Case Study on Absorption Costing

Bohemia Industries Discussion

Impact of alternate costing methods on profit measurement Production =Sales Production < Sales Production >Sales

Difference in profit •

Cost of goods sold (absorption costing)

July (£000’s) August (£000’s) 3,000 3,300

Cost of goods sold (variable costing) 2,000 Fixed production costs incorporated in cost of goods sold 1,000

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2,200 1,100

Fixed overhead volume variance (10) 300 Fixed production costs included in absorption costing profit statement 990 1,400 Fixed production costs included in variable costing profit statement 1,200 1,200 Difference between absorption and variable costing fixed costs (210) 200 Reconciliation of difference between absorption and variable costing profits: Variable costing profit 200 500  Absorption costing profit 410 300 210 (200)

Cont…. large decline in opening and closing inventory valuations in August implies sales > production; so profits under absorption costing system will be lower Profit differences can also be derived in the changes in inventory valuations: £000’s Decrease in inventory with absorption costing (6,300  – 5,700) 600 Decrease in inventory with variable costing (4,200  – 3,800) 400  Absorption costing additional fixed costs included in difference in opening and closing inventory (August) 200

 Absorption costing profit for the 2 months (£710,000) exceeds the variable costing profit (£700,000) by £10,000. Combined July and August periods production volume > sales volume. This would have also have been true for July but not for August. If over the entire year production volume = sales volume then both systems will report the same profits, although profits will differ from month to month if monthly production and sales volumes differ.

ues on absorption costing profit is a function of production and sales volumes whereas with variable costing profit is a function of sales volume. Thus the differences in profits in the case arises from production volume changes. If production and sales volumes differ significantly there are stronger arguments for the adoption of variable costing.

Cont…. • Vaughan’s statement that variable costing would eliminate the need to undertake time-consuming allocations of fixed overheads may not be correct. It is likely that profits and inventory valuations would need to be prepared on an annual basis (or even semi-annually for interim statements) for external financial reporting. There may be a possibility that more simplistic approaches may be acceptable for external financial reporting such as apportioning the total manufacturing fixed overheads between inventories and cost of goods sold or using plant wide rates instead of departmental rates. However, it is possible that the external auditors may not accept such simplistic overhead allocations.

Cont… • Vaughan’s statement: variable costing is preferable for controlling fixed overheads is not necessarily correct. - Adoption of an absorption costing system for profit measurement and inventory valuation does not preclude the separate reporting and control of fixed overheads.

Cont… • Vaughan’s suggestion: absorption costing involves arbitrary allocations of fixed overheads that distorts product costs > moving to ABC can help • why absorption costing should be adopted for profit measurement and inventory valuation but productrelated decisions like product mix decisions, be based only on the assignment of relevant avoidable costs. Even some fixed costs change in the long run with change in product line and such costs should be incorporated in the product costs for decision-making.

Cont… • Director’s comment: variable costing may result in business being undertaken at margins that exceeded variable costs but that may not provide a sufficient contribution to covering fixed costs or generating sufficient profit • suggests a misunderstanding of marginal costing system If variable cost-plus pricing is used, under pricing can be avoided by larger profit margins being added to variable costs than that added to full cost

Cont… •

Director’s comment: adopting variable costing system would result in two profit reporting systems (one for internal reporting and the other  for external reporting) appears correct.

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Profit differences between the two systems depend on inventory changes [profits are sometimes higher with absorption costing if  production volume exceeds sales volume and lower if production is less than sales volume].

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So it is wrong to assume that variable costing always results in higher profits.

Question-3 •

No precise answer. Both the systems have some arguments in favour and against.

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If August is an abnormal month and substantial differences do not normally tend to occur with monthly sales and production volumes in the remainder of the year then there are strong arguments for adopting an absorption costing system for monthly profit reporting and inventory valuation.

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However, if there are significant mismatches between sales and production, absorption costing would distort profit and variable costing would be better. However, the choice should also envisage which costs to be used for decision-making and control.