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Absorption vs. Variable Costing Explained

Chapter 7 of Managerial Accounting and Finance 3A discusses the differences between absorption and variable costing systems, including how to prepare income statements and reconcile net profits. It outlines the arguments for and against each costing method, emphasizing their implications for decision-making and reporting. The chapter also includes examples and self-study topics to enhance understanding of the material.

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Mkhize Khabazela
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23 views16 pages

Absorption vs. Variable Costing Explained

Chapter 7 of Managerial Accounting and Finance 3A discusses the differences between absorption and variable costing systems, including how to prepare income statements and reconcile net profits. It outlines the arguments for and against each costing method, emphasizing their implications for decision-making and reporting. The chapter also includes examples and self-study topics to enhance understanding of the material.

Uploaded by

Mkhize Khabazela
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd

Managerial Accounting and

Finance 3A
Absorption and variable costing
Chapter 7
Learning objectives (pg. 149)
1. Explain the differences between an absorption and a variable
costing system.
2. Prepare income statement based on a variable and absorption
costing.
3. Reconcile absorption and variable costing net profits.
4. Discuss the arguments for and against absorption and variable
costing.
Example 1
• Direct Materials R420
• Direct labour (4 hrs R240
• Manufacturing overheads R200
• Selling and admin (50% variable) R100
The company pre-determine fixed overhead rate is determined based
on direct labour hours.
The total budgeted labour hours were 47 000 while total annual
budgeted fixed overheads amounted to R1 410 000
Absorption costing system
Type of cost Product Cost Period Cost
Direct Materials
Direct labour
Variable overheads
Fixed overheads
Selling and Admin
Variable costing system
Type of cost Product Cost Period Cost
Direct Materials
Direct labour
Variable overheads
Fixed overheads
Selling and Admin
Comparing absorption and Variable costing
Fixed Production
costs

Income
AC product
statement
cost

Variable production
costs
Comparing absorption and Variable costing

Fixed Costs Income statement

Variable
production VC product Income
costs costs statement
Absorption costing
Item R
Sales XXX
Less: Cost of sales (XXX)
- Opening stock XXX
-Production XXX
- Closing stock (XXX)
Normal gross profit XXX
Over/ (Under) absorption XXX
Actual gross profit XXX
Less: Selling and admin (XX)
Variable selling and admin XX
Fixed Selling and admin XX
Net Profit XX
Variable costing
Item R
Sales XXX
Less: Variable manufacturing costs (XXX)
- Opening stock XXX
-Production XXX
- Closing stock (XXX)
Less: Variable selling and admin XXX
Contribution XXX

Less: Fixed costs (XXX)


Fixed production costs XXX
Fixed Selling and admin XXX
Net Profit XX
The profit Reconciliation

• Production> Sales

• Production < Sales

• Production = Sales
The profit Reconciliation
R
Absorption costing profit XX
- Change in stock levels XXX
- FOAR XX
Variable costing profit XX
Arguments for Absorption costing
• AC does not understate the importance of fixed costs

• AC avoids fictitious losses being reported.

• Fixed overheads are essential for production

• Consistent with external reporting requirements


Arguments for Variable costing
• It provides more useful information for decision making.

• It removes from profit the effect of inventory changes.

• Avoids fixed costs being capitalized in unsaleable inventory.


Reconciliations
• What is a reconciliation?

• What can cause profit levels to be different?


Reconciliations

• What can be reconciled?

• Which is the best way to reconcile?


Self-study
• External and internal reporting (pg. 150)

• Alternative denominator –level measures (pg. 158)

• Appendix. 7.1

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