Discussion: Managerial Accounting

1. What are the advantages versus disadvantages of using absorption costing versus variable costing?

2. When is it more appropriate to use variable costing versus absorption costing?

With 400 words or 3 paragraphs and at least 2 references”

GUIDANCE 

This weeks’ readings focused on how costs and how they ‘behave’ under different methods of costing. The two main techniques are ‘absorption’ and ‘variable’ costing analysis. Depending on which method you use, it does affect how some fixed costs are treated. Absorption is also known as ‘full cost’ analysis in some companies and readings. While it is important to understand the distinctions of each, both can be very complex in tracking. Companies often employ the use of computerized systems that can ease the allocation burden.

When we are looking at these concepts, we also need to keep in mind what our capacity is in our manufacturing process. People and equipment can only do so much. You can push both when needed, but there will be consequences for that. Always think about both what normal capacity is and what practical capacity there will be some demands on customer activity and unavoidable interruptions that affect volume.

Introduction to Cost Behavior – Fixed, Mixed and Variable Costs

Cost Volume Profit Analysis (CVP): calculating the Break Even Point

Absorption and variable costing

Variable Costing

Lesson 4: Cost Behavior and Cost-Volume-Profit Analysis, Variable Costing and Analysis

By the end of this lesson, students should be able to:

· Describe types of cost behavior in relation to production and sales volume.

· Calculate the contribution margin and explain what it reveals about a company’s cost structure.

· Analyze changes in sales using the degree of operating leverage.

· Compute break-even points for a company

· Describe absorption and variable costing models.

· Prepare and analyze financial statements using absorption and variable costing

Managers are always wondering how much they should be producing and how changes in costs to those products and sales results affect the profit of a company. By identifying how costs ‘behave’ through Cost-Volume-Profit Analysis (CVP) managers can begin to understand what happens when costs ‘change’ in the production. Chapter 5 will delve into the arena of CVP and calculation of the contribution margin and break-even point for a company

Further, it is important to understand how costs are separated into product costs and period expenses. Chapter 6 will explain two costing methods, absorption and variable costing. Both utilize the same data but reflect the costs differently with regard to fixed overhead. This chapter will provide information on these costing models and how financial statements are prepared and analyzed using them.

READING: CHAPTER 5: Cost Behavior and Cost-Volume-Profit (CVP) Analysis

I. Identifying Cost Behavior

A. 4 factors to consider in CVP:

a. Sales price per unit

b. Variable costs per unit

c. Volume (Number of units)

d. Fixed Costs in total.

B. Fixed Costs

a. Do not change regardless of volume activity changes (within a relevant range)

b. Cost is the same regardless of productive capacity

c. Fixed cost per unit of output decreases when volume increases

C. Variable Costs

a. Changes in proportion to changes in volume activity.

b. Total variable costs changes with the level of production; however, variable cost per unit stays the same as volume changes

D. Mixed Costs

a. Includes both fixed and variable cost components.

b. Example is cell phone data plans. There is a fixed component (base level of the service) and then if the data plan exceeds the base level, a variable cost is included for the additional usage.

c. Other examples are electricity, water, natural gas.

E. Step-wise Costs

a. Costs that fall within a relevant range do not change. It is only when the costs fall outside of the relevant range that the cost changes.

II. Measuring Cost Behavior

A. Scatter Diagram – Each point over a range of costs (monthly for a year) and units produced is graphed in a scatter diagram and then and estimated line of cost behavior is developed

a. Estimated Line of Cost is drawn on the diagram to show the relation between cost and unit volume.

b. Total Cost is > 0 even when no units are produced and increases in proportion to increases in units

B. High-Low Method – Uses the highest and lowest volume level points to estimate the cost equation. 3-Step Process:

a. Identify the highest and lowest volume (note, these may not be the highest or lowest costs

b. Compute the slope (variable cost per unit) using the high and low volume

c. Compute total fixed costs by computing total variable cost at either the high or low volume, then subtracting that amount from the total cost at that volume

FORMULA:

C. Regression – Least-squares regression is a statistical method for identifying cost behavior. Use Excel to determine the fixed costs (Intercept) and variable costs (Slope) to determine the ‘best fit’ line for the cost data.

III. Contribution Margin (CM)

Contribution Margin = Sales – Variable Costs

A. Purpose is to ensure that we cover fixed costs. Any excess above that is ‘profit’

B. CM per Unit:

a. Product’s unit selling price exceeds its variable costs per unit.

Contribution Margin Per Unit = Selling Price per Unit – Variable Costs per Unit

C. CM Ratio:

a. The percent of each sales dollar that remains after deducting the unit variable cost.

b. For example, a CM ratio of 30% means that for each $1 in sales, 30 cents is what will cover fixed costs and produce income

IV. Break-Even (BE) Point

A. The sales level at which total sales = total costs and there is no income.

B. Can be stated in either units or dollars of sales

C. 3 Methods:

a. Formula Method

FORMULA:

b. Contribution margin income statement

i. Does not replace a formal income statement. For internal purposes only.

c. Cost-volume-profit chart (Break-Even Chart)

i. Total Costs

ii. Total Sales

V. Changes in Estimates

a. CVP uses past data to estimate future results

b. Can change the estimates depending on how sensitive the results change.

c. Often used for scenario testing or sensitivity analysis

VI. Applying CVP Analysis

A. Margin of Safety – The margin that sales can decline before the company experiences a loss.

a. Management must consider other factors such as variability, competition, consumer tases, economic conditions.

FORMULA:

Margin of Safety (in sales) = Expected (or actual) sales – Break-even sales

B. Computing Income from Expected Sales and Costs

C. Computing Sales for a Target Income – 2 Steps:

a. Calculate contribution margin at target income

b. Calculate Sales

FORMULA:

Computing Sales (Dollars) for a Target Income

Computing Sales (Units) for a Target Income

D. Evaluating Business Strategies – Use CVP to determine the effects of different business decisions. We might look at purchasing new assets, revising the budget/spending on a department, etc.

FORMULAS:

E. Sales Mix and Break-Even

a. Sales Mix: Proportion of sales volume for each product.

b. Break-Even is computed with a weighted average contribution margin per unit.

FORMULA:

F. Assumptions in CVP Analysis:

a. Costs are classified as variable or fixed.

b. Costs are linear within the relevant range

c. Inventory is constant (Units produced are units sold)

d. Sales Mix is constant

VII. Corporate Social Responsibility

A. CVP can be used to measure savings through use of sustained products such as packaging.

B. Use of recycled materials can affect both costs and result in greater sales.

VIII. Decision Analysis – Use of CVP in forecasting

A. Degree of Operating Leverage (DOL) – changes in the level of sales on income

FORMULA:

Then compute the change in income using the DOL computed: Change in sales % is what management wants to consider. For example if the change in sales is 30%, what is the resulting change in income %?

READING: CHAPTER 6: Variable Costing and Analysis

I. Variable and Absorption Costing Methods

A. Variable Costing Method: Direct Materials, Direct Labor, and Variable Overhead Costs are Product Costs. Fixed Overhead Costs are considered a ‘period expense’

B. Absorption Costing Method: All costs including Fixed Overhead Costs are considered product costs

C. Product Costs are included in Inventory until the goods are sold, then they are included in Cost of Goods Sold.

D. Period expenses are reported as expenses immediately in the period in which they are incurred.

II. Computing Unit Product Costs

A. Absorption Costing:

Direct Materials per Unit +Direct Labor per Unit + Variable OH + Fixed OH = Total Product Costs per Unit

B. Variable Costing:

Direct Materials per Unit +Direct Labor per Unit + Variable OH = Total Product Costs per Unit

The result is that under Absorption Costing, the total product costs per unit will be higher than under Variable Costing.

III. Income Reporting Impacts under Absorption and Variable Costing

A. Income differs between the costing methods when inventory levels change.

B. Inventory levels change when units produced do NOT equal units sold.

C. 3 scenarios:

a. When units produced = Units sold (no ending inventory)

i. It doesn’t matter under Absorption or Variable Costing, the Net Income will be identical

b. When units produced > Units sold (leaving a balance in ending inventory)

i. Under Absorption Costing, Net Income will be higher because the fixed expenses not included in the income statement. The remaining inventory is not included until sold.

ii. The difference between the two is due to fixed OH costs being included in the Finished Goods Inventory under absorption costing but not under variable costing.

c. When units produced < Units sold (no ending inventory-sold all of the units produced in the year + those that were in the beginning inventory account)

i. Net Income for Variable Costing will be higher because of the fixed OH.

ii. When the units from the beginning inventory are sold, the costs are reported in Absorption Costing in total.

To summarize, Income under absorption costing is higher when more units are produced than sold and is lower when less units are produced than sold.

IV. Production and Pricing

A. Planning Production – Managers who are incentivized to increase income would use absorption costing. However, that likely could result in managers overproduce and create excess inventory. Variable costing removes that incentive.

B. Setting Target Prices – Must cover all costs and provide an acceptable return (profit) to owners. Absorption costing reflects “full costs” and the selling price must exceed for the company to be profitable. 3-step process:

a. Determine the product cost per unit using absorption costing

b. Determine the target markup on the product cost per unit

c. Add the target markup to the product cost to find the target selling price

C. Analyzing Special Orders – Must cover all costs over the long run. Over the short run, as fixed costs do not change with production levels.

a. Managers should accept special orders if the special-order price exceeds the variable cost.

b. Fixed costs do not change in the short term regardless of accepting or rejecting an order as long as sales exceed the variable costs.

D. Assessing Costs for Services – Differences in income from absorption and variable costing do not apply

a. Variable costs change as volume of the services provided changes

b. Fixed costs do not change based on volume

V. Corporate Social Responsibility – Managers can review costs by putting environmental impacts into monetary terms.

VI. Contribution Margin (CM) Ratio

FORMULA:

Contribution Margin Ratio =	Contribution Margin
	Sales

Contribution Margin = Sales – Variable Expenses

A. Useful to analyze the performance of business divisions

B. Can be applied to divisions of the business and/or product lines of a business