As you look at these numbers, you can see whats happening to the costs.
The variable costs per unit remain constant. Youve learned previously that total
variable costs are expected to change in proportion to changes in production
volume, which means that variable costs per unit do not change. On the other
hand, total fixed costs remain constant (within the relevant production range).
Hence, as production volumes vary, the average fixed costs per unit will shift.
This is demonstrated in Masons per-hammer production cost numbers above.
Why are these changes in per-unit production costs important? Because
based on these cost changes, Mason is able to change its profit on the income
statement by simply adjusting its level of production. To see this, lets assume
that Mason produces 100,000 hammers and sells those hammers for Tk.15 per
hammer. In addition, lets see what would happen if sales remained at 100,000
hammers, but Mason increased production to 160,000 hammers.

Sales price per hammer Tk.15.00 Tk.15.00

Sales volume (in hammers) 100,000 100,000
Production volume (in
hammers) 100,000 160,000
Total fixed production cost Tk.400,000 Tk.400,000

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Fixed production costs per
hammer Tk.4.00 Tk.2.50
Variable production costs per
hammer Tk.6.50 Tk.6.50

Tk.1,500,00 Tk.1,500,00
Sales Revenue 0 0
Variable Costs of Goods Sold (650,000) (650,000)
Fixed Cost of Goods Sold (400,000) (250,000)
Tk. Tk.
Gross Profit 450,000 600,000
The important thing about these two income statements is that the profit should
not be changing! In both cases, Mason is selling 100,000 hammers. The reason
for the profit change is Mason is changing its production output, which really
isnt an appropriate reason for profits to shift on the income statement.
So, the real question is wheres the money? Mason has Tk.400,000 in
fixed production costs, but some of those costs are not on the income statement
when production volume exceeds sales volume of 100,000 hammers. The
answer is inventory. The fixed costs are allocated to hammers on an individual
basis. Hence, if Mason produces 160,000 hammers, each hammer is allocated
Tk.2.50 in fixed costs. Then, if Mason sells just 100,000 hammers, only
Tk.250,000 (100,000 x Tk.2.50 per hammer) in fixed production costs are
expensed to the income statement. The remaining fixed production costs of
Tk.150,000 are allocated (or absorbed) into the balance with the 60,000
hammers that go into inventory (60,000 hammers x Tk.2.50). Remember that
the Tk.400,000 of Masons production costs are fixed, and dont increase (as do
variable costs) when the production increases. Based on this fact, if Mason has a
gross profit goal of Tk.750,000 but still expects to sell 100,000 hammers, all it
has to do is produce 400,000 hammers (as shown below).

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Sales price per hammer Tk.15.00
Sales volume (in hammers) 100,000
Production volume (in
hammers) 400,000
Total fixed production cost Tk.400,000
Fixed production costs per
hammer Tk.1.00
Variable production costs per
hammer Tk.6.50

Sales Revenue (100,000 Tk.1,500,00

hammers) 0
Variable Costs of Goods Sold (650,000)
Fixed Cost of Goods Sold (100,000)
Tk.
Gross Profit 750,000

The fact that profit on the income statement can be managed by

adjusting the production volume can be a significant problem in two ways. First,
the income statement is used to assess the ability of an organization to generate
the best possible sales revenue at the lowest possible costs. If earnings can be
significantly changed by a decision to produce more inventory than is sold,
users of the income statement could become confused about the performance of
the organizationor worse, could be mislead about actual performance. This
first problem suggests that Mason may be on the path to a potentially more
significant second problem. As income is increased by increasing the production
beyond the level of sales, inventory starts building up in the company, which
brings new challenges and costs into the company. Eventually, the increasing
levels of inventory must be dealt with, and somehow sold or scrapped. When
that happens, all the past fixed production costs that have been absorbed onto
the balance sheet are effectively flushed to the income statement.

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 Lets take a look at what might happen at the Mason Tool Company over
several years of operations. Well assume that sales are constant at 100,000
hammers per year, but Mason varies its production volumes as shown below.
Lets also add in the companys variable and fixed selling and administrative
costs in order to calculate net income. Masons variable selling costs are
Tk.1.10 per hammer. Its fixed selling and administrative costs are Tk.230,000
per year.

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Sales and Production Data Year 1 Year 2 Year 3
Sales price per hammer Tk.15.00 Tk.15.00 Tk.15.00
Sales volume (in hammers) 100,000 100,000 100,000
Production volume (in hammers) 160,000 100,000 40,000
Total fixed production cost Tk.400,000 Tk.400,000 Tk.400,000
Fixed production costs per
hammer Tk.2.50 Tk.4.00 Tk.10.00
Variable production costs per
hammer Tk.6.50 Tk.6.50 Tk.6.50
Total fixed selling and admin.
costs Tk.230,000 Tk.230,000 Tk.230,000
Variable selling costs per hammer Tk.1.10 Tk.1.10 Tk.1.10

Absorption Costing Income

Statements
Tk.1,500,0 Tk.1,500,0 Tk.1,500,0
Sales Revenue 00 00 00
(650,000
Variable Costs of Goods Sold (650,000) (650,000) )
(640,000
Fixed Cost of Goods Sold (250,000) (310,000) )
Tk. Tk. Tk.
Gross Profit 600,000 540,000 210,000
Variable Selling and Admin. (110,000
Expense (110,000) (110,000) )
(230,000
Fixed Selling and Admin. Expense (230,000) (230,000) )
Tk. Tk. Tk.
Net Income 260,000 200,000 (130,000)

As we can see, the production manager built more hammers than were
needed for sales in Year 1. In the Year 2, the manager made a good decision to
reduce the production volume to equal the sales volume. However, this good
decision appears to be leading to a reduced gross profit (Tk.600,000 to

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Tk.540,000), which in turn leads to reduced net income. The situation in
following year is even tougher. Coming into Year 3, Mason Tool Company still
had 60,000 hammers in inventory. Because the production manager wisely
understood that excess inventory creates significant cost and management
problems, a difficult decision was made to scale back production further in
order to sell down the inventory. This good decision is made more difficult by
the fact that the income statement is reporting much lower gross profit of
Tk.210,000 and a net loss for the year of Tk.130,000! 1 As you can see, the fixed
costs of goods sold is getting larger each year, to the extent that fixed costs of
goods sold reported in Year 3 (Tk.640,000) are significantly more than total
fixed production costs actually incurred in Year 3 (Tk.400,000). The reason for
these troubling reports is due to the old fixed production costs that are coming
off of the balance sheet and onto the income statement.
Lets consider how Costs of Goods Sold were calculated for each year. As
the old inventory costs are flushed from the balance sheet to the income
statement, we need to point out that Mason Tool Company follows the FIFO
(first in first out) inventory method (these numbers would be different if Mason
followed a different inventory system such as LIFO). Assuming there was no
beginning inventory in Year 1, the calculation for Fixed Cost of Goods Sold is
straightforward.
Year 1: 100,000 hammers x Tk.2.50 = Tk.250,000 Fixed Cost of
Goods Sold
However, the calculation for Year 2 is more complicated. At the beginning of
this year, there were 60,000 hammers in inventory that were valued at following
cost.

1 Note that selling and administrative expenses do not vary based on production.
These costs are period costs. GAAP requires that all period costs are expensed
to the income statement in the period in which these costs are incurred.

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 Year 2: 60,000 hammers x (Tk.2.50 + Tk.6.50) = Tk.420,000
Beginning Inventory
Because Mason follows the FIFO inventory method, these 60,000 hammers
from Year 1 are the first hammers sold in Year 2. Since the variable production
costs per unit are constant at Tk.6.50 from year to year, the total Variable Cost
of Goods Sold reported on the Income Statement is constant from year to year.
However, the calculation for total Fixed Cost of Goods Sold for Year 2 includes
fixed production costs from Year 1 and from Year 2.2
60,000 hammers x Tk.2.50 = Tk.150,000 Fixed costs from
Year 1
40,000 hammers x Tk.4.00 = 160,000 Fixed costs
from Year 2
Year 2: Tk.310,000 Fixed Cost
of Goods Sold

And the calculation for Fixed Cost of Goods Sold for Year 3 includes fixed
costs from Years 2 and 3.

60,000 hammers x Tk. 4.00 = Tk.240,000 Fixed costs

from Year 2
40,000 hammers x Tk.10.00 = 400,000 Fixed costs
from Year 3
Year 3: Tk.640,000 Fixed
Cost of Goods Sold
Now that weve worked through these numbers together, its important to
place them in a larger context. First of all, this process of assigning fixed

2 This method assumes that actual fixed costs per unit are used to apply fixed
costs to Inventory and to Costs of Goods Sold. In contrast, normal (or expected)
fixed costs per unit could be applied, which would change the calculations used
in the Mason Tool Company example in this text.

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production costs to inventory is called absorption costing, and is required by
GAAP in creating financial statements for external users. The motivation for
absorption costing is to report the full cost of creating inventory. It is important
that investors and creditors, as well as other external users of financial
statements, understand the full cost of inventory. However, as you can see,
carrying (i.e., absorbing) the full cost of inventory on a unit-by-init basis to the
balance sheet (and then to the income statement) results in treating fixed costs
as if they were somehow variable. Hence, users of these reports need to be very
careful when interpreting these costs. Unfortunately, the heavy emphasis placed
on operating income performance creates an incentive for managers to shield
the income statement from some costs by increasing the production volume.
The problem with this incentive is that, as a result of producing more inventory
than is sold, excess inventory is created in the organization. And what is more
troubling, in order to avoid flushing the old fixed costs of inventory to current
income statements, managers are motivated to avoid reducing these excess
inventory levels. These unnecessary inventory levels then create significant
management problems in the organization, as you learned previously in
studying JIT theory.
There is an alternative approach to reporting profit using absorption
costing that does not create a strange incentive to build up excess inventory
its called contribution margin reporting. Youve studied this reporting approach
previously in the C-V-P chapter. Using variable (or direct) costing, the
contribution margin reporting system does not associate any fixed costs to
inventory. Instead, all fixed costs are treated as period costs and fully expensed
to the income statement in the period in which the fixed costs incurred.
Remember that under GAAP, gross profit and net income are calculated as
follows.

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Absorption Costing: Sales Revenue
Variable Cost of Goods Sold
Fixed Cost of Goods Sold
Gross Profit
Variable Selling and Administrative Costs
Fixed Selling and Administrative Costs
Net Income
The contribution margin approach does not compute a gross profit number.
Instead, contribution margin and net income are calculated as follows.

Variable Costing: Sales Revenue

Variable Cost of Goods Sold
Variable Selling and Administrative Costs
Contribution Margin
Fixed Production Costs
Fixed Selling and Administrative Costs
Net Income
Its important to understand that in both absorption and variable costing
systems, all selling and administrative costs are fully expensed to the income
statement in period in which these costs were incurred. Also, in both cases, the
variable production costs are assigned directly to inventory, which means that
only those variable production costs assigned to the inventory actually sold are
expensed as costs of goods sold on the income statement. The difference
between these two income methods (and the only difference) is in how fixed
production costs are handled. As weve demonstrated earlier with the Mason
Tool Company, under GAAP-approved absorption costing, fixed production
costs (like variable production costs) are assigned directly to inventory, and
subsequently expensed to the income statement as costs of goods sold when the
inventory is actually sold.

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 Lets now compare net income below for Mason Tool Company based on
variable costing with the net income we computed above (p. 4) for the same
three years based on absorption costing.
Sales and Production Data Year 1 Year 2 Year 3
Sales price per hammer Tk.15.00 Tk.15.00 Tk.15.00
Sales volume (in hammers) 100,000 100,000 100,000
Production volume (in hammers) 160,000 100,000 40,000
Total fixed production cost Tk.400,000 Tk.400,000 Tk.400,000
Fixed production costs per
hammer Tk.2.50 Tk.4.00 Tk.10.00
Variable production costs per
hammer Tk.6.50 Tk.6.50 Tk.6.50
Total fixed selling and admin.
costs Tk.230,000 Tk.230,000 Tk.230,000
Variable selling costs per hammer Tk.1.10 Tk.1.10 Tk.1.10
Variable Costing Income
Statements
Tk.1,500,0 Tk.1,500,0 Tk.1,500,00
Sales Revenue 00 00 0
(650,000
Variable Costs of Goods Sold (650,000) (650,000) )
Variable Selling and Admin. (110,000
Expense (110,000) (110,000) )
Tk. Tk. Tk.
Contribution Margin 740,000 740,000 740,000
(400,000
Fixed Production Expense (400,000) (400,000) )
(230,000
Fixed Selling and Admin. Expense (230,000) (230,000) )
Tk. Tk. Tk.
Net Income 110,000 110,000 110,000
The difference in net income between these two systems can be reconciled by
measuring the fixed production costs that are released from the balance sheet to
the income statement, and by measuring the fixed production costs that are

24
absorbed onto the balance sheet. Since Mason Tool Company uses the FIFO
method, the fixed production costs released from the balance sheet to the
income statement comes from beginning inventory for the period. The fixed
production costs absorbed onto the balance sheet are part of the ending
inventory for the period. The reconciliation of net incomes for each of the three
years is shown below.
Year 1 Year 2 Year 3
Sales volume (in hammers) 100,000 100,000 100,000
Production volume (in hammers) 160,000 100,000 40,000
Ending inventory (in hammers) 60,000 60,000 0

Tk. Tk.
Net Income Variable Costing Tk. 110,000 110,000 110,000
200,00 (130,00
Net Income Absorption Costing 260,000 0 0)
Tk. Tk. Tk.
Difference (150,000) (90,000) 240,000

Beginning inventory (hammers) 0.00 60,000 60,000

Fixed cost per hammer in inventory x Tk.0 x Tk.2.50 x Tk.4.00
Beg. inventory (released to income Tk.150,00 Tk.240,00
stmt) Tk.0 0 0

Ending inventory (hammers) 60,000 60,000 0.00

Fixed cost per hammer in inventory x Tk.2.50 x Tk.4.00 x Tk.0
End. inventory (absorbed to balance Tk.240,00
sheet) Tk.150,000 0 Tk.0

Net cost flow to absorption

statement Tk. Tk. Tk.
(Beg. inv. costs end. inv. costs) (150,000) (90,000) 240,000
In summary, what were seeing in this reconciliation is that the absorption
costing method retains fixed production costs on the balance sheet in the ending
inventory, and subsequently releases those fixed costs as costs of goods sold on

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the income statement (remember that Masons ending inventory becomes
beginning inventory in the next period and are sold). As a result, income can
vary significantly as levels of inventory in the organization rise and fall. In
contrast, the variable costing method expenses all fixed costsincluding fixed
production coststo the income statement in the period in which those costs are
incurred. The result of this alternative method of computing income is to more
appropriately focus income performance on the number of units sold, not the
number of units produced.
GAAP requires that absorption costing be used to create income
statements for external users. This allows external (and internal users) to see
the full cost of inventory. However, this approach causes fixed production costs
to act as if they were variable, which actually confuses the relationship between
sales and income. GAAP does not allow variable costing to be used to create
external income statements. However, managers are not constrained by GAAP
in creating internal reports for planning and evaluating performance. Managers
need to understand clearly the full cost of inventory, and managers need to
understand clearly the impact of sales on net income performance. So, the
question for you to consider is this. Which costing method should managers use
when reporting net income for internal useabsorption or variable?

Chapter Five
Findings and Conclusion

5.1 Findings
Advantages and Disadvantages of Variable Costing:
Following are the main advantages of using variable costing system::
1. The data that are required for cost volume profit (CVP) analysis can be
taken directly from a variable costing format income statement. These

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 data are not available on a conventional income statement based on
absorption costing.
2. Under variable costing, the profit for a period is not affected by changes
in inventories. Other things remaining the same (i.e. selling prices, costs,
sales mix, etc.), profits move in the same direction as sales when variable
costing is in use.
3. Managers often assume that unit product costs are variable costs. This is a
problem under absorption costing, since unit product costs are a
combination of both fixed and variable costs. Under variable costing, unit
product costs do not contain fixed costs.
4. The impact of fixed costs on profits is emphasized under the variable
costing and contribution approach. The total amount of fixed costs
appears explicitly on the income statement. Under absorption, the fixed
costs are mingled together with the variable costs and are buried in cost
of goods sold and in ending inventories.
5. Variable costing data make it easier to estimate the profitability of
products, customers, and other segments of the business. With absorption
costing, profitability is obscured by arbitrary allocations of fixed costs.
6. Variable costing ties in with cost control methods such as standard costs
and flexible budgets.
7. Variable costing net operating income is closer to net cash flow than
absorption costing net operating income. This is particularly important for
companies having cash flow problems.
With all of these advantages one might wonder why absorption costing
continues to be used almost exclusively for external reporting purposes and why
it is predominant choice for internal reports as well. This is partly due to
tradition, but absorption costing is also attractive to many accountants because
they believe it better matches costs with revenues. Advocates of absorption
costing argue that all manufacturing costs must be assigned to products in order

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to properly match the costs of producing units of product with the revenues
from the units when they are sold. The fixed costs of depreciation, taxes,
insurance, supervisory, salaries, and so on, are just as essential to manufacturing
products as are the variable costs. Advocates of variable costing argue that fixed
manufacturing costs are not really the costs of any particular unit of product.
These costs are incurred to have the capacity to make products during a
particular period and will be incurred even if nothing is made during the period.
Moreover, whether a unit is made or not, the fixed manufacturing cost will be
exactly the same. Therefore, variable costing advocates argue that fixed
manufacturing costs are not part of the costs of producing a particular unit of
product and thus the matching principle dictates that fixed manufacturing costs
should be charged to the current period. At any rate, absorption costing is the
generally accepted method for preparing mandatory external financial reporting
and income tax returns. Probably because of the cost and possible confusion of
maintaining two separate costing systems-one for external reporting and one for
internal reporting-most companies use absorption costing for both external and
internal reports.

Limitations of Variable Costing:

Practically speaking, absorption costing is required for external reports in
United States and almost all over the world. A company that attempts to use
variable costing (also called direct costing and marginal costing) on its external
financial reports runs the risk that its auditors may not accepts the financial
statements as conforming to generally accepted accounting principles
(GAAP). Tax laws almost all over the world require the usage of a form of
absorption costing for filling out income tax forms.

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Even if a company must use absorption costing for its external reports, a
manager can use variable costing statements for internal reports. No particular
accounting problems are created by using both costing methods--the variable
costing method for internal reports and the absorption costing method for
external reports. The adjustment from variable costing net operating income
to absorption costing net operating income is a simple one that can be easily
made at year-end.
Top executives are typically evaluated based on the earnings reported to
shareholders on the external financial reports. This creates a problem for top
executives who might otherwise favor using variable costing for internal
reports. They may feel that since they are evaluated based on absorption costing
reports, decisions should also be based on absorption costing data.

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5.2 Conclusion:
Most individuals would agree that if you paid a production supervisor a salary,
that the cost of that persons salary should be expensed in the period it was
incurred. However, the study can currently requires that fixed costs of
production be absorbed into the cost of inventory and put onto the balance
statement. These costs find their way to the income statement only when the
products are sold as cost of goods sold. Anytime sales volume differs from
production volume an artificial discrepancy in real income is created since fixed
costs of production are only expensed when the inventory is sold. The variable
costing method assigns all fixed costs of production to the period when they are
incurred. The income statement formula for the variable method is Sales
Revenue Variable Costs = Contribution Margin Fixed Production Expenses
= Net Income.
The absorption costing is used to create income statements for external users.
This method absorbs all the fixed costs of producing inventory into the
inventory account on the balance sheet. Fixed costs of production are expensed
as cost of goods sold only when the inventory is sold. To manage earnings,
companies can increase production which decreases the fixed cost per unit and
reduces the cost of goods sold for a period. Managers and users of financial
statements need to be aware of the artificial change in earnings as a result of
increased production.
Variable costing helps managers understand how changes in production affect
the cost of inventory. The variable costing method differs from the absorption
method since it expenses all the fixed costs of producing inventory in the period
those fixed costs were incurred. The income statement formula for the variable
method is Sales Revenue Variable Costs = Contribution Margin Fixed
Production Expenses = Net Income.

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References:
Garrison, Ray H; Eric W. Noreen; Peter C. Brewer (2009). Managerial
Accounting (13e ed.). McGraw-Hill Irwin. ISBN 978-0-07-337961-6.

Agri Benchmark (2011). The Agri Benchmark network. June 2011

http://www.agribenchmark.org/home.html

Agri Benchmark (2013). Analysis of cost, returns and profitability, Agri

Benchmark, Accessed on May 2013,
http://www.agribenchmark.org/methods_cost_analysis.html

Cesaro, L., S. Marongiu, F. Arfini, M. Donati, and M.G. Capelli (2008).

"Cost of production. Definition and Concept." FACEPA Deliverable
D1.1. 2 http://www2.ekon.slu.se/facepa/documents/Deliverable

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