Management Accounting: Concepts, Techniques & Controversial Issues

Chapter 2
Cost Accounting Systems and Manufacturing Statements

James R. Martin, Ph.D., CMA
Professor Emeritus, University of South Florida

MAAW's Textbook Table of Contents

LEARNING OBJECTIVES

After you have read and studied this chapter, you should be able to:

1. Describe the five components of a cost accounting system.
2. Define the concepts of pure historical, normal historical and standard cost systems.
3. Discuss four types of inventory valuation methods.
4. Describe and compare four types of cost accumulation methods.
5. Discuss three types of cost flow assumptions.
6. Explain the difference between perpetual and periodic systems.
7. Describe four functions of information or cost accounting systems.
8. Discuss the characteristics and requirements of the four functions referred to in objective 7.
9. Describe the manner in which a full absorption costing income statement is developed.
10. Describe the manner in which a direct (or variable) costing income statement is developed.
11. Prepare a full absorption costing income statement.
12. Prepare a direct (or variable) costing income statement.
13. Relate the matching concept to the statements in learning objectives 11 and 12.
14. Explain the difference between net income determined under full absorption costing and net income determined under direct costing.

INTRODUCTION

This chapter builds a foundation for developing an operational cost accounting system by describing the main components of such a system. In addition, the chapter includes discussions of the various functions of information systems and illustrations of the basic types of financial results that are obtained from cost accounting systems. More specifically, the purpose of this chapter is to: 1) describe the five major components of a cost accounting system, including the various alternatives associated with each component, 2) describe the four functions of information or cost accounting systems and 3) to illustrate the two major types of income statements that are generated from these systems. The chapter contains three main sections that are related to these three objectives. The emphasis in this chapter is still primarily conceptual, although several illustrations and practice problems require the preparation of income statements. While these illustrations and problems are mainly mechanical exercises, the objective is to build a foundation for our study of cost accounting systems that includes the necessary technical, as well as conceptual knowledge. An ability to prepare income statements is an important part of this foundation because these statements provide an overall summary of a company’s financial performance. They are used frequently in subsequent chapters.

This is an important chapter because it provides a foundation for studying subsequent chapters. Developing an understanding of how and why cost accounting systems are developed and used is a cumulative process. We will build on these concepts throughout the text.

THE FIVE PARTS OF A COST ACCOUNTING SYSTEM

A cost accounting system requires five parts that include: 1) an input measurement basis, 2) an inventory valuation method, 3) a cost accumulation method, 4) a cost flow assumption, and 5) a capability of recording inventory cost flows at certain intervals. These five parts and the alternatives under each part are summarized in Exhibit 2-1. Note that many possible cost accounting systems can be designed from the various combinations of the available alternatives, although not all of the alternatives are compatible. Selecting one part from each category provides a basis for developing an operational definition of a specific cost accounting system.

1) INPUT MEASUREMENT BASES

The basis of a cost accounting system begins with the type of costs that flow into and through the inventory accounts. There are three alternatives including: pure historical costing, normal historical costing and standard costing. These concepts are illustrated in Exhibit 2-2 and discussed individually below.

Pure Historical Costing

In a pure historical cost system, only historical costs flow through the inventory accounts. Historical costs refers to the costs that have been recorded. The term actual costs is sometimes used instead, but the term "actual" seems to imply that there is one true cost associated with a particular output. But determining the cost of a product, or service requires many cost allocations, e.g., allocating the cost of fixed assets to time periods, and allocating indirect manufacturing costs, or overhead to products. Since there are many alternative allocation methods, (e.g., straight line or accelerated depreciation) the calculated cost of a unit of product or service simply represents an attempt to approximate the true cost. A pure historical cost system is symbolized in the enlarged view shown below.

Normal Historical Costing

Normal historical costing uses historical costs for direct material and direct labor, but overhead is charged, or applied to the inventory using a predetermined overhead rate per activity measure. Typical activity measures include direct labor hours, or direct labor costs. The Amount of factory overhead charged to the inventory is determined by multiplying the predetermined rate by the actual quantity of the activity measure. The difference between the applied overhead costs and the actual overhead costs represents an overhead variance. The concept is represented in the enlarged graphic shown below. This type of cost system is illustrated in Chapters 4 and 5. Predetermined overhead rates and overhead variance analysis are discussed in those and subsequent chapters.

Standard Costing

In a standard cost system, all manufacturing costs are applied, or charged to the inventory using standard or predetermined prices, and quantities. The differences between the applied costs and the actual costs are charged to variance accounts as shown symbolically in the enlarged graphic below. The variances provide the basis for the concept of accounting control, that is somewhat different from the statistical control concept discussed in Chapter 1. This type of basic cost system is illustrated in Chapters 9 and 10. Standard cost variance analysis is given considerable attention in Chapter 10.

2) FOUR INVENTORY VALUATION METHODS

The four inventory valuation methods that appear in Exhibit 2-1 are arranged in the order of the Amount of cost that is traced to the inventory. The throughput method involves tracing the least Amount of cost to the inventory, while the activity based method includes tracing the greatest Amount of costs to the inventory. In direct (or variable) costing, a greater Amount of cost is traced than in the throughput method, but a lesser Amount than in the full absorption method. Direct costing and full absorption costing are the traditional methods, while the throughput and activity based methods are relatively new. These inventory valuation methods are very important because they control the manner in which net income is determined. As we shall see is this chapter and subsequent chapters, the Amount of net income can vary substantially for different inventory valuation methods. The four methods are described below. A symbolic overview of the four methods is provided in Exhibit 2-3.

The Throughput Method

The throughput method was developed to complement a concept referred to as the theory of constraints. In this method only direct material costs are charged to the inventory. All other costs are expensed during the period. The concept is symbolized in the enlargement below. Sales, less direct material costs is referred to as throughput which reflects how the method got its’ name. The throughput method does not provide proper matching (as defined by GAAP) because all manufacturing cost, other than direct material are expensed when incurred rather than capitalized in the inventory. Therefore, the throughput method is not acceptable for external reporting although advocates argue that it provides many advantages for internal reporting. The throughput method is described in more detail in Chapter 8 along with the broader concept referred to as the theory of constraints.

The Direct or Variable Method

In the direct (or variable) method, only the variable manufacturing costs are capitalized, or charged to the inventory. Fixed manufacturing costs flow into expense in the period incurred as illustrated in the enlargement below from Exhibit 2-3. This method provides some advantages and some disadvantages for internal reporting, (as we shall see in Chapters 8, 11, 12 and 13). However, it does not provide proper matching because the current fixed costs associated with producing the inventory are charged to expense regardless of whether or not the output is sold during the period. For this reason direct costing is not generally acceptable for external reporting.

The Full Absorption Method

Full absorption costing (also referred to as full costing and absorption costing) is a traditional method where all manufacturing costs are capitalized in the inventory, i.e., charged to the inventory and become assets. This means that these costs do not become expenses until the inventory is sold. In this way, matching is more closely approximated. All selling and administrative costs are charged to expense however, as indicated in the enlargement provided below from Exhibit 2-3. Technically, full absorption costing is required for external reporting, although many companies apparently use something less than a pure full absorption costing system.¹ The full absorption method is also frequently used for internal reporting. The second major section of this chapter compares the income statements for full absorption costing with those used for direct costing because they are by far the dominant methods. Chapters 4, 5, 6, 9 and 10 are based on full absorption costing. Chapters 8 and 12 compare all four methods and discuss the behavioral implications of using the different methods.

The Activity Based Method

Activity based costing is a relatively new type of procedure that can be used as an inventory valuation method.² The technique was developed to provide more accurate product costs. This improved accuracy is accomplished by tracing costs to products through activities. In other words, costs are traced to activities (activity costing) and then these costs are traced, in a second stage, to the products that use the activities. The concept of ABC is illustrated in the enlarged graphic below. Another way to express the idea is to say that activities consume resources and products consume activities. Essentially, an attempt is made to treat all costs as variable, recognizing that all costs vary with something, whether it is production volume or some non-production volume related phenomenon. Both manufacturing costs and selling and administrative costs are traced to products in an ABC system. Note that treating selling and administrative costs in this way is not acceptable for external reporting.

In traditional full absorption costing and direct (or variable) costing systems, indirect manufacturing costs are allocated to products on the basis of a production volume related measurement such as direct labor hours. Thus, the fundamental differences between traditional systems and activity based systems are: 1) how the indirect costs are assigned (ABC uses both production volume and non-production volume related bases) and 2) which costs are assigned to products (in ABC systems, an attempt is made to assign all costs to products including engineering, marketing, distribution and administrative costs, although some facility related costs may not be assigned³).

At the present time, most of the companies that use the activity based method have developed stand alone, micro-computer based systems separate from the company's mainframe cost accounting system used for external reporting.⁴ The idea is to develop more accurate product costs than the traditional cost accounting system provides so that management can make better strategic decisions such as product introduction, pricing, mix and discontinuance. In these systems, ABC is not used as an inventory valuation method. Activity based costs are not charged to the inventory accounts. However, it is used to determine product costs once per year, or more frequently when changes are made in the production process. The activity based method is described in Chapter 7 and referred to frequently in other parts of the text.

3) FOUR COST ACCUMULATION METHODS

Cost accumulation refers to the manner in which costs are collected and identified with specific customers, jobs, batches, orders, departments and processes. The center of attention for cost accumulation can be individual customers, batches of products that may involve several customers, the products produced within individual segments during a period, or the products produced by the entire plant during a period. The company’s cost accumulation method, or methods are influenced by the type of production operation and the extent to which detailed cost accounting information is needed by management. The four accumulation methods that appear in Exhibit 2-1 are discussed below.

Job Order

In job order costing, costs are accumulated by jobs, orders, contracts, or lots. The key is that the work is done to the customer's specifications. As a result, each job tends to be different. For example, job order costing is used for construction projects, government contracts, shipbuilding, automobile repair, job printing, textbooks, toys, wood furniture, office machines, caskets, machine tools, and luggage. Accumulating the cost of professional services (e.g., lawyers, doctors and CPA's) also fall into this category. Chapter 4 illustrates a cost accounting system that includes normal historical costing as the basic cost system, full absorption costing as the inventory valuation method and job order costing as the cost accumulation method.

Process

In process costing, costs are accumulated by departments, operations, or processes. The work performed on each unit is standardized, or uniform where a continuous mass production or assembly operation is involved. For example, process costing is used by companies that produce appliances, alcoholic beverages, tires, sugar, breakfast cereals, leather, paint, coal, textiles, lumber, candy, coke, plastics, rubber, cigarettes, shoes, typewriters, cement, gasoline, steel, baby foods, flour, glass, men's suits, pharmaceuticals and automobiles. Process costing is also used in meat packing and for public utility services such as water, gas and electricity. Chapter 5 illustrates a cost accounting system that includes normal historical costing as the basic cost system, full absorption costing as the inventory valuation method and process costing as the cost accumulation method.

Back Flush

Back flush costing is a simplified cost accumulation method that is sometimes used by companies that adopt just-in-time (JIT) production systems. However, JIT is not just a technique, or collection of techniques. Just-in-time is a very broad philosophy, that emphasizes simplification and continuously reducing waste in all areas of business activity. JIT systems were developed in Japan and depend on the communitarian concepts of teamwork and continuous improvement. In fact, many of the assumptions, attitudes and practices of communitarian capitalism are included in the JIT philosophy.

One of the many goals of JIT systems is zero ending inventory. In a backflush cost system, manufacturing costs are accumulated in fewer inventory accounts than when using the job order or process cost methods. In fact, in extreme backflush systems, most of the accounting records are eliminated. The production facilities are also arranged in self contained manufacturing cells that are dedicated to the production of a single, or similar products. In this way more of the manufacturing costs become direct product costs and fewer cost allocations are necessary. Thus, more accurate costing is obtained in spite of the fact that the cost accumulation method is simplified. The just-in-time philosophy and related accounting methods are discussed in Chapter 8.

Hybrid, or Mixed Methods

Hybrid or mixed systems are used in situations where more than one cost accumulation method is required. For example, in some cases process costing is used for direct materials and job order costing is used for conversion costs, (i.e., direct labor and factory overhead). In other cases, job order costing might be used for direct materials, and process costing for conversion costs. The different departments or operations within a company might require different cost accumulation methods. For this reason, hybrid or mixed cost accumulation methods are sometime referred to as operational costing methods.

4) FOUR COST FLOW ASSUMPTIONS

A cost flow assumption refers to how costs flow through the inventory accounts, not the flow of work or products on a production line. This distinction is important because the flow of costs is not always the same as the flow of work. The various types of cost flow assumptions include: specific identification (e.g., by job), first in, first out, last in, first out and weighted average.

Costs flow through the inventory accounts by the job in a job order cost system which represents an example of specific identification. The requirements of the various jobs determines the timing of the cost flows. Simple jobs tend to move through the system faster than more complex jobs. The first-in, first-out (FIFO) and weighted average cost flow assumptions are used in process costing. Since costs are accumulated by the process or department in a process cost environment, a cost flow assumption is needed to determine the treatment of the beginning inventory. When FIFO is used, it is assumed that the units of product in the beginning inventory are finished first and transferred to the next department before any of the units that are started during the period. The group of units in the beginning inventory maintain their separate identity and prior period costs. However, when the weighted average cost flow assumption is used, the beginning inventory units lose their separate identity because they are lumped together with the units of product started during the period. Process costing tends to be fairly challenging, therefore you may find these introductory concepts to be confusing. Don’t worry, these concepts will be easier to understand when we consider an operational process cost accumulation system in Chapter 5.

Although last-in, first-out (LIFO) is frequently used for tax reporting purposes, it is not normally used in the accounting records. For this reason, we consider the FIFO and weighted average cost flow assumptions in Chapter 5, but leave the LIFO cost flow assumption for courses that emphasize financial and tax reporting.

5) RECORDING INTERVAL CAPABILITY

Inventory records can be maintained on a perpetual or a periodic basis. Conceptually, the perpetual inventory method provides a company with the capability of maintaining continuous records of the quantities of inventory and the costs flowing through the inventory accounts. The periodic method, on the other hand, requires counting the quantity of inventory before inventory records can be updated. In the past, manufacturers tended to keep perpetual inventories, while retailers used the periodic method. However, today a variety of modern point of sale devices and dedicated microcomputer software are readily available to provide any company with perpetual inventory capability.

FUNCTIONS OF INFORMATION OR COST ACCOUNTING SYSTEMS

Now that you have an understanding of the components of a cost accounting system, we are ready to discuss the various purposes, or functions of information or cost accounting systems. The term information system is used to emphasize that although the accounting system is likely to be the organization’s major source of information, it is not the only source of information. In fact, for some purposes, accounting information is not as useful as other types of information. This idea is given considerable exposure later in the text, particularly in the sections on the just-in-time philosophy, the theory of constraints and activity based management in Chapter 8.

Generally the purposes, or functions of an information or cost accounting system fall into four categories. These include providing information for: 1) external financial statements, 2) planning and controlling activities or processes, 3) short term strategic decisions and 4) long term strategic decisions. These four functions relate to different audiences, emphasize different types of information, require different reporting intervals and involve different types of decisions. These characteristics and requirements of the four functions are summarized in Exhibit 2-4 and discussed individually below. ⁵

EXTERNAL FINANCIAL STATEMENTS

General purpose financial statements are designed for outsiders in accordance with generally accepted accounting principles and the regulations of the Internal Revenue Service (IRS) and the Securities and Exchange Commission (SEC). Of course outsiders include investors and creditors as well as the IRS and SEC. These users generally require information concerning the overall financial performance of the company on a quarterly basis. The information is highly aggregated because these outside users do not require detailed information about the performance or profitability of specific segments of the company such as divisions, departments, activities, processes, products, services and customers. The inventory valuation method is the key component in satisfying the requirements of GAAP and other regulatory agencies. Therefore, any of the sub-component combinations that appear in Exhibit 2-1 can be used for external reporting as long as full absorption costing is included as the inventory valuation method.

PLANNING AND CONTROLLING ACTIVITIES AND PROCESSES

Plant, production and operating managers and workers need information for planning and controlling specific activities and processes. These users need dis-aggregated quantitative and qualitative non-financial information on a timely basis. In some cases, information is needed daily, hourly or even on a real time (continuous) basis. For example, the operating managers of a nuclear power plant, a computer integrated factory and a jumbo jet need continuous non-financial information to monitor performance. Although standard costing was developed to aid in planning and measuring the financial consequences of performance variations, cost accounting reports and financial statements do not satisfy the requirements of these users. Cost accounting reports and financial statements are useful to plant managers for planning and measuring financial results, but they are not designed to control the activities, processes and work performed on a day to day basis. Many measurements that are considered more useful for this audience are discussed in Chapter 8.

SHORT TERM STRATEGIC DECISIONS

Marketing, product, business and senior level managers require information to provide guidance for a variety of short term strategic decisions. Disaggregated, quantitative and qualitative information is needed on both the financial and non-financial aspects of specific products, services, customers and suppliers. For example, the life cycle costs associated with a product or service are needed for pricing products and services. Life cycle costs include design, production, promotion, distribution and service after the sale. Traditional cost accounting systems are frequently inadequate for short term strategic decisions because product costs are distorted and incomplete. These two deficiencies of traditional cost accounting systems are given considerable attention by Johnson and Kaplan, the CAM-I sponsors and many other critics of accounting. The proposed solutions include activity based costing and activity based management. As mentioned earlier, these concepts are mainly discussed in Chapters 7 and 8.

LONG TERM STRATEGIC DECISIONS

Marketing, product, business and senior level managers also need information for a variety of long term strategic decisions. Decisions such as the replacement of a machine, building a new plant, re-engineering a product or process and implementing a JIT system require dis-aggregated quantitative and qualitative financial and nonfinancial information on a periodic basis. These decisions usually require special studies that fall into the topical areas of relevant costing, capital budgeting and investment management. Special studies and analysis are needed because none of the cost accounting systems that can be designed from the components in Exhibit 2-1 are capable of providing forecasts of future cash flows for hypothetical situations. Some long term relevant cost decisions are discussed in Chapter 18 under the heading of capital budgeting and investment management.

THE NEED FOR MULTIPLE SYSTEMS

Someone may eventually design a single information system that satisfies all of the requirements of the four functions discussed above. The continuing development of activity based accounting concepts is a movement in that direction. However, most companies will need multiple systems for the foreseeable future. The main point to grasp from this section is that the information generated for one purpose such as external reporting is not likely to be very useful for other purposes such as controlling activities, pricing products or decisions concerning competitive strategy. Recognition of this fact of business life is another important building block in the conceptual foundation of management accounting. It will help you understand many of the controversial issues that you are likely to encounter in practice. A number of these issues are discussed in subsequent chapters.

INCOME STATEMENTS

This section shifts the emphasis from a purely conceptual orientation to a mixed conceptual-practice orientation by discussing and illustrating the two main types of income statements. This topic is introduced in this chapter for several reasons. First, full absorption and direct costing income statements have traditionally been the major product of a management accounting system. In addition, the format of the income statement is controlled by the inventory valuation component of the system. The throughput, direct, full absorption and activity based methods (See Exhibit 2-1) involve different income statement formats. This is an important consideration because the different formats can produce radically different financial results for a period when inventories are increasing or decreasing. Furthermore, these differences have very significant behavioral implications for management. In addition, an understanding of the statement formats is needed in several other chapters of the text. For these reasons, full absorption and direct costing statements are emphasized in this section. The throughput and activity based formats are much less significant, at least in terms of the number of users. In addition, their introduction here might tend to confuse rather than enlighten before you internalize the conceptual foundation. For these reasons, a discussion of the throughput and activity based formats is postponed until Chapters 8, 11 and 12.

FULL ABSORPTION COSTING STATEMENTS

The symbols used to illustrate the relationships in a full absorption costing income statement are provided in Exhibit 2-5.

CALCULATIONS FOR A MERCHANDISING FIRM

An income statement algorithm for a merchandising firm appears in Exhibit 2-6. In step 1, the cost of merchandise purchases (P) is added to the cost of the beginning inventory of merchandise for resale (B) to arrive at the cost of merchandise available for sale. Subtracting the cost of the ending inventory of merchandise (E) from the Amount available for sale completes the step and provides the cost of goods sold (COGS). If the periodic recording interval is used, rather than the perpetual method, then the ending inventory (E) would have to be counted (i.e., taking a physical inventory) and then priced using a cost flow assumption.

Step 2 involves subtracting cost of goods sold (COGS) from sales (S) to obtain the Amount or gross profit (GP) for the period. In step 3 selling and administrative expenses (S&A) are subtracted from gross profit to determine the Amount of net income before taxes (NIBT).

CALCULATIONS FOR A MANUFACTURING FIRM

A manufacturer requires several types of inventory including an inventory of raw or direct materials, an inventory of work in process, and a finished goods inventory. As a result, the procedure for calculating net income for a manufacturing organization is somewhat more involved than for a merchandising firm. An income statement algorithm for a manufacturing firm appears in Exhibit 2-7.

In step 1 the beginning direct materials costs (BM) are added to the cost of direct material purchased (PM) to arrive at the cost of direct material available for use. Subtracting the cost of the ending inventory of direct materials (EM) provides the cost of direct material used (DM) and completes the step. Step 2 involves adding the cost of direct material (DM), the cost of direct labor used (DL) and factory overhead (FO) to provide the total manufacturing costs (TMC). Total manufacturing costs represents the factory costs charged to the work in process inventory during the period.

Adjusting for the change in the work in process inventory in step 3 provides the cost of goods manufactured (COGM). Adding the cost of the beginning inventory of work in process (BWIP) to the total manufacturing cost (TMC) and subtracting the cost of the ending inventory of work in process (EWIP) generates the cost of the products completed and charged to finished goods inventory. Adjusting for the change in finished goods inventory provides the cost of goods sold in step 4. Adding the cost of the beginning inventory of finished goods to the cost of goods manufactured provides the cost of goods available for sale. Then subtracting the cost of the ending finished goods inventory from the cost of the goods available provides the cost of goods sold. Gross profit and net income are determined in the same manner illustrated for a merchandising firm, therefore steps 5 and 6 in Exhibit 2-7 are the same as steps 2 and 3 in Exhibit 2-6. Notice that although the costs must be separated by functional areas, i.e., factory and selling/administrative, the full absorption costing algorithm does not require separating these costs into fixed and variable elements.

Cost Flow Diagram for Full Absorption Costing

In full absorption costing, the costs flow through the inventory accounts in the manner illustrated in Exhibit 2-8.This exhibit builds on the abstract view of absorption costing provided in Exhibit 2-3 and reveals several important concepts. First, observe that all factory costs are charged to the inventory. Second, all inventory costs represent assets until the products are sold. Then these costs are charged to an expense account referred to as cost of goods sold. Cost of goods sold represents expired factory costs that are matched with sales revenue on the income statement. Also note from Exhibit 2-8 that all selling and administrative costs are charged to expense or period costs as incurred. Generally, this is because the quantities and timing of any future benefits associated with selling and administrative costs cannot be objectively measured.

EXAMPLE 2-1: FULL ABSORPTION COSTING INCOME STATEMENT

Now that you have a grasp of the concepts and algorithm for developing full absorption costing statements, consider the following example. The Hollow Company is a small manufacturer of leather products. The financial results needed to produce an income statement for January appear in Exhibit 2-9.

Using the Income Statement Algorithm

The calculations that support the various parts of an absorption costing income statement appear in Exhibit 2-10. These calculations are based on the algorithm presented in Exhibit 2-7. Study and compare Exhibits 2-7, 2-9 and 2-10 to insure that you understand these calculations.

Preparing the Income Statement and Supporting Statements

An absorption costing income statement appears in Exhibit 2-11. Observe that the detailed calculations for cost of goods manufactured and selling and administrative expenses are provided in separate statements, or schedules (See Exhibits 2-12 and 2-13). This three statement approach is fairly common, although there are some alternatives. For example an even more abbreviated income statement can be prepared by combining the adjustment for the change in finished goods inventory with the statement of cost of goods manufactured. Then the supporting statement becomes a statement of cost of goods sold rather than a statement of cost of goods manufactured. On the other hand, all of the calculations can be presented on a single detailed income statement. The specific approach adopted for internal purposes depends on the personal preferences and needs of internal users.

Income Statement Relationship to System Functions

Referring back to the four functions of an information system outlined in Exhibit 2-4, one might logically ask what part monthly internal income statements play in satisfying the requirements of internal users. Although the emphasis on financial results tends to vary somewhat from company to company, internal statements play a supporting roll for all of the decisions referred to in Exhibit 2-4. The supporting information comes mainly in the form of estimates of the effects each decision will have on future profitability. Although many other types of information are needed, (e.g., disaggregated, qualitative and non-financial) the effect on future profitability can never be ignored. In addition, internal income statements play an important roll in planning and monitoring the financial results of the various decisions after the decisions are made and implemented.

DIRECT OR VARIABLE COSTING STATEMENTS

As indicated earlier in this Chapter, direct or variable costing is an inventory valuation method where only the variable manufacturing costs are charged to the inventory. Fixed manufacturing costs, i.e., fixed overhead costs, are charged to expense in the current period. In other words, all fixed costs are treated as period costs in direct costing. All other costs, including selling and administrative costs are treated in the same manner used in full absorption costing. Although this approach does not provide proper matching of cost and benefits, it is frequently used for internal reporting because it tends to be less confusing than full absorption costing. Advocates also argue that direct costing is more consistent with economic reality because fixed costs do not vary with production in the short run. A more in-depth discussion of the conceptual differences between the various inventory valuation methods is provided in Chapters 8 and 12. Later we will also see why both of the traditional inventory valuation methods have been criticized by the advocates of activity based costing and the lean enterprise concepts of just-in-time and the theory of constraints.

The Need For Fixed and Variable Costs

Since only variable manufacturing costs are charged to the inventory in direct costing, this method requires separating all manufacturing costs into fixed and variable elements. To prepare a complete income statement based on this approach we must also separate the selling and administrative costs into fixed and variable elements. We will examine several approaches that might be used to accomplish this separation in the next chapter.

Some Revised and Some New Symbols for Direct Costing

Some revised, as well as some new symbols are needed to illustrate direct costing and to emphasize the differences between the direct and absorption costing statement formats. In direct costing, factory overhead, total manufacturing cost, beginning and ending work in process, cost of goods manufactured and cost of goods sold are stated at variable manufacturing cost rather than full cost. To emphasize this difference, the letter V is added to the symbols used previously. These revised symbols are presented in the top section of Exhibit 2-14. In addition to these revisions, five new symbols are needed to represent the separation of the various costs into fixed and variable elements. These new symbols are provided in the lower section of the Exhibit.

CALCULATIONS FOR DIRECT COSTING

An algorithm for the preparation of direct costing income statements is presented in Exhibit 2-15. The equations reflect the revised and new symbols provided in Exhibit 2-14.

Step 1 of the direct costing algorithm involves calculating direct materials costs and is the same as in absorption costing. In step 2, the cost of direct labor used (DL) and the cost of variable factory overhead incurred (VFO) are added to the cost of direct material (DM) to arrive at the total variable manufacturing costs (TVMC). This is the Amount charged to work in process (see the cost flow diagram below).

Step 3 involves adjusting total variable manufacturing cost for the change in work in process inventory. This step generates the variable cost of goods manufactured (VCOGM). Note that beginning work in process (BWIP) is added and ending work in process (EWIP) in subtracted in the same manner illustrated for full absorption costing, but of course, the beginning and ending inventories do not include fixed overhead costs in direct costing. Arriving at variable cost of goods sold (VCOGS) in step 4 requires adjusting for the change in finished goods inventory. The cost of the beginning inventory of finished goods (BFG) is added to the variable cost of goods manufactured (VCOGM) to arrive at the cost of goods available for sale. Then the cost of the ending inventory of finished goods (EFG) is subtracted from this Amount to produce the variable cost of goods sold (VCOGS). Note that the only difference between this calculation and step 4 in full absorption costing is that the finished goods inventory contains variable manufacturing costs rather than full costs.

Manufacturing Margin and Contribution Margin

Steps five and six include two new terms. In step 5, sales (S) less variable cost of goods sold (VCOGS) provides the manufacturing margin (MM), i.e., the revenue over and above the variable manufacturing costs. Then, subtracting variable selling and administrative expenses from manufacturing margin (MM) in step 6 yields the contribution margin (CM). Contribution margin represents the revenue over and above the variable costs that contributes towards covering the fixed costs and, after the fixed costs are covered, providing a profit.

Step seven is needed to arrive at the Amount of net income before taxes. Note that all fixed costs are subtracted from contribution margin in this step, including fixed factory overhead (FFO) and fixed selling and administrative expenses (FS&A).

Cost Flow Diagram for Direct costing

In direct costing, the costs flow through the inventory accounts in the manner illustrated in Exhibit 2-16. This exhibit builds on the abstract view of direct costing provided in Exhibit 2-3 and emphasizes several important concepts. First, observe that only variable factory costs are charged to the inventory. This includes direct material, direct labor and variable factory overhead. This means that the beginning and ending inventories, total manufacturing costs, cost of goods manufactured and cost of goods sold contain only variable factory costs. The fixed factory costs are charged to expense during the period along with all of the selling and administrative costs. In direct costing, the fixed factory costs are viewed as the costs of maintaining the readiness to produce, rather than part of the costs of producing products. The economic reality, according to the advocates of direct costing, is that fixed costs are incurred during the period whether the company produces or not. Thus, these costs should be treated as expenses of the period, rather than costs of production. We will consider this controversy and other interesting issues concerning inventory valuation methods later in the text.

EXAMPLE 2-2: DIRECT OR VARIABLE COSTING INCOME STATEMENT

The Hollow Company costs (Example 2-1) have been separated into variable and fixed cost categories to facilitate the preparation of a direct costing income statement. This revised set of data appears in Exhibit 2-17.

Using the Income Statement Algorithm

The calculations required to develop a direct costing income statement are presented in Exhibit 2-18. These calculations are based on the algorithm presented in Exhibit 2-15. Study and compare exhibits 2-15, 2-17 and 2-18 to insure that you understand the calculations. Observe that the fixed costs that appear in the beginning inventories in Exhibit 2-17 (i.e., $18,900 for work in process and $12,960 for finished goods) are not included in the calculations that appear in Exhibit 2-18. These fixed costs are omitted because they would have been charged to expense in the previous period under direct costing. While comparing the exhibits, also consider the fixed costs associated with the ending inventories in absorption costing (i.e., $20,520 for work in process and $14,040 for finished goods). These costs are included in the $85,500 fixed manufacturing costs incurred during the period and are charged to expense in step 7 of Exhibit 2-18.

Preparing the Income Statement and Supporting Statements

A direct costing income statement is presented in Exhibit 2-19. Supporting statements are provided in Exhibits 2-20 and 2-21 for the cost of goods manufactured and selling and administrative expenses. The format of these statements follows the logic of the algorithm presented in Exhibit 2-15.

COMPARISON BETWEEN FULL ABSORPTION AND DIRECT COSTING

A comparison of the income statements in Exhibit’s 2-11 and 2-19 indicates that net income for full absorption costing is $40,000, while net income for direct costing is only $37,300. The reason these Amounts are different is that all of the current period fixed costs are charged to expense in direct costing, but $2,700 of the current period fixed costs remains in the ending inventories under full absorption costing.

Analyzing The Fixed Costs In Absorption Costing

Examining the changes in the fixed costs in the inventory under full absorption costing reveals the difference between the two net income amounts. This analysis appears in Exhibit 2-22.

What the analysis in Exhibit 2-22 appears to show is that a greater number of products were produced than sold. This caused the inventory to increase.⁶ Since fixed overhead is charged to the products produced in full absorption costing, an increase in the inventory means that some of the current period fixed costs remain in the ending inventories. These costs will be released into expense when the inventory is sold in a subsequent period. However, this $2,700 is charged to expense in direct costing, along with all the other current period fixed costs.

Comparing The Total Inventory Changes

Another way to explain the difference between the two net income Amounts is to examine the changes in the total inventory costs under the two methods. This information can be found in the previous exhibits, but for convenience consider Exhibits 2-23 and 2-24 instead. Exhibit 2-23 shows that the inventory increased by $5,000 under absorption costing, including a $3,000 increase in work in process and a $2,000 increase in finished goods. On the other hand, Exhibit 2-24 shows that the inventory increased by only $2,300 under direct costing including a $1,380 increase in work in process and a $920 increase in finished goods. The $2,700 difference between the total changes under the two inventory valuation methods (i.e., $5,000 - $2,300) is equal to the difference between the two net income Amounts in Exhibits 2-11 and 2-19. Of course the difference between the inventory changes in Exhibits 2-23 and 2-24 is caused by the fixed costs that are deferred in the inventory under absorption costing. These include increases of $1,620 (i.e., $3,000 - $1,380) in work in process and $1,080 (i.e., $2,000 - $920) in finished goods. We know the differences between the increases in the two exhibits represents fixed costs because the variable costs are treated exactly the same in both exhibits. Although the terminology and format of the income statements is different under the two inventory valuation methods, the variable costs are treated the same in the accounting records.

Comparing The Total Expenses

A third way to explain the $2,700 net income difference is by comparing the total Amount of expenses under the two inventory valuation methods. Notice from Exhibit 2-23 that the total expenses under absorption costing are $335,000 (i.e., $300,000 COGS + $35,000 S&A). However, in Exhibit 2-24, total expenses are $337,700 (i.e., $217,200 VCOGS + $120,500 for S&A and FFO). The $2,700 difference in total expenses explains the extra net income that appears in the full absorption costing income statement.

Generalizations Concerning Direct and Absorption Costing

There are three generalizations that are helpful in understanding the relationship between absorption and direct costing net income.

1) When the number of units sold are equal to the number of units produced, net income under the two inventory valuation methods will usually be equal.

2) When the number of units sold are less than the number of units produced, i.e., the inventories increase, absorption costing net income will usually exceed direct costing net income. This is because some of the current period's fixed manufacturing costs are capitalized (or deferred) in the inventory under absorption costing, while all fixed manufacturing costs are expensed under direct costing.

3) When the number of units sold are greater than the number of units produced, i.e., the inventories decrease, direct costing net income will usually exceed absorption costing net income. This is because some prior period fixed manufacturing costs are expensed under absorption costing along with the current period's fixed manufacturing costs.

These three generalizations are valid as long as the fixed overhead per unit remains constant. Since this will not always be true, the generalizations are not always valid. Now you are probably confused. Relax, we will postpone the discussion of the fixed overhead rate change effect until Chapter 12.

FOOTNOTES

¹ One researcher reported that "despite what the literature says, variable costing has been acceptable for public reporting...". On the basis of a survey of 1,200 manufacturing firms, 671 firms (56%) did not charge all fixed manufacturing cost to inventory in published financial statements. See Michael Schiff, 1987, "Variable Costing: A Closer Look", Management Accounting, (February): 36-39.

² Although ABC systems were not used until recently, the concept is not new. Hamilton Church seems to have understood the basic idea 100 years ago. See H. Thomas Johnson and Robert S. Kaplan, 1987, Relevance Lost: The Rise and Fall of Management Accounting, (Harvard Business School Press): Chapter 2. Many other terms have also been used in connection with this idea including transactions costing, attributable costing and traceable costing. (MAAW's Relevance Lost Topic).

³ This point is explained in considerable detail by Robin Cooper, 1990, "Cost Classification in Unit-Based and Activity-Based Manufacturing Cost Systems," Journal of Cost Management, (Fall): 4-14.

⁴ See Troxel, Richard B. and Milan G. Weber, Jr.,1990, "The Evolution of Activity-Based Costing," Journal of Cost Management, (Spring ): 14-22; Nanni, Alfred J. Jr., J. Robb Dixon and Thomas E. Vollmann,1992, "Integrated Performance Measurement: Management Accounting to Support the New Manufacturing Realities," Journal of Management Accounting Research, (Fall): 6. For a discussion of available software packages see, "ABC: Key Players And Their Tools," 1991, Management Accounting, (February 1991): 18.

⁵ Many of the ideas in this section came from H. Thomas Johnson and Robert S. Kaplan, 1987, Relevance Lost (Harvard Business School Press): Chapter 10.

⁶ There is another possibility that is discussed briefly in the next section.

QUESTIONS

1. Describe the components of a cost accounting system. (See What is a cost accounting system).

2. What is the difference between pure historical costing and normal historical costing? (See Input measurement bases).

3. Which cost system component includes both historical costs and standard costs for all manufacturing costs categories? (See Input measurement bases).

4. Why is standard costing said to be a better system than historical costing for cost control? (See Input measurement bases).

5. Which system component determines the format of the income statement and how net income is determined? (See Inventory valuation methods).

6. What is the main difference between variable (or direct) costing and full absorption costing? (See Inventory valuation methods).

7. Which inventory valuation methods do not provide proper matching according to GAAP? (See Inventory valuation methods).

8. Which inventory valuation method attempts to treat all costs as variable? Why? (See Inventory valuation methods).

9. How does activity based costing violate GAAP? (See Inventory valuation methods).

10. Which inventory valuation method, or methods, includes an underlying assumption that production volume is the only major cost driver? (See Inventory valuation methods).

11. What is throughput costing? (See Inventory valuation methods).

12. Is job order costing a cost accounting system? Explain. (See Cost accumulation methods).

13. What is the key difference between job order costing and process costing? (See Inventory valuation methods).

14. What is backflush costing? (See Inventory valuation methods).

15. Which cost accumulation method is used by most service companies? (See Inventory valuation methods).

16. What are the main purposes or functions of an information or cost accounting system? (See Functions of a system and Exhibit 2-4).

17. Discuss the different audiences, types of information and reporting intervals associated with the functions in question above. (See Functions of a system and Exhibit 2-4).

18. Which audience was full absorption costing mainly designed to serve? (See Exhibit 2-4).

19. Which audience was direct or variable costing designed to serve? Why? (See Exhibit 2-4).

20. Which audience was activity based costing designed to serve? Why? (See Exhibit 2-4).

21. Why are selling and administrative costs excluded from the inventory in both full absorption costing and variable costing? (See Inventory valuation methods).

22. In calculating net income under full absorption costing, when will total manufacturing costs equal cost of goods sold? (See Exhibits 2-7 and 2-8 and related discussion).

23. In the full absorption costing income statement algorithm, which of the following measurements represent expenses? Refer to the symbols in the text. DM, DL, FO, TMC, COGM, COGS. Explain your answer. (See Exhibits 2-7 and 2-8 and related discussion).

24. What type of analysis must be performed before variable (or direct) costing statements can be prepared? (See Direct costing).

25. What is contribution margin? (See Exhibit 2-15 and the subsequent discussion).

26. Is gross profit comparable to contribution margin? Explain. (Compare Exhibit 2-7 with Exhibit 2-15 or Exhibit 2-11 with Exhibit 2-19).

27. Generally, when will net income under full absorption costing be different from net income under variable costing? Why? (See Generalizations).

28. Which of the two traditional inventory valuation methods would you expect to provide the largest Amount of net income when the number of units produced are greater than the number of units sold? Why? (See Generalizations).

29. Which net income Amount is more meaningful, direct costing net income or absorption costing net income? (See Exhibit 2-4 for an idea).

30. Do you see a potential behavioral problem with absorption costing? Explain. (See Comparison).

31. Would the use of variable costing correct the problem in the previous question? Explain.

32. Do you see any potential behavioral problems associated with variable costing? Explain.

33. Would the use of absorption costing correct the problem in the previous question? Explain.

34. The advocates of variable costing say that variable costing is more consistent with economic reality. What do you think they mean by this?

35. Why are the generalizations about the relationship between absorption costing and variable (or direct) costing called generalizations? (See Generalizations).

PROBLEMS

PROBLEM 2-1

1. Which of the following statements is true?  
   Cost accounting systems may include,
    a. Either historical costing or standard costing.
    b. Either absorption costing or direct (or variable) costing.
    c. Either job order costing or process costing.
    d. All of the above are true.
    e. None of the above are true.

2. Which of these statements is false?
    a. Full absorption costing charges all manufacturing costs to the inventory.
    b. Direct costing charges all direct manufacturing cost to the inventory as well as some  indirect manufacturing costs.
    c. Full absorption costing provides proper matching.
    d. Direct costing charges both variable manufacturing costs as well as variable selling & administrative costs to the inventory.

3. Which of these statements is true?
    a. Normal costing provides a better system for controlling some manufacturing costs than pure historical costing.
    b. Standard costing provides a better system for controlling manufacturing costs than normal costing.
    c. The main difference between normal costing and pure historical costing is the use of a predetermined overhead rate in normal costing.
    d. All of these are true.
    e. None of these are true.

4. A manufacturing plant where a continuous mass production or assembly operation is involved would most likely use
    a. Normal historical costing.
    b. Standard costing.
    c. Full absorption costing.
    d. Process costing.
    e. Direct costing.

5. Which of the following does not represent an asset in conventional cost accounting systems?
    a. Unexpired costs.
    b. Work in process inventory.
    c. Total manufacturing costs.
    d. Factory overhead.
    e. Selling costs.

6. Which statement is true. In Full Absorption costing, product costs do not include
    a. inventoriable costs.     
    b. period costs.
    c. unexpired costs.
    d. assets.
    e. fixed costs.

PROBLEM 2-2

1. Which of these statements is true?
    a. Full absorption costing charges all variable and some fixed costs to the inventory.
    b. Direct costing charges all variable cost to the inventory.
    c. Direct costing includes separating all costs into variable and fixed elements.
    d. All of the above are true.
    e. None of the above are true.

2. Which of these statements is true?
    a. Pure historical costing represents an input measurement basis where only actual  manufacturing costs are charged to the inventory.
    b. Normal historical costing represents an input measurement basis where a predetermined overhead rate is used to charge overhead costs to the products produced.
    c. Standard costing is an input measurement basis where all manufacturing costs are charged to the inventory using predetermined cost per unit.
    d. a. and b.
    e. a., b. and c.

3. Which of the following represent inventory valuation methods?
    a. Either financial accounting or managerial accounting.
    b. Either job order costing or process costing.
    c. Either historical costing or standard costing.
    d. Either absorption costing or variable costing.
    e. Periodic or perpetual.
    f. None of the above.

4. Which of the following represent cost accumulation methods?
    a. Either financial accounting or managerial accounting.
    b. Either job order costing or process costing.
    c. Either historical costing or standard costing.
    d. Either absorption costing or variable costing.
    e. Periodic or perpetual.
    f. None of the above.

5. Which of the following represent cost flow assumptions?
    a. Either financial accounting or managerial accounting.
    b. Either job order costing or process costing.
    c. Either historical costing or standard costing.
    d. Either absorption costing or variable costing.
    e. Periodic or perpetual.
    f. None of the above.

6. Which of these statements is false?
    a. Manufacturing costs are classified as direct material, direct labor and factory overhead.
    b. All manufacturing costs are inventoriable costs in absorption costing*.
    c. All manufacturing cost are product costs in absorption costing*.
    d. All variable costs are product costs in direct costing*.
    e. All of these.
* Ignore losses.

PROBLEM 2-3

Using the identifying letters A through E, match the main components:

A = Input measurement basis,
B = Inventory valuation method,
C = Cost accumulation method,
D = Cost flow assumption and
E = Recording interval capability

with the sixteen sub-components listed below.

----- 1. Backflush
----- 2. FIFO
----- 3. Standard
----- 4. Process
----- 5. Periodic
----- 6. Direct
----- 7. By job
----- 8. Throughput
----- 9. Normal historical
----- 10. Perpetual
----- 11. LIFO
----- 12. Activity based
----- 13. Job order
----- 14. Full absorption
----- 15. Pure historical
----- 16. Weighted average

PROBLEM 2-4

Using the identifying letters A through D, match the system functions:

A = External financial statements,
B = Planning & controlling activities,
C = Short term strategic decisions and
D = Long term strategic decisions

with the 12 characteristics and requirements listed below.

----- 1. Annual or life cycle information.
----- 2. Marketing, product or senior managers.
----- 3. Are specific processes in control?
----- 4. Aggregated quantitative financial results.
----- 5. Real time, hourly or daily information
----- 6. Special studies performed periodically.
----- 7. Outside investors.
----- 8. Disaggregated quantitative and qualitative financial and nonfinancial information.
----- 9. Quarterly information.
----- 10. Pricing products.
----- 11. Plant, production and operating managers.
----- 12. Should the company convert to a JIT system?

PROBLEM 2-5

Assume the following information is available for the Hollow Company for February 201X.

Required

Assume full absorption costing is used and calculate the following Amounts.

1. Cost of direct material used.
2. Total manufacturing costs.
3. Cost of goods manufactured.
4. Cost of goods sold.
5. Gross profit (or gross margin).
6. Net income.
7. Prepare an Income Statement and separate Schedule of Cost of Goods Manufactured for the Hollow Company for February.

PROBLEM 2-6

The following information (in dollars) is given for the Allen Company for the year ended 201X:

Required

Assume full absorption costing is used and calculate the following Amounts.

1. Cost of direct material used.
2. Total manufacturing costs.
3. Cost of goods manufactured.
4. Cost of goods sold.
5. Gross profit (or gross margin).
6. Net income.
7. Prepare an income statement with a separate schedule of Cost of goods manufactured.
8. Could you prepare an income statement based on direct costing for this company? Explain.

PROBLEM 2-7

Manufacturing Statements Full Absorption and Direct Costing

Assume the following information (in thousands of dollars) is given for the RGP Company for the year ended 201X:

Required:

Part I. Assume full absorption costing is used and calculate the following Amounts.

1. Cost of direct material used.
2. Total factory overhead costs incurred.
3. Total manufacturing costs.
4. Cost of goods manufactured.
5. Total selling and administrative expenses.
6. Cost of goods sold.
7. Gross profit (or gross margin).
8. Net income before taxes.
9. Prepare an income statement and schedule of cost of goods manufactured.

Part II. Assume Direct or Variable costing is used and calculate the following Amounts.

1. Cost of direct material used.
2. Total variable factory overhead costs incurred.
3. Total variable manufacturing costs.
4. Variable cost of goods manufactured.
5. Total variable selling and administrative expenses.
6. Variable cost of goods sold.
7. Manufacturing margin.
8. Contribution margin.
9. Net income before taxes.
10. Reconcile and explain the difference between the net income in Parts I and II.
11. Prepare an income statement and schedule of variable cost of goods manufactured.

PROBLEM 2-8

Manufacturing Statements for Direct and Absorption Costing. Assume the following data are given for the Kale Company.

Required:

1. Calculate the cost of direct material used.
2. Calculate the cost of goods manufactured assuming absorption costing is used.
3. Calculate the cost of goods manufactured assuming direct costing is used.
4. Calculate cost of goods sold for absorption costing.
5. Calculate cost of goods sold for direct costing.
6. Calculate gross profit.
7. Calculate contribution margin.
8. Calculate net income for absorption costing.
9. Calculate net income for direct costing.
10. If net income is different in questions 8 and 9, show why.

Problem Solutions

Extra MC Questions