Bohemia Industries

Discussion
 Impact of alternate costing
methods on profit measurement
Production =Sales

Production < Sales

Production >Sales
 Difference in profit
July (000s) August (000s)
Cost of goods sold (absorption costing) 3,000 3,300

Cost of goods sold (variable costing) 2,000 2,200

Fixed production costs incorporated in cost of goods sold 1,000 1,100

Fixed overhead volume variance (10) 300

Fixed production costs included in absorption costing
profit statement 990 1,400
Fixed production costs included in variable costing profit
statement 1,200 1,200
Difference between absorption and variable costing
fixed costs (210) 200
Reconciliation of difference between absorption and variable costing profits:
Variable costing profit 200 500
Absorption costing profit 410 300
210 (200)
 Cont.
large decline in opening and closing inventory valuations in August implies
sales > production; so profits under absorption costing system will be lower
Profit differences can also be derived in the changes in inventory valuations:
000s
Decrease in inventory with absorption costing (6,300 5,700) 600
Decrease in inventory with variable costing (4,200 3,800) 400
Absorption costing additional fixed costs included in
difference in opening and closing inventory (August) 200

Absorption costing profit for the 2 months (710,000) exceeds the variable
costing profit (700,000) by 10,000.
Combined July and August periods production volume > sales volume. This
would have also have been true for July but not for August.
If over the entire year production volume = sales volume then both systems
will report the same profits, although profits will differ from month to month if
monthly production and sales volumes differ.
Question 2
absorption costing profit is a function of
production and sales volumes whereas with
variable costing profit is a function of sales
volume. Thus the differences in profits in the
case arises from production volume changes. If
production and sales volumes differ significantly
there are stronger arguments for the adoption
of variable costing.
 Cont.
Vaughans statement that variable costing would
eliminate the need to undertake time-consuming
allocations of fixed overheads may not be correct. It is
likely that profits and inventory valuations would need to
be prepared on an annual basis (or even semi-annually
for interim statements) for external financial reporting.
There may be a possibility that more simplistic
approaches may be acceptable for external financial
reporting such as apportioning the total manufacturing
fixed overheads between inventories and cost of goods
sold or using plant wide rates instead of departmental
rates. However, it is possible that the external auditors
may not accept such simplistic overhead allocations.
 Cont
Vaughans statement: variable costing is
preferable for controlling fixed overheads is not
necessarily correct.
- Adoption of an absorption costing system for
profit measurement and inventory valuation
does not preclude the separate reporting and
control of fixed overheads.
 Cont
Vaughans suggestion: absorption costing involves
arbitrary allocations of fixed overheads that distorts
product costs > moving to ABC can help
why absorption costing should be adopted for profit
measurement and inventory valuation but product-
related decisions like product mix decisions, be based
only on the assignment of relevant avoidable costs. Even
some fixed costs change in the long run with change in
product line and such costs should be incorporated in
the product costs for decision-making.
 Cont
Directors comment: variable costing may result in
business being undertaken at margins that exceeded
variable costs but that may not provide a sufficient
contribution to covering fixed costs or generating
sufficient profit
suggests a misunderstanding of marginal costing system
If variable cost-plus pricing is used, under pricing can be
avoided by larger profit margins being added to variable
costs than that added to full cost
 Cont
Directors comment: adopting variable costing system would result in
two profit reporting systems (one for internal reporting and the other
for external reporting) appears correct.

Profit differences between the two systems depend on inventory

changes [profits are sometimes higher with absorption costing if
production volume exceeds sales volume and lower if production is
less than sales volume].

So it is wrong to assume that variable costing always results in

higher profits.
 Question-3
No precise answer. Both the systems have some arguments in
favour and against.
If August is an abnormal month and substantial differences do not
normally tend to occur with monthly sales and production volumes in
the remainder of the year then there are strong arguments for
adopting an absorption costing system for monthly profit reporting
and inventory valuation.
However, if there are significant mismatches between sales and
production, absorption costing would distort profit and variable
costing would be better. However, the choice should also envisage
which costs to be used for decision-making and control.