Question

1-What is meant by incremental analysis?
2-What is the unit product cost under variable costing?
3-What is the amount of the difference between the variable costing and absorption costing net operating incomes? What is the cause of this difference?
4-Distinguish between (a) a variable cost, (b) a fixed cost, and (c) a mixed cost.
5-What is meant by the margin of safety?
6-What are the arguments in favor of treating fixed manufacturing overhead costs as product costs?

Answer 1

1-What is meant by incremental analysis?

Incremental analysis involves the examination of alternative choices, based on the cost differences between them. This analysis is solely concerned with the costs that will change if one alternative is selected over another. Any costs that do not change if either alternative is selected are ignored for the purpose of deciding which alternative to pursue. For example, costs that have already been incurred (known as sunk costs) are ignored. Also, if any type of cost will be incurred for both alternatives, then it also can be ignored.

For example, a company receives an order from a customer for 1,000 units of a green widget for $12.00 each. The company controller looks up the standard cost for a green widget and finds that it costs the company $14.00. Of this $14.00, $11.00 is variable cost and $3.00 is fixed cost. Since the fixed cost is being incurred irrespective of the proposed sale, it is classified as a sunk cost and ignored. This means that the incremental cost of the widget is $11.00. The company should accept the order, since it will earn $1.00 per unit sold, or $1,000 in total.

2-What is the unit product cost under variable costing?

Variable costing is a concept used in managerial and cost accounting in which the fixed manufacturing overhead is excluded from the product-cost of production.

Under variable costing, the following costs go into the product:

Direct material (DM)

Direct labour (DL)

Variable manufacturing overhead (VMOH)

Unit product cost under variable costing is sum of above costs per unit.

3-What is the amount of the difference between the variable costing and absorption costing net operating incomes? What is the cause of this difference?

Absorption Costing:

Generally accepted accounting principles require use of absorption costing (also known as “full costing”) for external reporting. Under absorption costing, normal manufacturing costs are considered product costs and included in inventory.

As sales occur, the cost of inventory is transferred to cost of goods sold, meaning that the gross profit is reduced by all costs of manufacturing, whether those costs relate to direct materials, direct labour, variable manufacturing overhead, or fixed manufacturing overhead. Selling, general, and administrative costs (SG&A) are classified as period expenses.

The rationale for absorption costing is that it causes a product to be measured and reported at its complete cost. Because costs like fixed manufacturing overhead are difficult to identify with a particular unit of output does not mean that they were not a cost of that output. As a result, such costs are allocated to products.

Variable Costing

To allow for deficiencies in absorption costing data, strategic finance professionals will often generate supplemental data based on variable costing techniques. As its name suggests, only variable production costs are assigned to inventory and cost of goods sold. These costs generally consist of direct materials, direct labour, and variable manufacturing overhead. Fixed manufacturing costs are regarded as period expenses along with SG&A costs.

In some ways, this understates the true cost of production. How then can it aid in decision making? The short answer is that the fixed manufacturing overhead is going to be incurred no matter how much is produced.

So in both the methods there is a difference between the net operating income and the main cause of this difference is valuation of inventory and its effect on the cost of goods sold.

4-Distinguish between (a) a variable cost, (b) a fixed cost, and (c) a mixed cost.

As the level of business activities changes, some costs change while others do not. The response of a cost to a change in business activity is known as cost behaviour. Managers should be able to predict the behaviour of a particular cost in response to a change in particular business activity. For this purpose, costs are classified as variable, fixed and mixed costs.

Variable cost:

A cost that changes, in total dollar amount, with the change in the level of activity is called variable cost. A common example of variable cost is direct materials cost, direct labour cost, variable manufacturing cost.

Variable cost per unit remain the same on any level of output but changes in total. Variable cost has direct relation with the production activity, if production increases total variable cost increases and if production decreases total variable cost decreases.

Fixed cost:

A cost that does not change, in total, with the change in activity is called fixed cost. A common example of fixed cost is rent, Interest on loan taken for fixed assets, salary of admin staff.

Total fixed cost does not change with the change in activity but per unit fixed cost changes with the rise and fall in the level of activity. There is an inverse relationship between per unit fixed cost and activity. If production increases, per unit fixed cost decreases and if production decreases, per unit fixed cost increases.

Mixed or semi-variable cost:

A cost that has the characteristics of both variable and fixed cost is called mixed or semi-variable cost. For example, the rental charges of a machine might include $500 per month plus $5 per hour of use. The $500 per month is a fixed cost and $5 per hour is a variable cost. Another example of mixed or semi-variable cost is electricity bill. The electricity bill can be divided into two parts – (1) line rent and (2) cost of units consumed. The line rent is not affected by the consumption of electricity whereas the cost of units consumed varies with the change in units consumed.

Three commonly used methods to divide a mixed or semi-variable cost into its fixed and variable components are high-low point method, scatter graph method and least squares regression method.

5-What is meant by the margin of safety?

The margin of safety is the amount of sales over a company’s break-even point. In other words, the margin of safety is the amount of sales a company can lose before it actually starts to lose money or stops making a profit.

The breakeven point for a production process is when the sales income from the goods produced equals the actual cost of producing the products. This is where the company breaks even and doesn’t actually make a profit.

The margin of safety is also an important figure because it shows how safe the business is in producing products. For example, assume a manufacturer calculates it’s breakeven to be 100 units. Based on its sales projections, the company anticipates selling 150 units during the next quarter. The margin of safety on this product is 50 units.

This means that the company could potentially lose 50 sales during the period without creating a loss from operations. If the company loses 60 sales during the period, it won’t make its breakeven point and will actually lose money producing the product. The margin of safety calculation helps management assess the risk of producing a produce and aids in the overall decision to manufacture to product or leave the market.

6-What are the arguments in favour of treating fixed manufacturing overhead costs as product costs?

In accordance with the accounting standards for external financial reporting, the cost of inventory must include all costs used to prepare the inventory for its intended use. It follows the underlying guidelines in accounting – the matching principle. Absorption costing better upholds the matching principle, which requires expenses to be reported in the same period as the revenue generated by the expenses.

The rationale for absorption costing is that it causes a product to be measured and reported at its complete cost. Because costs like fixed manufacturing overhead are difficult to identify with a particular unit of output does not mean that they were not a cost of that output. As a result, such costs are allocated to products.