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Bohemia Industries

Discussion

Profit under alternative costing methods


Units
Opening stock
Manufactured during the period*
Unit selling price
Admin., Selling & Distribution cost (Fixed)
How much is the profit under total costing &
marginal costing if 10,000 units are sold?
What if, 10,500 units are sold?
What if 9,000 units are sold?
* Fixed manufacturing cost is Rs.2,00,000.

Amount in INR

1,000

1,00,000

10,000

10,00,000
150
2,00,000

Impact of alternate costing


methods on profit measurement
Production =Sales
Production < Sales
Production >Sales

Difference in profit

Cost of goods sold (absorption costing)

July (000s) August (000s)


3,000
3,300

Cost of goods sold (variable costing)


2,000
Fixed production costs incorporated in cost of goods sold 1,000

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:
000s
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.

Question
Absorption2 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: Variable costing would eliminate the need to
undertake
time-consuming
allocations
of
fixed
overheads.
It may not be correct. It is likely that profits and inventory
valuations need to be computed on an yearly basis (or
even quarterly for interim financial 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.

Blanket rate vs. Departmental rate


Department

Machine
Hours

Labour
Hours

Overhead
(Rs.)

Machine hour Machine hour


required for
required for
Job A
Job B
Job A

Job B

Fabrication

12,000

8,000

1,50,000

30

20

Machining

15,000

7,000

1,80,000

40

60

Assembly

9,000

10,000

1,40,000

70

10

Finishing

8,000

4,000

90,000

10

60

5,60,000

150

150

44,000

Cont
Vaughan: Variable costing is
controlling fixed overheads.

preferable

for

It 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: 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:
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 mark-ups over
variable costs than that added to full cost.

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

Profit differences between the two systems depend on inventory


changes

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.

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.

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.

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