Reconciliation Statement for Absorption and Variable Costing

Assalamualaikum and good evening.

Today I want to talk about reconciliation statement. You may heard about Bank Reconciliation Statement? But now we talk about Reconciliation Statement in evaluating performance by using absorption costing and variable costing. What really means by reconciliation?

An accounting process used to compare two sets of records to ensure the figures are in agreement and are accurate. Reconciliation is the key process used to determine whether the money leaving an account matches the amount spent, ensuring that the two values are balanced at the end of the recording period.

The has 2 ways to make Reconciliation Statement in Absorption and variable costing.

1- Long way to Reconciling income.

2- Shortcut to Reconciling Income

The main thing you need to remeber is :

1. Need to know the amount ending inventory. Is there has beginning inventory and ending inventory?
2. The net income or net loss for each method – absorption costing and variable costing.
3. The price per unit for fixed-overhead.

 

Some notes

Assalamualaikum and good evening.

Here I have found some notes and exercise. I found it on internet. Thanks to Mr Google for helping me to find more information about accounting.

Here there are :

1. 2Chapter07
2. CH7 VARIABLE COSTING

 

Variable Costing—A Tool for Management

Learning Objectives

1. Explain how variable costing differs from absorption costing and compute unit product costs under each method.

2. Prepare income statements using both variable and absorption costing.

3. Reconcile variable costing and absorption costing net operating incomes and explain why the two amounts differ.

4. Understand the advantages and disadvantages of both variable and absorption costing.

Chapter Overview

A. Overview of Variable and Absorption Costing. At least two methods can be used in manufacturing companies to value units of product for accounting purposes—absorption costing and variable costing. These methods differ only in how they treat fixed manufacturing overhead costs.

1. Variable Costing. Variable costing includes only variable production costs in product costs. Direct materials, direct labor and variable manufacturing overhead costs would ordinarily be included in product costs under variable costing. Fixed manufacturing overhead is not treated as a product cost under this method. Rather, fixed manufacturing overhead is treated as a period cost and is charged against income each period.

2. Absorption Costing. Absorption costing treats all production costs as product costs, regardless of whether they are variable or fixed. Under absorption costing, a portion of fixed manufacturing overhead is allocated to each unit of product.

B. Comparison of Absorption and Variable Costing. When comparing absorption costing and variable costing income statements, a number of points should be noted:

1. Deferral of fixed manufacturing costs under absorption costing. Under absorption costing, if inventories increase then a portion of the fixed manufacturing overhead costs of the current period is deferred to future periods in the inventory account. When the units are later taken out of inventory and sold, the deferred fixed costs flow through to the income statement as part of cost of goods sold.

2. Differences in inventories under the two methods. The ending inventory figures under the variable costing and absorption costing methods are different. Under variable costing, only the variable manufacturing costs are included in inventory. Under absorption costing, both variable and fixed manufacturing costs are included in inventory.

3.Suitability for CVP analysis. An absorption costing income statement is not well suited for providing data for CVP computations since it makes no distinction between fixed and variable costs. In contrast, the variable costing method classifies costs by behavior and is very useful in setting-up CVP computations.

C. Extended Comparison of Income Data. Exhibit 7-3 in the text presents a comparison of absorption costing and variable costing income statements over three years in which production is constant but sales vary. Exhibit 7-6 in the text also presents comparative income statements over three years but holds annual sales constant and varies annual production. From these Exhibits, several generalizations can be drawn. (All of these generalizations assume the LIFO inventory flow assumption is being used. The generalizations may not hold in some rare cases if a company uses an inventory flow assumption other than LIFO.)

1. Production equals sales (no change in inventories). When production equals sales, inventories do not change. If inventories do not change, then there is no change in the fixed manufacturing overhead costs in inventories under absorption costing. Therefore, under both costing methods all of the current fixed manufacturing overhead will flow through to the income statement as an expense. In the case of absorption costing it will be part of cost of goods sold. In the case of variable costing, it will be a period expense.

2. Production exceeds sales (inventories increase). When production exceeds sales, inventories grow. If inventories grow, then some of the current fixed manufacturing overhead costs will be deferred in inventories under absorption costing. Since all of the current fixed manufacturing overhead costs are expensed under variable costing, the net operating income reported under absorption costing will be greater than the net operating income reported under variable costing.

3. Sales exceed production (inventories decrease). When sales exceed production, inventories shrink. If inventories decrease, then some of the fixed manufacturing overhead costs that had been deferred in inventories in previous periods will be released to the income statement as part of cost of goods sold as well as all of the current fixed manufacturing overhead costs. Since only the current fixed manufacturing overhead costs are expensed under variable costing, the net operating income reported under absorption costing will be less than the net operating income reported under variable costing.

4. Long-term differences in income. Over an extended period of time, the cumulative net operating income figures reported under absorption costing and variable costing will be about the same; they will differ only by the amount of fixed manufacturing overhead cost in ending inventories under absorption costing. Cumulative net operating income figures will be identical whenever ending inventories are reduced to zero.

5. Changes in production volume. Variable costing net operating income is notaffected by changes in production volume. On the other hand, absorption costing net operating income is affected by changes in production volume. For any given level of sales, net operating income under absorption costing will increase as the level of output increases and hence inventories increase.

D. The Matching Principle. Accountants and managers have been arguing for decades concerning the relative merits of absorption and variable costing. In practice, absorption costing is used far more than variable costing even for internal reports. The reasons for this are not entirely clear, although the perception that absorption costing is required for external reporting undoubtedly plays a key role. The argument for using absorption costing in external reports seems to be based on the matching principle.

1. Argument for absorption costing. Advocates of absorption costing argue that all manufacturing costs must be assigned to units of product so as to properly match costs with revenues. They argue that fixed manufacturing overhead costs are essential to the production process and must be included when costing units of product, regardless of how the cost behaves.

2. Argument for variable costing. Advocates of variable costing argue that fixed manufacturing overhead costs are incurred in order to have the capacity to produce. Moreover, they will be incurred regardless of whether anything is actually produced. Since these costs are not caused by any particular unit of product and are incurred to provide capacity for a particular period, the matching principle would dictate that fixed manufacturing overhead costs must be expensed in the current period.

E. Advantages of the Contribution Approach. There are a number of advantages to using variable costing (and the contribution approach) in internal reports and analysis.

1. More useful for CVP analysis. Variable costing statements provide data that are immediately useful for CVP analysis since they categorize costs on the basis of their behavior. In contrast, it is often difficult to rework absorption costing data so that they can be used in CVP analysis and in decisions.

2. Income is not affected by changes in production volume. Under absorption costing, reported net operating income is affected by changes in production since fixed costs are spread across more or fewer units. This can distort income and may even result in income moving in an opposite direction from sales. This does not occur under variable costing.

3. Avoids misunderstandings concerning unit product costs. Absorption costing unit product costs can be easily misinterpreted as variable costs since they are stated on a per unit basis. Such a misperception can lead to serious errors in making decisions. Variable costing avoids this problem since unit costs include only variable costs.

4. Fixed costs are more visible. The impact of fixed costs on profits is emphasized because the total amount of such costs for the period appears separately and is highlighted in the income statement rather than being buried in cost of goods sold and ending inventory.

5. Understandability. Managers should find it easier to understand variable costing reports because data are organized by behavior and because variable costing is much closer to cash flow.

6. Control is facilitated. Variable costing ties in with cost control methods such as flexible budgets.

7. Incremental analysis is more straight-forward. Variable cost corresponds closely with the current out-of-pocket expenditure necessary to produce and sell products and services and can therefore be used more readily in incremental analysis than absorption costing data. And since variable costing net operating income is closer to net cash flow than absorption costing net operating income, it is likely to be more useful to companies that have cash flow problems.

However, variable costing is not generally accepted by auditors for external financial reports and is not permitted by the IRS in the United States and by tax authorities in many other countries for income tax calculations. There is some question about whether variable costing is actually prohibited in the United States by official pronouncements and some companies do use some form of variable costing in their external reports, but absorption costing must be considered the most generally accepted practice.

F. Impact of JIT Inventory Methods. When companies use JIT methods for controlling their operations, the distortions of income that can occur under absorption costing largely (or completely) disappear.

1. The cause of distortions in net operating income. Erratic movements in net operating income under absorption costing and the differences in net operating income between absorption and variable costing can be traced to changing levels of inventory. When inventory levels are constant or negligible, absorption costing and variable costing methods yield the essentially same net operating income.

2. The JIT solution. Under an ideally functioning JIT system, goods are produced strictly to customers’ orders. Finished goods inventories almost disappear and work in process inventories are kept to a minimum. With little or no inventories, fixed manufacturing overhead costs cannot be shifted between periods under absorption costing. As a result, both variable and absorption costing will show essentially the same net operating income figure, and the net operating income under absorption costing will move in the same direction as movements in sales.

Sources : http://www.smccd.net/accounts/nurre/online/chtr7.html

 

How to Find Variable Cost Per Unit Using High-low Method

The different between “Fixed” and “Variable” costs.

Fixed costs are those that do not change regardless of the level of change in activity (activity can be a number of cost drivers, or measures of output, such as labor or machine hours or whichever “activity” your specific situation uses).

Variable costs are those that do move in relation to fluctuations in activity. For example, the total variable costs move in relation to the units produced or sold. (see the “Tips” section below for one more note on variable costs)

To use the high-low (hi-lo) method you will use data on a month to month schedule using two parts of information.

• First is the total number of units (let’s assume it’s Gallons of paint for your large painting company).
• Second is the total cost of the gallons of paint each month.
• Pick a range of consecutive months and make three columns.
• From left to right the columns should be; MONTH-UNITS-TOTAL COST.
• Let’s say you pick June to December, so your first column will be June, July, August….to December.
• The UNITS column will have a varying amount of gallons of paint per month for the designated period (in our case 7 months).
• The TOTAL COST column will simply be the amount of that months’ gallons of paint used or sold.
• The high low cost behavior process now requests you to identify the highest and lowest UNITS, not cost, for the time period.
• After you have those also note the costs associated with those two months.

What we are actually measuring is the change in the level of costs by the change in activity (this case “gallons of paint). Let’s assume the costs for the highest and lowest activity months were July and September respectively.
Units Costs
June       1,700     $3,500
July         3,000    $9,750
Aug.        2,340    $7,400
Sep.        1,550    $3,100
Oct.         2,100    $4,300
Nov.         2,750    $5,750
Dec.        1,980    $3,780

Because the high-low method dictates we choose the corresponding figures from the Units column we ignore the costs column regardless if it seems it should be higher or lower based on the units. Now we take the difference in costs and divide by the difference in units to find our variable cost per unit. Start with the highest figure July (3,000 units or “gallons”) and its cost $9,750 less than September (1,550 units or “gallons”)cost, $3,100. So:
$9,750 – $3,100 / 3,000 – 1,550 = Variable cost per unit
$6,650 / 1,450 = $4.58

Tips & Warnings

• Please note that the variable per unit cost never changes in fluctuations with the activity level. It’s the total cost that actually changes.
• Be sure to use the Units (highest and lowest quantities)to influence which months you use.
• The Hi-Lo (high low) method is by far the easiest to calculate of the different options to measure cost behavior which is why non-accounting managers (maybe a plant manager) like to use it. However, it’s not the most precise.
• Other methods include the scatter diagram and the most accurate, least squares regression analysis (which requires a computer program)

Sources : http://www.ehow.com/

 

What happens when the high low method ends up with a negative amount?

The high low method of determining the fixed and variable portions of a mixed cost relies on only two sets of data:

1) the costs at the highest level of activity

2) the costs at the lowest level of activity. If either set of data is flawed, the calculation can result in an unreasonable, negative amount of fixed cost.

To illustrate the problem, let’s assume that the total cost is $1,200 when there are 100 units of product manufactured, and $6,000 when there are 400 units of product are manufactured. The high low method computes the variable cost rate by dividing the change in the total costs by the change in the number of units of manufactured. In other words, the $4,800 change in total costs is divided by the change in units of 300 to yield the variable cost rate of $16 per unit of product. Since the fixed costs are the total costs minus the variable costs, the fixed costs will be calculated to a negative $400. This unacceptable answer results from total costs of $1,200 at the low point minus the variable costs of $1,600 (100 units times $16), or total costs of $6,000 at the high point minus the variable costs of $6,400 (400 units times $16).

The negative amount of fixed costs is not realistic and leads me to believe that either the total costs at either the high point or at the low point are not representative. This brings to light the importance of plotting or graphing all of the points of activity and their related costs before using the high low method. (The number of units uses the scale on the x-axis and the related total cost at each level of activity uses the scale on the y-axis.) It is possible that at the highest point of activity the costs were out of line from the normal relationship—referred to as an outlier. You may decide to use the second highest level of activity, if the related costs are more representative.

If the $6,000 of cost at the 400 units of activity is an outlier, you might select the next highest activity of 380 units having total costs of $4,000. Now the variable rate will be the change in total costs of $2,800 ($4,000 minus $1,200) divided by the change in the units manufactured of 280 (380 minus 100) for a variable rate of $10 per unit of product. Using the variable rate of $10 per unit manufactured will result in the fixed costs being a positive $200. The positive $200 of fixed costs is calculated at either 1) the low activity: total costs of $1,200 minus the variable costs of $1,000 (100 units at $10); or at 2) the high activity: total costs of $4,000 minus the variable costs of $3,800 (380 units at $10).

Sources : http://blog.accountingcoach.com/

 

Inventory

Assalamualaikum and good evening…

Now I would like to continue with inventory. Do you know what is inventory? When you hear the word inventory, what you imagine. Actually inventory is the entire stock of a business, including materials and finished product. It like a complete list of items such as goods in store.

There has 3 types of inventory :
1- Raw material
Includes all materials before they are placed into production.

2- Work-in-process
Manufactured products that are only partially completed at the date when the balance sheet is prepared.

3- Finished-goods
Manufactured goods that are complete and ready to sale.

We need to know these type of inventory when constructing balance sheet. We need to classified it and record the ending inventory according with their type on balance sheet.

Example :
Partial Balance sheet

Current asset
Raw materials                  xxx
Work in progress             xxx
Finished goods                xxx

 

Product Cost, Period Cost and Expenses

Assalamualaikum and good evening…

Today I would like to discuss about Expenses. Before that,do you know what is exactly the meaning of cost?
Cost is the sacrifice made that usually measured by the resources given up to achieve particular purpose.

So, what is expenses?
Expenses
The cost incurred when an asset is used up / sold for the purpose of generating revenue.

The part in expenses
1- Product cost / Inventoriable cost
A cost assigned to goods that either purchased / manufactured for resale.
It also used to value the inventory of manufactured goods / merchandise until the goods are sold. (COGS)
Merchandise inventory : Beginning Inventory + Purchase – Ending Inventory + Shipping charges
Manufactured goods : Beginning Inventory + COGM – Ending Inventory
COGM include Direct Labour + Direct Material + Manufacturing Overhead

2- Period cost
Identified with the period of time in which they incurred rather that with units of purchased / produced goods.
eg : Research and development expenses (R&D cost) , Selling and administrative expenses (salaries, commission, travel cost, advertising cost), Operating expenses