Some Concluding Comments on Transfer Prices Accounting Help

Transfer prices usually are not paid in cash; they are only entries made ill the accounting records to record the “flow” of goods and services among departments within the business.” In essence, the transfer price may be viewed as revenue earned by the segment supplying the products and as a cost (or expense) to the segments receiving them. As these departmental revenues and costs are of equal amount, transfer prices have no direct effect on the company’s overall net income.

Nonfinancial Objectives and Information

Thus far, we have emphasized measuring only the financial performance of responsibility centers within a business organization. In addition to financial criteria, many firms specify nonfinancial objectives that they consider important to their basic goals. ‘A responsibility accounting system canoe designed to gat’ier both financial and non financial information about each of its centers. Shown on the following page are some common nonfinancial measures that managers often evaluate

Nonfinancial Objectives and Information

Nonfinancial Objectives and Information

case in point

case in point

RESPONSIBILITY CENTER REPORTING IN FINANCIAL STATEMENTS

In this chapter, we have focused on responsibility centers from the perspective of management, From this perspective, centers are defined along areas of management responsibility. beginning with the very smallest units of the business, such as departments or each salesperson’s “territory.”

the responsibility center information developed for management. But of course it serves _ a very different purpose. The users of an annual report are evaluating the overall profitability and future prospects of the company viewed as a whole, not evaluating the efficiency of every department, store, and production process. For financial reporting purposes, some publicly owned corporations subdivide their operations into only two “segments”; few (if aQY) show more than 10.

VARIABLE COSTING

Our preceding examples involving NuTech Electronics illustrated the activities of a typical company. In a merchandising company. the entire cost of goods sold represents a variable cost, In the financial statements of a manufacturing company. however, the cost of goods sold is based on what it costs to manufacture the inventory that was sold, As we learned in earlier chapters, some of these manufacturing costs are variable.

while others are fixed. The conventional practice of including both variable and fixed manufacturing costs in the valuation of inventories and costs of goods sold is called full costing, Full costing is the method required by generally accepted accounting principles and by income tax regulations.

Under variable costing. the cost of goods sold includes only variable manufacturing costs. Fixed manufacturing costs are’ viewed as period costs and are deducted separately in the income statement after the determination of the contribution margin. Before discussing variable costing further, let us briefly review some of the basic concepts of accounting for manufacturing costs.

full Costing The Traditional View of Product Costs

we made the distinction between product costs and period costs. Product costs are the costs of manufacturing inventory and are debited to the Work in Process Inventory account. From this account. product costs flow into the Finished Goods Inventory account. from which they eventually flow into the Cost of Goods Sold account.

Thus product costs are offset against revenue in the period in which the related goods are sold. Period costs. on the other hand, are charged directly to expense accounts and are deducted from revenue in the period in which they are

Variable Costing A Different View of Product Costs

Some manufacturing costs are variable co-ts and some manufacturing costs arc fixed. The costs of direct materials anJ direct labor arc examples of variable costs. Examples of fixed manufacturing costs include overhead items such as depreciation on plant (1<;- sets, factory jp urance prcr ..ium , and supervisor salaries. Recall that under full costing. these fixed overhead cost were applied to products using an activity base such as direct labor hours

FLOW OF COSTS UNDER FULL AND VARIABLE COSTING

FLOW OF COSTS UNDER FULL AND VARIABLE COSTING

The treatment of these fixed manufacturing costs creates an important difference between full costing and variable costing. Under full costing, we will use the $13 unit cost to determine the cost of goods sold and ending inventory. Under variable costing, these amounts will be determined using the $8 unit cost.

Partial income statements and ending inventory figures for the Nashville Plant prepared under full and variable costing are illustrated below

full costing

full costing

treatment of Fixed Manufacturing Costs

We have stressed the point that under full costing, fixed manufacturing costs are viewed as’ product costs, whereas under variable costing, they are viewed as period costs. Let us now illustrate what that means in terms of the valuation of inventories and the amount of profit (responsibility margin) reported under each method.

Observe how the full costing method affects the amount of responsibility margin reported by Hamilton’s Nashville plant. Under full costing, fixed manufacturing costs are deferred to future periods. Instead of being deducted from revenue immediately..a portion of these costs is carried forward as part of the cost of inventory. These costs are released from inventory and included as part of costs of goods sold in the period in which the inventory to which they have been assigned is sold. In our illustration, $5.000 in fixed manufacturing cost was carried forward in inventory under the full costing method.

This explains why the corresponding ending inventory figure and responsibility margin are $5,000 higher under full costing

·In summary. full costing results in a higher responsibility margin than does variable costing when more units are produced than are sold (that is. when finished goods inventory increases during the period). In periods when more units are sold than art?produced (that is, when finished goods inventory decreases for the period). full costing results in lower responsibility margins because previously deferred fixed costs are included in the cost of goods sold

Fluctuation in the level of Production

Two accounting measurements widely used in evaluating the performance of a manufacturing center of a business are the unit cost of manufactured products and responsibility margin. A significant shortcoming in the full costing approach is that both of these performance measurements are affected by short-term fluctuation in the level of .production.

This complicates the process of evaluating the performance of a center. The manager performing the evaluation must determine whether changes in unit cost and in responsibility margin represent important changes in performance or merely the effects of a temporary change in the number of units produced

This problem arises because under full costing. fixed manufacturing costs are Included in the cost of finished goods manufactured. If the level of production temporarily rises, fixed costs perunit will decline. If production temporarily declines, fixed costs per unit

will increase. In either case, the changes in fixed costs per unit will also affect total unit . manufacturing cost. In addition to causing changes in unit cost, fluctuations in the level of production may cause some fixed costs to be deferred into inventory, or released from inventory, For example, if production rises above the level of current sales, some of the fixed costs of the period are deferred into inventory, rather than being offset against the revenue of the current period. If production temporarily falls below the level of sales. the fixed costs of prior periods are released from inventory and charged against the, revenue of the current priod

To illustrate, we will take two years of operatiors at the Jogrnan Stereo Division of Ya to Manufacturing. We will assume that sales, variable costs per unit. and total fixed costs remain unchanged in both years, The only change i,~a temporary fluctuation in the division’s annual level of production. Specifically, it. produced 60,UOO units in Year I and only 40.000 units in Year 2.2 Operating data for the two years arc shown below

Operating Data for the Jogman Stereo Division

Operating Data for the Jogman Stereo Division

From these Openating data. the responsibility income statements on the next page were prepared under the variable and full costing approaches

income stetment

income stetment

Summary

Because the full costing method associates fixed manufacturing costs with units of production, the amount of fixed manufacturing cost offset against revenue varies with the relationship between the number of units produced and the number sold. If production temporarily exceeds unit sales, some fixed manufacturing costs are deferred to future periods. and ‘responsibility margin will be higher than would be reported under variable costing. If fewer units are produced during the period than are sold, fixed costs·

deferred in prior periods are offset against current revenue as inventory is drawn down. Thus. responsibility margin reported for the current period will be lower than would result from variable costing.

In the long run, the total amounts of responsibility margin reported under ful! costing and variable costing should be very similar. Over the long run. the number of units produced tends to equal the number of units sold. in. the short run, however. variable. costing provides managers with more reliable measurement of the performance of the sub units engaged in manufacturing activities.

Why Is Variable Costing Unacceptable tor Use in Financial Statements and Income Tax Returns?

We have shown that in several respects variable costing may be more useful than full costing as a basis for many management decisions. Why then is variable costing not also used in financial statements and income tax returns? The answer to this question is that variable costing omits fixed manufacturing costs from the valuation of the ending inventory.

Financial accountants and income tax. authorities argue that variable costing <significantly understates the “full” cost of manufacturing this asset. As a result of understating ending inventories. variable costing may understate net income, especially for a growing business with steadily increasing inventories

net connection

net connection

Posted on November 24, 2015 in Responsibility Accounting and Performance Evaluation

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