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ALTERNATIVE COSTING SYSTEMS:

Variable Costing, JIT Costing, Throughput Costing


Objectives
• understand why the use of variable costing results in income measures
which directly reflect movements in sales;
• prepare income statements on a variable costing basis as well as on an
absorption costing basis;
• reconcile the different incomes reported under variable costing and
absorption costing;
• understand why it is important to eliminate non-value-added activities and
why this is an aim of JIT production;
• operate a JIT costing system using different trigger points for recording;
• perform throughput costing.

Vic Fatseas: Chapter 8 Alternative Costing Systems 1


VARIABLE COSTING
• Absorption costing: All factory costs are charged to products - that is they
were treated as product costs.
• A criticism of absorption costing is that a change in sales revenue does not
always reflect a similar change in profit.
• The major distinguishing feature of variable costing is that only variable
production costs are charged to products: direct materials, direct labour
and variable overhead (direct materials and direct labour typically being
regarded as variable costs). Fixed production costs, i.e. fixed overhead, is
treated as a period cost and written off as a lump sum in the period in
which it is incurred.
• It is this treatment of fixed overhead which accounts for the difference in
profit that can result from the use of variable and absorption costing
methods.

Chapter 8 Alternative Costing Systems 2


METHODS OF CALCULATING PROFIT UNDER
ABSORPTION AND VARIABLE COSTING
• A second distinguishing feature of variable costing is a somewhat
different method of calculating profit and presenting income:
ABSORPTION COSTING VARIABLE COSTING
Sales XXX Sales XXX
Less Cost of Sales XX Less Variable Costs:
Gross Profit XX Manufacturing XX
Less Selling & Administration Expenses X Selling & Admin XX XX
Net Profit X Variable Profit (or Contribution Margin) XX
Less Fixed Costs:
Manufacturing X
Selling & Admin X XX
Net Profit X
Variable costing focuses on the behaviour of costs with respect to volume. Costs are treated as
fixed or variable with respect to production volume (in the case of manufacturing costs) or
sales volume (in the case of selling, distribution and administration costs).
Chapter 8 Alternative Costing Systems 3
EXAMPLE
• A company commenced operations on 1 July, 20X4 making a single
product which sold for $50 per unit. Units of product produced and
sold during the quarter ended 30 September, 20X4 were as shown
below:
July August September
Opening inventory 0 50 20
Units produced 150 100 90

Available for sale 150 150 110


Units sold 100 130 90

Closing inventory 50 20 20

Chapter 8 Alternative Costing Systems 4


Fixed overhead: $1000 per month for an expected production level of 100 units per month.
Thus, for absorption costing purposes, the predetermined fixed overhead rate was $1000/100 = $10 per unit;
any monthly fixed overhead variance was to be written off to Cost of Goods Sold. Under variable costing
fixed overhead is not allocated to product so that there can be no fixed overhead variance.

Variable overhead was expected to be $5 per unit. Direct materials were expected to cost $10 per unit and
direct labour to cost $5 per unit.

Absorption cost per unit was expected to be $30 ($10+$5+$5+$10) for direct materials, direct labour,
variable overhead and fixed overhead respectively).

Variable cost per unit was expected to be $20 ($10+$5+$5) for direct materials, direct labour and variable
overhead. All actual variable costs per unit turned out to be the same as estimated.

Chapter 8 Alternative Costing Systems 5


Actual revenues and costs for the quarter were as follows:
July August September
Sales revenue $5000 $6500 $4500
Production costs:
Direct materials 1500 1000 900
Direct labour 750 500 450
Variable overhead 750 500 450
Fixed overhead 1000 1000 1000
Selling & Admin Expenses:
Fixed 500 500 500
Variable 500 650 450

Chapter 8 Alternative Costing Systems 6


Absorption Costing
ABSORPTION COSTING
July August September
$ $ $ $ $ $
Sales 5000 6500 4500
Less Cost of Sales:
O/Inventory [0,50,20 @ $30] 0 1500 600
Cost of Goods Manufactured [$30 ea] 4500 3000 2700

4500 4500 3300


Less C/Inventory [50,20,20 @ $30] 1500 600 600
Cost of Goods Sold (Normal) 3000 3900 2700
Add(Less) Under(Over)-Allocated Fixed
Overhead [(50),0,10 @ $10] 1 (500) 0 100
Adjusted Cost of Goods Sold 2500 3900 2800
Gross Profit 2500 2600 1700
Less Selling & Admin Expenses:
Variable 500 650 450
Fixed 500 500 500
1000 1150 950
Profit 1500 1450 750

1. The total fixed overhead was $1000 per month, the same as estimated in determining the fixed
overhead rate of $10 per unit. Therefore any under(over) allocated overhead is due to actual production
being less(more) than the 100 units expected and used to determine the fixed overhead rate. For example
in July production was 150 units, 50 units more than expected, so fixed overhead was overallocated by
$500 (50 units x $10).
Chapter 8 Alternative Costing Systems 7
Variable Costing
VARIABLE COSTING
July August September
$ $ $ $ $ $
Sales 5000 6500 4500
Less Variable Costs:
O/Inventory [0,50,20 @ $20] 0 1000 400
Cost of Goods Manufactured [$20 ea] 3000 2000 1800
3000 3000 2200
Less C/Inventory [50,20,20 @ $20] 1000 400 400
Variable Manufacturing COGS 2000 2600 1800
Variable Selling $ Admin Expenses 500 650 450
Total Variable Costs 2500 3250 2250
Variable Profit (Contribution Margin) 2500 3250 2250
Less Fixed Costs:
Fixed Overhead 1000 1000 1000
Selling & Administration 500 500 500
1500 1500 1500
Profit 1000 1750 750

Chapter 8 Alternative Costing Systems 8


Reconciliation of Profit
• The difference between absorption costing profit and variable costing profit can be attributed to the fact that when sales
units do not equal production units the amount of fixed overhead expensed against revenue differs.
• Under variable costing the fixed overhead expensed in any period is equal to the fixed overhead incurred during that
period. Under absorption costing, however, the amount of fixed overhead expensed depends upon the number of units of
product sold.
• Under absorption costing, if in any period more units are sold than are produced, the total fixed overhead expensed
would exceed the sum incurred. Absorption costing profit would be lower by a sum equal to the decrease in finished
goods (units) inventory multiplied by the fixed overhead per unit.
• Conversely, in any period in which fewer units are sold than are produced, the total fixed overhead expensed under
absorption costing would be less than the sum incurred. Absorption costing profit would be higher by a sum equal to the
increase in finished goods inventory multiplied by the fixed overhead per unit.
• It will be noted that in September when units sold equalled units produced (no change in finished goods inventory) the
profit of $750 is the same under both methods.
• Summing up, we can posit two rules:
1. When there is a decrease in inventory, absorption costing profit is lower than variable costing profit.
2. When there is an increase in inventory, absorption costing profit is higher than variable costing profit.
and the difference can be shown to be equal to the change in finished goods inventory multiplied by the fixed overhead rate
per unit.
Chapter 8 Alternative Costing Systems 9
RECONCILIATION
July August September
Opening inventory (units) 0 50 20
Production (units) 150 100 90
Available for sale 150 150 110
Sales (units) 100 130 90
Closing inventory (units) 50 20 20
Increase (Decrease) in inventory 50 (30) 0
Fixed overhead per unit $10 $10 $10
Absorption income higher (lower) by $500 ($300) $0

Check
Absorption costing income $1,500 $1,450 $750
Variable costing income $1,000 $1,750 $750
Absorption costing income higher (lower) by $500 ($300) $0

Chapter 8 Alternative Costing Systems 10


JUST-IN-TIME (JIT) PRODUCTION
• In traditional manufacturing there are many activities carried out which do not directly
add value to a product; these activities have been called non-value-added activities. Yet
the costs of these activities (non-value-added costs) are still included as part of product
cost.
• Total manufacturing time (or throughput time) consists of five steps:
1. process time, which is the amount of time that a product is actually being worked on.
We can also call this value-added time.
2. inspection time, which is the time spent assuring high quality products or reworking
the product to an acceptable quality level.
3. move time, which is the time spent moving the product from one location to another.
4. queue time, which is the time spent waiting, for processing or moving or inspecting
etc.
5. storage time, which is the time spent in stock before shipment.
• Of these five steps, only process time adds value to the product. All the other activities
add cost but no value to the product, and are called non-value-added activities. If non-
value-added time can be eliminated, throughput time is minimised.
Chapter 8 Alternative Costing Systems 11
JIT systems pursue the goals of zero inventories, zero defects, flexibility in production, and zero interruptions to
production. Product quality is improved to eliminate defects and the associated costs of scrap, rework, inspection and
returns.

A feature of JIT production is a shift, from the traditional notion of holding three sets of inventories (raw materials, work
in process and finished goods) as buffers against variations in supply and demand and uneven work flows at differen
work stations, to holding small or even zero inventories. Inventories are simply thought of as waste. They occupy space
tie up money, and hide inefficiencies and poor quality.

Chapter 8 Alternative Costing Systems 12


JIT COSTING
• When a firm employs JIT systems (of purchasing and production),
ideally there are no inventories. Consequently, all the manufacturing
expenses incurred during a period become the cost of goods sold for
that period.
• There should be no need to have ledger accounts for raw material
inventory or work-in-process inventory or finished goods inventory. In
practice, however, it is unlikely that a zero-inventory position will be
realised. Nevertheless it is possible to change the accounting system
to match the characteristics of the JIT production approach, and
simplify the recording of cost flows in the ledger.

Chapter 8 Alternative Costing Systems 13


Features of JIT Costing Systems
1. There is usually no distinction in the general ledger between raw
materials and work in process. A single account labelled Raw and In-
Process (RIP) Inventory is used to record both.
2. Because inventory holdings are viewed as an aberration, finished goods
inventories may be recorded at their material cost only.
3. Unlike traditional costing systems, costs are not recorded sequentially,
but at discrete points in time. There is no single discrete point common
to all systems. The events which signal a record in the general ledger are
called trigger points. The selection of trigger points will affect the way
costs are treated as part of inventory value. Two possible sets of trigger
points are:
(i) purchase of raw materials, and completion of finished goods
(ii) purchase of raw materials, and sale of finished goods
Chapter 8 Alternative Costing Systems 14
Example of Method 1
Method 1 Using purchase of raw materials as the first trigger point and completion of
finished goods as the second trigger point

1 Record direct materials purchased

RIP Inventory (3000 x $20) $60 000


Accounts Payable $60 000

2 Record conversion costs incurred

Conversion Costs $120 000


Accrued Payroll $40 000
Accumulated Depreciation 50 000
Sundries 30 000

3 Record cost of finished goods completed

Finished Goods (2800 x $60) $168 000


RIP Inventory (@ $20) $56 000
Conversion Costs Allocated (@ $40) 112 000

4 Record cost of goods sold

Cost of Goods Sold (2500 x $60) $150 000


Finished Goods $150 000

5 Dispose of under-/over-allocated conversion costs to Cost of Goods Sold

Conversion Costs Allocated $112 000


Cost of Goods Sold 8 000
Conversion Costs $120 000

Ending Inventories appearing in the ledger are:

RIP Inventory (200 x $20) $4 000


Finished Goods (300 x $60) $18 000

Chapter 8 Alternative Costing Systems 15


Method 2
Method 2: Using purchase of raw materials as the first trigger point and sale of finished
goods as the second trigger point

1 Record direct materials purchased

RIP Inventory (3000 x $20) $60 000


Accounts Payable $60 000

2 Record conversion costs incurred

Conversion Costs $120 000


Accrued Payroll $40 000
Accumulated Depreciation 50 000
Sundries 30 000

3 Record cost of goods sold

Cost of Goods Sold (2500 x $60) $150 000


RIP Inventory (@ $20) 50 000
Conversion Costs Allocated (@ $40) $100 000

4 Dispose of under-/over-allocated conversion costs to Cost of Goods Sold

Conversion Costs Allocated $100 000


Cost of Goods Sold 20 000
Conversion Costs $120 000

Ending Inventories appearing in the ledger are:

RIP Inventory (500 x $20) $10 000

Chapter 8 Alternative Costing Systems 16


THROUGHPUT COSTING
Under conventional absorption costing systems all material, labour and
overhead costs are absorbed into the units of production. To the extent
that many of these costs are fixed, at least in the short run, the more
units produced the lower the unit costs obtained because a given
bundle of fixed costs are spread over a larger number of units.
As a consequence production managers may be rewarded for long
production runs which are seen to realise lower unit product costs. If
the output from long production runs is not sold there is a build-up in
finished goods inventory as well, so that some of the fixed costs are
held back in inventory and not expensed until the inventory is sold in
following periods. This helps to improve the firm’s profit performance.
The following example illustrates the situation.
Chapter 8 Alternative Costing Systems 17
Example of Traditional System
Illustrative Example 8-3
XYZ Mill Ltd sells paper for $1700 per tonne. Raw materials cost $500 per tonne. All other
production costs are fixed at $99 000 per month and are allocated to production using actual
capacity as the cost driver. Production and sales quantities over three months were:

Month Production Sales


1 100 tonnes 100 tonnes
2 110 tonnes 100 tonnes
3 90 tonnes 100 tonnes

Chapter 8 Alternative Costing Systems 18


Traditional Profit Calculations
Month 1 Month 2 Month 3
Production Increase in Reduction in
equals sales Inventory Inventory
Sales [100t @ $1700] $170,000 $170,000 $170,000
Cost of Sales
Materials [100t @ $500] 50,000 50,000 50,000
Conversion 1 99,000 90,000 108,000
Total 149,000 140,000 158,000
Profit $21,000 $30,000 $12,000

1. Month 1: Cost/t=$99,000/100t=$990/t COGS=$990*100t C/INV= $0


Month 2: Cost/t=$99,000/110t=$900/t COGS=$900*100t C/INV= 10t*$900
Month 3: Cost/t=$99,000/90t=$1,100/t COGS=$9,000+$1,100*90t

The unit conversion cost is lowest in Month 2 at $900 per tonne when production was
greatest. Also, conventional accounting rewards a build up in inventory, with the highest
reported profit in Month 2, while it penalises inventory reduction with the lowest reported
profit in Month 3.

Chapter 8 Alternative Costing Systems 19


Features of throughput costing
Throughput costing has been promoted as a better alternative to
support modern production objectives. In throughput costing the
conventional gross margin is replaced by throughput contribution.
Throughput contribution is defined as sales revenue less materials
consumed. In the paper mill materials consumed are expensed even if
the resulting output is not sold. This acts as an incentive to reduce the
holding of old inventory and to deter accumulating new inventory. Also,
all conversion costs are fully expensed each period and not absorbed
into inventory – an extension of the variable costing idea. Profit
calculations for Example 8-3 using throughput costing as described
here would be as follows.
Chapter 8 Alternative Costing Systems 20
Throughput Costing Calculations
Month 1 Month 2 Month 3
Production Increase in Reduction in
equals sales Inventory Inventory
Sales [100t @ $1700] $170,000 $170,000 $170,000
Cost of Sales
Materials [100t, 110t, 90t @ $500] 50,000 55,000 45,000
Throughput Contribution 120,000 115,000 125,000
Less Conversion 99,000 99,000 99,000
Profit $21,000 $16,000 $26,000

Now we see that throughput costing supports management objectives. It rewards inventory
reduction because the highest profit is recorded in Month 3. It penalises inventory accumulation
with the lowest profit reported in Month 2.
Chapter 8 Alternative Costing Systems 21