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Income effects of alternative cost accumulation systems

5 important questions on Income effects of alternative cost accumulation systems

Variable costing / marginal costing / direct costing

Under this system, only variable manufacturing costs are assigned to products and included in the inventory valuation. Fixed manufacturing costs are not allocated to the product, but are considered as period costs and charged directly tot the profit statement. Non-manufacturing costs are treated as period costs.

Period cost adjustment

Under absorption costing, over- and under-recovery of fixed overhead might occur as a result from budgeted activity differing from actual activity.

Arguments in favor of variable costing

1. Variable costing provides more useful information for decision making.
2. Variable costing removes from profit the effect of inventory changes. Under absorption costing, managers can deliberately defer some of the field overhead allocation to future periods by unnecessarily increasing inventories over successive periods, thereby increasing their profits. Under variable costing this incentive is removed.
3. Variable costing avoids fixed overheads being capitalized in unsaleable inventories.

When absorption costing systems are used, estimated fixed overhead rates must be calculated. These rates will be significantly influence by the choice of the activity level: that is, the denominator activity level that is used to calculate the overhead rate. Which four different denominator levels can we use?

1. Theoretical maximum capacity: 100% efficiency with no interruptions
2. Practical capacity: represents the maximum capacity that is likely to be supplied by the machine.
3. Normal activity si a measure of capacity required to satisfy average customer demand over a longer time period.
4. Budged activity is based on the capacity utilization required for the next budget period.

Cost of unused capacity

The cost of unused capacity (know as volume variance) is the under-recovery of overhead arising from actual activity being different from the activity level used to calculate the overhead rate.