Ch20SM - CHAPTER 20 DISCUSSION QUESTIONS Q20-1 Direct costs...

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CHAPTER 20 DISCUSSION QUESTIONS 20-1 Q20-1. Direct costs are direct materials, direct labor, and other costs directly assignable to a product. Direct costing is a procedure by which only prime costs plus variable factory overhead are assigned to a product or inventory; all fixed costs are considered period costs. Q20-2. Product costs are associated with the manu- facture of a product and include direct materi- als, direct labor, and factory overhead. These costs are charged against revenue as cost of goods sold, or shown on the balance sheet as inventories of work in process and finished goods. Period costs are associated with the passage of time and are included as expenses in the income statement. Under direct costing, fixed factory overhead is treated as a period cost rather than as a product cost. Q20-3. Under direct costing, only variable manufactur- ing costs are included in inventory. Under absorption costing (the current, generally accepted method of costing inventory for exter- nal reporting), all manufacturing costs, both variable and fixed, are included in inventory. Q20-4. It is argued that fixed manufacturing costs are the expenses of maintaining productive capacity. Such expenses are more closely associated with the passage of time than with production activity and should, therefore, be charged to period expense rather than to the product. Q20-5. The direct costing method is useful for inter- nal reporting because it focuses attention on the fixed-variable cost relationship and the contribution margin concept. It facilitates man- agerial decision making, product pricing, and cost control. It allows certain calculations to be readily made, such as break-even points and contribution margins of products, sales territories, operating divisions, etc. The focus on the contribution margin (sales revenue less variable costs) enables management to emphasize profitability in making short-run business decisions. Fixed costs are not easily controllable in the short run and hence may not be particularly relevant for short-run busi- ness decisions. Q20-6. Arguments for the use of direct costing include the following: (a) For profit-planning and decision-making purposes, management requires cost- volume-profit relationship data that are more readily available from direct cost statements than from absorption cost statements. (b) Since fixed factory overhead is absorbed as a period cost, fluctuations in produc- tion and differences between the number of units produced and the number sold do not affect the per unit product cost. (c) Direct costing reports are more easily understood by management because the statements follow management’s deci- sion-making processes more closely than do absorption cost statements. (d) Reporting the total fixed cost for the period in the income statement directs management’s attention to the relation- ship of such cost to profits.
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