Answer to Question #196628 in Accounting for Andy

Question

(ii) In terms of allocating fixed manufacturing overheads, what is the IFRS requirements in terms of budgeted, normal and actual quantities as a possible denominator? (1)

(iii) Explain why the choice of an appropriate denominator level is important. (3)

(iv) Give a short description of the three methods that are available to distinguish between variable and fixed costs. (6)

Answer 1

Solution:

ii). Under IFRS, fixed manufacturing overheads are allocated to each unit of production based on the normal capacity of the production facilities. The actual quantities are normally used as the possible denominator in allocating the fixed manufacturing overheads.

 

iii). The choice of an appropriate denominator level is important since it can have a significant effect on product cost and absorption costing net income. The choice of a denominator can help provide more accurate product costs and prevent a death spiral effect that may arise when planned capacity is utilized.

 

iv). The three methods that are available to distinguish between variable and fixed costs are:

1.     High-low method – This uses two points that are the highest and the lowest as inputs from a given set of data pairs of activity levels and the corresponding total cost figures. These are then used to calculate average variable cost per unit and total fixed cost and obtain a cost line.

2.     Scatter graph method – This is a graphical technique of separating fixed and variable components of cost by plotting activity level along the x-axis and corresponding total cost along the y-axis. A regression line is then drawn on the graph by visual inspection. The line drawn is used to estimate the total fixed cost and variable cost per unit. The point where the line intercepts the y-axis is the estimated fixed cost and the slope of the line is the average variable cost per unit.

3.     Least-squares regression – This is a statistical technique that may be used to estimate a linear total cost function for a mixed cost based on the past cost data. The cost function is then used to predict the total cost at a given activity level, such as the number of units produced or labor hours used. It mathematically calculates the line of best fit to a set of data pairs: a series of activity levels and corresponding total cost at each activity level.