Module 11 Costs for Decision Making 11 2 The Dilemma of the Denominator Overheads can be allocated using the following equation Budgeted manufacturing or non manufacturing overhead Budgeted Volume of output units or hours The numerator actual overhead may vary throughout the year but these variations are usually not significant The numerator is always fixed overhead The denominator however may vary widely due to market demand Example A manufacturer planned to produce and sell 10 000 pens Costs of manufacture were as follows Direct Material Direct Labor Variable costs of production Fixed Production costs such as depreciation management salaries etc totaling 100k 100k 10k 10 Full production cost 20 30 50 10 60 Note fixed production costs fixed manufacturing overhead If each pen sells for 100 then the gross profit is 40 from which non manufacturing overheads would be deducted salaries selling distribution etc Assume these total 200 000 The P L would look like this Sales 10 000 pens 100 Less Full cost of Sales 10 000 60 Gross Profit Other Expenses non manufacturing overhead Net Profit 1 000 000 600 000 400 000 200 000 200 000 This is called Full or Absorption cost accounting because each unit is asked to absorb its share of fixed production overhead Let s assume the business only produced what was required by the market due to competitive pressures Because of this the company did not attempt to allocate fixed production overhead to each product Assuming it sold exactly the same amount of pens as above its P L would look like this Sales 10 000 pens 100 Less Variable Cost of sales 10 000 50 Contribution Margin Fixed Production Costs Other Expenses Net Profit 100 000 200 000 1 000 000 500 000 500 000 300 000 200 000 This form of accounting is called variable or direct costing because it accounts for fixed costs in a lump sum As in the above cases the net profit will always be the same for both methods as long as a The actual production equals planned production b The company sells all it produces Production Sales Example Say the absorption method is used by the above company but instead of producing and selling 10 000 they produce 11 000 and sell 10 000 Throughout the year the pens will be allocated 10 fixed production when in fact they should have been allocated 100 000 11 000 9 09 So each pen was allocated or over absorbed 0 91 that totals 0 91 x 11 000 This caused an incorrect denominator volume being selected this is corrected by including a denominator volume variance in the P L account To take into account this over absorption the P L includes the over absorption 10 000 figure Absorption Profit and Loss Sales 10 000 pens 100 Less Full cost of sales 10 000 60 Gross Profit Denominator Volume Variance Other Expenses Net Profit The Variable Costing P L remains unchanged 1 000 000 600 000 400 000 190 000 210 000 Sales 10 000 pens 100 Less Variable Cost of sales 10 000 50 Contribution Margin Fixed Production Costs Other Expenses Net Profit 100 000 200 000 10 000 200 000 1 000 000 500 000 500 000 300 000 200 000 In the above scenario 1000 pens are put into inventory absorption costing values them at 60 ea while Variable costing values them at 50 ea the difference is 1000 x 10 10 000 So according to Absorption costing 10 000 worth of costs has been held back in inventory to be released next year Hence absorption gives 10 000 more profit this year Remember according to accounting conventions only the costs incurred on goods sold goes into the P L Production Sales Example Same as above but production of only 9000 this time even thought the estimate was 10 000 Actual Sales are still 10 000 Absorption Profit and Loss Sales 10 000 pens 100 Less Full cost of sales 10 000 60 Gross Profit Denominator Volume Variance Other Expenses The Variable Costing P L remains unchanged 1 000 000 600 000 400 000 210 000 190 000 Sales 10 000 pens 100 Less Variable Cost of sales 10 000 50 Contribution Margin Fixed Production Costs Other Expenses Net Profit 100 000 200 000 10 000 200 000 1 000 000 500 000 500 000 300 000 200 000 The Denominator volume variance is caused by the fact that each unit was under absorbed by 0 91 causing the write off the shortfall of 10 000 The difference in profits is caused by the fact that 1000 units need to come from inventory these units being valued at 60 in Absorption costing and 50 in Variable So what we gained last year in profits we lose this year Summary Denominator Volume Variance is caused when actual production is not equal to Bottom line profit difference arises when actual sales is not equal to actual planned production production Example P 11 17 Assuming budgeted total fixed production costs of 100 000 and a budgeted level of production of 10 000 pens per anum Sale price of pen 100 Cost of pen Direct Materials Direct Labor Fixed Production Costs Full Cost 20 30 10 60 in 000s Sales Production Sales rev Absorption Cost of Sales Gross Profit Less Volume Variance Net Profit Variable Costing Cost of Sales Contribution Margin Fixed Costs Net Profit 1 10 10 1000 2 8 8 800 3 11 11 1100 4 9 10 900 5 7 8 700 6 10 11 1000 600 480 660 540 420 600 400 0 320 20 440 10 360 0 280 20 400 10 7 12 10 1200 720 480 0 8 9 8 900 540 360 20 400 300 450 360 260 410 480 340 530 500 400 550 450 350 500 500 400 550 450 350 500 600 600 450 450 100 400 100 300 100 450 Produ Sales 100 350 100 250 Prod Sales 100 400 100 500 Production Sales 100 350 9 13 11 1300 780 520 10 650 650 100 550 Q1 Why the difference of profits in column 5 Ans 1000 more units are produced than sold and so they go into the closing stock there is a difference of 10 per unit in how absorption and variable costs values these 1000 units So 10 000 has been held back in costs from this year to be released next year according to Absorption costing method 10 000 less costs this year means 10 000 more profit this year Q2 in column 9 why the difference in profits of 20 000 when the volume variance is only 10 000 Ans The difference in profits is caused by the difference between actual sales and actual production 2000 units had to be taken from inventory to satisfy demand Absorption values these units at 60 while variable values them at 50 Hence the difference between how absorption and variable values each of these units is 10 unit hence 2000 x 10 20 000 20K more profit in Variable 11 3 Managerial Implications of Absorption versus Variable Costing Tax Authorities usually insist on absorption …