Concept Of Variance Analysis And Types Of Variances

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The terms variance refers to the deviation of the actual costs from the standard costs due to various causes.
Variance analysis is the process of calculating the deviation of the actual costs from the standards and of interpreting the results. Variance analysis helps to ascertain the magnitude of each of the variances and causes of variance so that corrective actions can be taken.
For three main elements of costs, variances are to be calculated and analyzed- material, labor and overheads.

Types Of Variances

1. Material Variance
- material cost variance
- material price variance
- material usage variance
- material mix variance
- material yield variance

2. Labor Variance
- labor cost variance
- labor rate variance
- labor efficiency variance
- labor idle time variance
- labor mix variance
- labor yield variance

Related Topic
Calculation Of Direct Material Variances

Disadvantages Of Standard Costing

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The following are the notable limitations or disadvantages of standard costing system:

* Standard costing system may be tedious, expensive and time consuming to install and keep up to date.

* The standard costing system controls the operating part of an organization only as it ignores the other items like quality, lead-time, service, customer satisfaction and so on.

* The standard costing system will become less useful in modern factories where the just in time principles are adopted.

* The standard costing system may not be applicable in case of small firms as it requires high degree of skill.

* The standard costing may not be very effective in those organizations where non-standardized products are manufactured and services are rendered.

Related Topics
Concept And Meaning Of Standard Costing
Advantages Of Standard Costing
Distinction Between Standard Cost And Estimated Cost
Distinction Between Standard Costing And Budgetary Control

Advantages Of Standard Costing

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The following are the advantages of the standard costing system:

* A standard costing is a rule of measurement established by authority, which provides a yardstick for performance evaluation.

* Standard costing system minimizes the wastage by detecting variance and suggesting for corrective actions.

* Under the standard costing system, cost centers are established and responsibility is assigned to the concerned departments and persons and thus it helps to increase the effective delegation of authority.

* A properly developed standard costing system with full participation and involvement creates a positive, cost effective attitude through all levels of management.

* The standard system encourages reappraisals of methods, materials and techniques that help to reduce the unfavorable variances.

* The standard costing system helps to draw management's attention towards those items which are not proceeding according to plan.

* Standard costing system makes the whole organization cost-conscious as it gives the focus to the standard cost and variance analysis.

* Standard costing system provides a basis for incentive scheme to workers and supervisors.

* Standard costing system simplifies the cost control procedures.

* Standard costing acts as an effective tool for business planning, budgeting, marginal costing , inventory valuation etc.

Related Topics
Concept And Meaning Of Standard Costing
Disadvantages Of Standard Costing
Distinction Between Standard Cost And Estimated Cost
Distinction Between Standard Costing And Budgetary Control

Distinction Between Standard Costing And Budgetary Control

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Although budgetary control and standard costing both are based on some common principles; both are pre-determined, comparison will be made with the actual costs and both system need a revision of the standards or the budget, these two systems have certain differences which are as follows:

1. Budgetary control deals with the operation of a department or the business as a whole in terms of revenue and expenditure. Standard costing is a system of costing which makes a comparison between standard costs of each product or service with its actual cost.

2. Budgetary control covers as a whole in terms of revenue and expenditures such as purchases, sales, production, finance etc. Standard costing is related to a product and its cost only.

3. Budgetary control is applicable to utmost all business organizations. Standard costing is applicable to manufacturing concerns producing standard products and services.

4. Budgetary control is concerned with a specific period and is based on the totals of amounts. Standard costing is concerned with the standard costs, which are worked out generally per unit of production.

5. Budgetary control is not based on standard costing system. Standard costing cannot exist in the absence of a budgetary control system.

Related Topics
Concept And Meaning Of Standard Costing
Advantages Of Standard Costing
Disadvantages Of Standard Costing
Distinction Between Standard Cost And Estimated Cost

Distinction Between Standard Cost And Estimated Cost

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Estimates are the expressions of of opinion based upon past experiences whereas the standard costs are based upon standard rate that are very carefully developed and set as scientifically as possible. However, both estimated costs and standard costs are related to future period of time but there are some significant differences between them. Some major differences between standard costs and estimated costs are listed below:

1. Estimated costs are the expressions of opinion based upon experience. Standard costs are based upon standard rates that are carefully developed and set as scientifically as possible.

2. Estimated costs are used by those firms that follow historical costing system. Standard costs are used by those organizations that follow standard costing.

3. Estimated costs are based on actual costs and anticipated costs. Standard costs are fixed after scientific analysis of relevant cost elements.

4. Estimated costs are based on approximation. Standard costs are based upon specifications.

5. Estimated costs are normally used as guideline for price determination, quoting the selling price etc. Main purpose of standard costs is to serve as a tool for cost control.

Related Topics
Concept And Meaning Of Standard Costing
Distinctions Between Standard Costing And Budgetary Control
Advantages Of Standard Costing
Disadvantages Of Standard Costing

Standard Costs And Their Types

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Standard costs are also known as predetermined costs in terms of money, quantity or time as the basis of standard costing. Standard costs are target costs, which should be attained and can be considered as a measuring rod or norms for performance evaluation.

Terminology
There are various types of standards in use. Out of these, the suitable standards should be selected for effective cot control. The following are the main types of standards.

* Basic standards
* Ideas/expected standards
* Attainable standards
* Historical standards

Concept And Meaning Of Standard Costing

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Historical costs are the actual costs that are ascertained after they are incurred. During the initial stages of development of cost accounting, historical costing systems like process costing, contract costing, service costing etc. were available for ascertaining the costs. The historical costing methods are used to determine the cost incurred for the production of a particular products or completion of a particular job.
The historical costing systems suffer from several limitations; some of them are as follows:
* No basis for cost control
* No yardstick for measuring efficiency
* Delay in availability of information
* Expensive
Although standard costing attempts to overcome the limitations of historical costing system, it is not an alternative to the existing historical costing. Standard costing is the most widely used technique of controlling costs.

Standard costing is a technique that establishes predetermined estimates of the cost of products and services and compares these costs with the actual costs as they incur. Standard costing can be considered as a yardstick to measure the efficiency with the actual cost incurred. Hence, standard costing is system of costing which makes a comparison between the standard cost of each product or service with its actual cost to determine the efficiency of the operation, with a view to take corrective actions at the earliest possible time.
Thus, standard costing is the preparation and uses of standard costs, which involves the following process:
* Establishment of standard costs
* Ascertainment of actual costs
* Comparison of the above two and measurement of variances
* Analysis of variances
* Reporting to responsibility centers to take appropriate and necessary remedial actions.

Related Topics
Distinction Between Standard Cost And Estimated Cost
Distinction Between Standard Costing And Budgetary Control
Advantages Of Standard Costing
Disadvantages Of Standard Costing

Role Of Responsibility Accounting

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Following are the main roles or contribution of responsibility accounting:

* Decentralization
By dividing the total organization in smaller subunits, the organization becomes more manageable.

* Performance Evaluation
Responsibility accounting establishes a sound and fair system of performance evaluation of each manager and personnel. The performance of each responsibility center is measured and presented periodically on performance report.

* Motivation
Responsibility accounting emphasizes on the individual achievement-based performance evaluation. Therefore, the job becomes more challenging for the employees and motivates them to use their full potentiality in achieving the results.

* Transfer Pricing
Responsibility accounting divides the organization in different autonomous responsibility centers or subunits. In such circumstances, product or service of one division or unit can be transferred to another division or unit within the same organization charging a transfer price. This creates an inter-competitive environment to make each subunit of the organization more profitable and efficient.

Drop Or Continue Decision
If the organization is divided into subunits, it becomes possible to measure division wise or product wise profitability of the organization. If saving in costs exceeds the foregone revenues, the center can be discontinued.

Related Topics
Concept And Meaning Of Responsibility Accounting
Responsibility Centers For Responsibility Accounting
Process Of Responsibility Accounting

Process Of Responsibility Accounting

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Responsibility accounting is a concept that views the organization in parts or sub-systems rather than in total or a single system. Of course, the ultimate goal is to achieve organization's objective but that does not come at once. Total achievement is the aggregation of the achievements individual sector.
Responsibility accounting encompasses the following steps:

1. Identifying The Responsibility Centers
The basis of responsibility accounting system is the designation of each sub-unit in the organization as a particular type of responsibility center. A responsibility center is a sub-unit in an organization whose manger is held accountable for specific financial results of sub-unit's activities. The important criteria for creating a responsibility center is that the unit of the organization should be separable and identifiable for operating purposes and its performance measurement should be possible. An organization can be broadly subdivided into four main responsibility centers as cost center, revenue center, profit center and investment center.

2. Delegation Of Authority And Responsibility Or Decentralization
To increase managerial and operational efficiency, the manger of each subunit should be assigned specific authority and responsibility for the activity of that division. No one can be held accountable without having any prior responsibility and responsibility always accompanies corresponding authority. Responsibility centers are the decision centers also, and the decision requires the power or authority.

3. Controllable Of The Object
The manger of a cost center can be held accountable only for the costs, which are controllable by him. Therefore, it is an essential part of responsibility accounting to identify the controllable and non-controllable costs. The same thing applies in the case of revenues, profits and investment.

4.Establishing Performance Evaluation Criteria
Main purpose o responsibility accounting is to measure the divisional or subunit performance. Performance evaluation is a yardstick measurement of whether the results are obtained as ought to be or not. Most often the following criteria are applied for divisional performance evaluation.
*Standard Costing
* Budgetary control
*Profitability ratios
* Valuation measures

5. Electing Cost Allocation Bases
Divisional profitability heavily depends on the bases of allocation of joint overheads and corporate overheads. Switching from one method to another of cost allocation over the products or divisions, product wise profitability change to a great deal. Remember that for decision-making purpose, such allocated overheads should be carefully treated and well understood.

Related Posts
Concept And Meaning Of Responsibility Accounting
Responsibility Centers For Responsibility Accounting
Role Of Responsibility Accounting

Responsibility Centers For Responsibility Accounting

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1. Cost Center
A cost center is an organizational sub-unit such as department or division, whose manager is held accountable for the costs incurred in that division. For example, a Power and Airco Department can can be defined as a cost center within the Operation and Maintenance Department in United Telecommunication Company. Manager of a cost center is responsible for controllable costs incurred in the department, but is not responsible for revenue, profit or investment in that center. A cost center is a responsibility center in which inputs, but not outputs are measured in monetary value.

2. Revenue Center
A manager of a revenue center is held accountable for the revenue attributed to the sub-unit. Revenue centers are responsibility centers where managers are accountable only for financial outputs in the form of generating sales revenue. A revenue center's manger may also be held accountable for selling expenses such as sales persons' salaries, commissions, and order receiving costs.

3. Profit Center
Profits are the excess of revenue over the total expenses. Therefore, the manager of a profit center is held accountable for the revenues, costs, and profits of the center. A profit center is a responsibility center in which inputs are measured in terms of expenses and outputs are measured in terms of revenues.

4. Investment Center
The manger of investment center is held accountable for the division's profit and the invested capital used by the center to generate its profits. Investment centers consider not only costs and revenues but also the assets used in the division. Performance of an investment center are measured in terms of assets turnover and return on the capital employed.

Related Topics
Concept And Meaning Of Responsibility Accounting
Process Of Responsibility Accounting
Role Of Responsibility Accounting

Concept And Meaning Of Responsibility Accounting

Advanced Content Marketing Certification Training
Responsibility accounting is a system of dividing an organization into similar units, each of which is to be assigned particular responsibilities. These units may be in the form of divisions, segments, departments, branches, product lines and so on. Each department is comprised of individuals who are responsible for particular tasks or managerial functions. The managers of various departments should ensure that the people in their department are doing well to achieve the goal. Responsibility accounting refers to the various concepts and tools used by managerial accountants to measure the performance of people and departments in order to ensure that the achievement of the goals set by the top management.

Responsibility accounting, therefore, represents a method of measuring the performances of various divisions of an organization. The test to identify the division is that the operating performance is separately identifiable and measurable in some way that is of practical significance to the management. Responsibility accounting collects and reports planned and actual accounting information about the inputs and outputs of responsibility centers.

Related Topics
Responsibility Centers For Responsibility Accounting
Process Of Responsibility Accounting
Roles Of Responsibility Accounting

Concept And Types Of Capacity Levels

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The term 'capacity' means a "constraint" or an upper limit. Determining the right level of capacity is one of the most challenging tasks facing managers. Having too much capacity relative to demand means incurring sizable costs to an unused capacity. Having too low capacity means that the demand from some customers may be unfilled. These customers may go to other sources of supply and never return. Therefore, it is equally important to understand the concepts and impact of an appropriate capacity level.

Theoretical Capacity
Theoretical capacity is the denominator-level concept that is based on producing at full efficiency all the time.
For example, if Everest steel industries can produce 15 units of wardrobe per shift when the production lines are operating at maximum sped and if a shift consists of 8 working hours giving 3 shifts per 24 hour a day then the annual theoretical capacity is 15 units x 3 shifts x 360 days = 16,200 units.

Practical Capacity
Practical capacity is a denominator-level concept that reduces the theoretical capacity by unavoidable operating interruptions such as scheduled maintenance time, shutdowns for holidays and so on. Assume that the practical production rate is 12 units per shift and the industry can run 300 days a year, then the practical annual capacity is 12 units x 3 shifts x 300 days = 10,800 units.

Normal Capacity
Both theoretical and practical capacity measure what a plant can supply. In contrast, normal capacity measures the denominator level in terms of demand for the output of the plant. Normal capacity utilization is a concept based on the level of capacity utilization that specifies the average customer demand over a time period, that includes seasonal, cyclical and trend factors.

Budget Capacity
Budget capacity is the denominator-level concept based on the expected level of capacity utilization for the budget period.


Reconciling The Differences In Net Operating Income Under Variable Costing And Absorption Costing

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Income reported under variable costing and absorption costing are different. It is only the different value of inventory under the two costing income statements that changes the amount of the net income. Except the value of inventory, we do not find any other differences. As the size of inventory increases or decreases during the year, the reported income differs under variable and absorption costing. This results from the fixed overheads that are included in the inventory valuation under absorption costing but are expended immediately under variable costing. Under absorption costing this period's factory overheads are postponed to the next year whereas under variable costing it is expended during the same year.

Difference in net income
= (Change in the size of inventory units) x (Difference in product cost per unit)

The difference in net income is the same as the difference in the size of inventory value. So with a change in the size of inventory, profit also change.

Related Topics
Concept And Meaning Of Variable Costing And Absorption Costing
Comparison Between Variable Costing And Absorption Costing
Determination Of Income Under Variable Costing
Determination Of Profit Under Variable Costing
Valuation Of Finished Goods Inventory Under Variable And Absorption Costing

Valuation Of Finished Goods Inventory Under Variable Costing And Absorption Costing

Advanced Content Marketing Certification Training
Since inventory is an asset, the difference in the value of inventory changes the size of income and the size of assets in a balance sheet. Income statement and balance sheet both are affected by the value of inventory. That is why we get different income and assets under these two costing methods. Inventoriable costs are product costs, which differ under the two costing system as under.

Inventory value under variable costing
= Direct material+ Direct labor+Variable manufacturing costs

Inventory value under absorption costing
= Direct material+Direct labor+variable manufacturing costs+Fixed manufacturing costs

Finished goods inventories are over-stated in absorption costing as it includes one more cost element in inventory value than under variable costing, i.e the fixed manufacturing cost.

Related Topics
Concept And Meaning Of Variable Costing And Absorption Costing
Comparison Between Variable Costing And Absorption Costing
Determination Of Income Under Variable Costing
Determination Of Profit Under Absorption Costing
Reconciling The Differences In Net Operating Income Under VCA And ACA

Determination Of Profit Under Absorption Costing Approach (ACA)

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Income Statement Under Absorption Costing Approach (ACA)

Working Notes:
1. PCR = PCR as per variable costing approach + FMOR
2. FMOR = Standard fixed manufacturing overheads/ Standard Output
3. Stock Valuation = Units X PCR
4. Capacity Variance = (AO-SO) X Fmor.
5. Non- Mfg. Costs:
* Administrative overhead costs
* Selling overhead costs
* Distribution

Particulars................................................................................Amount
A. Sales Revenue (SU X SR)..........................................................XXX
B. Total Mfg. COGS
i. Direct Material (AO X Rate)..........................................................XXX
ii. Direct Labor (AO X Rate).............................................................XXX
iii. Direct Expenses (AO X Rate)......................................................XXX
iv. Variable Mfg. Overheads (AO X Rate)........................................XXX
v. Fixed Mfg. Overheads (AO X FMOR) ...........................................XXX
vi. Opening stock of finished goods..................................................XXX
vii. Less: Closing stock of finished goods........................................(XXX)
C. Unadjusted Gross Profit (A-B)....................................................XXX
Add: Capacity Variance (If AO>SO)................................................XXX
Or,
Less: Capacity Variance (If AO< SO)..............................................XXX
D. Adjusted Gross Profit...................................................................XXX
E. Total Non-Manufacturing Costs
i. Variable Non-Mfg. Costs (SU X Rate) ..........................................XXX
ii. Fixed Non-Mfg. Costs ( Standard)................................................XXX
Net Income Before Tax (D-E)..........................................................XXX

Here,
SU = Sales Unit, SR = Sales Rate, AO = Actual Output, FMOR = Fixed Manufacturing Overhead Rate, Mfg. COGS = Manufacturing Cost Of Good Sold, SO = Standard Output.


Related Topics
Concept And Meaning Of Variable Costing And Absorption Costing
Comparison Between Variable Costing And Absorption Costing
Determination Of Income Under Variable Costing
Valuation Of Finished Goods Inventory Under Variable And Absorption Costing
Reconciling The Differences In Net Operating Income Under VCA And ACA


Uses Of Variable Costing System

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The variable costing system is widely used for internal management purposes rather than for external reporting. It is more useful for taking managerial decision making. As such the variable costing system is useful for:

1. Profit Planning
It is a technique of preparing and using an operational plan for the objective of achieving the profit target. It gives focus on the contribution margin which facilitates for understanding the inter-relationship between cost, volume and profit.
Variable costing helps in determining the break-even sales as well as sales level at which the firm will able to attain the target profit. Variable costing also helps in evaluating the impact of changes in volume, variable and fixed cost and product mix on profit. The contribution margin makes it comfortable in selecting the most profitable product, territories and customers.

2. Cost Control
The major tool for controlling the costs are standard costing and flexible budget. This costing system segregates the costs into fixed and variable for the purpose of controlling the cost. So, the attention is given to the fixed cost which is treated as the period cost and deducted from the contribution margin to get profit.

3. Decision Making
The cost associated with the product plays a key role in decision making. Variable costing identifies and classify costs into fixed and variable cost and provide valuable information for making decisions. Fixed costs, generally, create problem in making decision because of difficulties in their allocation. Under variable costing, they are assumed to remain constant and are not considered relevant in decision making. The fixed costs are treated as period costs and contribution margin above the fixed cost is the profit. In a decision involving alternative choices, alternative one with the highest contribution margin is selected. The decision areas where variable costing is particularly useful and relevant are pricing decisions, make or buy decision, product mix decision etc.

4. Pricing Decision
Variable costing helps the management for fixation of price, volume or sales mix as variable costing clearly identifies the reasons of fluctuation in profit is due to fluctuation in sales rather than of production. Moreover, it is also helpful in evaluating the performance of various departments of the firms which generates the revenues.

Related Topics
Concept And Meaning Of Variable Costing And Absorption Costing
Advantages And Disadvantages Of Variable Costing
Advantages And Disadvantages Of Absorption Costing
Features Of Variable Costing System

Features Variable Costing System

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Features Of Variable Costing System

1. Variable costing differentiates the manufacturing overheads into fixed and variable. The variable costs are treated as the product cost and fixed costs are treated as period cost.

2. Variable costing does not show differences in average unit cost of production with the fluctuation of output.

3. Unit cost of production decreases with increase in output due ti constant level of fixed cost.

4. Separate of mixed cost into fixed and variable proportion.

5. Variable costing helps in decision making procedures providing necessary informations and data.

The fixed cost such as rent, depreciation, salary etc. are incurred even if there is no production. So, they are not considered product cost and are treated as period cost. Hence fixed costs are treated as expenses of the period. They are not transferable to next period as such they are not included in inventories.

Related Topics
Concept And Meaning Of Variable Costing And Absorption Costing
Advantages And Disadvantages Of Variable Costing System
Advantages And Disadvantages Of Absorption Costing
Uses Of Variable Costing System

Advantages And Disadvantages Of Absorption Costing System

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Advantages Of Absorption Costing System
Following are the main advantages of absorption costing system:

1. Absorption costing recognizes fixed costs in product cost. As it is suitable for determining price of the product. The pricing based on absorption costing ensures that all costs are covered.

2. Absorption costing will show correct profit calculation than variable costing in a situation where production is done to have sales in future ( eg. seasonal production and seasonal sales).

3. Absorption costing conforms with accrual and matching accounting concepts which requires matching costs with revenue for a particular accounting period.

4. Absorption costing has been recognized for the purpose of preparing external reports and for stock valuation purposes.

5. Absorption costing avoids the separating of costs into fixed and variable elements.

6. The allocation and apportionment of fixed factory overheads to cost centers makes manager more aware and responsible for the cost and services provided to others.

Disadvantages Of Absorption Costing System

1. Absorption costing is not useful for decision making. It consider fixed manufacturing overhead as product cost which increase the cost of output. As a result, it does not help in accepting specially offered price for the product. Various types of managerial problems relating to decision making can be solved only with the help of variable costing system.

2. Absorption costing is not helpful in control of cost and planning and control functions. It is not useful in fixing the responsibility for incurrence of costs. It is not practical to hold a manager accountable for costs over which he/she has not control.

3. Some current product costs can be remove from the income statement by producing for inventory. As such, managers who are evaluated on the basis of operating income can temporarily improve profitability by increasing production.

Related Topics
Concept And Meaning Of Variable And Absorption Costing
Advantages And Disadvantages Of Variable Costing System
Features Of Variable Costing System
Uses Of Variable Costing System

Advantages And Disadvantages Of Variable Costing System

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Advantages Of Variable Costing System
The major advantages of variable costing are summarized as follows:

1. Variable costing is easy to understand and use. It is applicable to standard costing and budgetary control.

2. The valuation of closing stock on the basis of variability of cost will not facilitate the transfer of part of fixed cost to next period.

3. No need of computation of unit fixed cost, over and under absorption of fixed overhead because contribution margin over and above the fixed cost is the profit margins.

4. In variable costing system, profit is calculated on the basis of sales volume rather than production units.

5. Variable costing system assist management to take rationale decision analyzing the effects of sales and production policy.

6. Variable costing system concentrates management on controlling the controllable costs i.e Direct costs and avoids the tension of allocating the fixed cost without taking any basis.

7. Variable costing assist to management for taking rational decision regarding profit planning and cost control.

Disadvantages Or Limitations Of Variable Costing System
The major drawbacks of variable costing system are as follows:

1. Difficulty in segregating overhead cost into fixed and variable cost.

2. It is not justifiable to exclude fixed manufacturing overhead from inventories.

3. Wide fluctuation in profits due to seasonal demand.

4. Variable costing is not useful for long term planning and decision making.

Determination Of Income Under Variable Costing Approach (VCA)

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We can determine Income under variable costing approach (VCA) as follows:

*Essential Working Notes:
i. Product cost rate, PCR= Total per unit cost of:
* Direct Material
* Direct Labor
* Direct Expenses
* Variable manufacturing overheads

ii. Stock valuation = Units X PCR
iii. Closing stock of finished goods = Opening stock + Actual output - Sales unit
iv. Standard manufacturing fixed costs = SO X FMOR
where, SO = Standard output or budgeted output or normal output or planned output
FMOR = Fixed manufacturing overhead cost per unit.

Income Statement Under Variable Costing Approach(VCA)
Particulars............................................................Amount
A. Sales Revenue (SU X SR)..........................................XXX
B. Variable manufacturing cost of good sold:
i. Direct material (AO X rate)...........................................XXX
ii. Direct labor (AO X rate)...............................................XXX
iii. Direct expenses (AO X rate).......................................XXX
iv. Variable mfg. overheads (AO X rate)..........................XXX
V. opening stock of finished goods.................................XXX
Vi Less: closing stock of finished goods........................(XXX)
C. Total mfg. contribution (A-B).....................................XXX
Less: Total Non-mfg. variable costs.............................(XXX)
D. Total final contribution...............................................XXX
E. Total fixed costs:
i. Manufacturing fixed costs (standard)...........................XXX
ii. Non-manufacturing fixed costs (standard)...................XXX
F. Net income before tax (D-E).......................................XXX

Here,
SU = Sales Unit, SR = Sales Rate, AO = Actual Output, Mfg. Costs = Manufacturing costs.

Related Topics
Concept And Meaning Of Variable Costing And Absorption Costing
Comparison Between Variable Costing And Absorption Costing
Determination Of Profit Under Absorption Costing
Valuation Of Finished Goods Inventory Under Variable And Absorption Costing
Reconciling The Differences In Net Operating Income Under VCA And ACA

Comparison Between Variable Costing And Absorption Costing

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The heart of the difference between variable costing and absorption costing for financial accounting is the accounting for fixed manufacturing costs. All variable manufacturing costs are inventoriable product costs under the both methods. But fixed manufacturing costs are treated differently. Under variable costing, fixed manufacturing costs are treated as expenses of the period. Under absorption costing, fixed manufacturing costs are inventoriable costs. They are then deducted as the costs of goods sold when sales occur.

Since fixed manufacturing costs are excluded in inventoriable product costs under variable costing, it shows a lesser inventory value. In other words, the value of inventory is understated under variable costing.

Unlike that, under absorption costing, product costs are inflated by fixed manufacturing costs. Therefore, inventories are over-stated in absorption costing.
There is a direct relation between the difference in the value of inventory or asset and the net income of the period. Inventory is a current asset. As the size of an asset increases profit also increases and vice-verse.

Related Topics
Concept And Meaning Of Variable Costing And Absorption Costing
Determination Of Income Under Variable Costing Approach
Determination Of Profit Under Absorption Costing Approach
Valuation Of Finished Goods Inventory Under Variable And Absorption Costing
Reconciling The Difference In Net Operating Income Under VCA And ACA

Concept Of Product Costs And Period Costs

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Product Cost
The cost of making a product is called product cost. Product cost is also known as manufacturing cost.Product costs are taken for inventory valuation. Therefore, product costs are sometimes called the inventorial costs. Inventorial costs are all costs of a product that are regarded as assets when they are incurred and then become cost of good sold when the product is sold. If we define product costs differently, it affects the value of inventory and our profits differ. So, the understanding of product costs has a greater value from the perspective of inventory valuation and income reporting. Raw material cost is a precise example of product cost.

Period Cost
The costs that are indifferent to the level of production are period costs. Period costs do not change with the change in production volume. Rather, these costs are incurred either for sales activity or with the passage of time. Office and administrative department costs, and marketing department costs are good examples of period costs. Period costs are not taken for inventory valuation. All period costs are deducted from the revenues of the same period.

Concept And Meaning Of Variable Costing And Absorption Costing

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Variable Costing

variable costing is a method of inventory costing in which all variable manufacturing costs are included as inventoriable costs. In variable costing method, all fixed manufacturing costs are excluded from inventoriable costs. They are instead treated as costs of the period in which they are incurred. Variable costing is a method of recording and reporting costs that regards only those manufacturing costs, which tend to vary directly with the volume of activity, as product costs. Variable costing is also known as 'Marginal Costing' or 'Direct Costing.

Product cost under variable costing:Direct material+ Direct labor+ Variable manufacturing costs
Period cost under variable costing:
Fixed manufacturing costs+ General & administration costs+ Selling and distribution costs

Absorption Costing
Absorption costing is the method of inventory costing in which all variable manufacturing costs and all fixed manufacturing costs are included in inventoriable costs. In absorption costing method, inventory 'absorbs' all manufacturing costs.Absorption costing is also known as 'Conventional Costing' or 'Full Costing'.

Product cost under absorption costing:
Direct material+Direct labor+Variable manufacturing costs+ Fixed manufacturing costs.
Period costs under absorption costing:
General & administrative costs + Selling and distribution costs.

Related Topics
Comparison Between Variable Costing And Absorption Costing
Determination Of Income Under Variable Costing Approach
Determination Of Profit Under Absorption Costing Approach
Valuation Of Finished Goods Inventory Under Variable And Absorption Costing
Reconciling The Differences In Net Operating Income Under VCA And ACA