Management Accounting

1

A REPORT ON

COMPARATIVE ANALYSIS OF THE EFFECT IN PRODUCTION ON NET OPERATING INCOME DUE TO USE OF VARIABLE

AND ABSORPTION COSTING: A CASE STUDY ON SQUARE PHARMACEUTICALS LTD.

PATUAKHALI SCIENCE AND TECHNOLOGY UNIVERSITY

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COMPARATIVE ANALYSIS OF EFFECTS IN PRODUCTION ON NET OPERATING INCOME DUE TO USE OF VARIABLE AND ABSORPTION

COSTING: A CASE STUDY ON SQUARE PHARMACEUTICALS LTD.

Prepared For:

M. Takibur Rahman

Lecturer

Department of Accounting and Information System

Faculty of Business Administration and Management

Prepared By:

Group: 01(Warrior)

Level- 3, Semester- II

Faculty of Business Administration and Management

Management Accounting

Course Code: AIS 325

Date of Submission: November 22, 2008

PATUAKHALI SCIENCE AND TECHNOLOGY UNIVERSITY

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Sl. No. Name of the students Position Roll No. Reg. No.

01 Md. Kamruzzaman Group Leader 01 00660

02 Shuvradeb Barai Asst. Group leader 09 00668

03 Abu Zafour Member 21 00680

04 Sahana Parveen Member 07 00666

05 Nazmul Alam Siddiqui Member 25 00565

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Date: November 22, 2008

To

M. Takibur Rahman

Lecturer

Department of Accounting and Information System

Faculty of Business Administration and Management

Subject: Letter of Transmittal

Dear Sir,

Here is the report on “Comparative Analysis of Effects in Production on Net

Operating Income Due to Use of Variable and Absorption Costing: ‘A Case Study

on Square Pharmaceuticals Ltd.’ you asked us to prepare this report as a course

requirement of Management Accounting.

This report focuses on the Management Accounting. We are proud of making this

report. We have tried our level best to make the report informative and fruitful.

For any classification we will be available and looking for such term paper in

coming days. We will be happy to get such type of report further.

Sincerely Yours

Md. Kamruzzaman

(Group Leader)

Group: 01(Warrior)

Level-3, Semester-2

Faculty of Business Administration and Management

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Acknowledgment

At first we desire to express our deepest sense of gratitude of almighty Allah.

With profound regard we gratefully acknowledge our respected course teacher

M. Takibur Rahman, Lecturer, Department of Accounting and Information

System, Faculty of Business Administration and Management for his generous

help and day to day suggestion during the survey.

We like to give thanks especially to our friends & many individuals, for their

enthusiastic encouragements and helps during the preparation of this report and for

their assistance in typing and proofreading this manuscript.

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Table of Contents

Introduction

► Introduction 01

► Origin of the report 02

► Purpose of the report 02

► Limitations and scope of the report 03

► Methodology of the Report 04

Description ► Overview of variable costing and absorption costing 10

► Cost classifications 11

► Comparison between variable costing and absorption costing 12

► The matching principles 13

► Advantages of variable costing 14

► Impact of JIT 17

► Format under differences under two methods 18

► Rules regarding absorption costing versus variable costing 20

Problems and Suggesting Actions► Analysis of absorption costing and variable costing 21► Summary result at a glance 28► Overall comments 29Conclusions 30References 31

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Overview of Square Pharmaceuticals Limited

► Overview of Square group 05

► Corporate information 06

► About Square Pharmaceuticals Limited 07

► Mission, Vision and Objectives 08

►Square quality policy 08

►Chronology since inception 09

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Executive Summary

This report is an assigned job as a partial fulfillment of course requirement by

honorable Course teacher M. Takibur Rahman Lecturer, Department of

Accounting & Information System, Faculty of Business Administration and

Management, Patuakhali Science and Technology University. It is the optimum

aggregated outcome of 5 pupils’ about “Comparative Analysis of Effects in

Production on Net Operating Income Due to Use of Variable and Absorption

Costing: ‘A Case Study on Square Pharmaceuticals Ltd.’. The view of this report

is to find out the effects of variable and absorption costing in production on the net

operating in come of a company (Square Pharmaceuticals Ltd.). Now its make a

great position in the market of Bangladesh. Variable costing and absorption costing

are significant elements of a company for the determination of the cost of

production, it is also important to know ‘what are the effects of variable and

absorption costing on the net operating income of a company.

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introduction

Management accounting is undergoing a renaissance in response to technological

changes, globalization, growing risk management concerns. In these challenging

times management accountants help ‘steady of the sleep’ by acting as their

organizations interprets, sage advisors, and ethical keepers of the numbers.

Management accountants are qualified to help their fellow managers achieve good

business results because they have earned an advanced certification that addresses

all important aspects of accounting inside organizations. For the internal decision

making of a company variable costing method is too much significant. Another

costing method is absorption costing; this costing method is known as full costing

method. This costing method is used for external purpose. It is logical that

producing more units would have no impact on profits unless the units are sold. As

we will discover in this report, absorption costing—the most widely used method

of determining products costs—can artificially increase profits by increasing the

quantity of units produced.

Origin of the report

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We are lucky to say that our honorable course teacher M. Takibur Rahman

Lecturer, Department of Accounting and Information System, of Faculty of

Business Administration and Management. Assigned us a report on ‘Comparative

Analysis of Effects in Production on Net Operating Income Due to Use of Variable

and Absorption Costing: ‘A Case Study on Square Pharmaceuticals Ltd.’. This

report is prepared on the basis of surveying the Square Pharmaceuticals Limited.

Purpose of the Report

As a business expectative of future, we should have to gather experience beside our survey. We should not concern our lesion only in classroom but to implement it in practical life that will help us in our future life .A clear objective help in preparation of well decorated report in which other take the right type of decision .So, we identifying objectives is very much important. Our purpose of preparing this report is:

To know about the absorption costing and variable costing

To explain the difference between absorption (full) costing and variable costing.

To prepare an income statement using variable costing and absorption

(full) costing.

To discuss the effect in production on net operating income due to use of

absorption (full) costing and variable costing.

To explain the impact of JIT (just-in-time) on the difference between full

and variable costing income.

To discuss the benefits of variable costing for internal reporting purposes.

To discuss the benefits of variable costing for internal reporting purposes.

To understand the advantages and disadvantages of both variable and

absorption costing.

Limitations & Scope of the Report

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As a student of faculty of Business Administration and Management, 6th semester,

this is our initiative for making a report on ‘Comparative Analysis of Effects in

Production on Net Operating Income Due to Use of Variable and Absorption

Costing: ‘A Case Study on Square Pharmaceuticals Ltd.’ by meeting a survey.

Beside this we have faced the following hindrances in preparing this report:

► Lack of knowledge and experience

► Short of time

► Lack of computer facilities

► Lack of sufficient privileges

► Lack of communication facilities

The survey report focuses on ‘Comparative Analysis of Effects in Production on

Net Operating Income Due to Use of Variable and Absorption Costing: ‘A Case

Study on Square Pharmaceuticals Ltd.’. The survey may not be more comparable

or more valid. Moreover, the report is emphasized on the primary data such as

interview of the manager of Square Pharmaceuticals Limited, as well as secondary

data such as annual report of Square Pharmaceuticals Limited.

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Methodology of the Report

This report is based on both primary and secondary data. Initially, the work is

started with data those were available at Company’s Annual Report and

company’s news letter. Moreover, it becomes helpful to gather some more

information from the website of the company.

Later on, the work progressed through some depth interviews of good range

professionals trying to heat some expected area of the study. After that, an

effective questionnaire is designed to collect likely data from the target group of

people.

Then we analyze those data from many angles, in different aspect and present the

information in different segment according to their category, in compact way. We

highlight different important things, which we found during our survey. After

doing all of those we submit the report to the proper authority.

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OVERVIEW OF SQUARE GROUP

Square Pharmaceuticals Ltd is the flagship company of Square Group. In stark contrast to its present stature, Square had a rather humble beginning. In 1958, the Company started out as a small scale pharmaceutical venture at Pabna, a small town in Northern Bangladesh. It was a partnership effort of four young and enterprising men under the leadership of the Chairman, Mr. Samson H Chowdhury, whose determination and passion saw it through the turmoil of the early days.

In 1964, the Company was turned into a Private Limited Company. After the independence of Bangladesh, 1975 was quite a significant year for Square as it established a technical collaboration with Janssen Pharmaceuticals of Belgium; a subsidiary of Johnson & Johnson, USA. In its relentless quest for higher technology, Square signed a technological collaboration agreement with F. Hoffman-La Roche & Co. Ltd in 1982.

1985 was another historical year for Square as the Company gained the market leadership for the first time in Bangladesh pharmaceuticals market and since then it has been maintaining its position as the leading pharmaceutical Company of the country. In 1987, Square became the first Bangladeshi company to export its product abroad.

The Company stepped into a new era when it was transformed into a Public Limited Company in 1991 and subsequently it was publicly listed at both the stock exchanges in the year 1995. Square Pharmaceutical Ltd has been successfully retaining its market leader position in Bangladesh for the last consecutive 22 years and its current market share is approximately 16%.

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CORPORATE INFORMATION

Corporate Focus:-

Our vision, our mission and our objectives are to emphasize on the quality of product, process and services leading to growth of the company imbibed with good governance.

Corporate Governance:-

Top Management: Board of Directors

As per provisions of the Article of Association, Board of Directors holds periodic meetings to resolve issue of policies and strategies, recording minutes/decisions for implementation by the Executive Management.  Executive Management

The Executive Management is headed by the Managing Director, the Chief Executive Officer (CEO) who has been delegated necessary and adequate authority by the Board of Directors. The Executive Management operates through further delegations of authority at every echelon of the line management.

The Executive Management is responsible for preparation of segment plans/sub-segment plans for every profit centers with budgetary targets for every item of goods & services and are held accountable for deficiencies with appreciation for exceptional performance. These operations are carried out by the Executive Management through series of committees, sub-committees, ad-hock committees, standing committees assisting the line management.

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ABOUT SQUARE PHARMACEUTICALS LIMITED

SQUARE today symbolizes a name – a state of mind. But its journey to the growth and prosperity has been no bed of roses. From the inception in 1958, it has today burgeoned into one of the top line conglomerates in Bangladesh. Square Pharmaceuticals Ltd., the flagship company, is holding the strong leadership position in the pharmaceutical industry of Bangladesh since 1985 and is now on its way to becoming a high performance global player.

SQUARE Pharmaceuticals Limited is the largest pharmaceutical company in Bangladesh and it has been continuously in the 1st position among all national and multinational companies since 1985. It was established in 1958 and converted into a public limited company in 1991. The sales turnover of SPL was more than Taka 7.5 Billion (US$ 107.91 million) with about 16.92% market share (April 2006– March 2007) having a growth rate of about 23.17%.

SQUARE Pharmaceuticals Limited has extended her range of services towards the highway of global market. She pioneered exports of medicines from Bangladesh in 1987 and has been exporting antibiotics and other pharmaceutical products. This extension in business and services has manifested the credibility of Square Pharmaceuticals Limited.

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VISION, MISSION, AND OBJECTIVES

We view business as a means to the material and social wellbeing of the investors, employees and the society at large, leading to accretion of wealth through financial and moral gains as a part of the process of the human civilization.

Our Mission is to produce and provide quality & innovative healthcare relief for people, maintain stringently ethical standard in business operation also ensuring benefit to the shareholders, stakeholders and the society at large.

Our objectives are to conduct transparent business operation based on market mechanism within the legal & social frame work with aims to attain the mission reflected by our vision.

SQUARE's Quality Policy

SQUARE is committed to ensure better life through quality medicine. Ensure strict compliance with WHO standards and local regulatory norms in every phase of sourcing & procuring quality materials, manufacturing, quality assurance and delivery of medicines.

Ensure all activities through documented Quality Management System (QMS) complying International Standard requirements of ISO 9001 through continuously developing Human Resources by regular training and participation.

SQUARE is committed to undertake appropriate review, evaluation and performance measurement of processes, business activities and Quality Management System for continual improvement to ensure highest standard, customer satisfaction, developing human resources and company's growth.

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MISSION

OBJECTIVES

VISION

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CHRONOLOGY SINCE INCEPTION

1958 : Debut of Square Pharma as a Partnership Firm.

1964 : Converted into a Private Limited Company.

1974 : Technical Collaboration with Janssen Pharmaceutica, Belgium, a

subsidiary of Johnson and Johnson  International, USA.

1982 : Licensing Agreement signed with F. Hoffmann-La Roche Ltd.,

Switzerland.

1985 : Achieved first position in the Pharmaceutical Market of Bangladesh

among all national and multinational companies.

1987 : Pioneer in pharmaceutical export from Bangladesh.

1991 : Converted in to a Public Limited Company

1994 : Initial Public Offering of Square Pharmaceutical Shares.

1995 : Chemical Division of Square Pharmaceuticals Ltd. starts production of

pharmaceutical bulk products (API).

1997 : Won the National Export trophy for exporting pharmaceuticals.

1998 : Agro-chemicals & Veterinary Products Division of Square Pharma

starts its operation.

2001 : US FDA/UK MCA standard new Pharmaceutical factory goes into

operation built under the supervision of Bovis Lend Lease, UK.

2004 : Signing of agreement with ROVIPHARM, Vietnam to manufacture and

market SQUARE products under license in Vietnam.

Secured the top position for the best published accounts and report for

2003 in the manufacturing category for transparency and excellence in

corporate reporting.

2005 : New State-of- the-Art Square Cephlosporins Ltd. goes into operation;

built under the supervision of TELSTAR S.A. of Spain as per US FDA/

UK MHRA requirements.

2007 : Square Pharmaceuticals Ltd., Dhaka Unit gets the UK MHRA

approval.

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Overview of Variable and Absorption Costing

At least two methods can be used in manufacturing companies to value units of product for accounting purposes— absorption costing and variable costing. These methods differ only in how they treat fixed manufacturing overhead costs.

Variable Costing

Variable costing includes only variable production costs in product costs. Direct materials, direct labor and variable manufacturing overhead costs would ordinarily be included in product costs under variable costing. Fixed manufacturing overhead is not treated as a product cost under this method. Rather, fixed manufacturing overhead is treated as a period cost and is charged against income each period. This costing system is used for the internal purpose. So, variable costing considered the following—

Under variable costing, no fixed overhead is assigned to inventory

Fixed overhead is a period expense which enters the income statement as a

line item every period regardless of the number of units sold

Variable costing excludes fixed manufacturing overhead from inventoriable

costs. Absorption Costing

Absorption costing treats all production costs as product costs, regardless of whether they are variable or fixed. Under absorption costing, a portion of fixed manufacturing overhead is allocated to each unit of product. Absorption costing is treated as full cost and this costing system is used for the external purpose. So, variable costing considered the following—

Under absorption costing, fixed overhead is assigned to units of inventory

and shows up in the income statement as part of the cost of goods sold

(COGS) when the units are sold

When units are produced and not sold, fixed overhead stays in finished

goods inventory

Absorption costing includes fixed manufacturing overhead in inventoriable

costs.

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Cost Classifications

Cost Classifications—Absorption costing versus Variable CostingUnder absorption costing and variable costing, cost can be classified into two ways,

1. Product cost, and 2. Period cost

The cost categories under this two cost classification in case of absorption costing and variable costing are shown in the following figure—

Figure: Cost classifications

From the above figure we see that under absorption costing method, all manufacturing costs, variable and fixed, are included when determining the unit product cost. Direct materials, direct labor, variable manufacturing overhead, fixed manufacturing overhead costs are included for determining the product costs under absorption costing, and variable selling and administrative expenses and fixed selling and administration expenses are included for determining the period costs.

Under the variable costing method, only the variable manufacturing costs are included in product costs and fixed manufacturing overhead, variable and fixed selling and administrative expenses are included for determining the period costs.

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Absorption Costing Variable Costing

Direct materials Direct labor Product Costs

Product Costs Variable manufacturing overhead Fixed manufacturing overhead

Variable selling and administrative expenses Period costsPeriod Costs

Fixed selling and administrative expenses

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Comparison between Absorption Costing and Variable Costing

When comparing absorption costing and variable costing income statements, a number of points should be noted:

1. Deferral of fixed manufacturing costs under absorption costing Under absorption costing, if inventories increase then a portion of the fixed manufacturing overhead costs of the current period is deferred to future periods in the inventory account. When the units are later taken out of inventory and sold, the deferred fixed costs flow through to the income statement as part of cost of goods sold.

2. Differences in inventories under the two methods The ending inventory figures under the variable costing and absorption costing methods are different. Under variable costing, only the variable manufacturing costs are included in inventory. Under absorption costing, both variable and fixed manufacturing costs are included in inventory.

3. Suitability for CVP analysis An absorption costing income statement is not well suited for providing data for CVP computations since it makes no distinction between fixed and variable costs. In contrast, the variable costing method classifies costs by behavior and is very useful in setting-up CVP computations.

Extended Comparison of Income DataThe comparative income statement’s effects under the variable costing and absorption costing are as follows—

1. Production equals sales (no change in inventories)When production equals sales, inventories do not change. If inventories do not change, then there is no change in the fixed manufacturing overhead costs in inventories under absorption costing. Therefore, under both costing methods all of the current fixed manufacturing overhead will flow through to the income statement as an expense. In the case of absorption costing it will be part of cost of goods sold. In the case of variable costing, it will be a period expense.

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2. Production exceeds sales (inventories increase) When production exceeds sales, inventories grow. If inventories grow, then some of the current fixed manufacturing overhead costs will be deferred in inventories under absorption costing. Since all of the current fixed manufacturing overhead costs are expensed under variable costing, the net operating income reported under absorption costing will be greater than the net operating income reported under variable costing.

3. Sales exceed production (inventories decrease) When sales exceed production, inventories shrink. If inventories decrease, then some of the fixed manufacturing overhead costs that had been deferred in inventories in previous periods will be released to the income statement as part of cost of goods sold as well as all of the current fixed manufacturing overhead costs. Since only the current fixed manufacturing overhead costs are expensed under variable costing, the net operating income reported under absorption costing will be less than the net operating income reported under variable costing.

Relation Between Production and Sales for the Period

Effects on Inventories

Relation Between Absorption and Variable Costing Net Operating Income

Production = Sales No change Absorption costing NOI = Variable costing NOI

Production > Sales Increase Absorption costing NOI > Variable costing NOI

Production < Sales Decrease Absorption costing NOI < Variable costing NOI

Figure: Comparative income effects— Absorption Costing and Variable Costing

4. Long-term differences in income Over an extended period of time, the cumulative net operating income figures reported under absorption costing and variable costing will be about the same; they will differ only by the amount of fixed manufacturing overhead cost in ending inventories under absorption costing. Cumulative net operating income figures will be identical whenever ending inventories are reduced to zero.

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5. Changes in production volume Variable costing net operating income is not affected by changes in production volume. On the other hand, absorption costing net operating income is affected by changes in production volume. For any given level of sales, net operating income under absorption costing will increase as the level of output increases and hence inventories increase.

The Matching Principles

Accountants and managers have been arguing for decades concerning the relative merits of absorption and variable costing. In practice, absorption costing is used far more than variable costing even for internal reports. The reasons for this are not entirely clear, although the perception that absorption costing is required for external reporting undoubtedly plays a key role. The argument for using absorption costing in external reports seems to be based on the matching principle.

1. Argument for absorption costingAdvocates of absorption costing argue that all manufacturing costs must be assigned to units of product so as to properly match costs with revenues. They argue that fixed manufacturing overhead costs are essential to the production process and must be included when costing units of product, regardless of how the cost behaves.

2. Argument for variable costing Advocates of variable costing argue that fixed manufacturing overhead costs are incurred in order to have the capacity to produce. Moreover, they will be incurred regardless of whether anything is actually produced. Since these costs are not caused by any particular unit of product and are incurred to provide capacity for a particular period, the matching principle would dictate that fixed manufacturing overhead costs must be expensed in the current period.

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Advantages of Variable Costing

Advantages of Variable Costing and the Contribution ApproachThere are a number of advantages to using variable costing (and the contribution approach) in internal reports and analysis.

1. More useful for CVP analysis Variable costing statements provide data that are immediately useful for CVP analysis since they categorize costs on the basis of their behavior. In contrast, it is often difficult to rework absorption costing data so that they can be used in CVP analysis and in decisions.

2. Income is not affected by changes in production volume Under absorption costing, reported net operating income is affected by changes in production since fixed costs are spread across more or fewer units. This can distort income and may even result in income moving in an opposite direction from sales. This does not occur under variable costing.

3. Avoids misunderstandings concerning unit product costsAbsorption costing unit product costs can be easily misinterpreted as variable costs since they are stated on a per unit basis. Such a misperception can lead to serious errors in making decisions. Variable costing avoids this problem since unit costs include only variable costs.

4. Fixed costs are more visible The impact of fixed costs on profits is emphasized because the total amount of such costs for the period appears separately and is highlighted in the income statement rather than being buried in cost of goods sold and ending inventory.

5. Understandability Managers should find it easier to understand variable costing reports because data are organized by behavior and because variable costing is much closer to cash flow.

6. Control is facilitated Variable costing ties in with cost control methods such as flexible budgets.

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7. Incremental analysis is more straight-forward

Variable cost corresponds closely with the current out-of-pocket expenditure necessary to produce and sell products and services and can therefore be used more readily in incremental analysis than absorption costing data. And since variable costing net operating income is closer to net cash flow than absorption costing net operating income, it is likely to be more useful to companies that have cash flow problems.

However, variable costing is not generally accepted by auditors for external financial reports and is not permitted by the IRS in the United States and by tax authorities in many other countries for income tax calculations. There is some question about whether variable costing is actually prohibited in the United States by official pronouncements and some companies do use some form of variable costing in their external reports, but absorption costing must be considered the most generally accepted practice.

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Impact of (just in time) JIT

Impact of JIT Inventory Methods When companies use JIT methods for controlling their operations, the distortions of income that can occur under absorption costing largely (or completely) disappear.1. The cause of distortions in net operating income

Erratic movements in net operating income under absorption costing and the differences in net operating income between absorption and variable costing can be traced to changing levels of inventory. When inventory levels are constant or negligible, absorption costing and variable costing methods yield the essentially same net operating income.

2. The JIT solution Under an ideally functioning JIT system, goods are produced strictly to customers’ orders. Finished goods inventories almost disappear and work in process inventories are kept to a minimum. With little or no inventories, fixed manufacturing overhead costs cannot be shifted between periods under absorption costing. As a result, both variable and absorption costing will show essentially the same net operating income figure, and the net operating income under absorption costing will move in the same direction as movements in sales.

Absorption Costing (External reporting) and Income Taxes

Absorption costing is required for external reporting for a company. A company that attempts to use variable costing on its external financial reports runs the risk that its auditors may not accept the financial statements as conforming to generally accepted accounting principles (GAAP). Tax law on this issue is cleat cut. A company must use absorption costing for its external reports; a manager can also use variable costing income statements for internal reports. No particular accounting problems are created by using both costing methods- the variable costing method for internal reports and the absorption costing method for external reports. Top executives are typically evaluated based on the earnings reported to shareholders on the company’s external financial reports.

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Absorption Costing

Revenues ………………………… ***Less cost of goods sold ………….. ***

Gross margin ………………..…… ***

Less selling and administration expenses:

Variable ……………………….. ***

Fixed …………………………... ***

Net operating income (NOI) ***

Variable Costing

Revenues ………………………… ***Less variable cost:

Manufacturing cost …………..….. ***

Selling and administration cost ….. ***

Contribution margin (CM) ....….… ***

Less fixed costs:

Manufacturing costs ………….. ***Selling and administration costs.. ***

Net operating income (NOI) ***

Format Differences Under Two Methods

Format (Technical) Differences

Absorption costing makes a primary classification of costs according to manufacturing and non-manufacturing functions, emphasizing the gross margin (that is, Sales - COGS) available to cover all fixed and variable selling and administrative expenses.

Direct costing makes a primary classification of costs into variable and fixed categories, emphasizing the contribution margin (that is, sales - variable costs) available to cover all fixed costs.

Report Formats

The formats for profit reporting under direct costing and absorption costing are different.

The figures under the two approaches will not always be the same.

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Interpretation of the Difference

The difference between the two income measurement approaches is essentially the difference in the timing of the charge to expense for fixed factory overhead cost. In the absorption costing method, fixed factory overhead is first charged to inventory; thus, it is not charged to expense until the period in which the inventory is sold and included in cost of goods sold (an expense). In contrast, in the variable costing method, fixed factory overhead is charged to expense immediately, and only variable manufacturing costs are included in product inventories. Therefore, if inventories increase during a period (i.e., production exceeds sales), the variable costing method will generally report less operating income than will the absorption costing method; when inventories decrease, the opposite effect will take place.

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Rules Regarding Absorption Costing Versus Variable Costing

Rules about unit sales and production under the two costing methods are as follows:

If sales are variable and production constant

a. When production is equal to sales, then absorption costing and variable costing will give the same amount of net income.

b. When production is greater than sales, then Net Income under absorption costing will be greater than net income under variable costing because a portion of the fixed costs was deferred to other years under the absorption method.

c. When production is less than sales, then Net Income under absorption costing will be less than net income under variable costing because a portion of the fixed costs that were deferred from previous years will be absorbed into this year’s cost of goods sold.

d. The value of inventory will be greater under the absorption method because of the deferred costs; however the total unit count will be the same for each accounting method.

e. Over the long-term, net income will be equal under both methods.

If sales are constant and production is variable then

a. Net income under variable costing is not influenced by the fluctuations in sales (given a constant production) because none of the fixed manufacturing costs are deferred.

b. Net income under absorption costing is influenced by the fluctuations in sales (given a constant production) because a portion of the fixed manufacturing costs are deferred and may be used each year to increase costs.

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Calculation of Product and Period cost of SQUARE PHARMACEUTICALS LTD.

Calculation of product and period cost of SQUARE PHARMACEUTICALS LTD. by using both Absorption Costing and Variable Costing Methods for the 2007 are shown in the following two tables:

Calculation of Product Cost under Absorption Costing and Variable Costing:

Particulars Total (TK.) Per Unit Cost (TK.)

Production in units 3,076,850,000 Absorption Costing Variable Costing

Direct Material note-1

Variable Manufacturing OverheadFixed Manufacturing Overhead note-2

Total

3,569,146,000215,379,500523,064,500

4,307,590,000

1.160.070.171.40

1.160.07

1.23

Calculation of Period Cost under Absorption Costing and Variable Costing:

Particulars Total (TK.) Per Unit Cost (TK.)

Sales in units 3,076,620,000 Absorption Costing Variable Costing

Fixed Manufacturing Overhead note-2

Variable selling and distribution expensesFixed selling and distribution expensesVariable administrative expensesFixed administrative expensesTotal

523,064,000

399,960,600

615,324,00092,298,600

307,662,0001,938,309,200

-----

0.13

0.200.030.100.46

0.17

0.13

0.200.030.100.63

Note-1

Direct material includes the raw materials, packaging materials, and purchase of finished goods.Note-2

Fixed manufacturing includes the salaries, allowances and wages, factory employee’s fees lunch, rental expenses, depreciation and others.

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SQUARE PHARMACEUTICALS LTD.Absorption Costing Income Statement

For the Year Ended 31 March 2007

Particulars Amounts (TK.) Amounts (TK.)Sales (3,076,620,000 units) note-1

Less Cost of Goods Sold:Beginning inventory note-2

Add cost of goods manufactured note-3

Goods available for sale Less ending inventory note-4

Gross MarginLess Selling and Administration Expenses

Variable selling and distribution expensesFixed selling and distribution expensesVariable administrative expensesFixed administrative expenses

Net Operating Income

258,696,2004,307,590,0004,566,286,200

259,018,200

399,960,600615,324,00092,298,600

307,662,000

7,691,550,000

4,307,268,0003,384,282,000

1,415,245,2001,969,036,800

Note-1

Sales during the year is 3,760,620,000 units and selling price per unit is tk. 2.50

Note-2

Beginning inventory in the year is 184,783,000 units

Note-3

Production during the year is 3,076,850,000 units

Note-4

Ending inventory is 185,013,000 units

Product cost per unit is tk. 1.40.

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SQUARE PHARMACEUTICALS LTD.Variable Costing Income StatementFor the Year Ended 31 March 2007

Particulars Amounts (TK.) Amounts (TK.)

Sales (3,076,620,000 units)Less Variable Expenses:Variable Cost of Goods Sold:

Beginning inventory Add cost of goods manufactured Goods available for sale Less ending inventoryTotal

Variable selling and distribution expenses Variable administrative expensesContribution Margin (CM)

Less Fixed Expenses:Fixed manufacturing overhead Fixed selling and distribution expensesFixed administrative expenses

Net Operating Income

227,283,0903,784,525,5004,011,808,590

227,565,9903,784,242,600

399,960,60092,298,600

523,064,000615,324,000307,662,000

7,691,550,000

4,276,501,8003,415,048,200

1,446,050,0001,968,998,200

In 2007 opening inventory is 184,783,000 units and ending inventory is 185,013,000 units. Here we see that inventories are increased (185,013,000 – 184,783,000) = 230,000 units during the year, as a result net operating income is increased under the absorption costing method than the variable costing method. The net operating income under absorption costing method is tk. 1,969,036,800 and variable costing method’s net operating income is tk. 1,968,998,200.

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Calculation of Product and Period cost of SQUARE PHARMACEUTICALS LTD.

Calculation of product and period cost of SQUARE PHARMACEUTICALS LTD. by using both Absorption Costing and Variable Costing Methods for the 2006 are shown in the following two tables:

Calculation of Product Cost under Absorption Costing and Variable Costing:

Particulars Total (TK.) Per Unit Cost (TK.)

Production in units 2,779,500,000 Absorption Costing Variable Costing

Direct Material note-1

Variable Manufacturing OverheadFixed Manufacturing Overhead note-2

Total

3,224,220,000194,565,000523,064,500

3,941,849,500

1.160.07

0.18818651.4181865

1.160.07

1.23

Calculation of Period Cost under Absorption Costing and Variable Costing:

Particulars Total (TK.) Per Unit Cost (TK.)

Sales in units 2,768,567,000 Absorption Costing Variable Costing

Fixed Manufacturing Overhead note-2

Variable selling and distribution expensesFixed selling and distribution expensesVariable administrative expensesFixed administrative expensesTotal

523,064,000

359,913,710

615,324,00083,057,010

307,662,0001,938,309,200

-----

0.13

0.22225360.03

0.11112680.4933804

0.1889295

0.13

0.22225360.03

0.11112680.6823099

Note-1

Direct material includes the raw materials, packaging materials, and purchase of finished goods.Note-2

Fixed manufacturing includes the salaries, allowances and wages, factory employee’s fees lunch, rental expenses, depreciation and others.

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SQUARE PHARMACEUTICALS LTD.Absorption Costing Income Statement

For the Year Ended 31 March 2006

Particulars Amounts (TK.) Amounts (TK.)Sales (2,768,567,000 units) note-1

Less Cost of Goods Sold:Beginning inventory note-2

Add cost of goods manufactured note-3

Goods available for sale Less ending inventory note-4

Gross MarginLess Selling and Administrative Expenses

Variable selling and distribution expensesFixed selling and distribution expensesVariable administrative expensesFixed administrative expenses

Net Operating Income

246,551,7233,941,849,3774,188,401,100

262,056,756

359,913,710615,324,00083,057,010

307,662,000

6,921,417,500

3,926,344,3442,995,073,156

1,365,956,7201,629,116,436

Note-1

Sales during the year is 2,768,567,000 units and selling price per unit is tk. 2.50

Note-2

Beginning inventory in the year is 173,850,000 units

Note-3

Production during the year is 2,779,500,000 units

Note-4

Ending inventory is 184,783,000 units

Product cost per unit is tk. 1.4181865.

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SQUARE PHARMACEUTICALS LTD.Variable Costing Income StatementFor the Year Ended 31 March 2006

Particulars Amounts (TK.) Amounts (TK.)

Sales (2,768,567,000 units)Less Variable Expenses:Variable Cost of Goods Sold:

Beginning inventory Add cost of goods manufactured Goods available for sale Less ending inventoryTotal

Variable selling and distribution expenses Variable administrative expensesContribution Margin (CM)

Less Fixed Expenses:Fixed manufacturing overhead Fixed selling and distribution expensesFixed administrative expenses

Net Operating Income

213,835,5003,418,785,0003,632,620,500

227,283,0903,405,337,410

359,913,71083,057,010

523,064,000615,324,000307,662,000

6,921,417,500

3,848,308,1303,073,109,370

1,446,050,0001,627,059,370

In 2006 opening inventory is 173,850,000 units and ending inventory is 184,783,000 units. Here we see that inventories are increased (184,783,000 – 173,850,000) = 10,933,000 units during the year, as a result net operating income is increased under the absorption costing method than the variable costing method. The net operating income under absorption costing method is tk. 1,629,116,436 and variable costing method’s net operating income is tk. 1,627,059,370.

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Reconciliation of Net Operating Income

The reconciliation of the variable costing and absorption net operating income are shown in the following figure—

Particulars Amount (TK.) Amount (TK.)

Year 2007 2006Variable costing net operating income

Add fixed manufacturing overhead costs deferred in inventory under absorption costing

Deduct fixed manufacturing overhead costs released from inventory under absorption costing

Absorption costing net operating income note-1

1,968,998,200

31,452,210

31,413,110

1,969,037,300

1,627,059,370

31,413,110

29,356,500

1,629,115,980

Note-1

Absorption costing income statement show that the Net operating Income of SQUARE PHARMACEUTICALS LTD. for the year 2007 is tk. 1,969,036,800 but in reconciliation it shows that the company’s Net Operating income is 1,969,037,300. This difference is tk. (1,969,037,300 — 1,969,036,800) =500 and in 2006 absorption costing Net Operating Income is tk. 1,629,116,436 but in reconciliation we see that this is tk. 1,629,116,436. Difference is tk. (1,629,116,436—1,629,115,980) = 456. These differences occurred due to the fractions in different figure.

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Summary Result at a Glance

The total result of our calculation for the comparison of net effect on net operating income under both methods Absorption Costing and Variable Costing are shown in the following:

Particulars Year-2007 Year-2006

Costing method Absorption Variable Absorption Variable

Product cost 1.40 1.23 1.4181865 1.23

Period cost 0.46 0.63 0.4933804 0.6823099

Net operating income 1,969,036,800 1,968,998,200 1,629,116,436 1,627,059,370

Effects

Inventories Increased during the year Increased during the year

Net operating incomeAbsorption costing net operating income > Variable costing net operating income

Absorption costing net operating income > Variable costing net operating income

Net operating income 1,969,036,800>1,968,998,200 1,629,116,436>1,627,059,370

Group-1 (Warrior)

Year-2006

Year-2007

1629116436 19690368001627059370

1968998200

Comparison of Net Operating IncomeAbsorption Costing NOI Variable Costing NOI

35

Overall Comments

From the calculations of net operating income of variable costing and absorption costing of Square Pharmaceuticals Limited we see that, in 2006 their net operating income under absorption costing is tk. 1,629,116,436 and under variable costing net operating income is tk. 1,627,059,370. Here a question arise that why this difference is occurred. This difference is occurred due to use of different accounting method. We know that if inventory increase during the year then the net operating income is increased under absorption costing than that of viable costing net operating income statement. Because when inventory increase then fixed manufacturing overhead cost of these ending inventories is deferred to the next period, as a result total cost during the year is decreased. Here fixed manufacturing overhead cost is treated as product cost, but in case of variable costing method fixed manufacturing overhead cost is treated as period cost. So total manufacturing overhead cost is charged in the period regardless their sales volume. As a result net operating income under this method is lower than that of absorption costing method. In 2006 opening inventory is 173,850,000 units and ending inventory is 184,783,000 units. Here we see that inventories are increased (184,783,000 – 173,850,000) = 10,933,000 units during the year, as a result net operating income is increased under the absorption costing method than the variable costing method.

In the same way in 2007 opening inventory is 184,783,000 units and ending inventory is 185,013,000 units. Here we see that inventories are increased (185,013,000 – 184,783,000) = 230,000 units during the year, as a result net operating income is increased under the absorption costing method than that of the variable costing method. The net operating income under absorption costing method is tk. 1,969,036,800 and variable costing method’s net operating income is tk. 1,968,998,200.

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CONCLUSION

Two general approaches are used in manufacturing companies for costing products for the purpose of valuing inventories and cost of goods sold. Absorption costing is generally used for external financial reports. The other approach, called variable costing, is preferred by some managers for internal decision making and must be used when an income statement is prepared in the contribution format. Ordinarily, absorption costing and variable costing produces different figures for net operating income, and the difference can be quite large. In addition to showing how these two methods differ, we will consider the arguments for and against each costing method and we will show how management decisions can be affected by the costing method chosen.

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BIBLIOGRAPHY

H. Garrison Ray, W. Noreen Eric, and C. Brewer Peter, Managerial Accounting, 12th Edition, McGraw-Hill, pp 276-292.

Annual report of Square Pharmaceuticals Limited, 2007-2008.

Roychowdhury, S. (2006). Management of earnings through the manipulation of real activities that affect cash flow from operations. Working Paper. MIT Sloan School of Management.

Kinney, M. and W. Wempe (2005). JIT Adoption: The effects of LIFO reserves and financial reporting and tax incentives. Contemporary Accounting Research 21(3), 603-638.

Jiambalvo, J, E. Noreen and T. Shevlin (2007). Incremental information content of the change in percent of production added to inventory. Contemporary Accounting Research, 14(1), 69-97.

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