Management Accounting 2nd year notes on: Cost Systems and term 2 work: Budgets, Strategy, Valuations and Variance Analysis. Includes question examples, templates and all the work needed for A2S1
Variable manufacturing cost
(direct material, labour & variable overheads) - allocated to products
Fixed manufacturing overheads - allocated to products
Non-manufacturing overheads (i.e. admin cost) - not allocated to products
DIRECT COSTING SYSTEM
Variable manufacturing cost
(direct material, labour & variable overheads) - allocated to products
Fixed manufacturing overheads - not allocated to products
Non-manufacturing overheads (i.e. admin cost) - not allocated to products
Difference: Absorption vs Direct method? =Allocation of FIXED manufacturing overheads
Absorption: Part of inventory valuation
Direct: Treated as periodic expense
(directly to profit and loss)
DIRECT: ABSORPTION:
- excludes fixed cost from inventory valuation - includes fixed cost from inventory
- calculates contribution valuation
- fixed OH cost = periodic expense - calculates gross profit
- no under/ over recovery - fixed OH cost is not a periodic expense
- fixed OH cost causes under / over
recovery in cost of sales
DIRECT: ABSORPTION:
Sales Sales
(Cost of Sales) (Cost of Sales)
(Other variable costs) Under / (over) recovery
CONTRIBUTION GROSS PROFIT
(All fixed costs) (All non-production costs)
NET PROFIT NET PROFIT
1
,arguments to support each method:
DIRECT:
- more useful information for decision making
- removes profit from the effect of inventory changes
- avoids fixed OH capitalised in unsaleable inventory
ABSORPTION:
- fixed OH = essential for production
- does not understate the importance of fixed costs
- consistency with external reporting
- avoids fictitious losses being reported
MANAGEMENT INCOME STATEMENTS:
DIRECT: ABSORPTION:
Sales Sales
(Cost of Sales) (Cost of Sales)
opening stock opening stock
cost of production cost of production
direct labour direct labour
direct material direct material fixed OH rate x actual activity =
variable overheads variable overheads allocated overheads
(closing stock) fixed overheads
(Non-manufacturing overheads) (closing stock)
CONTRIBUTION under / (over) recovery actual fixed OH – allocated fixed OH
(All fixed costs) GROSS PROFIT
NET PROFIT (Non-manufacturing variable
costs)
(Non-manufacturing fixed costs)
NET PROFIT
No under/(over)-recovery in the direct method:
- The direct method excludes FIXED manufacturing overheads from inventory valuation.
- The FIXED manufacturing overheads are treated as a periodic expense; therefore there is no under/(over)-
recovery of fixed manufacturing overheads.
under / (over) recovery in the absorption method:
- The absorption method includes FIXED manufacturing overheads from inventory valuation.
actual fixed OH – allocated fixed OH
2
, PERFORMANCE EVALUATION
1. DIRECT METHOD
example:
How will the direct method help us with the performance evaluation of the sales manager?
- Profit is only a function of sales volumes (only influenced by this factor) – if all other information remains the
same.
3
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