CHAPTER 5

ALTERNATIVE COST ACCUMULATION SYSTEMS

Objective Questions
5-1. (d)
5-2. (d)
5-3. (c)
5-4. (d)
5-5. (b)
5-6. (a)
5-7. (a)
5-8. (b)
5-9. (c)
5-10. (b)

Review Questions
5-11. The contingency approach to management accounting is based on the premise that
there is no unanimously pertinent accounting system applying equally to all
organizations in all contexts. To a large extent, the use of specific attributes of an
accounting system will depend upon the unique company-specific circumstances.
The design effectiveness of an accounting system is subject to its potential to adapt to
changes in both external and internal factors. The management accounting systems,
thus, facilitate managers in realizing some desired company goals or outcomes. If a
management accounting system is found to be appropriate, then it is likely to provide
managers with enhanced information leading to better decision-making, and hence
achieving corporate goals and improving the bottom line.

5-12 The contingency-based theoretical framework is exhibited in the figure below. The
described process influences the choice of management accounting practice as well
 Alternative Cost Accumulation Systems 2

as the effectiveness of performance measurement and evaluation. The contingencies

are classified as external and internal factors. External factors indicate the features of
both business environment and accounting environment. External factors have an
impact on both the internal characteristics of an organization and its management
accounting practices. For example, cut-throat competition influences the choice of
strategy, structure of the organization and also the implementation of pertinent cost
management and control mechanisms. Internal contingencies pertain to company-
specific aspects, technology, and strategy. The effectiveness of performance
measurement and evaluation hinges on the internal factors and the management
accounting practices. In addition, feedback with regards to the efficacy of
performance measurement and evaluation can be further incorporated.

External Factors
 Business
Feedback
environment
 Accounting
environment

Effectiveness of
Management
Performance
Accounting
Measurement and
Practices
Evaluation

Internal Factors
 Company-specific
aspects
 Technology
 Strategy

Fig. Theoretical Framework of Contingency Approach

5-13. Product costing systems can be classified in relation to their level of

sophistication based on four dimensions for assigning indirect
costs. The first dimension of sophistication pertains to the number of cost pools.
The basic premise is that making use of a larger number of cost pools enables the
costing system to better represent the variability in cost pool resource consumption
by products/services. The second dimension relates to the usage of different types of
second stage cost drivers, with a diverse range better capturing the resources
consumed by cost objects. The third dimension applies to the use of transaction or
 Alternative Cost Accumulation Systems 3

duration drivers in the second stage of the allocation process. Duration drivers are
considered to be more sophisticated as they are based on the time taken to perform
an activity, in contrast to transaction drivers where the quantity of resources
consumed are assumed to be the same. Finally, higher levels of sophistication are
realized by relying more extensively on first stage resource drivers or direct
assignment.

5-14. Product costing systems can be classified in relation to their level of

sophistication. The figure below classifies the costing systems on a
continuum by their level of sophistication. The most simple system as
regards assignment of indirect costs to cost objects is the variable costing system
which is positioned on the left of the continuum. Throughput costing is an extreme
form of variable costing system, wherein, the central assumption is that direct
materials embodied in the final outputs sold to customers are the only variable costs.
As a result, it is inferred that all other expenses, including direct and indirect labour,
generally behave as fixed costs relative to changes in the volume and mix of the
company’s final outputs. As one moves along the continuum, the level of
sophistication increases, with activity based cost system representing the extreme
form of absorption costing. Activity based costing (ABC), as a method of absorption
costing looks backward in time and views different types of products (as well as sales
channels, distribution modes, and customers) place varying demands on the time and
usage of the resources. They trace and assign operating expenses into products and
all other final cost objects. ABC is, thus, located on the right side of the continuum as
the most sophisticated cost system with many cost pools, different types of cost
drivers, and extensive use of both direct first stage assignments or resource drivers
and second stage duration drivers.

Lowest Level of Sophistication Highest Level of Sophistication

Throughput Costing Activity Based Costing

 Alternative Cost Accumulation Systems 4

('Extreme form' of Variable ('Extreme form' of Absorption

Costing) Costing)
Fig. Levels of Cost System Sophistication
5-15. Theory of constraints focuses attention on constraints or bottlenecks within the
organization which hinder speedy production. A constraint can be a resource, a
company policy, or management way of thinking. TOC aims at alleviating, if not,
completely removing constraints or bottlenecks. The main objective is to maximise
the rate of manufacturing output, i.e., the throughput. TOC prioritizes the selection of
customers whose orders needs to be met based on the highest throughput-per-
constraint-minute for orders that use up the bottleneck resource.
TOC does not follow traditional accrual accounting. TOC’s principal objective
is to maximize throughput contribution, by maintaining as constant or, better still,
minimizing the amount of money used for inventory/investment, and operating
expense. Throughput contribution is the rate at which the system generates money
through sales. Inventory/investment is the total amount of investment made in
purchasing the assets and materials that a company plans to sell or will make use of
to manufacture products. Operating expense is the amount the system spends in
converting inventory into throughput. TOC is a short-term profit maximising
technique that is very similar in approach to variable costing. The only real
difference is that all conversion costs are assumed to be fixed costs.

5-16. Throughput is defined as sales rupees less direct materials in the products sold. More
specifically, direct materials include raw materials, components and sub-components
that are part of the products that are sold.
Throughput costing is an extreme version of variable costing as it considers
only direct material as variable and all labour and overhead costs as fixed. Thus,
throughput costing measures only unit-level spending for direct costs as the costs of
products or services. Proponents of throughput costing purport that adding any
indirect, past, or committed costs to product cost would create inappropriate
incentives to bring down the average cost per unit by making more products that can
be sold. Under throughput costing, only spending for resources is counted as costs of
products, and all other costs are expensed, thereby aligning the financial incentives of
 Alternative Cost Accumulation Systems 5

managers with the objective of using resources wisely.

5-17. Throughput costing is a significant development in modern accounting that enables

managers to be aware of the contribution of constrained resources to overall
corporate profitability. The benefits, from using throughput accounting as a
measurement and decision making tool, are that it:
 assists in making product or service mix decisions as it focuses sales efforts
on viable products or services;
 enables better judgment by identifying investments that give better return;
 facilitates make or buy decisions based on the real effect on the bottom line;
 clarifies the contribution of sub-system to the system as a whole; and
 makes realistic reporting of the effectiveness of the system all in all in relation
to its goal.
Traditional costing is premised on accounting concepts that were delineated to
meet the requirements of external and regulatory financial reporting. In order to be
reliable, accounting systems for decision-making under TOC must be resilient to
meet these standards. Specific criticisms levelled at TOC and throughput costing
system are that it is:
 valid only as short-term decision tool;
 relevant only if applied to the totality of the supply chain including
management, production, resources, and support; and
 dependent on conditions, which puts to doubt the comprehensibility of the
approach.

5-18. Variable costing measures the cost of product or service according to the resources
used to provide it. It includes only variable manufacturing overhead as a product cost
that flow through the manufacturing accounts. Absorption costing includes both
variable and fixed manufacturing overhead in the product costs that flow through the
manufacturing accounts. Therefore, the cost of the product would consist of its
variable costs (direct materials, direct labour, and variable production overheads)
plus a share of fixed production overheads using an allocation base.
 Alternative Cost Accumulation Systems 6

Variable costing and absorption costing differ in only one respect to accounting
for fixed manufacturing costs. Under variable costing, fixed manufacturing costs are
excluded from inventoriable costs and are a cost of the period in which they are
incurred. Under absorption costing, fixed manufacturing costs are inventoriable and
become a part of cost of goods sold in the period when sales occur.

5-19. The variable costing income statement is based on the contribution-margin format.
Under it, operating income is driven by the unit level of sales. Under absorption
costing, the income statement follows the gross-margin format. Operating income is
driven by the unit level of production, the unit level of sales, and the denominator
level used for assigning fixed costs.
When production exceeds sales, part of fixed manufacturing overhead will
remain in inventory. In variable costing, the entire amount of fixed manufacturing
overhead will be expensed since it is treated as a period cost. Thus, income computed
under full costing will exceed income computed under variable costing when
production exceeds sales.

5-20. When absorption costing is used, managers can increase current operating income by
producing more units for inventory. Producing for inventory absorbs more fixed
manufacturing costs into inventory and reduces costs expensed in the period. This
manipulation of income is the major negative consequence of treating fixed
manufacturing costs as inventoriable costs.
In throughput only unit-level direct cost is counted as product cost, thereby
leaving no leeway for managers to reduce average costs of committed or past
resource spending by increased production and storing costs in inventory by making
more than they can sell.

5-21. Throughput costing considers only direct material as variable and all labour and
overhead costs as fixed. Thus, throughput costing measures only unit-level spending
for direct costs as the costs of products or services. Proponents of throughput costing
maintain that adding any indirect, past, or committed costs to product cost would
 Alternative Cost Accumulation Systems 7

create inappropriate incentives to bring down the average cost per unit by making
more products that can be sold. Under throughput costing, only spending for
resources is counted as costs of products, and all other costs are expensed, thereby
aligning the financial incentives of managers with the objective of using resources
wisely.
Throughput costing treats all costs except direct materials as costs of the period
in which they are incurred. Variable costing includes only variable manufacturing
overhead as a product cost that flow through the manufacturing accounts. Absorption
costing includes both variable and fixed manufacturing overhead in the product costs
that flow through the manufacturing accounts. Thus, throughput costing results in a
lower amount of manufacturing costs being inventoried than either variable or
absorption costing.

5-22. Variable costing provides improved management information for planning and
decision-making as it provides distinct advantages over other costing systems,
including:
 provision of a ready source of data for solving decision problems, since it is
consistent with short-term decision making techniques;
 comprehension of the distinction between variable costs and fixed costs is
readily discernible for managers;
 accentuation of contribution margin encourages managers to concentrate on
sales volume, rather than production volume, as surplus production do not add
to profits;
 operation of the system is simple, since, materials and direct labour are the
main variable costs and almost all other costs are period costs;
 relation with cost control methods such as standard costs and flexible budgets;
and
 identification of minimum selling prices is easier.

5-23. It is far simpler to apply absorption costing in manufacturing industries as tangible

products and its related costs are easy to track through the manufacturing processes.
 Alternative Cost Accumulation Systems 8

However, it is difficult to apply absorption costing in service industries because the

necessary cost tracking systems do not normally exist. Many service organizations,
therefore, calculate average costs for their outputs, i.e., total variable and fixed costs
divided by units of service. The information gained may be not be that useful vis-à-
vis separating out the variable costs (if any) and calculating the contribution from
each product, but it is reasonably easy to understand.

5-24. In comparison with variable costing, absorption costing is more complex to operate
and lacks providing information necessary for decision-making. The limitations of
absorption costing relate to:
 absorption of manufacturing fixed overheads to product units by means of
overhead absorption rate can sometimes be arbitrary;
 inaccurate reflection of cost of goods sold, if a company produces and sells an
irregular amount of units each period;
 costs remain hidden in inventories, as inventories are carried on a company's
balance sheet as an asset until they are sold off; and
 possible manipulation of profits in the short-run by adjusting the inventory
level.
The consequences of these drawbacks are that many companies have
abandoned absorption costing in favour of activity based costing. Activity based
costing has been developed to deal with the perceived weaknesses of traditional
absorption costing.

5-25. The just-in-time concept, or JIT, is an inventory management system that is designed
to improve efficiency and reduce waste in a production process, as well as to
minimize inventory carrying costs. The aim is to receive production inputs only as
they are needed in the production process. When inventory stocks are kept to a
minimum, it is expected that quality would be maintained at each stage of the
production process. In fact, with a focus on the elimination of waste and inefficiency,
the adoption of a JIT philosophy is a strategic choice made by management.
JIT encourages companies to eliminate all types of inventory (materials, work-
 Alternative Cost Accumulation Systems 9

in-process and finished goods). If there is very little inventory, then changes in
inventories will be very small and both variable and absorption costing will show
basically the same operating income figure.

Exercises and Caselets

5-26. The treatment of the amount of fixed manufacturing overhead under alternative cost
accounting systems for Shifa Industries in 2014:
Absorption Variable Throughput
Costing Costing Costing
Fixed manufacturing overhead
₹2 - -
(₹1,000,000 ÷ 500,000 units)
Fixed manufacturing overhead
(a) - (c) ₹40,000 - -
expensed (20,000 × ₹2)
Fixed manufacturing overhead in
(d) ending inventory (₹1,000,000  ₹960,000 - -
₹40,000)

5-27. The operating statement of Vivid Weaves Ltd. for the current year:
(₹ '000)
Silk Wool Cotton Total
Rugs Rugs Rugs
Sales 1,000 2,000 500 3,500
Variable costs:
Materials 400 700 250 1,350
Direct labour 250 340 50 640
Variable production overheads 30 80 10 120
Total variable costs 680 1,120 310 2,110
Contribution 320 880 190 1,390
Fixed costs:
Production overheads 1,300
Selling and distribution overheads 800
Administration overheads 280
Total fixed costs 2,380
Profit (loss) (990)
 Alternative Cost Accumulation Systems 10

5-28. (a) For Roshesh Bakers, the unit product cost under absorption costing:
Period 1 Period 2
Fixed manufacturing overhead per unit ₹10 ₹10
(₹150,000 ÷ 15,000 units)
Variable production costs ₹40 ₹40
Unit product cost ₹50 ₹50

Comparative absorption costing income statement of Roshesh Bakers:

Period 1 Period 2 Total
Sales (12,000 units × ₹70 per unit; ₹840,000 ₹1,260,000 ₹2,100,000
18,000 units × ₹70 per unit )
Less: Cost of goods sold
Beginning inventory ₹0 ₹100,000
(2,000 units × ₹50 per unit)
Add: Cost of goods manufactured 750,000 750,000
(15,000 units × ₹50 per unit)
Good available for sale 750,000 850,000
Less: Ending inventory ₹100,000 ₹0
(2,000 units × ₹150 per unit)
Gross margin 190,000 410,000
Less: Selling and administrative 50,000 50,000
expenses (assumed balance fixed
expenses)
Operating income ₹140,000 ₹360,000 ₹500,000

(b) For Roshesh Bakers, the unit product cost under variable costing:
Period 1 Period 2
Variable production costs ₹40 ₹40
Unit product cost ₹40 ₹40

Comparative variable costing income statement of Roshesh Bakers:

Period 1 Period 2 Total
Sales (12,000 units × ₹70 per unit; ₹840,000 ₹1,260,000 ₹2,100,000
18,000 units × ₹70 per unit )
Less: Variable expenses
 Alternative Cost Accumulation Systems 11

Variable cost of goods sold 480,000 720,000

(12,000 units × ₹40 per unit;
18,000 units × ₹40 per unit )
Contribution 360,000 540,000
Less: Fixed expenses
Fixed production overhead 150,000 150,000
Fixed selling and administrative 50,000 50,000
expenses
Operating income ₹160,000 ₹340,000 ₹500,000

5-29. (a) The budgeted operating statement of Jugmug Thela Ltd. for the year using
absorption costing method:
Quantities ₹ per kg (₹ '000) (₹ '000)
('000 kg)
Sales 500 300 150,000
Production costs:
Add: Opening inventory Nil
Materials 600 70 42,000
Variable production overheads 600 80 48,000
Fixed production costs 600 15 9,000
99,000
Less: Closing inventory 100 165 16,500 82,500
Gross margin 67,500
Less: Selling and distribution costs
Selling and distribution variable cost 500 30 15,000
Selling and distribution fixed cost 5,000
20,000
Operating income 47,500

(b) The budgeted operating statement of Jugmug Thela Ltd. for the year using
variable costing method:
Quantities ₹ per kg (₹ '000) (₹ '000)
('000 kg)
Sales 500 300 150,000
Variable production costs:
Add: Opening inventory Nil
Materials 600 70 42,000
Variable production overheads 600 80 48,000
 Alternative Cost Accumulation Systems 12

90,000
Less: Closing inventory 100 150 15,000
75,000
Variable selling and distribution costs 500 30 15,000
Total variable costs 500 180 90,000
Contribution 60,000
Less: Fixed expenses
Production 9,000
Selling and distribution 5,000
Administration 2,000
Total fixed costs 16,000
Operating income 44,000

5-30. (a) For Heatrex Ltd., the unit product cost under absorption costing:
Year 1 Year 2 Year 3
Fixed manufacturing overhead per unit ₹60 ₹50 ₹75
(₹600,000 ÷ 10,000 units;
₹600,000 ÷ 12,000 units;
₹600,000 ÷ 8,000 units)
Variable manufacturing costs ₹100 ₹100 ₹100
Unit product cost ₹160 ₹150 ₹175

Comparative absorption costing income statement of Heatrex Ltd.:

Year 1 Year 2 Year 3 Total
Sales (10,000 units × ₹200 per unit) ₹2,000,000 ₹2,000,000 ₹2,000,000 ₹6,000,000
Less: Cost of goods sold
Beginning inventory ₹0 ₹0 300,000
(2,000 units × ₹150 per unit)
Add: Cost of goods manufactured 1,600,000 1,800,000 1,400,000
(10,000 units × ₹160 per unit;
12,000 units × ₹150 per unit;
8,000 units × ₹175 per unit)
Good available for sale 1,600,000 1,800,000 1,700,000
Less: Ending inventory ₹0 300,000 ₹0
(2,000 units × ₹150 per unit)
Gross margin 400,000 500,000 300,000
Less: Selling and administrative 200,000 200,000 200,000
expenses
 Alternative Cost Accumulation Systems 13

Operating income ₹200,000 ₹300,000 ₹100,000 ₹600,000

The value of ending inventory in Year 2 is ₹300,000.

(b) Profit fluctuates from year-to-year even though the number of units sold, the
selling price, and the cost structure remain constant because different quantities are
produced in each period. Differential production has an impact on the fixed
manufacturing overhead per unit calculations, which, has an impact on cost of goods
sold.

(c) For Heatrex Ltd., the unit product cost under variable costing:
Year 1 Year 2 Year 3
Variable manufacturing costs ₹100 ₹100 ₹100
Unit product cost ₹100 ₹100 ₹100

Variable costing income statement of Heatrex Ltd.:

Year 1 Year 2 Year 3 Total
Sales (10,000 units × ₹200 per unit) ₹2,000,000 ₹2,000,000 ₹2,000,000 ₹6,000,000
Less: Variable expenses
Variable cost of goods sold 1,000,000 1,000,000 1,000,000
(10,000 units × ₹100 per unit)

Contribution 1,000,000 1,000,000 1,000,000

Less: Fixed expenses
Fixed manufacturing overhead 600,000 600,000 600,000
Fixed selling and administrative
expenses 200,000 200,000 200,000

Operating income ₹200,000 ₹200,000 ₹200,000 ₹600,000

The value of ending inventory in Year 2 is ₹200,000 (2,000 units × ₹100 per unit).

(d) When using variable costing system, the profit does not fluctuate from year-to-
year because fixed manufacturing overhead is treated as a period cost and expensed
each year even if more units are produced than sold. The operating income is the
same under variable and absorption costing in Year 1, since, the quantity produced is
equal to the quantity sold. Income under absorption costing is higher than variable
 Alternative Cost Accumulation Systems 14

costing income in Year 2 since the quantity produced is greater than the quantity
sold. Income under absorption costing is less than income under variable costing in
Year 3 since the quantity produced is less than the quantity sold.

5-31. (a) For Kitchen Master Ltd., the unit product cost under absorption costing:
2012 2013 2014
Fixed manufacturing overhead per unit ₹100 ₹100 ₹125
(₹200,000 ÷ 2,000 units;
₹200,000 ÷ 2,000 units;
₹200,000 ÷ 1,600 units)
Variable manufacturing costs ₹80 ₹80 ₹80
Unit product cost ₹180 ₹180 ₹205

Absorption costing income statement of Kitchen Master Ltd.:

2012 2013 2014 Total
Sales ₹400,000 ₹360,000 ₹360,000 ₹1,120,000
(2,000 units × ₹200 per unit;
1,800 units × ₹200 per unit;
1,800 units × ₹200 per unit)
Less: Cost of goods sold
Beginning inventory ₹0 ₹0 36,000
(200 units × ₹180 per unit)
Add: Cost of goods manufactured 360,000 360,000 328,000
(2,000 units × ₹180 per unit;
2,000 units × ₹180 per unit;
1,600 units × ₹205 per unit)
Good available for sale 360,000 360,000 364,000
Less: Ending inventory ₹0 36,000 ₹0
(200 units × ₹180 per unit)
Gross margin 40,000 36,000 (4,000)
Less: Selling and administrative 3,000 3,000 3,000
expenses
Operating income ₹37,000 ₹33,000 ₹(7,000) ₹63,000

The value of ending inventory in 2013 is ₹36,000.

 Alternative Cost Accumulation Systems 15

(b) For Kitchen Master Ltd., the unit product cost under variable costing:
2012 2013 2014
Variable manufacturing costs ₹80 ₹80 ₹80
Unit product cost ₹80 ₹80 ₹80

Variable costing income statement of Kitchen Master Ltd.:

2012 2013 2014 Total
Sales ₹400,000 ₹360,000 ₹360,000 ₹1,120,000
(2,000 units × ₹200 per unit;
1,800 units × ₹200 per unit;
1,800 units × ₹200 per unit)
Less: Variable expenses
Variable cost of goods sold 160,000 144,000 144,000
(2,000 units × ₹80 per unit;
1,800 units × ₹80 per unit;
1,800 units × ₹80 per unit)
Contribution 240,000 216,000 216,000
Less: Fixed expenses
Fixed manufacturing overhead 200,000 200,000 200,000
Fixed selling and administrative
expenses 3,000 3,000 3,000

Operating income ₹37,000 ₹13,000 ₹13,000 ₹63,000

The value of ending inventory in 2013 is ₹16,000 (200 units × ₹80 per unit).

(c) Under absorption costing, management could manipulate profit in 2013 by

overproducing (producing more units than really needed in 2013). This results in
fixed manufacturing overhead being buried in ending inventory. It can be seen that in
2013, the difference in profit between absorption and variable costing is equal to the
difference in ending inventory under absorption and variable costing.

5-32. (a) For Kite Tree Ltd., the unit product cost under absorption costing:
2013 2014
Direct material per unit ₹200 ₹200
Direct labour per unit ₹400 ₹400
Variable manufacturing overhead per unit ₹50 ₹50
 Alternative Cost Accumulation Systems 16

Fixed manufacturing overhead per year ₹10 ₹20

(₹100,000 ÷ 10,000 units;
₹100,000 ÷ 5,000 units)
Unit product cost ₹660 ₹670

Absorption costing income statement of Kite Tree Ltd.:

2013 2014 Total
Sales ₹8,000,000 ₹7,000,000 ₹15,000,000
(8,000 units × ₹1,000 per unit;
7,000 units × ₹1,000 per unit)
Less: Cost of goods sold
Beginning inventory ₹0 ₹1,320,000
(2,000 units × ₹660 per unit)
Add: Cost of goods manufactured 6,600,000 3,350,000
(10,000 units × ₹660 per unit;
5,000 units × ₹670 per unit)
Good available for sale 6,600,000 4,670,000
Less: Ending inventory ₹1,320,000 ₹0
(2,000 units × ₹660 per unit)
Gross margin 2,720,000 2,330,000
Less: Selling and administrative expenses 50,000 50,000

Operating income ₹2,670,000 ₹2,280,000 ₹4,950,000

(b) The performance of the company is actually not worse in 2014, since, the
company had the same cost structure and the same level of sales. The difference is
due to greater production in 2013 which lowered unit cost and buried fixed
manufacturing overhead in inventory.

(c) For Kite Tree Ltd., the unit product cost under variable costing:
2013 2014
Direct material per unit ₹200 ₹200
Direct labour per unit ₹400 ₹400
Variable manufacturing overhead per unit ₹50 ₹50
Unit product cost ₹650 ₹650
 Alternative Cost Accumulation Systems 17

Variable costing income statement of Kite Tree Ltd.:

2013 2014 Total
Sales ₹8,000,000 ₹7,000,000 ₹15,000,000
(8,000 units × ₹1,000 per unit;
7,000 units × ₹1,000 per unit)
Less: Variable expenses
Variable cost of goods sold 5,200,000 4,550,000
(8,000 units × ₹650 per unit;
7,000 units × ₹650 per unit)
Contribution 2,800,000 2,450,000
Less: Fixed expenses
Fixed manufacturing overhead 100,000 100,000
Fixed selling and administrative expenses 50,000 50,000
Operating income ₹2,650,000 ₹2,300,000 ₹4,950,000

(d) Variable costing presents a more realistic view of corporate performance, since,
income is the same in both years. This is consistent with companies having the same
cost structure and level of sales in both years.

5-33. a) (i) & (ii) For India Telecom Ltd., the unit product cost under absorption costing
and variable costing:
Absorption Costing Variable Costing
Direct materials 480 480
Variable manufacturing overhead 20 20
Fixed manufacturing overhead 300 -
(₹3,600,000 ÷ 12,000 units)
Unit product cost 800 500

(b) Absorption costing income statement of India Telecom Ltd.:

Sales (10,000 units × ₹1,500 per unit) ₹15,000,000
Less: Cost of goods sold
Beginning inventory ₹0
Add: Cost of goods manufactured
(12,000 units × ₹800 per unit) 9,600,000
Good available for sale 9,600,000
Less: ending inventory 1,600,000 8,000,000
(2,000 units × ₹800 per unit)
 Alternative Cost Accumulation Systems 18

Gross margin 7,000,000

Less: Selling and administrative expenses 6,800,000
[(12% × ₹15,000,000) + ₹5,000,000]
Operating income ₹200,000

(c) Variable costing income statement of India Telecom Ltd.:

Sales (10,000 units × ₹1,500 per unit) ₹15,000,000
Less: Variable expenses
Variable cost of goods sold:
Beginning inventory ₹0
Add: Variable manufacturing costs 6,000,000
(12,000 units × ₹500 per unit)
Goods available for sale 6,000,000
Less: Ending inventory
(2,000 units × ₹500 per unit) 1,000,000
Variable cost of goods solda 5,000,000
Variable selling and administrative expenses 1,800,000 6,800,000
Contribution margin 8,200,000
Less: Fixed expenses
Fixed manufacturing overhead 3,600,000
Fixed selling and administrative expenses 5,000,000 8,600,000
Operating loss ₹(400,000)
Note: aThis could be computed more simply as 10,000 units × 500 per unit = ₹5,000,000

(d) A manager may prefer to take the statement prepared under the absorption costing
in part (b), when meeting with a group of prospective investors, since, it shows a
profit for the month. As long as inventory levels are rising, absorption costing will
report higher profits than variable costing. The ethics of this approach, however, are
debatable.

(e) Reconcile the absorption costing and variable costing net operating income
figures:
Variable costing operating loss ₹(400,000)
Add: Fixed manufacturing overhead cost deferred in inventory 600,000
under absorption costing (2,000 units × ₹300 per unit)
Absorption costing operating income ₹200,000
 Alternative Cost Accumulation Systems 19

5-34. (a) (i) & (ii) For Colaba Company, the unit product cost under absorption costing and
variable costing:
Absorption Costing Variable Costing
Direct materials ₹5 ₹5
Direct labour ₹10 ₹10
Variable manufacturing overhead ₹5 ₹5
Fixed manufacturing overhead ₹20 -
(₹300,000 ÷ 15,000 units)
Unit product cost ₹40 ₹20

(b) Variable costing income statement of Colaba Company:

January February
Sales ₹600,000 ₹900,000
(12,000 units × ₹50 per unit;
18,000 units × ₹50 per unit)
Less: Variable expenses
Variable cost of goods sold 240,000 360,000
(12,000 units × ₹20 per unit;
18,000 units × ₹20 per unit)
Variable selling and administrative expenses 12,000 18,000
(12,000 units × ₹1 per unit;
18,000 units × ₹1 per unit)
Contribution margin 348,000 522,000
Less: Fixed expenses
Fixed manufacturing overhead 300,000 300,000
Fixed selling and administrative expenses 100,000 100,000
Operating income ₹(52,000) ₹122,000

c) Reconciling the variable costing and absorption costing operating income figures
for January and February:
January February
Variable costing operating income ₹(52,000) ₹122,000
Add: Fixed manufacturing overhead cost
deferred in inventory under absorption costing 60,000
(3,000 units × ₹20 per unit)
 Alternative Cost Accumulation Systems 20

Less: Fixed manufacturing overhead cost

released in inventory under absorption costing (60,000)
(3,000 units × ₹20 per unit)
Absorption costing operating income ₹8,000 ₹62,000

5-35. (a) Profit performance under throughput costing for Rafiq & Sons Ltd.:
Month 1 Month 2 Month 3
Sales revenue ₹50,000 ₹50,000 ₹50,000
a
Less: Throughput cost of units sold (10,000) (8,333) (10,000)
Throughput ₹40,000 ₹41,667 ₹40,000
Less: Operating expenses
Direct labour (12,000) (11,667)b (9,000)
Indirect labour (8,000) (5,000) (10,000)
Indirect operating cost (16,000) (16,000) (16,000)
Operating income ₹4,000 ₹9,000 ₹5,000
a
Notes: (₹10,000 ÷ 600) × 500
b
(₹14,000 ÷ 600) × 500

(b) Profit performance under variable costing for Rafiq & Sons Ltd.:
Month 1 Month 2 Month 3
Sales revenue (₹) ₹50,000 ₹50,000 ₹50,000
Less: Variable cost of units sold
Direct material (10,000) (8,333) a (10,000)
Direct labour (12,000) (11,667) b (9,000)
Contribution margin ₹28,000 ₹30,000 ₹31,000
Less: Fixed costs
Indirect labour (8,000) (4,770) c (10,000)
Indirect operating cost (16,000) (16,000) (16,000)
Operating income (₹) ₹4,000 ₹9,230 ₹5,000
Notes: a (₹10,000 ÷ 600) × 500
b
(₹14,000 ÷ 600) × 500
c
₹5,000 - (100 × ₹2.3)

(c) Profit performance under absorption costing for Rafiq & Sons Ltd.:
Month 1 Month 2 Month 3
Sales revenue ₹50,000 ₹50,000 ₹50,000
Less: Absorption cost of units sold
 Alternative Cost Accumulation Systems 21

Direct material a (10,000) (8,333) (10,000)

b
Direct labour (12,000) (11,667) (9,000)
c
Indirect labour (8,000) (3,975) (10,000)
Gross margin ₹20,000 ₹26,025 ₹21,000
Less: Indirect operating cost (16,000) (16,000) (16,000)
Operating income ₹4,000 ₹10,025 ₹5,000
a
Notes: (₹10,000 ÷ 600) × 500
b
(₹14,000 ÷ 600) × 500
c
(₹4,770 ÷ 600) × 500

5-36. (a) (i) Throughput cost of units sold = ₹367,000 (Refer to working note 1)
(ii) Variable cost of units sold = ₹534,000 (Refer to working note 2)
(iii) Absorption cost of units sold = ₹1,170,000 (Refer to working note 3)

(b) The following table depicts the contribution to profit, operating expense and
operating income under alternate costing methods for Dakshin Computers Ltd.
(₹ ‘000)
Costing Method Contribution to Operating Operating
Profit Expense Income
Throughput 367 1,357 976
Variable 534 1,157 1,009
Absorption 1,170 440 1,090

(c) The following table reconciles the differences in operating income measures
under alternate costing methods for Dakshin Computers Ltd.
(₹ ‘000)
Conversion and
Operating
Costing Method Total Expense Indirect Cost added to
Income
Inventory
Throughput 976 1,724
0
(Working note 1) (₹367 + ₹1,357)
Difference between
(33) 33
Throughput and Variable 33
Variable 1,009 1,691 33
(Working note 2) (₹534 + ₹1,157) = 2 units × ₹16.70
Difference between
81 (81) 81
Variable and Absorption
114
Absorption 1,090 1,610
= 2 units × (₹16.70 +
(Working note 3) (₹1,170 + ₹440)
487 ÷ 12)
 Alternative Cost Accumulation Systems 22

Working Notes:
1. Profit performance under throughput costing for Dakshin Computers Ltd.:
(₹ ‘000)
Sales revenue 2,700
Less: Throughput cost of units solda 367
Throughput 2,333
Less: Operating expenses
Direct labourb 167
Depreciation 180
Manufacturing supervisor salaries 50
Manufacturing overheads 520
Marketing costs 440 1,357
Operating income 976
a
Notes: (₹440,000 ÷ 12,000) × 10,000
b
(₹200,000 ÷ 12,000) × 10,000

2. Profit performance under variable costing for Dakshin Computers Ltd.:

(₹ ‘000)
Sales revenue 2,700
Less: Variable cost of units sold
Direct materiala 367
Direct labourb 167 534
Contribution margin 2,166
Less: Operating expenses
Depreciation 180
Manufacturing supervisor salaries 50
Manufacturing overheadsc 487
Marketing costs 440 1,157
Operating income 1,009
a
Notes: (₹440,000 ÷ 12,000) × 10,000
b
(₹200,000 ÷ 12,000) × 10,000
c
₹520,000  ₹33 (2 units × ₹16.7)

3. Profit performance under absorption costing for Dakshin Computers Ltd.:

(₹ ‘000)
Sales revenue 2,700
Less: Absorption cost of units sold
 Alternative Cost Accumulation Systems 23

Direct materiala 367

b
Direct labour 167
Depreciation 180
Manufacturing supervisor salaries 50
c
Manufacturing overheads 406 1,170
Gross margin 1,530
Less: Operating expenses
Marketing costs 440
Operating income 1,090
Notes: a (₹440,000 ÷ 12,000) × 10,000
b
(₹200,000 ÷ 12,000) × 10,000
c
(₹487,000 ÷ 12,000) × 10,000

5-37. (a)
Girdhari Enterprises
Absorption Cost Income Statement

2013 2014
Sales revenue ₹10,000,000 ₹10,000,000
Less: Cost of goods sold
Beginning inventory 0 0
a
Add: Cost of goods manufactured 5,850,000 7,650,000b
Goods available for sale ₹5,850,000 ₹7,650,000
Less: Ending inventory 0 2,025,000c
Cost of goods sold 5,850,000 5,625,000
Gross Margin ₹4,150,000 ₹4,375,000
Less: Marketing and administrative expenses
Variable marketing and administrative expenses 625,000 625,000
Committed marketing and administrative expenses 850,000 850,000
Net operating income ₹2,675,000 ₹2,900,000
Notes: 250,000 × ₹23.40 [20 + 3.40 (850,000 ÷ 250,000)] = ₹5,850,000
a
b
340,000 × ₹22.50 [20 + 2.50 (850,000 ÷ 340,000)] = ₹7,650,000
c
90,000 × ₹22.50 = ₹2,025,000

(b)
Girdhari Enterprises
Variable Cost Income Statement

2013 2014
Sales revenue ₹10,000,000 ₹10,000,000
Less: Variable cost of goods sold
 Alternative Cost Accumulation Systems 24

Beginning inventory 0 0
a
Add: Variable manufacturing costs 5,000,000 6,800,000b
Goods available for sale 5,000,000 6,800,000
Less: Ending inventory 0 1,800,000c
Variable cost of goods sold 5,000,000 5,000,000
Add: Variable marketing and administrative expenses 625,000 625,000
Contribution margin ₹4,375,000 ₹4,375,000
Less: Committed costs
Manufacturing costs 850,000 850,000
Marketing and administrative expenses 850,000 850,000
Net operating income ₹2,675,000 ₹2,675,000
Notes: a 250,000 × ₹20 = ₹5,000,000
b
340,000 × ₹20 = ₹6,800,000
c
90,000 × ₹20 = ₹1,800,000

(c) Absorption costing (full costing) includes both variable and fixed manufacturing
overhead in the product costs that flow through the manufacturing accounts. Variable
costing, on the other hand, measures the cost of product or service according to the
resources used to provide it. It includes only variable manufacturing overhead as a
product cost that flow through the manufacturing accounts. This is quite evident from
the income statements prepared under both the costing methods.
Further, under absorption costing if inventories increase then some of the fixed
manufacturing costs of the current period will not appear on the income statement as
part of cost of goods sold. Instead, these costs are deferred to a future period and are
carried on the balance sheet as part of the inventory account. Such a deferral of cost
is known as fixed manufacturing overhead deferred in inventory.
The process involved can be explained by referring to income statements
prepared above for the year 2014. During the current period 340,000 units have been
produced but only 250,000 units have been sold leaving 90,000 unsold units in the
ending inventory. Under the absorption costing system each unit produced was
assigned ₹2.50 in committed manufacturing cost. Therefore, each unit going into
inventory at the end of the period has ₹2.50 in committed manufactured cost attached
to it, or a total of ₹225,000 for 90,000 units (90,000 × ₹2.50). This fixed
manufacturing overhead cost of the current period deferred in inventory to the next
period, when hopefully these units will be taken out of inventory and sold. This
 Alternative Cost Accumulation Systems 25

deferral of ₹225,000 of fixed manufacturing overhead costs can be clearly seen by

analyzing the ending inventory under the absorption costing method:
Variable manufacturing costs (90,000 units × ₹20 per unit) ₹1,800,000
Fixed manufacturing overhead costs (90,000 units × ₹2.50 per unit) ₹ 225,000
Total ending inventory value ₹2,025,000

In summary, under absorption costing, of the ₹850,000 in committed

manufacturing costs incurred during the period, only ₹625,000 has been included in
the cost of goods sold. The remaining ₹225,000 (90,000 units not sold ₹2.50 per
unit) has been deferred in inventory to the next period. Under variable costing
method the entire ₹850,000 in committed manufacturing costs has been treated as an
expense of the current period (see the bottom portion of the variable costing income
statement).

5-38. (a) The unit cost under absorption in presenting inventory on the balance sheet at
December 31 is ₹ 7.70 (See working note 1, 154,000 ÷ 20,000 units).

(b) The unit cost under absorption in presenting inventory on the balance sheet at
December 31 is ₹ 5.60 (See working note 2, 112,000 ÷ 20,000 units).

(c) The operating profit using variable costing is ₹ 182,000 (See working note 2).

(d) The operating profit using absorption costing is ₹ 224,000 (See working note 1).

(e) The ending inventory using absorption costing is ₹ 154,000 (See working note 1).

(f) The ending inventory using variable costing is ₹ 112,000 (See working note 2).

Working Notes:

1. Profit performance of Promila Ltd. under absorption costing:

Sales Revenue ₹960,000
Less: Variable cost of units sold
Direct materiala ₹200,000
 Alternative Cost Accumulation Systems 26

Direct labourb 120,000

Factory overhead (unit-level) 64,000
c
Factory overhead (capacity) 168,000
3
Marketing and administrative costs (unit-level) 64,000 616,000
Gross Margin ₹344,000
Less: Operating expenses
Marketing and administrative costs (capacity) 120,000
Operating Income ₹224,000
Ending inventory (₹)
= Beginning inventory, 0 + Costs of goods completed, ₹154,000
[100,000 × (2.50 + 1.50 + 0.80 + 0.80)] + 210,000  Costs
of goods sold, 616,000
Notes: a (₹250,000 ÷ 100,000) × 80,000
b
(₹250,000 ÷ 100,000) × 80,000
c
(₹210,000 ÷ 100,000) × 80,000

2. Profit performance of Promila Ltd. under variable costing:

Sales Revenue ₹960,000
Less: Variable cost of units sold
Direct materiala ₹200,000
b
Direct labour 120,000
Factory overhead (unit-level) 64,000
Marketing and administrative costs (unit-level) 64,000 448,000
Contribution margin ₹512,000
Less: Operating expenses:
Factory overhead (capacity) c 210,000
Marketing and administrative costs (capacity) 120,000 330,000
Operating income ₹182,000
Ending inventory (₹)
= Beginning inventory, 0 + Costs of goods completed, ₹112,000
[100,000 × (2.50 + 1.50 + 0.80 + 0.80)]  Costs of goods
sold, 448,000
Notes: a (₹250,000 ÷ 100,000) × 80,000
b
(₹250,000 ÷ 100,000) × 80,000
c
₹240,000 - 30,000 (20,000 units × ₹1.50)

5-39. (a) (i) & (ii) For Ahmed Medical Disposable Devices Ltd., the unit product cost of
disposable gloves for each year is as follows:
 Alternative Cost Accumulation Systems 27

Absorption Variable Costing

Costing
2013 2014 2013 2014
Variable production costs ₹40 ₹40 ₹40 ₹40
Fixed manufacturing overhead costs:
(₹1,500,000 ÷ 100,000 units; ₹15 - -
₹1,500,000 ÷ 125,000 units) ₹12
Unit product cost ₹55 ₹52 ₹40 ₹40

(b) Variable costing income statement of Ahmed Medical Disposable Devices Ltd.
is as follows:
2013 2014
Sales ₹20,000,000 ₹20,000,000
Less: Variable expenses
Variable cost of goods sold:
Beginning inventory ₹0 ₹0
Add: Variable manufacturing 4,000,000 5,000,000
costs
Goods available for sale 4,000,000 5,000,000
Less: Ending inventory 0 1,000,000
a
Variable cost of goods sold 4,000,000 4,000,000
Variable selling expense and 500,000 4,500,000 500,000 4,500,000
administrative expenses
100,000 units × ₹5 per unit)
Contribution margin 15,500,000 15,500,000
Less: Fixed expenses
Fixed manufacturing overhead 1,500,000 1,500,000
Fixed selling and administrative 500,000 2,000,000 500,000 2,000,000
expenses
Operating income ₹13,500,000 ₹13,500,000
Note: aThis could be computed more simply as 100,000 units × ₹40 per unit = ₹4,000,000.

(c) Reconciling the variable costing and absorption costing net operating income
figures for each year :
2013 2014
Variable costing operating income ₹13,500,000 ₹13,500,000
Add: Fixed manufacturing overhead cost
deferred in inventory under absorption costing 300,000
(25,000 units × ₹12 per unit)
 Alternative Cost Accumulation Systems 28

Absorption costing operating income ₹13,500,000 ₹13,800,000

(d) The increase in production in 2014, in the face of level sales, caused a build-up of
inventory and a deferral of a portion of fixed manufacturing overhead costs
(₹300,000) to the next year. Thus, operating income was ₹300,000 higher in 2014
than in 2013, even though the same number of units were sold each year. In
summary, by increasing production and building up inventory, profits increased
without any increase in sales or reduction in costs. This is a major criticism of the
absorption costing approach.

(e) Under JIT, the operating income for 2014 using absorption costing would have
been ₹13,500,000  the same as in 2013. With production geared to sales, there
would have been no inventory build-up at the end of 2014 resulting in no fixed
manufacturing overhead costs deferred in inventory. The entire ₹1,500,000 in fixed
manufacturing overhead costs would have been charged against 2014 operations,
rather than having ₹300,000 of it deferred to future periods through the inventory
account. Thus, operating income would have been about the same in each year under
both variable and absorption costing.