pp07-Chapter7Edited

Slide 7.
Income effects of alternative

stock-costing methods
Chapter 7
Bhimani, Horngren, Datar and Rajan, Management and Cost Accounting, 6th edition © Pearson Education Limited 2015
Slide 7.2
Introduction
n The reported profit number captures the

attention of managers in a way few other
numbers do.
n This chapter examines two types of cost
accounting choices in which the reported
profit number of manufacturing companies
is affected by stocks.
Slide 7.3
Learning objectives
1 Identify what distinguishes variable costing

from absorption costing
2 Construct income statements using absorption
costing and variable costing
3 Explain differences in profit under absorption
costing and variable costing
Slide 7.4
Learning objectives (Continued)
4 Understand how absorption costing influences

performance evaluation decisions
5 Describe the various denominator-level
concepts that can be used in absorption costing
6 Explain how the choice of denominator level
affects reported operating profit and stock
costs
Slide 7.5
Learning objective 1
Identify what distinguishes variable

costing from absorption costing
Slide 7.6
Stock-costing methods
n Variable costing and absorption costing

methods differences are based on the treatment
of fixed manufacturing overhead.
Slide 7.7
Stock-costing methods (Continued)
n Under variable costing, fixed manufacturing

overhead costs are excluded from stock costs
and are a cost of the period in which they are
incurred.
n Under absorption costing, these costs are stock
costs and become expenses only when a sale
occurs.
Slide 7.8
Stock-costing methods (Continued)
n Under both methods all non-manufacturing

costs in the value chain (such as research and
development and marketing), whether variable
or fixed, are recorded as expenses when
incurred.
Slide 7.9
Variable costing
n All variable manufacturing costs are assigned

to production and they become part of the unit
cost.
n Fixed costs are charged to the P&L account.
Slide 7.10
Variable costing (Continued)
Direct material stock
Payroll Work-in-progress
Variable stock
factory
labour
Variable overhead
Slide 7.11
Variable costing (Continued)
Payroll Work-in-progress
Fixed stock
factory
labour
P&L Finished goods
Cost of goods sold
Slide 7.12
Construct income statements

using absorption costing and
variable costing
Slide 7.13
Comparing P&L accounts
n The following data relates to Fredonia fixtures:

n Finished goods
Year 1 Year 2 Total
Opening stock 0 2,000 0
Produced 10,000 11,500 21,500
Sold 8,000 13,000 21,000
Closing stock 2,000 500 500
Slide 7.14

(Continued)
n The following information is on a per unit

basis:
Sales price: £71.00
Variable manufacturing costs:
Direct materials: £4.00
Direct manufacturing labour: £21.00
Indirect manufacturing costs: £24.00
Fixed manufacturing costs: £4.50
Slide 7.15

(absorption costing)
n Total fixed production costs are £54,000

at a normal capacity of 12,000 units.
n Fixed non-manufacturing costs are £30,000
per year.
n Variable non-manufacturing costs are £2.00
per unit sold.
Slide 7.16

(absorption costing) (Continued)
n What are the revenues for Year 1?

8,000 × £71 = £568,000
n What is the cost of goods sold?
8,000 × £53.50 = £428,000
n Is there a volume variance?
(12,000 − 10,000) × £4.50 = £9,000 under
allocated fixed manufacturing costs
Slide 7.17

n What is the gross margin?

£568,000 − (£428,000 + £9,000) = £131,000
n What are the non-manufacturing costs?
8,000 units sold × £2.00 = £16,000 variable
costs + £30,000 fixed costs = £46,000
Slide 7.18

n What is the operating profit before taxes?

£131,000 − £46,000 = £85,000
Slide 7.19

Absorption
Revenues £568,000
Cost of goods sold 428,000
Volume variance (U) 9,000
Gross margin 131,000
Non-manufacturing costs 46,000
Operating profit £85,000
Slide 7.20

(variable costing)
n Revenues for Year 1 are £568,000.

8,000 × £49 = £392,000
n What is the manufacturing contribution
margin?
£568,000 − £392,000 = £176,000
Slide 7.21

(variable costing) (Continued)
n What is the net contribution margin?

£176,000 − £16,000 variable non-
manufacturing costs = £160,000 net
contribution margin.
£160,000 − £54,000 fixed indirect
manufacturing costs − £30,000 fixed non-
manufacturing costs = £76,000
Slide 7.22

Variable
Revenues £568,000
Cost of goods sold 392,000
Variable non-manufacturing costs 16,000
Contribution margin 160,000
Fixed manufacturing costs 54,000
Fixed non-manufacturing costs 30,000
Operating profit £76,000
Slide 7.23
Explain differences in profit

under absorption costing and
variable costing
Slide 7.24
Operating profit
n What are revenues for Year 2?

13,000 × £71 = £923,000
13,000 × £53.50 = £695,500
n Is there a volume variance?
(12,000 − 11,500) × £4.50 = £2,250 under
allocated fixed manufacturing costs
Slide 7.25
Operating profit
n What is the gross margin?

£923,000 − (£695,500 + £2,250) = £225,250
n What are the non-manufacturing costs?
13,000 units sold × £2.00 = £26,000 variable
costs + £30,000 fixed costs = £56,000
Slide 7.26
Operating profit

£225,250 − £56,000 = £169,250
n What is the operating profit for the two years
combined?
£85,000 + £169,250 = £254,250
Slide 7.27
P&L accounts
Year 1 Year 2 Combined

Revenues £568,000 £923,000 £1,491,000
Cost of goods sold 428,000 695,500 1,123,500
Volume variance (U) 9,000 2,250 11,250
Gross margin 131,000 225,250 356,250
Non-mfg costs 46,000 56,000 102,000
Operating profit £85,000 £169,250 £254,250
Slide 7.28
Operating profit
(variable costing)
n Revenue for Year 2 is £923,000.

13,000 × £49 = £637,000
n What is the manufacturing contribution margin?
£923,000 − £637,000 = £286,000
Slide 7.29
Operating profit
n What is the net contribution margin?

£286,000 − £26,000 variable non-
manufacturing costs = £260,000 net
contribution margin
£260,000 − £54,000 fixed manufacturing costs
− £30,000 fixed non-manufacturing costs =
£176,000
Slide 7.30
Operating profit
n What is the combined operating profit for

the two years under variable costing?
£76,000 + £176,000 = £252,000
Slide 7.31
P&L accounts
(variable costing)

Revenues £568,000 £923,000 £1,491,000
Cost of goods sold 392,000 637,000 1,029,000
Mfg contr. margin 176,000 286,000 462,000
Variable non-mfg 16,000 26,000 42,000
Net contr. margin £160,000 £260,000 £420,000
Slide 7.32
P&L accounts

Net contr. margin £160,000 £260,000 £420,000
Fixed mfg costs 54,000 54,000 108,000
Fixed non-mfg costs 30,000 30,000 60,000
Operating profit £76,000 £176,000 £252,000
Slide 7.33
Comparison of variable and

absorption costing
n Stock values are smaller for variable costing

because it capitalises only £49.00 variable
cost as asset.
n Stock values using absorption costing have
an additional £4.50 fixed factory overhead
per unit.
Slide 7.34

absorption costing (Continued)
n Variable costing operating profit Year 1:

£76,000
n Absorption costing operating profit Year 1:
£85,000
n Absorption costing operating profit is £9,000
higher.
n Why?
Slide 7.35

n Production exceeds sales in Year 1.

n The 2,000 units in closing stock are valued as
follows:
Absorption costing Variable costing
2,000 × £53.50 = 2,000 × £49 =
£107,000 £98,000
£9,000
difference
Slide 7.36

n Variable costing operating profit Year 2:

£176,000
n Absorption costing operating profit Year 2:
£169,250
n Variable costing operating profit is £6,750
higher.
n Why?
Slide 7.37

n Sales exceeded units produced in Year 2.

n 13,000 − 11,500 = 1,500 units decrease in stock
n Absorption costing: 1,500 × £53.50 = £80,250
n Variable costing: 1,500 × £49.00 = £73,500
n £80,250 − £73,500 = £6,750 higher cost of goods
sold under absorption costing
Slide 7.38

n Variable costing combined net profit:

£252,000
n Absorption costing combined net profit:
£254,250
n £254,250 − £252,000 = £2,250 absorption
costing higher
n 500 units in stock × £4.50 = £2,250
Slide 7.39

n Absorption costing operating profit

– variable costing operating profit
= fixed manufacturing costs in closing stock
under absorption costing
– fixed manufacturing costs in opening stock
under absorption costing
Slide 7.40

n Absorption costing operating profit Year 2

£169,250 – variable costing operating profit
Year 2 £176,000 = (£6,750).
n Fixed manufacturing cost in closing stock
under absorption costing £2,250 – fixed
manufacturing cost in opening stock under
absorption costing £9,000 = (£6,750).
Slide 7.41
Understand how absorption

costing influences performance
evaluation decisions
Slide 7.42
Stock build-up
n Absorption costing enables a manager to

increase operating profit in a specific period
by increasing the production schedule, even
if there is no customer demand for the
additional production.
Slide 7.43
Stock build-up (Continued)
n Assume that Fredonia fixtures produced

4,400 units in Year 1 and sold 4,100.
n What is the production volume variance?
(12,000 – 4,400) × £4.50 = £34,200 U
n What is the net operating profit or loss for
the period?
Slide 7.44
Revenues (4,100 × £71) £291,100

Cost of goods sold
(4,100 × £53.50) 219,350
Volume variance 34,200
Gross margin 37,550
Net loss (£650)
Slide 7.45
n How many units are in closing stock?

4,400 – 4,100 = 300
n How much cost is in closing stock?
300 × £53.50 = £16,050
Slide 7.46
n Suppose that management decides to produce

9,000 units next year.
n Sales remain the same (4,100 units).
n What is the volume variance?
(12,000 – 9,000) × £4.50 = £13,500 U
n What is the operating profit or loss?
Slide 7.47
Revenues (4,100 × £71) £291,100

Cost of goods sold
(4,100 × £53.50) 219,350
Volume variance 13,500
Gross margin £58,250
Net profit £20,050
Slide 7.48
n How many units are in closing stock?

300 + 9,000 – 4,100 = 5,200
n How much cost is in closing stock?
5,200 × £53.50 = £278,200
Slide 7.49
n Sales volume remained constant during the

two years.
n Variable expenses also remained constant.
Slide 7.50
n By increasing stock level in the second year,

management can show a net profit rather than
a loss.
n What are some undesirable effects of
producing for stock?
Slide 7.51
n Production of items that absorb minimal fixed

manufacturing costs may be delayed.
n A plant manager may accept a particular order
to increase production, even though another
plant in the same company is better suited to
handle that order.
n A plant manager may defer maintenance.
Slide 7.52
Revising performance evaluation
1 Budget carefully and use stock planning.

2 Discontinue the use of absorption costing for
internal reporting and instead use variable
costing.
3 Incorporate a carrying charge for stock.
4 Change the time period used to evaluate
performance.
Slide 7.53
Revising performance evaluation

(Continued)
5 Include non-financial as well as financial

variables in the measures used to evaluate
performance.
n Closing stock in units this period ÷
closing stock in units last period
n Sales in units this period ÷
closing stock in units this period
Slide 7.54
Describe the various denominator-

level concepts that can be used in
absorption costing
Slide 7.55
Alternative denominator-level
concepts
n The choice of the denominator used to allocate

budgeted fixed manufacturing costs to
products can greatly affect the numbers a
normal or standard costing system will report
prior to the end of an accounting period.
Slide 7.56
Alternative denominator-level
concepts (Continued)
n Theoretical capacity
n Practical capacity
n Normal capacity
n Master-budget capacity
Slide 7.57
Theoretical capacity
n Theoretical capacity (maximum or ideal

capacity) is the denominator-level concept
that is based on producing at full (peak)
efficiency all the time.
Slide 7.58
Practical capacity
n Practical capacity is the denominator-level

concept that reduces theoretical capacity by
unavoidable operating interruptions.
n The use of practical capacity is required by
the IRS (USA).
Slide 7.59
Normal capacity
n Normal capacity is the denominator-level

concept based on the level of capacity
utilisation that satisfies average customer
demand over several periods.
n It includes seasonal, cyclical and trend factors.
Slide 7.60
Master-budget capacity
n Master-budget capacity is the denominator-

level concept based on the expected level of
capacity utilisation for the next budget period
(typically one year).
Slide 7.61
Budgeted fixed manufacturing

overhead rate
n The use of these four denominator levels

(denominator-level capacity) can affect the
budgeted fixed manufacturing overhead rate.
Slide 7.62

overhead rate (Continued)
n Lloyd’s Bicycles produces bicycle parts for

domestic and foreign markets.
n Fixed overhead costs are £200,000 within the
relevant range of the various capacity volume.
Slide 7.63

n Assume that the theoretical capacity is 10,000

machine hours, practical capacity is 85%,
normal capacity is 75% and master-budget
capacity is 60%.
n What is the budgeted fixed manufacturing
overhead rate at the various capacity levels?
Slide 7.64

n Theoretical 100%:
£200,000 ÷ 10,000 = £20.00/machine hour
n Practical 85%:
£200,000 ÷ 8,500 = £23.53/machine hour
n Normal 75%:
£200,000 ÷ 7,500 = £26.67/machine hour
n Master-budget 60%:
£200,000 ÷ 6,000 = £33.33/machine hour
Slide 7.65
Explain how the choice of

denominator level affects reported
operating profit and stock costs
Slide 7.66
Effect on financial statements
n The magnitude of the operating profit and

stock costs in an absorption costing system
will be affected by the choice of the
denominator level.
n Assume that Lloyd’s Bicycles actually used
8,400 machine hours during the year.
n What is the production volume variance?
Slide 7.67

(Continued)
Production volume variance

= (denominator level − actual level)
× budgeted fixed manufacturing overhead rate
n Theoretical capacity:
(10,000 − 8,400) × £20.00 = £32,000 U
n Practical capacity:
(8,500 − 8,400) × £23.53 = £2,353 U
Slide 7.68

(Continued)
n Normal capacity:
(7,500 – 8,400) × £26.67 = £24,003
n Master-budget capacity:
(6,000 – 8,400) × £33.33 = £79,992
n From learning objective 5, we remember that:
Theoretical = £20.00/machine hour
Practical = £23.53/machine hour
Normal = £26.67/machine hour
Master-budget = £33.33/machine hour
Slide 7.69

(Continued)
n From the examples, we can see that the

smaller the denominator level chosen, the
larger the proportion of fixed manufacturing
overhead cost per output unit that can be
allocated to stock.
n This will mean that reported stock costs will
therefore be higher and the operating profit
figure will also be higher.
Slide 7.70
End of Chapter 7

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Slide 7.

Income effects of alternative

n The reported profit number captures the

1 Identify what distinguishes variable costing

Learning objectives (Continued)

4 Understand how absorption costing influences

Identify what distinguishes variable

n Variable costing and absorption costing

Stock-costing methods (Continued)

n Under variable costing, fixed manufacturing

Stock-costing methods (Continued)

n Under both methods all non-manufacturing

n All variable manufacturing costs are assigned

Variable costing (Continued)

Direct material stock

Variable costing (Continued)

Cost of goods sold

Construct income statements

Comparing P&L accounts

n The following data relates to Fredonia fixtures:

Comparing P&L accounts

n The following information is on a per unit

Comparing P&L accounts

n Total fixed production costs are £54,000

Comparing P&L accounts

n What are the revenues for Year 1?

Comparing P&L accounts

n What is the gross margin?

Comparing P&L accounts

n What is the operating profit before taxes?

Comparing P&L accounts

Comparing P&L accounts

n Revenues for Year 1 are £568,000.

Comparing P&L accounts

n What is the net contribution margin?

Comparing P&L accounts

Explain differences in profit

n What are revenues for Year 2?

n What is the gross margin?

n What is the operating profit before taxes?

Year 1 Year 2 Combined

n Revenue for Year 2 is £923,000.

n What is the net contribution margin?

n What is the combined operating profit for

Year 1 Year 2 Combined

Year 1 Year 2 Combined

Comparison of variable and

n Stock values are smaller for variable costing

Comparison of variable and

n Variable costing operating profit Year 1:

Comparison of variable and

n Production exceeds sales in Year 1.

Comparison of variable and

n Variable costing operating profit Year 2:

Comparison of variable and

n Sales exceeded units produced in Year 2.

Comparison of variable and

n Variable costing combined net profit:

Comparison of variable and

n Absorption costing operating profit

Comparison of variable and

n Absorption costing operating profit Year 2

Understand how absorption