Presented by : Aarushi sharma Dipen bhardwaj Sabir ali Vibhor agarwal

Variable costing & absorption costing

Absorption Costing vs Variable Costing
Absorption costing: includes all manufacturing costs

--- including direct materials, direct labor, and BOTH variable and fixed manufacturing overhead. Absorption Costing = Full Costing Variable costing: includes only variable manufacturing costs --- direct materials, direct labor, and variable manufacturing overhead.

Variable costing & absorption costing RULES

When production is equal to sales, then absorption

costing and variable costing will give the same amount of net income. When production is greater than sales, then Net Income under absorption costing will be greater than net income under variable costing because a portion of the fixed costs was deferred to other years under the absorption method. When production is less than sales, then Net Income under absorption costing will be less than net income under variable costing because a portion of the fixed costs that were deferred from previous years will be absorbed into this years cost of goods sold.

Let us understand this with the help of an example ! Hypothetical Ltd had the following relevant information for years 1 & 2.
Standard variable costs per unit Sales price per unit Fixed manufacturing overhead (capacity of 150000) Selling and administrative expenses Fixed Variable ( percent sales) Production volume: year 1 2 Sales volume 1 2 130000 5 1,70,000 1,40,000 1,40,000 1,60,000 Rs 6 10 3,00,000

 There was no inventory in the beginning of year 1 and

the income tax rate is 35 per cent Prepare income statements for 2 years under absorption and variable costing

Year 1 No of units produced Number of units sold Sales revenue Less:cost of manufacturing Standard variable cost Fixed cost Total cost of manufacturing Plus: cost of inventory(beginning)

Year 2

Less: cost of inventory (ending)

Cost of goods manufactured and sold

Gross margin manufacturing (unadjusted)

+- capacity varience Gross margin adjusted

Less:non production costs

Selling and adm expenses

Net income before taxes Less: Income tax Net income after taxes

Year 1

Year 2

No of units produced
Number of units sold Sales revenue

Less: variable costs

Standard variable cost +cost of inventory(beginning) _cost of inventory (ending) Standard cost of goods manufactured and sold Contribution (manufacturing)

Less: variable non production costs Selling and adm costs Contribution (final) less: fixed costs Fixed overheads Selling and adm expenses Net income before tax

Less: taxes
Net income after taxes

Reconciliation
What is Reconciliation?
A process to compare 2 sets of records to ensure the

figures are in agreement Find the differences and the reason of such differences Format of Reconciliation between Variable Costing and Absorption Costing


Profit as per Variable Costing Less: Fixed OH in opening Stock

Rs xxx xxx
xxx xxx

xxx Add: Fixed OH in closing Stock xxx Profit as per Absorption Costing

Example Sale in a month= 20,000 units Opening Stock= 10,000 units Current month production= 50,000 units Closing Stock= 40,000 units Variable cost pu= Rs.5 Fixed Cost= Rs.1,00,000 Budgeted Monthly Production= 50,000 units Fixed Cost pu= 1,00,000= Rs.2 50,000

 Variable Costing Statement Rs. Revenue 5,00,000 Less: Variable Cost (20,000x5) 1,00,000 4,00,000 Fixed Cost 1,00,000 3,00,000 Absorption Costing Statement Rs. Revenue 5,00,000 Less: Cost of Production (20,000x(5+2)) 1,40,000 3,60,000

Profit

Profit

 Reconciliation between Variable Costing and Absorption

Costing

Rs. Profit as per Variable Costing 3,00,000 Less: Fixed OH in opening Stock 20,000 (10,000x2) Add: Fixed OH in closing Stock 80,000 (40,000x2) . Profit as per Absorption Costing 3,60,000

Variable costing & short term decision making

Fixing price on special orders
Optimal sales mix Adding new product line

Dropping a product line

Making or buying component parts

Fixing price on special orders

Q= Premier importers ltd offers to place a special order with hypothetical ltd for 1000 units at 7 per unit. The management of the company is doubtful as the current selling price in the home market of its product is Rs 10
Present sales ( units) Production capacity(units) Variable cost (per unit) Fixed overheads ( at normal capacity) Total cost(variable cost Rs 6 + fixed overhead Rs 2) 4000 5000 Rs 6 10000 8

Analysis
Sales revenue Less variable costs 7000 6000

Contribution

1000

The firm is advised to accept the offer as the acceptance of this offer will increase its contribution by Rs 1000

Make or buy parts?

Hypothetical ltd has prepared the following cost

estimates per unit for the manufacturer of a sub component hitherto purchased from an outside at rs 32 a unit. Ordering and inspection costs are estimated at Rs 2 a unit the firm has spare capacity and no extra fixed costs will be required to be incurred. The annual requirement is 10,000 units

Analysis
make Direct materials Direct labor Variable overheads Purchase price Rs 10 14 6 32 Buy? Make 100,000 140,000 60,000 320,000 Buy?

Ordering and inspection cost

30

2
34 300,000

20,000
340,000

Advantages of variable costing

1.

Variable costing ties in with cost control methods such as standard costs and flexible budgets. 2. Variable costing net operating income is closer to net cash flow than absorption costing net operating income. This is particularly important for companies having cash flow problems. 3. Variable costing data make it easier to estimate the profitability of products, customers, and other segments of the business. 4. The data that are required for cost volume profit (CVP) analysis can be taken directly from a variable costing format income statement 5. Under variable costing, the profit for a period is not affected by changes in inventories.

Limitations of Variable Costing

1.)Segregation of total cost into fixed and variable elements is a

difficult task particularly in the case of semi-variable costs. In such situations resort to arbitrary classification may have to be made. 2.)Variable costing carries the potential danger of encouraging a short signed approach to profit planning at the cost of long term view. There is the danger of too many sales being made at a price slightly higher than variable cost possibly resulting in losses or very low profits. Management is likely to gather a very wrong impression of recovering only variable costs from the selling price. 3.)Variable costing carries the danger of misinterpretation particularly where products require high investment outlay and the variable cost may constitute a small proportion of total cost of product.

 3.)Focusing attention on the contribution margin and the

possible non-recognition of fixed costs by management may be dangerous.

4.)There is a difficulty in applying the technique to

industries where large stocks of work in progress are locked up particularly in contracting firms. If overheads were not included in the closing value of work in progress of each year of the contract there would b losses while at the end of the contract when revenue is received there would b large profit. the fluctuations in profits in partly evened out by valuing work-in-progress at the total cost plus some element of profit.