Management Accounting Book

Chapter 7: Profit and Stock-Costing Methods

Importance of Profit in Management Decisions

• Profit figures are critical for managerial decision-making.

• Examples of how profit impacts decisions:

  • Planning Decisions: Analysis of options that affect future reported profits.

  • Cost Reduction Decisions: Managers focus on increasing reported profit through cost reduction initiatives.

  • Performance Evaluations: Reported profit serves as a key metric for evaluating managerial performance.

Stock-Costing Choices Affecting Reported Profit

• Manufacturing companies' reported profit is influenced by cost accounting, especially relating to stock.

• The chapter explores two main types of choices:

  1. Stock-Costing Choices: Methods of determining which costs are recorded as stock. Key methods:

     • Variable Costing: Includes only variable manufacturing costs as inventoriable.

     • Absorption Costing: Includes all manufacturing costs (both fixed and variable) as inventoriable.

  2. Denominator-Level Choices: Determines the pre-selected level for cost allocation used to set budgeted fixed manufacturing cost rates. Types include:

     • Theoretical Capacity

     • Practical Capacity

     • Normal Utilization

     • Master-Budget Utilization

• Warning: Managerial compensation and reward systems may incentivize decisions that enhance short-term reported earnings, compromising long-term financial health.

Learning Objectives

• Distinguish between variable costing and absorption costing.

• Construct income statements using both costing methods.

• Explain profit differences under each costing method.

• Understand the influence of absorption costing on performance evaluations.

• Describe various denominator-level concepts in absorption costing.

• Explain the impact of denominator level on reported operating profit and stock costs.

Part A: Stock-Costing Methods

Overview of Variable vs. Absorption Costing

• Absorption Costing: Required for external reporting under generally accepted accounting principles. It treats all manufacturing costs as inventoriable, including fixed costs.

• Variable Costing: Commonly used by management for decision-making and performance evaluations, excluding fixed manufacturing costs from inventoriable costs.

• The critical conceptual distinction involves whether fixed manufacturing costs are considered inventoriable.

The Centurion Case Example

• Centurion Manufacturing: Produces specialty clothing belts using a normal costing system.

  • Direct costs tracked with actual prices and inputs.

  • Indirect costs allocated via budgeted rates based on outputs.

• For 2022, production data:

  • Produced: 1,100,000 units

  • Sold: 1,000,000 units

  • Closing Stock: 100,000 units

Fixed Costs Accounting Under Costing Methods

• Variable Costing: Fixed manufacturing costs are period costs and expensed in the period incurred.

• Absorption Costing: Fixed costs are absorbed into the cost of goods sold as products are sold, creating stock inventory that absorbs fixed costs.

• Exhibit 7.2 highlights unit inventoriable costs under both methods for Centurion.

Part B: Denominator-Level Concepts

Denominator-Level Concepts in Absorption Costing

• Definition of Capacity: Refers to constraints determining how much can be produced.

• **Types of Capacity: **

  • Theoretical Capacity: Maximum output without interruptions.

  • Practical Capacity: Adjusted theoretical capacity, reflecting unavoidable interruptions.

  • Normal Utilisation: Average expected demand.

  • Master-Budget Utilisation: Anticipated capacity for the next period.

Example: Cocobot and Production Decisions

• Cocobot: A coconut juice bottling entity demonstrating impacts of different denominator-level concepts using absorption costing.

• Fixed monthly costs: €50,000; variable costs per bottle: €0.35.

• Budget rates vary significantly across denominator concepts affecting profitability.

Implications of Costing Methods

Financial Reporting and Managerial Decisions

• Operating Profit Variability: Volatile under variable costing due to direct relation to sales levels. Under absorption costing, driven by both production and sales levels.

• Strategic Production Decisions:

  • Managers can increase profits under absorption costing by producing exceeding demand for stock.

  • Completes the loop where production responses may yield short-term gains at the expense of long-term sustainability.

Recommendations for Management Evaluation

• Consider changing evaluation periods for management performance to include longer-term metrics.

• Use varied performance measures, including non-financial metrics, to mitigate negative incentives from absorption costing.

Summary of Key Concepts

1. Variability in Costs: Fixed manufacturing overhead treatment is the key difference between costing methods.

2. Income Statement Formats: Variable costing focuses on contribution margins; absorption costing relies on gross margins.

3. Operating Profit Drivers: Under variable costing, dictated by sales levels, while absorption costing incorporates production levels.

4. Different Denominator Levels: Chosen denominator affects operational costs reported, influencing pricing and profitability across production levels.

5. Critique on Absorption Costing: Incentivizes stock buildup, harming long-term planning.