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» Variable / Direct / Marginal
and Absorption Costing Discussion Questions and Answers
Variable/Direct/Marginal and Absorption Costing Discussion Questions and Answers:
Differentiate between direct
costs and direct costing.
Distinguish between period
costs and product costs.
Why does the direct costing
or variable costing theorist exclude fixed manufacturing costs from
In the process of
determining a proper sales price, what kind of cost figures are likely
to be most helpful?
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?
Why should the chart of
accounts be expanded when direct costing is used?
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
Has the Internal Revenue
Service approved direct costing for tax purposes?
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?
List the arguments for and
against the use of direct costing.
Select the answer which best
completes the statement:
||The term meaning
that all manufacturing costs (direct and indirect, fixed and variable)
which contribute to the production of the product and traced to output
and inventories is: (1) job order costing; (2) process costing; (3)
absorption costing; (4) direct costing.
||The term that is
most descriptive of the type of cost accounting often called direct
costing is (1) out of pocket costing; (2) variable costing; (3) relevant
costing; (4) prime costing.
||Costs treated as
product costs under direct costing are: (1) prime costs only; (2)
variable production costs only; (3) all variable costs; (4) all variable
and fixed manufacturing costs.
assumptions made in direct costing with respect to fixed costs is that
fixed cost is: (1) controllable cost; (2) a product cost; (3) an
irrelevant cost; (4) a period cost
computed using direct costing would generally exceed operating income
computed using absorption costing if: (1) units sold exceed units
produced; (2) units sold are less than units produced; (3) units sold
equal units produced; (4) the unit fixed cost is zero
||A company has
operating income of $50,000; using direct costing for a given period.
Beginning and ending inventories for that period were 13,000 units and
18,000 units, respectively. If the fixed factory overhead application
rate is $2 per unit, the operating income using absorption costing is:
(1) $40,000; (2) $50,000; (3) $60,000; (4) not determinable from the
costing differs from direct costing in the: (1) fact that standard costs
can be used with absorption costing but not with direct costing; (2)
kinds of activities for which each can be used to report ; (3) amounts
of costs assigned to individual units of product; (4) amount of fixed
costs that will be incurred.
||When a firm uses
direct costing: (1) the cost of a unit of product changes because of
changes in the number of units manufactured; (2) profits fluctuate with
sales; (3) an idle capacity variance is calculated by a direct costing
system; (4) product cost include variable administrative costs.
under absorption costing can be reconciled to operating income
determined under direct costing by computing the difference between: (1)
inventoried fixed costs in the beginning and ending inventories and any
deferred over or under applied fixed factory overhead; (2) inventoried
discretionary costs in the beginning and ending inventories; (3) gross
profit (absorption costing method) and contribution margin (direct
costing method); (4) sales as recorded under the direct costing method
and sales as recorded under the absorption costing method.
||Under the direct
costing concept, unit product cost would most likely be increased by:
(1) a decrease in the remaining useful life of factory machinery
depreciated by the units of production method; (2) a decrease in the
number of units produced; (3) an increase in the remaining useful life
of factory machinery depreciated by the sum of the years digits method;
(4) an increase in the commission paid to salespersons for each units
direct costing information, the contribution margin discloses the excess
of: (1) revenue over fixed cost; (2) projected revenue over the break
even point; (3) revenue over variable cost; (4) variable cost over fixed
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.
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.
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.
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.
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.
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.
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;
stockholder's equity is understated--particularly the retained earnings
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.
The Internal Revenue Service
(IRS) does not permit the use of direct costing for tax purposes because
it does not clearly reflect income.
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
(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
(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
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
(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
(f) The similarity of the underlying concepts of direct costing,
break even analysis, and standard costs facilitates
the adoption and use of these methods for reporting, cost control and
(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
(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.
(b) 2; (c) 2; (d) 4; (e) 1; (f) 3*;
(g) 3; (h) 2; (i) 1; (j) 1 (k) 3
income under direct costing + Cost deferred in inventory
$50,000 + $10,000
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