Question

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• What is the difference between absorption costing and variable costing?

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• Are selling and administrative expenses treated as product costs or as period costs under variable costing?

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• Explain how fixed manufacturing overhead costs are shifted from one period to another under absorption costing.

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• What are the arguments in favor of treating fixed manufacturing overhead costs as product costs?

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• What are the arguments in favor of treating fixed manufacturing overhead costs as period costs?

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• If the units produced equals the units sold, which method would you expect to show the higher net operating income, variable costing or absorption costing? Why?

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• If the units produced exceed the units sold, which method would you expect to show the higher net operating income, variable costing or absorption costing? Why?

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• If fixed manufacturing overhead costs are released from inventory under absorption costing, what does this tell you about the level of production in relation to the level of unit sales?

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• Under absorption costing, how is it possible to increase net operating income without increasing sales?

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• How does Lean Production reduce or eliminate the difference in reported net operating income between absorption and variable costing?

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• What is a segment of an organization? Give several examples of segments.

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• What costs are assigned to a segment under the contribution approach?

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• Distinguish between a traceable fixed cost and a common fixed cost. Give several examples of each.

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• Explain how the contribution margin differs from the segment margin.

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• Why aren’t common fixed costs allocated to segments under the contribution approach?

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• How is it possible for a fixed cost that is traceable to a segment to become a common fixed cost if the segment is divided into further segments?

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• Should a company allocate its common fixed costs to business segments when computing the break-even point for those segments? Why?

Answer 1

1. Absorption costing means capturing all costs related to manufacturing of a particular product. It includes direct and indirect costs associated with manufacturing of a product like direct materials, direct labor, indirect materials, indirect labor, variable manufacturing overheads and fixed manufacturing overheads. Such costs are allocated to a product in calculating per unit production costs

Variable costing is a costing method where all the variable costs associated with manufacturing of the product are allocated to the product. It includes all the direct and indirect variable costs in cost of goods sold like direct materials, direct labor, indirect materials, indirect labor and variable manufacturing overheads but excludes fixed overhead costs as it considers such cost as a period cost and are allocated to operating profit rather than cost of goods sold. Thus it results in higher contribution and lower breakeven point

2. Under variable costing the organisation treat only variable manufacturing overheas as product costs. Thus fixed selling and administrative expenses are period costs which will continue to be same from period to period but variable selling and administrative expenses are neither product costs nor period costs they are variable costs which form a part of contribution margin statement which reduces variable expenses being cost of goods sold(product costs) and selling expenses(variable) from sales price

3. Fixed manufacturing overheads are a part of product cost in absorption costing i.e. the per unit cost of a product is derived using total manufacturing costs being fixed and variable. Hence, if the total units produced exceed the total units sold there would be closing inventory costs of which include a portion of fixed manufacturing costs which would be transferred to next period as cost of opening stock when such inventories would be sold

4. Fixed manufacturing overhead as product costs: If The fixed costs which are directly attributable to manufacturing a product are allocated to the product costs it would help in determining accurate cost per unit which would help in better pricing of mark-up products. It also helps in determining accurate picture of profits particularly when production exceeds sales or cost of goods sold

5. Fixed manufacturing overhead as period costs: Cost volume profit analysis becomes easier if fixed overhead are treated as period costs with the availability of contribution margin. It helps the management to understand the effect of period costs have on profits and facilitates better decision making.

6. If the units produced equals units sold though there would be difference in gross margin which would be lower in absorption costing and higher in variable costing but the operating profits will remain the same because the fixed manufacturing overhead would be absorbed in the same period as incurred in both the cases

7. If the units produced exceed the units sold the fixed manufacturing overhead allocated to the product cost of closing inventory in absorption costing will be transferred from current period to next period lowering the current period costs and hence operating income under absorption costing would be higher

8. If fixed manufacturing overheads are released from inventory meaning the portion of fixed manufacturing overhead cost of a prior period that becomes an expense of current period under absorption costing is a result of sales exceeding the production of the current period

9. Under absorption costing the fixed manufacturing costs are allocated as a product costs and as the number or units of goods produced in a period increases the per unit cost decreases even if the sales do not increase the fixed costs being absorbed in inventories would be transferred to next period increasing the current operating incomes

10. Lean production means the production without limited resources and negligible waste. Lean production helps in reduction of the fixed costs being factory space, machining capacity, etc. It also tends to limit the production to the demand and eliminate mass production which requires excess space to store inventory. The main difference in absorption and marginal costing is due to fixed cost allocation which is different in both the method which affets the cost per unit of inventory elimination of excess inventory in lean production will ensure production equivalent to sales and hence there would be no operating profit differences in both the methods

11. Segment of an organisation: A business segment is a part of an organisation which is identified by different products it produces or geographical location it operates in. Business managers often divides the companies into segments to identify what areas are performing and what areas need improvement

Example of product segments of FMCG: Beverages, packed foods, Toiletries, etc.

Example of geographical segment: North region, west region, south region, etc.

12. Costs assigned to segment: Under contribution approach costs are assigned to a segment if and only if the costs are traceable to the segment i.e. it could be avoided if the segment is eliminated. Common costs are not assigned to segments under contribution approach

13. Traceable fixed costs and common fixed costs: traceable fixed costs are costs that could be avoided if the product is not manufactured or eliminated. They are incurred only if a particular product is produced whereas common fixed costs are irrespective of a segment and does not defer if the product is eliminated. They are costs that the organisation has to bear whether or not a product is manufacture, a segment or organisation makes profit or not

Example: traceable fixed cost: fixed selling costs of a particular product or advertising costs for a particular product

Example: common fixed cost: Office rent

14. Contribution margin and segment margin: contribution margin is the difference between sales is variable expenses whereas segment margin is the amount remaining after deducting traceable fixed expenses from contribution margin. The segment margin is useful in assessing overall profitability of a segment

15. Common fixed costs are sunk costs and not opportunity costs. They have to be incurred whether or not a product is produced or even if there is no production. The decision of a segment profitability is indifferent from such costs and hence they are not allocated to segments under contribution approach

16. Some traceable fixed costs that are considered traceable can become a common costs if the same is divided into several segments for example the cost of factory space of toiletries in FMCG can become a common cost of further segments as shampoo, oil, soaps, tooth paste, detergent segments are the space is common for all the sub segments and their individual profitability will not be derived from such costs, even if one of the sub segment is eliminated the costs will have to be incurred for other segments

17. Common fixed costs may be eliminated to decide make or buy or inhouse or outsource decisions but such costs are fixed period costs and irrespective of their nature shall be calculated for determining break-even analysis as ultimately the organisation profits will be impacted by such costs