Variable/Direct/Marginal and Absorption CostingDiscussion Questions and Answers:

Questions:

1. Differentiate between direct costs and direct costing. See answer.

2. Distinguish between period costs and product costs. See answer.

3. Why does the direct costing or variable costing theorist exclude fixed manufacturing costs from inventories? See answer

4. In the process of determining a proper sales price, what kind of cost figures are likely to be most helpful? See answer

5. Why is it said that an income statement prepared by the direct costing procedure is more helpful to management than an income statement prepared by the absorption costing method? See answer

6. Why should the chart of accounts be expanded when direct costing is used? See answer

7. A manufacturing concern follows the practice of charging the cost of direct materials and direct labor to work in process but charges off all indirect costs (factory overhead) directly to income summary. State the effects of this procedure on the concern’s financial statements and comment on the acceptability of the procedure for use in preparing financial statements. See answer

8. Has the Internal Revenue Service approved direct costing for tax purposes? See answer

9. A speaker remarked that even though direct costing has attractive merits, there are certain items that should be concerned before converting the present system. What hidden dangers or disadvantages are present in direct costing? See answer

10. List the arguments for and against the use of direct costing. See answer

11. Select the answer which best completes the statement: See answer

Answers:

1. Direct costs are direct materials, direct labor, and other costs directly assignable to a product. Direct costing or variable costing is a procedure by which only prime costs plus variable factory overhead are assignable to a product or inventory; all fixed costs are considered period costs.

2. Period costs are costs charged against the income of the current period. In direct costing, the fixed factory overhead as well as selling and administrative expenses are treated as period costs. Expenses that apply to the production of goods are called product costs. Variable manufacturing costs are typical product costs in direct costing and are charged against income when the units to which they relate are sold.

3. Fixed manufacturing costs are the expenses of maintaining capacity; such expenses occur with the passage of time and not with the utilization of the facilities.

4. There is no way to prove that one type of cost figure is going to be more helpful than another in the determination of the sales price. The sales price must exceed all costs of every kind before a profit is realized, but this does not mean that some sales of a single product or sales of products could not be made at a price which recovers at least the variable costs or makes a contribution to the recovery of fixed expenses. The absorption or conventional cost approach to pricing looks at the long run total cost recovery. The marginal costing or direct costing approach looks at the short run profit contribution aspect of immediate sales. It seems probable that direct costing is more appropriate in making short run decisions with regard to production schedules and pricing products offered for sales, provided the total cost recovery in the long run is kept in mind.

5. An income statement prepared by the direct costing method presents cost of goods sold figures with variable costs only. These variable costs, based on the number of units sold, facilitate computing a contribution margin figure. Thus the direct costing income statement is preferred by the management because it follows management’s decision making processes more closely that the statement based on absorption costing.

6. Under a direct costing plan, all variable expenses are channeled into the fixed category at the time the expenses are incurred. This procedure means that the chart of accounts has to be expanded to take care of the new accounts needed.

7. The cost to manufacture usually includes the sum of direct materials, direct labor, and applicable indirect factory costs. Consequently, by omitting indirect factory costs from work in process (WIP) the concern is understanding inventory accounts in comparison with concerns which follow the usual practice. At any particular time, then, its financial position (balance sheet) is incorrectly stated because: (a) work in process and finished goods are understated; (b) current assets are understated and so is the net working capital–and therefore the current ratio is understated; (c) total assets are under stated; (d) stockholder’s equity is understated–particularly the retained earnings amount.
   Of at least equal importance is the effect on the recorded results of operations. Unless the sum of the work in process and finished goods accounts happens to be the same at each balance sheet date, costs and revenue will not be matched in the usual manner, resulting in a corresponding distortion of reported income. Thus, if these inventories at the end of the year exceed the corresponding totals at the beginning of the year, Profits will be understated; if these inventories are below those at the beginning of the year, profits will be overstated.
   It is not accepted accounting practice to omit all factory overhead from inventories. While the costs of idle facilities, excessive spoilage, and certain other variances and usual items may be treated as period costs, the usual indirect costs are considered assignable to the production of the period. These indirect factory costs are ordinarily not as easily assignable to products as are the direct cost; but at the time they are incurred, they are recoverable from future revenues. Therefore, they should be added to the direct costs and flow through inventories.

8. The Internal Revenue Service (IRS) does not permit the use of direct costing for tax purposes because it does not clearly reflect income.

9. The hidden dangers or disadvantages present in direct costing are:
   (a) A change to direct costing will prohibit a comparison with the company’s accounting information for any prior year unless past periods are changed to a direct costing basis.
   (b) A seasonal business which produces for six months and sells its entire production in the next six months would show a sizeable loss for the first six months and a sizeable profit for the last six months.
   (c) Those who use direct costing figures must understand the difference between conventional gross profit on sales and contribution to fixed costs and profits and realize the limitations of the contribution theory.
   (d) In planning price and sales policies, the full cost to develop, produce, and market a product must be known. Using direct costs and looking at marginal contributions only would certainly be fallacious when new extensive use of existing expensive equipment or expansion of facilities.
   (e) Direct costing might bring unsatisfactory management action when sales outrun production and inventories are being drawn on. Under these conditions, direct cost profits are higher than under absorption costing. The opposite is true when sales lag behind production.
   (f) When used as the sole vehicle for the management decisions, direct costing can lead to a disregard for the need to recover fixed costs.

10. Arguments for the use of direct costing include the following:
    (a) For profit planning purposes, management requires cost volume profit relationship data which are more readily available from direct cost statement than from absorption costing.
    (b) Since fixed factory overhead is absorbed as a period cost, increasing or reducing production and differences in the number of units produced versus the number sold do not affect the per unit production cost.
    (c) Direct costing reports are more easily understood by management because the statements follow management’s decision making process more closely than do absorption costing statements.
    (d) Reporting the total fixed cost for the period in the income statement directs management’s attention to the relationship of this cost to profits.
    (e) The elimination of allocated joint fixed cost permits a more objective appraisal of income contributions according to products, sales areas, kinds of customers, etc. Cost volume relationships are highlighted.
    (f) The similarity of the underlying concepts of direct costing, flexible budgets, break even analysis, and standard costs facilitates the adoption and use of these methods for reporting, cost control and financial planning.
    (g) Direct costing provides a means of costing inventory that is similar to management’s concept of inventory cost as the current out of pocket expenditures necessary to produce or replace the inventory.
    (i) The computation of product costs is simpler and more reliable under direct costing because a basis of allocating the fixed cost, which involves estimates and personal judgment, is eliminated.
    (j) A “true and proper” profit results from direct costing because only variable costs should be identified with production. Fixed costs occur with the passage of time.
    Arguments against the use of direct costing include the following:
    (a) Separation of costs into fixed and variable costs might be difficult, especially when such costs are semi variable in nature. Moreover, all costs–including fixed costs–are variable at some level of production and in the long run.
    (b) Long-range pricing of products and other long range policy decisions require a knowledge of complete manufacturing cost which would require additional separate computations to allocate fixed overhead.
    (c) The pricing of inventories by the direct costing method is not acceptable for income tax computation purposes.
    (d) Direct costing has not been recognized as conforming with generally accepted accounting principles (GAAP) applied in the preparation of financial statements for stockholders and general public.
    (e) Profits determined by direct costing are not “true and proper” because of the exclusion of fixed production costs which are a part of total production costs. and inventory. Production would not be possible without plant facilities, equipment, etc. To disregard these fixed costs violates the general principle of matching costs with revenues.
    (f) The elimination of fixed costs from inventory results in a lower figure and consequent reduction of reported working capital for financial analysis purposes. The decrease in working capital may also weaken the borrowing position.

11. (a) 3; (b) 2; (c) 2; (d) 4; (e) 1; (f) 3*; (g) 3; (h) 2; (i) 1; (j) 1 (k) 3
    *Operating income under direct costing + Cost deferred in inventory
    $50,000 + $10,000
    $60,000

You may also be interested in other articles from “variable costing system” chapter

1. Variable Costing Vs Absorption Costing
2. Income Comparison of Variable and Absorption Costing
3. Advantages and Disadvantages of Absorption Costing
4. Limitations of variable costing – GAAP and External Reports
5. Advantages of Variable Costing
6. Variable Costing and Theory of Constraints
7. Impact of Just In Time (JIT) Inventory Methods
8. Variable | Direct Costing and Absorption Costing Discussion Questions and Answers