Quiz 20: Variable Costing for Management Analysis
Comment the Ethical manner of Aston: S Division of TI uses absorption costing for reporting income statement figures. The general manager of the division is under pressure to meet income targets. He is planning to increase production even though there are no corresponding customer orders. Aston, the controller of production, is acting with integrity by reporting the information to the division manager. As a controller, he has overall jurisdiction over the operations. However, he may not have the powers to question the general manager's actions of increasing production solely for meeting the division's profit targets. By reporting the matter to the division manager, Aston is indirectly questioning the decision of the general manager. It is the responsibility of the divisional manager to present a true picture of the division's performance. Condoning the general manager's actions would show a lack of integrity for the following reasons: • The division is resorting to a deliberate increase in production without corresponding customer demand in order to show increased earnings. The result is that fixed costs are allocated over a larger inventory base. This effectively decreases the unit cost of production decreases for the same sales level and artificially boosts net income for the period. The fixed costs become part of unsold inventory and thus get transferred to the balance sheet. • The true state of profitability and net income is glossed over and hidden behind artificial reporting. The income information in such financial reports can be misleading to senior management. • Since there is an avenue available to cover up lackluster performance, there is no incentive to improve performance and profitability. Senior management, believing that the division's performance is good, will not intervene to improve things. • Increasing production without corresponding sales (production exceeds sales) provides short-term benefits. When inventory gets used later, the costs must be allocated to the period's sales, reducing profits for the subsequent reporting period. Therefore the general manager's action will adversely affect future period net income. • The objective of financial reporting is to present a true picture of the company's affairs to users. The general manager has utilized a loophole in absorption costing under GAAP, which permits transfer of fixed costs to inventory. This is tantamount to misrepresentation.
a. Absorption Costing: Under Absorption Costing, the cost of manufactured goods includes: 1. Direct materials costs 2. Direct labor costs 3. Factory overhead costs consisting of (i) variable and (ii) fixed factory overheads. b. Variable Costing: Under Variable Costing, only variable costs are included for determining the cost of goods manufactured. Fixed costs relating to factory overheads are treated as a period expense. The costs included are: 1. Direct materials costs 2. Direct labor costs 3. Variable factory overheads The cost of goods manufactured will be higher when Absorption Costing is adopted, as it includes fixed factory overheads also.
a. Absorption costing: Under the absorption costing approach all the costs incurred for manufacturing a product will be allocated to the costs. The cost incurred for manufacturing will consist of direct material, direct labor, variable overhead and fixed overheads. The absorption costing includes both fixed and variable overheads. Calculate Valuation of Closing Inventory as per Absorption Costing: Under absorption costing the fixed manufacturing costs are treated as manufacturing costs and are added to direct material, direct labor and other direct expenses to arrive at costs of goods sold. Consider the below table: Therefore from the above calculations, it is clear that the value of Inventory calculated using absorption costing is $876,800 b. Variable costing: • Under variable costing, all the variable costs are treated as product costs. All the fixed costs are treated as period costs. Therefore, all the costs related to the manufacturing of products, that will vary will the production such as direct material, direct labor and variable manufacturing overhead are treated as product costs. • Further, costs such as selling and administration expenses which are fixed in nature, are treated as period costs, as these expenses are incurred throughout the period irrespective of production. Calculate Valuation of Closing Inventory as per Variable Costing: Under variable costing concept, fixed manufacturing costs are not included while calculating the cost of goods sold. Hence to calculate the contribution margin, variable costing uses the below formula: Consider Below Table: Therefore from the above calculations, it is clear that the value of Inventory calculated using Variable costing is $780,800.