Reviewing Absorption Costing Profits

An Empirical Research of UK Industrial Machinery Manufacturers for the period

2000-2007

Table of Contents
Chapter 1 Introduction
1.1 Background

1.2 Aims and Objectives

1.3 Methodology

1.4 Expected Outcomes

1.5 Structure of the Research

Chapter 2 Literature Review
2.1 Matching and Revenue Recognition

2.2 Role of Alternative Costing Techniques in Management Accounting

2.3 The Effect on Taxation

2.4 Significance of Accounting Bodies and Other Institutes

2.5 Scope for Costing Techniques and Accounting Standards

Chapter 3 Research Plan
3.1 Research Focus

3.2 Research Method

3.3 Study Limitations

Chapter 4 Data Collection and Analysis
4.1 Data Sources

4.2 Estimated Values for Fixed Costs Levels

4.3 Analysis
Chapter 5 Conclusion and Recommendations
5.1 Conclusion

5.2 Recommendations
References

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 Chapter 1

Introduction
1.1 Background
The use of full or direct costing has been fiercely debated in the accounting circles
during the last and present century. In UK, the full and direct costing argument
reached a new height by 1950 due to a developing challenge of direct costing. It
came as a result of the developments in the US. An article with the title ‘What did we
earn last month?’ was written in a paper in the National Association of Cost
Accountants Bulletin by Harris in 1936 which presented answer to this question by
using a new term, ‘direct costing’( Armstrong 1995).

The terms “full costing” or “absorption costing”, “direct or variable costing” or

“marginal costing” and “stock” or “inventory” will be used interchangeably in this
paper as these are different names of same objects and/or processes. The
supporters of the direct costing and the advocates of full costing engaged in debate
over the merits and demerits of these methods. The basic difference between the
two costing systems is dealing of fixed manufacturing costs. Direct costing treat
these costs as the period costs while the full costing system include these costs in
the product cost.

The stock valuation, according to SSAP 9, 1975 (revised 1988) in UK corporate

financial reporting, requires the inclusion of all production costs and also the
representation of all the expenditures incurred in bringing the product or service to its
present condition. Also in Appendix 1, par. 4 of SSAP 9 the following rule has been
provided for the allocation of overhead costs. “The classification of overhead
necessary to achieve this allocation [of overheads to stock] takes the function of
overheads as its distinguishing characteristic rather than whether overhead tends to
vary with time or with volume” (SSAP 9, Appendix 1, par. 4).

The introduction of SSAP 9 paved the way for full costing to overcome direct or
variable costing. There are defects in direct costing. Because of some outflows that

2
do not affect materials and labour but more general expenses and are therefore
treated as overhead, the direct cost estimates could be inappropriate or partial.
Theoretically these hidden expenses might be found as a drop in expense that would
follow rejection of the product or work in question. It would be very difficult to find
these figures when the products manufacturing is done in a chain of departments.

It seems that a large number of accountants have accepted absorption costing.

Many accountant authoritative bodies also have adopted it without unnecessary
objection. Accordingly SSAP 9 did not argue clearly that absorption costs should be
used because in order to bring stock back to its present condition, overheads are
required. Absorption costing is stated as a high achievement of the cost accountants.
But with the passage of time, the complexity of absorption costing has increased.
Direct costing proved to be a simpler and better method for problem solving and
decision making for managers.
Decision making becomes difficult with absorption costing due to the inclusion of
overheads. During nineteenth century overheads grew bigger as compared with
direct costs in many firms. At times these become too much in excess to the direct
costs. Therefore managers charge these overheads to product costs to cover their
cost. Whereas marginal cost was too small to represent and full cost was more
useful.

The inventory left at the end of the accounting period affects the profit calculation
because of the difference of opening and closing inventory values. Due to inventory
adjustment the cost of sales figure is reduced(increased) if the closing inventory
value is greater (smaller) than that of opening stock, which results in increasing
(reducing) the gross profit. The absorption and marginal inventory valuation will
result in same profit figures if there is no difference between opening and closing
inventory values, which is very uncommon. The difference in profit figures obtained
by using absorption and marginal costing methods is important and depends on:
(1) Fixed cost level
(2) Inventory adjustment value relative to the components of the profit computations
i.e. the sales and cost of sales values.

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In the long run term it is expected that the relative significance of factor (2) will
reduce. So, a little difference to aggregate profits is caused by the inventory
valuation basis and inventory adjustment over the time period. On the other hand the
greater significance of inventory relative to other profit and loss account variables
means that the method of inventory valuation and inventory adjustment are expected
to have a greater prospective to impact periodic profits and consequently the pattern
of these profits significantly.

Theoretically, where the change in inventory levels is known and the percentage of
fixed production cost to total production cost remains constant during the accounting
period it is likely to recognize the impact of the choice between absorption and
marginal Inventory valuations on profit. Depending on the direction of the inventory
adjustment, the profits could be raised or lowered by changing from one basis to the
other. In a cost structure with constant production, absorption (marginal) costing will
give higher (lower) profits when inventories are increasing (decreasing).

1.2 Aims and Objectives

This research will discover and analyse the effect of using absorption costing on the
profitability of UK industrial machinery manufacturers from 2000–2007. This effect
would be identified by checking the difference of these companies’ profits using
marginal costing and thus representing the potential of this method for performance
measuring. In order to check the long term effects of the selected method on the
time series of companies, equations will be used. It has to be done because of the
following reasons.

1. Some new empirical research emphasised on the practical use of marginal

costing in management accounting. For example Dugdale et al. (2005)
focused on management accounting environment and concluded that
marginal costing sustains wide-ranging practical demand in management
accounting. Many management accountants think that direct costing gives
better profit information than absorption costing.

2. Likewise the requirement of accepting absorption costing is to be extended

broadly through the authority of international accounting standards. Interest

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 will be developed in countries (e.g.Scandinavia), where marginal costing
practice is leading at this time (Virtanen et al. 1996), by the knowledge of the
effects of approving absorption costing in the UK.

3. It has been a matter of great importance over the last two decades to control
the levels of inventory. Practically some systems like just-in-time and Kanban
proved their popularity (Wilkinson and Oliver 1998); (Billesbach 1994);
(Balakrishran et al.1996), co-operative supplier networks (Dyer 1996);
Langfield-Smith and Greenwood (1998), ERP and MRP systems for resource
planning (Wagle (1998), Davenport (1998) and encouragement and effective
use of lean production ideal (e.g. Cooper, 1995; Darlington, 1999) have
decreased the inventory significance in calculating income. Because the
reduction of inventory results in low profits with absorption costing. It is not
unjust to assess the value of choice between the two costing systems for
profit computation and stock valuation which could result in fairer reporting.

4. Adoption of Absorption costing will give higher reported profits with increased
stock. It is criticised because it motivates managers to raise stock intentionally
to get advantage. Also enough time has passed since SSAP 9 was
established to facilitate an examining study of the sensitivity of reported profits
to the adopted technique of inventory valuation in the UK.

1.3 Methodology

This research is an empirical investigation of UK industrial machinery manufacturing

companies for the effects of using direct costing as an alternative to full costing on
reported profitability for the 8 years period i.e. 2000-2007. The two years (2008 and
2009) were excluded from the research as these years turned out to be unusual for
many businesses and likewise for the manufacturing sector. The manufacturing
sector is facing a period of recession during this period Rozenberg (2007),
Monaghan (2008) and Conway (2008).

Including these years in the research would not give us a fair view of the effects of
using direct costing as an alternative to full costing on reported profitability. The

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research is intended to generate evidence of change of actual reported profit by
altering the accounting technique. Present literature will provide a set of fixed
production cost levels. As it is a limitation of the research that actual fixed costs
levels for companies are not known. These cost levels would be used to calculate
the difference of reported profit by altering the accounting method. Actual profits will
be computed using direct costing and their sensitivity will be analysed.

It will be a time series research design. Time series profits would be used in the
study. Additionally, it is assumed that fixed costs levels obtained would pertain for
the study period for performing the sensitivity analysis of time series profits. Though
it is likely that fixed costs remain stable for a long-term period but, at least for some
of the companies, it is possible that their level will change considerably over 8 year
period. I shall be using the equation developed by Solomons (1965:111–112) which
showed that marginal costing profit could be converted to absorption costing profit by
the following equation

X i, t
Pv , i ,t=Pf ,i , t+(Ss ,i , t−Se ,i ,t )
Y i ,t

Wherei= company, t = time, Pv= Profit for the period before tax using variable
(marginal) costing, Pf = Profit for the period before tax using full (absorption) costing,

Ss= Total cost of opening inventory, Se= Total cost of closing inventory, X = Total
fixed cost of production for the period, Y = Total (fixed and variable) cost of
production for the period. Pf , Ss and Se could be obtained from the annual reports.
But the fixed and production costs (fixed and variable) are not reported by the
companies for public viewing. Cost structures of previous studies will provide a basis
for calculating these costs.

1.4 Expected Outcomes

The result might be that average annual stock in some companies during the time
period of study may increase, supporting the full costing method of inventory
valuation. While a decline in average annual stock could be viewed because of the

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modern methods of stock control pointed out earlier. This will favour the use of
marginal costing. Though the result will base on annual increase or decrease in the
levels of inventory for the time period for more of the modern industrial machinery
manufacturing companies of UK. The fluctuations in sales figures during the period
would also have an impact on the profitability with both accounting systems. The
study will indicate the more appropriate method of costing.

1.5 Structure of the Research

This paper will include four chapters. Chapter 1will is the brief introduction of the
research subject with the description of research aim and objectives. It will also
explain the methodology of the research along with the expected outcomes of the
research. Literature review will be focused in chapter 2.The explanation of the
previous study results and outcomes of the researches carried out previously, in this
area, will be done in chapter 2 of this paper.

Chapter 3 will explain the research plan, research design, and the limitations of the
study. While chapter 4 comprises details of the data i.e. its sources, analysis etc and
the outcome of the data analysis. In the end there will a conclusion of the study and
a section for the references.

Chapter 2
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 Literature Review
It has been a long time since the debate started about absorption and direct costing
procedures and since then it has always been an issue for discussion among the
accountants and managers that which one is the better of the two. After 1925
Management accounting become idle because of the supremacy of the requirements
of financial reporting over those of management information (Johnson and Kaplan
1987).It seemed that nearly all management accounting practices used today were
established by 1925 and at this point the swift of improvement stopped.

On the other hand it was argued by some that developments in accounting started
from discussion of self-interest of various groups and the requirement for theoretical
explanations were satisfied by excuses .For example Watts and Zimmerman (1978,
1979, 1986).According to them theories come out after the determination of those
practices which fulfil the objectives of different interest groups. But it is a process
with more dimensions. One of which is the provision of knowledge and improvement
in understanding that could results in better accounting practices.

In UK, a reflection of theoretical dominance of absorption costing was observed by

1920 to 1950.Some examples include Wheldon (1937) who divided the overheads
and wrote them under four centres i.e. production, distribution, administration and
selling and later on dissected in a way making sure the fair allocation to departments
to include them in each individual manufactured unit. Similarly Carter (1938) stated
that indirect expenses must be equitably apportioned to different executed orders.
Generally it was thought that government activities in wartime promoted the full
costing practice.

Ahmed and Scapens (2000) narrate that the use of absorption costing became
usual because government factories used it. Viewing this most firms used full costing
for the cost estimates and get them verified by government accountants. The
government was allowed, by the acts of the parliament, to use its own techniques for
calculating the cost of production and to set a maximum price for any manufactured

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object during the war (The Accountant 1941: 98).But weaknesses developed in the
active price control system in the Second World War.

A report was issued by Select Committee on National Expenditure on Supply

Services in the beginning of 1939.This report pointed out wide spread problems and
the Committee presented wide ranging and complete recommendations (Ahmed and
Scapens 2000).The report went along the theory of absorption costing while giving
proper attention to the division of overheads. It divided the overheads into general
overheads and shop on cost (Ahmed and Scapens 2000).The dominance of
absorption costing was challenged by a new term “direct costing” which was used by
Harris (1936) in US.

Ideas from break even analysis, cost volume profit and flexible budgeting were
mingled with the periodic reporting of income and expenditure by double entry
system in direct costing. Thereby It becomes a way of reporting historic results that
might be different from results obtained by using absorption costing. Because it
values inventory at variable, instead of full, manufacturing cost. Which was
mentioned as ” the most controversial issue of direct costing” (NACA, 1953: 1097).
On the other hand nothing was stated by NACA to adopt one or the other method,
instead it stated that the selection should be made on the basis of comparative
usefulness of figures obtained by both the methods and therefore each company
must reach the conclusion itself (NACA, 1953: 1117).

2.1 Matching and Revenue Recognition

Supporters of absorption costing emphasise on considering all the costs whether
fixed or variable to be matched with the revenue recognized for the same period.
Horngren and Sorter (1961, 1962) propose that only variable production costs should
be matched. They further state that the created value, which is generated by sales is
not a base for the intrinsic future economic benefits in the ownership of inventory but,
instead, it shows the future costs that will be saved by owning it at the present. In
view of the definition of an asset, their understanding of the matching principle
seems reasonable.

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The receipt of the income is deferred until its normal realisation at sales point. To
achieve objectivity, one must delay recognition of all costs associated to the deferred
income, if he wishes to recognise income late (Fess and Ferrara 1961).They view
income generation because the value is added. However, the costs should be
delayed as the recognition of income is delayed. Fremgen (1962) urges that stock
value should take account of fixed production overhead. He views income generation
at the time of sale but desires that all the contributing costs should be carried forward
and matched against the earned income.

Change in production levels does not affect most fixed costs. Usually, by having
inventory, only the variable costs of production will be saved in future. According to
Green (1960) fixed costs are period costs and it is suitable to match them to an
accounting period and these should be included in the profit and loss account.
This treatment is justified by prudence and also by the nature of the fixed costs. It
could be viewed that representation of capacity providing resources for a time period
is done typically by many fixed costs (McFarland, 1966).

So if the capacity is not utilized completely, during an accounting period, then idle
capacity costs would be shown by some of the fixed costs. Treating the idle capacity
costs as an asset would not be prudent. In direct costing there is no problem of this
nature as the fixed costs are written off instantly. There lies a risk in absorption
costing that costs of idle capacity could be treated as assets incorrectly. This is
because the fixed costs are included in the inventory values at the start.

2.2 Role of alternative costing techniques in Management accounting

In fact, both inventory valuation methods could be criticised because of lack of

objectivity. Absorption costing lacks objectivity because of the illogical allocation
methods used to attach fixed costs to individual product lines. While the need to split
production costs into fixed and variable components in marginal costing could brings
additional subjectivity to reporting. It does not seem possible to accurately recognize
fixed and variable costs because many costs do not clearly belong to either group.
Thus subjective estimation methods may be used.

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Thomas (1969, 1974) initiated flexibility to a certain level in financial accounting by
which comparability and reliability of the financial statements could be compromised.
Marginal costing was supported over the absorption costing because it is practically
more relevant and also shows the costs relationship more directly. Horngren and
Sorter (1961) stated direct costing as more appropriate and useful for external
reporting. They viewed the service potential of an asset as the main feature.

They were of the view that inventory produced in advance of sales might only save
variable cost of future and thus direct costing is a better method of valuing stock.
Managers become able to raise the operating income in the short run by escalating
the production plan ignoring the demands for products. Costs of doing business are
raised without any assistant increase in sales, by such a difference in the plan of
production. The fixed manufacturing overhead that is expense of the period is
absorbed in each unit produced extra.

Thus absorption costing provides unwanted incentives for managers, which may
encourage mangers to take steps which are against the long run interests of the
company (Horngren and Foster 1991). In case of direct costing these incentives are
not present therefore it is considered more appropriate by some accountants and
managers. According to the Anglo-American Council on Productivity (1950), the use
of direct costing for inventory valuation is more suitable. Because in this method no
part of the overheads is not carried forward to the next accounting period, as only
direct incurred expenses of manufacturing are included in inventory valuation.

2.3 The affect on taxation

As a consequence, it completely changes the base of month by month profit

measurement. The profit measurement also has an impact on the income tax of the
companies. Companies are unwilling to alter their accounting methods in case of
opposition from the internal revenue department (Horngren, 1962: 353).It was
observed that the tax authority of UK i.e. Inland Revenue was concerned over
inventory valuation procedures. The Inland Revenue have always been reluctant to
set down strict rules to follow for calculating taxable profits but the interest of Inland
Revenue in the inventory valuation has been on the rise.

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In the case of Duple Motor Bodies vs. Inland Revenue Commissioners, a direct
costing method was used by Duple Motor Bodies for many years but the Inland
Revenue challenged Duple Motor Bodies, to include the manufacturing overhead in
stock value. This was done to increase the taxable profit of the company
(Accountancy, 1961).The Chairman of the Board of Inland Revenue sent a letter to
the President of Institute of Chartered Accountants of England and Wales (ICAEW)
stating that the Inland Revenue wants the inclusion of overheads in inventory
valuation (Accountancy 1961).

The Inland Revenue was not willing to see a switch to the direct method by most of
the manufacturing companies in the wake of the Duple case. Inland Revenue was
trying to discourage the use of direct costing and asked the companies to stop its
practice and employ absorption costing instead. It is assumed that the Inland
Revenue wanted to maximise tax revenue therefore it was pushing hard for the
adoption and use of absorption costing. A rise in the closing value of inventory will
result in higher profit figure and hence higher tax liability.

Interest continued to develop in direct costing in UK, regardless of opposition of the

tax authorities. Accounting statements prepared using the absorption costing were
considered as complex. (Dixon 1966:76) argues that the mangers might try to ignore
altogether, a statement presented by their accountants, which is too difficult to
understand fully in a short time. He criticised the absorption costing method by
stating that theoretically as well as practically it is incorrect to carry forward fixed
expense of one period to the next period in inventory valuation.

2.4 Significance of accounting bodies and other institutes

In 1961, a report was published on marginal costing by ICWA which presented
the concept of contribution and segregation of variable costs from fixed costs (ICWA,
1961).It also showed the combination of contribution with limiting factors and its use
in pricing and make or buy decisions (ICWA 1961). This report showed that marginal
costing is a good technique for decision making and understanding different cost
behaviour. Work-in-progress valuation and finished stock was also discussed in the

12
report. Though, the treatment of fixed costs was not clear. Marginal costing is not as
informative as absorption costing for financial reporting (ICWA 1961).

The report favoured the use of absorption costing by emphasising on the importance
of the apportionment of fixed and service costs to cost centres. The use of marginal
costing was supported for managerial decision making only. Theoretically, managers
were free to use either system for internal reporting. As far as external reporting is
concerned, they were limited to the use of absorption costing by the Inland Revenue
and Accounting Standards Steering Committee along with the recommendations of
the ICAEW.
The internal reporting system is affected by external reporting requirements due to
certain reasons. These reasons are:
Firstly, the confusion that might arise by different reported profits figures by internal
and external systems. Secondly, the single system is cheaper to implement. Thirdly,
the management might seek the recommendation of “best practice” by external
authorities. Lastly, a consistently used system would make auditing easier for the
management and auditors.

In direct costing reports of the US, the use of direct costing method was seen as
positive by the accountants. Considering the statement of the Committee on
Accounting Procedure, the reports indicated the use of direct costing in external
reporting. Conversely, the absorption costing was seen as provider of more useful
information on inherent worth of the products and total costs in UK report (ICWA,
1961). The value of marginal costing for informal decisions was also recognised in
the report. Marginal costing became more popular during mid-1960s and, in the
1970s, it was considered superior for information of management.

After 1965 the support for direct costing became conventional in management
accounting. Many studies of management accounting favoured marginal costing.
Perhaps most firms, by illogical allocation of overheads, still puzzle the cost
measurement while attempting to calculate full average cost of production (Bourn
1967:273). The accountants and managers seem more convinced by marginal
costing.

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Kate (1970) describes the introduction of direct costing as a result of the confusion
created by over and under absorption of fixed overheads. He further stated that
management decisions should not be based on costs allocations and that’s why he
termed it as a non productive work. ,

2.5 Scope for Costing Techniques and Accounting Standards

ASSC issued SSAP9 in 1975 after debate on its exposure draft ED6 released in
1972. In the early 70s the marginal costing grew in practice but ED6 discouraged its
use for external reporting. There were reservations among the industry and
accounting professional bodies relating to ED6.Fundamentally the concept of
carrying forward of overheads is not correct especially when prices are not based on
costs and this concept is also in opposition to the prudence (Manchester Society of
Chartered Accountants, 1972).

The exposure draft ED6 was also criticised by different companies. A feeling of great
danger arises because ICAEW are now extolling absorption costing for excluding
marginal costing (Chloride Electrical Storage Co. Ltd, 1972).Other companies and
professional bodies also pointed out the short comings of the draft. But ASSC paid
more attention to the consistency rather than the benefits of the costing systems and
issued SSAP9 in 1975. Another standard (IAS2), for inventory and work in progress,
became effective in 1976.This standard repeated the superiority of absorption
costing for inventory valuation.

This provided a structure for UK inventory reporting for the coming period. So the
dominance of absorption costing was recognized in financial reporting in UK and in
many other countries as well. It is hard to understand that why the use of absorption
costing was so broadly authorised. Although, the accounting standard setters were
not concerned much about inventory valuation until 1960s yet three factors can be
distinguished as reasons for the UK and international accounting standards.

First, the irregularities and scandals in accounting in 1960s paved the way for
launching of ASSC. Reduction of the variety of stock valuation methods was one of
the initial tasks performed by this committee. So, it provided a simple base for

14
harmonisation of procedures if most companies were using absorption costing.
Second, the financial reporting directives in US clearly supported absorption costing
for reporting. Third, Inland Revenue was firm in its position of supporting absorption
costing. It was a significant persuader in structuring SSAP9.

In view of the previous studies it is obvious that there is a wide scope for discussion
about these two accounting methods for inventory valuation and external reporting.
Both accounting systems have merits and demerits but neither of the method is
proved to be the “best practice”. Both accounting methods i.e. absorption and
marginal have support with strong arguments. Also there are arguments against both
the methods. Same accounting principles are interpreted differently, in most of the
cases, to generate arguments. Neither of these methods is superior to the other
theoretically, because accounting principles favour both methods.

Considering this, it became important to determine whether these inventory valuation

systems give different profit figures when applied practically. This paper will give
some new empirical evidence of the use of these systems. The empirical study aims
to analyse the importance of inventory valuation for modern financial reporting.
Chapter 3 will explain the methods to be used to analyse and provide evidence for
different profits figures.

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 Chapter 3

The Research Plan

3.1 Research Focus

This research will reveal empirically, the effects of shifting from absorption to
marginal costing, on the profits of UK industrial machinery manufacturing companies
over the period 2000–2007. It is planned to point out the vulnerability of the actual
reported profits to this alteration of accounting procedure by providing a set of
indirect evidence. The two factors finding out the profit differential level, caused by
these methods, are related to the collected evidence. Which are
1. Identification and assessment of the significance of annual inventory adjustment
as a part of profit measurement.
2. To find out the actual profit sensitivity to the use of variable costing, a range of
fixed cost levels will be used to explore the sensitivity of reported profit to this
accounting technique selection. This will be carried out for time series profits guide.

The fixed cost levels would be obtained from existing literature.

We can only draw conclusions about the possibility that the choice between
absorption and marginal costing is one which alters reported profits considerably.
Because the evidence found is indirect.

3.2 Research Method

The profit calculated by using absorption costing could be converted to marginal

costing based profit by an equation used by Solomons (1965, p.111–112). Similarly
marginal costing profit could be converted to absorption costing profit by a simple
adjustment. But for either conversion one should be aware of the values for opening
and closing inventories and the fraction of fixed production costs to total costs of
production. Also the profit figure for one of the accounting methods i.e. Marginal or
Absorption should also be known. The equation to be used is

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 X i, t
Pv , i ,t=Pf ,i , t+(Ss ,i , t−Se ,i ,t )
Y i ,t

Hereiis for the company, t is for time, Pvis profit for the period before tax using direct
or variable costing, Pf is profit for the period before tax using full costing,
Sshas been used for total cost of opening stock while Sefor total cost of closing stock,
X is the total fixed cost of production for the period andY represents the total (fixed
and variable) cost of production for the period. For this study Pf , Ss and Se will be
acquired from the annual reports of the companies. As the fixed and production
costs (fixed and variable) are not available in the annual reports, therefore these
values will be calculated on the basis of cost structure used in previous studies.

Fixed costs levels were obtained from section 4.2 to estimate the vulnerability of
profitability of UK industrial machinery manufacturers to considerable variation from
the adoption of marginal costing.

3.3 Study Limitations

The actual fixed cost levels of individual companies are not known, which is a
limitation of this study. The obtained evidence therefore cannot expose the real
impact of direct costing on each year reported profits directly. The range of possible
fixed cost levels are used as a substitute for the actual costs. Additionally, the given
fixed costs levels are assumed to be applying for the research period duration for the
sensitivity analysis of time series profit. Fixed costs are imagined to have a stability
which holds for a long term. However, it is possible that at least in some companies
the level of fixed cost change considerably over 8 years period.

Chapter 4

Data Collection and Analysis

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4.1 Data Sources

The UK industrial machinery manufacturing companies were used for this empirical
study. Because it is likely that these kinds of companies have large inventories and
also significant level of fixed production costs are incurred by these companies. For
this research, the study sample comprises of companies in which the calculation of
profit would be vulnerable to the factors causing absorption and marginal costing
profits to differ. Only manufacturers of industrial machinery were included in the
research. The companies used for the study are listed on FTSE 350 index of London
Stock exchange.

Most of the financial data was obtained from annual reports of these companies. All
major companies which manufacture industrial machinery and are listed on FTSE
350 index were included, except those which did not exist for whole of the study
period i.e. 2000-2007. The companies performing other functions along with
industrial machinery manufacturing were also excluded for this research. This was
done because of the importance of inventory valuation. As the reported inventory
values for these companies also comprise of inventory used for operations other
than manufacturing industrial machinery.

4.2 Estimated Values for Fixed Costs Level

Some previous studies provide evidence for high level of fixed costs in modern
manufacturing companies. For example see Boer and Jeter (1993), Cooper and
Kaplan (1987) etc. There are a number of reasons which were pointed out in
different studies for the change in cost structure. Because of automation in
industries, the cost structure has changed and fixed costs have increased while
variable costs have decreased (Lee 1987).

Supporters of throughput accounting consider all manufacturing costs as fixed

except the cost of bought-in material. These include Dugdale and Jones (1996) and
Waldron and Galloway (1998) and also some others. McNair et al., (1988) stated
that the outcome of change in cost structure is the minimization of variable costs in

18
modern manufacturing process. This opinion was supported by Dugdale and Jones
(1996) and Noreen et al. (1995).

It is not a reporting requirement for any company to disclose its costs of production
as fixed and variable components but some earlier studies indicate the level of fixed
cost of production in UK and some other countries. To estimate the level of fixed
cost, for empirical testing, the observations of these studies would be used as a
base. The cost structure in some of the findings was seen as below

Table 1

Country Industry Cost Structure Study by Year of Study

UK Engineering 35% Production Innes and 1990
overhead, 60% Direct Mitchell
Material and 5%
Direct Labour
USA Measuring 20% Production McNair et al. 1988
Products Overhead and 80%
Direct Material
USA Machine 40% Total fixed costs Cooper and 1987
Tools and 60% Total Kaplan
Variable cost
UK Electronics 40% Production Innes and 1990
Overhead (Inclusive Mitchell
of a very low
percentage of Direct
Labour) and 60%
Direct Material
UK Iron-foundry 37% Total fixed cost Coates et al. 1987
and 63% Variable
costs

A survey of UK manufacturing companies which included 137 companies showed

that 27% of the total production costs are the controllable production overheads
(Develin and Partners 1990).As this survey include manufacturing companies which
are different from the companies in this study. This cost structure could be ignored.
The cost structures in the table, which represent engineering and other similar
industries, have been considered for this study. The table gives us an indication of
the range of fixed cost levels. Fixed costs represent 20-40% of total production costs
according to the findings of studies in the table (If fixed production costs are
classified as part of overheads).

19
After viewing the cost structures in the table, it is evident that 20% of total production
costs would be a lower limit for fixed production costs as it is lowest indirect cost of
previous studies for the type of industry under study while 40% could be the upper
boundary which is the highest mentioned percentage for direct costs in engineering
or alike industries. Therefore 30% is an average estimate for fixed production cost
level, in particular, if it is likely that fixed costs are a major part of most of the
production costs except direct material. These three figures would be used for
sensitivity analysis now.

4.3 Analysis

Four major industrial machinery manufacturing companies were included in the

sample for the study. These included Bodycote PLC, IMI PLC, Morgan Crucible Weir
Group PLC. The inventory values reported in the financial statements of the
companies were used in the analysis. These values are in accordance with the UK
GAAP (In UK GAAP, the monetary value for finished goods is also added to the
value of inventory at the end of the accounting period). It has also been assumed
that the companies were reporting inventory according to UK GAAP through the
whole study period for consistency of results.

Reporting under International Financial Reporting Standards (IFRS) for some of the
years and under UK GAAP for the rest of the period would not give a true picture of
the inventory change. The role of the inventory control systems in industry has been
described as a crucial one by critics of absorption costing. Because these inventory
control systems reduce the significance of stock for reporting. Table 2 is showing the
results of the observations for the 8 year study period.

Table 2
UK Industrial machinery manufacturing sector inventory levels 2000-2007

Years Mean Standard Average Annual Annual percentage

(£000) Deviation (£000) Stock change* change in average
(£000) stock* (%)

20
 2000 122,523 94,976 5,715 5.65
2001 120,965 91,395 -1,558 9.39
2002 96,460 75,636 -24,505 -4.48
2003 88,809 65,785 -7,651 -12.05
2004 84,244 63,867 -4,566 -6.77
2005 72,162 98,114 -12,082 -10.53
2006 72,525 93,153 364 -4.84
2007 94,200 115,849 21,675 19.28
*Based on individual companies over a 2 years period

The study period indicates a decline in the average value of inventory based on full
costing for more of the period. The average value for inventory dropped in 6 years
and rose in 2 years of the research period. For the sample of the companies, the
value of inventory dropped from £122,523,000 to £94,200,000 during eight years
period. It has been a continuous reduction process from 2000 to 2005. The value of
inventory has not reduced evenly over the period. The decreasing trend for inventory
growth shows a decline in profits using full costing for most of the years.

The average annual stock value is showing more fluctuations. The annual
percentage change in average inventory has been negative for 5 years of the study
which is inconsistent with the reporting profit using absorption costing technique. The
full costing method will show increasing profit every year if the inventory value rises.
The annual percentage change in average stock in this study favour the use of
marginal costing reporting as it would be presenting increase in profit with the
reduction in stock.

However, we could not decide for the reporting method just by viewing the annual
percentage increase or decrease in average stock. This gives us an indication for the
potential use of marginal costing for reporting. Although the stock has decreased in
absolute terms but we also have to see its role in relative terms. Table 3 gives a brief
view of stock relation with components of balance sheet and income statement.

The impact of reduction or increase in stock on the sales and cost of sales figures
could be analysed by the figures of the table 3. The significance of inventory in
calculating income is reduced due to the inventory control systems like co-operative
supplier networks, just-in-time and Kanban etc. To check the effect of these systems

21
 on industrial manufacturing profit computation, it is necessary to calculate the stock
turnover and average stock/sales percentage.

Table 3 indicates that the inventory value has declined in relative terms as well.
The average stock/sales figures show a marginal decline over the study period.
Also slight but consistent fall is observed in the average stock /total asset values
during most of the period of study. The figures for stock turnover and average annual
stock adjustment/annual profit before taxation show much variation.

Table 3
Relative significance of inventories in Industrial machinery manufacturing sector of
UK 2000-2007

Years Average Average Cost of Average annual Average annual

Stock/Sale Stock/Total Sales/Average stock stock adjustment/
s (%) assets (%) stock adjustment/ Annual profit
Annual sales* before taxation**
(%) (%)
2000 10.63 10.81 9.73 0.62 6.58
2001 10.6 11.05 10 0.48 9.78
2002 8.97 9.37 8.61 2.37 38.48
2003 8.61 9.14 9.29 0.65 8.33
2004 8.01 8.87 10.35 0.66 9.20
2005 7.13 7.77 12.7 1.97 42.46
2006 7.13 7.90 15.17 0.35 16.88
2007 8.66 8.73 13.65 2.01 18.87
1
n
S
| s ,i ,t e, i ,t|
−S 1
n
|S s ,i ,t −S e, i ,t|
* ∑ , ** ∑
n i=1 Salesi ,t n i=1 |Profit i ,t|

For the prospective of the selection of inventory valuation technique Table 3 gives us
a more direct signal to influence reported profit by examining the importance of stock
adjustment. The stock adjustment fluctuates between 0.35–2.37% (neglecting the
direction of inventory movement) of annual sales. Depending on the level of fixed
costs these percentages show the way the profit margin ratio could be manipulated
by the selection of accounting method. When compared to reported profits before
tax, the stock adjustment has high prominence in only 2 years of the period. For the
period of this study the average annual stock adjustment represents at maximum
42.46 % of the reported profit.

22
The effect of stock adjustment does not have a significance effect on the profitability
for most of the years. The Because of less difference between opening and closing
stock values for more of the years, the impact of stock adjustment on the profitability
would not be substantial. Therefore, the choice of accounting method would not be
affecting the reported profits significantly for more years of the study.

The average inventory figures were used because some managers might increase
inventory values deliberately at the year end to show more profits with absorption
costing. As it has been a point of criticism for full costing. The values for average
stock/sales and average stock/total assets indicate that the inventory holding has
reduced over the period until 2006 for the UK industrial equipment manufacturers.
However, in 2007 the inventory value has raised again in relation to total assets and
sales.

The figures of the table reveal the importance of inventory, as the figures of inventory
declined marginally in relation to total assets and sales and if we see at the last 2
years figures the value in relation to sales remained same as of 2005 while the
prominence of inventory as an asset has increased. The variation in stock turnover
values also point to the importance of inventory for profit computation as it showed
more increases than decreases during the period.

It could be said that stock control systems such as use of lean production ideal and
Kanban etc does not have a consistent affect on the UK industrial equipment
manufacturing. After looking at all the variables and their variations it might be
concluded that the importance of the choice of accounting systems between
absorption and marginal costing have sustained much of its worth for the
computation of profit during this period

Now we will assess the sensitivity of annual reported profits to the change in fixed
cost level and accounting method. This would be carried out by dividing annual stock
adjustment by annual profit before tax for the individual companies then multiplying
this figure with the ratio of fixed production cost to total production cost for each year
then adding the resulting figures for the number of years in the time period. This
could be written mathematically as

23
 N
( S s ,i ,t −S e, i ,t ) X i ,t
Aac =∑ ∕ N
1 |P f ,i , t| Y i ,t

Where Aac = Average annual change in profit, N = Time period.

Although Table 3 shows that stock adjustment is not a major part of the annual sales
for the companies under study. But its variation has been crucial for annual profits
calculation.

Table 4 represents the impact of change in the cost structures and inventory
valuation methods on the profitability of three Industry machinery manufacturers i.e.
Bodycote PLC, IMI PLC and Weir Group PLC after their four continuous years of
reporting starting from 2000 over a period of 5 years starting from 2003 to 2007 with
different fixed cost levels.

Table 4
The average annual changes in reported profits with different cost ratios with
marginal costing
N (In Years) Aac (in %age) at Aac (in %age) at Aac (in %age) at
20% Fixed cost 30% Fixed cost 40% Fixed cost
4 1.19 2.87 7.52
5 1.75 2.63 2.84
6 1.31 1.97 2.07
7 1.12 1.69 1.77
8 0.4841 0.73 0.55

This table shows average annual changes of three companies due to change in the
inventory valuation method with different cost structures. During the five years period
all the average changes have been positive. Some positive changes are more
significant than the rest. The positive change represents that the change in inventory
valuation system from absorption to marginal costing gave more profit. As the
inventory value decreases during the time period, it shows more profit with marginal
costing.

It is noting that with increase in fixed cost the change in profit give higher figures with
marginal costing. This is consistent with the views of marginal costing advocates,

24
who believe that due to more automation in the industries the fixed costs area have
expanded while the variable costs have reduced. The figures of the table also
convey us that more automation increased the fixed costs in the companies and due
to this increase the profits with variable or direct costing are more than with full
costing. It has been a practice to allocate overhead costs using direct labour hours.

Some of the studies done in US, reported that direct labour hour is the most
frequently and widely used method for overheads allocation to products. The
reasons for this widespread use of direct labours to allocate overheads could be
explained on the basis of cost versus benefits. It is likely that the many of the studies
might have given too much weight to the use of direct labour hour basis for overhead
allocation. But many organizations possibly consider direct labour hours as the most
suitable cost driver of their cost pools.

There are many advantages for allocating overheads using direct labour hours. The
figures for direct labour hours are easily accessible but on the other hand the other
cost drivers data might require high data collection costs. Moreover it is evident to
propose that methods with labour based allocation would not adversely affect
information produced for decision making. One of the reasons for automation is to
reduce the labour hours based costs in the long term and to improve the efficiency of
the organisation.

Increasing use of technology is encouraged by Japanese companies because it

improves quality, flexibility and speed (Hiromoto 1988).But the allocation of
overheads is done by Japanese managers on the basis of direct labour cost/hours to
focus on reducing the labour cost content of the products. Whereas these costs,
because of high automation, do not form a major part of variable costs now.

The increasing fixed costs in the companies require some new ways to allocate
overheads. It is argued by some people to include the machine hours in the cost of
the products in case of use of machinery for manufacturing because should labour
hours been utilised, would not be excluded from the product cost.

25
 To calculate the difference between the profits using full and direct costing for an
individual company and to analyse the results the following equation could be used
N
( Pv ,i , t −P f , i ,t )
T c =∑
1 |P f ,i , t|
As we know that,

X i, t
Pv , i ,t=Pf ,i , t+(Ss ,i , t−Se ,i ,t )
Y i ,t
(Solomon`s Equation)

Therefore we can write

N
( S s , i, t −S e ,i ,t ) X i , t
T c =∑
1 |Pf ,i ,t| Y i ,t

Where N= Time Period and T c = Total change in profit over the time period

Table 5 will show us the results for change in inventory valuation for the period of 5
years. Table 5 presents the difference of profits for the three sample companies. The
companies used as a sample had been reporting profit/loss annually over a period of
4 consecutive years. The time period started from 2003 i.e 4 years period means a
period from 2000-2003. The results are obtained over a period of five years.

These results are based on the values taken by using 30% fixed cost structure. The
profits have been calculated on the basis of direct costing and the full costing profit is
deducted from it and the result is divided by the positive full costing profit for the
year. This is done for each year and the resulting figures would be added to get the
total change in profit of the company over the time period.

Table 5
The effect of adopting marginal costing on the profitability of companies over the
time period of 5 years
N (in years) 4 5 6 7 8
PLC Bc IMI Wr Bc IMI Wr Bc IMI Wr Bc IMI Wr Bc IMI Wr
Companies
T c(in %age) 21.8 14.3 2.3 2.4 13. 3. 31. 0.4 2.7 32.2 0.58 1.4 27.5 -

26
 - 1 7 4 11.5
1.7
1
Years of 1 3 3 2 4 3 3 5 3 3 6 4 3 6 4
+ve change
Years of – 3 1 1 3 1 2 3 1 3 4 1 3 5 2 4
ve change

Where “Bc” is for Bodycote PLC, “IMI” for IMI PLC and “Wr” for Weir Group PLC.
Table 4 and Table 5 both show that average annual profits of companies rise when
calculated on the basis of marginal costing over 5 years of time period studies. A
decrease in profit has also been observed in some years for individual companies.
But the average profits change for those years remained positive for most of the
period.

For the first time period of four years (from 2000 to 2003), the total change in
Bodycote profits was negative with marginal costing but for IMI and Weir PLC, there
has been a positive change as inventory value in the these companies has
decreased during this period except in 2 years. In 2000 the value of inventory for IMI
has risen from £244,200,000 to £270,300,000 hence reducing the profit with
marginal costing. Also the stock value in Weir has declined in 2003 showing a
negative year of direct costing profit in the table.

The inventory value for Bodycote PLC in the first four years has increased from a
figure £8,600,000 to £12,900,000 which has reduced its profit using marginal
costing. The next period of five years brings about similar results as the profits of IMI
and Bodycote has increased with the change in the accounting method. But Weir
group PLC gives a negative figure for profit change. The inventory value of Weir has
reduced during 2004 but there was a significant drop in its sales, which seems to be
a cause of this profit decline. And one of the major reasons for this fall in sales in the
decline in order input of 10% of their clear liquid division (Annual Report 2003).

After 6 years the negative change in profits of Weir was observed due to reduction in
the stock value while decreasing stock value of IMI and Bodycote show higher profits
than previous year therefore adding a year of more direct costing profits. In 2006,

27
Bodycote only gives another negative change in profit. Next year the higher
inventories value in all of the three companies added another negative change year
to the total time period.

Procedures like ERP and MRP and other ways of reducing the inventory levels
played an important role in reducing the inventory levels of the companies and hence
decreasing the annual profits with marginal costing. This is consistent with the views
of direct costing supporters who raise the issue of less significance of stock in the
light of stock control methods For example Dyer (1996) and Langfield-Smith and
Greenwood (1998) discussed co-operative supplier networks for stock control.

Similarly some studies advocated the popularity of stock control systems (just-in-time
and Kanban) like Wilkinson and Oliver (1998), Billesbach (1994) and Balakrishran et
al.(1996).Systems like ERP and MRP for stock efficiency were pointed out by some
researches e.g. Wagle (1998) and Davenport (1998). The impact of sales on the
change in reporting profit using marginal costing has to be assessed as well.
Because in one of the years of this study Bodycote PLC has reported negative
change in profit along with increasing stock value due to decreasing sales.

To check the sensitivity of change in profit with different accounting systems to

change in sales, we have to compare the average change in sales to average
changes in reported profits with marginal costing over a time period. A formula could
be used to get the change in sales figures.

∑ Salesc ,i ,t −Salesl ,i , t
1
T cs=
Salesl , i ,t
Here Salesc ,i ,t = Current year sales and Salesl ,i ,t = Last year sales And T cs= Total
change in sales

The formula to assess the average percentage change in profit in relation to average
percentage change in sales could be written as

28
 T c T cs
/ , Where N = Time period
N N
Table 6 present the results of this computation.
Table 6
Impact of change in sales on marginal profit change over the time period
N 4 5 6 7 8
(in years)
PLC Bc IMI Wr Bc IMI Wr Bc IMI Wr Bc IMI Wr Bc IMI Wr
Companie
s
Tc -.9 40. 67. 0. 30. 21. 0.9 29. 0.3 0.1 20. 0.2 0.0 11. -
/T
N cs 7 6 4 7 2 3 3 1 1 5 3 1 7 9 2.
N
8
(in %age)

The table shows the percentage change in average profit in relation to change in
average sales over a time period of 5 years starting from 2003 to 2008. With more
negative changes in direct costing profit over the 5 years period, the change in
average profit in relation to average sales declined throughout the 5 years period for
Weir group PLC.

Similarly the values for IMI PLC also show a fall through the time period. Although
the company`s income statement shows positive change in profit figures. But the
increase in change in sales figures over the years has climbed which seems to be
the cause of drop in the value of profit in relation to sales. The figures for Bodycote
PLC rise in the first three years then fall sharply for the next two years. Sharp fall in
profits were the main cause of the increase.

Chapter 5

Conclusion and Recommendations

5.1 Conclusion

29
The results of the analysis show that the choice of inventory valuation method has a
substantial effect on the industrial machinery manufacturing companies of UK. The
impact of adoption of absorption costing by UK industrial machinery manufacturers
was assessed. And it was discovered that the inventory reduction policies affects the
stock adjustment significantly. Which, as a result, affect the reported profits.

As we know that stock adjustment represents the impact of inventory valuation

methods on reported profit. In this study it was found that stock adjustment affected
the profits of UK industrial machinery manufacturers negatively over the period of the
study. A direct costing method for reporting would have been more than the
absorption costing based profits for majority of the years/companies of the study.

Impact of change in sales on the alternative stock valuation method for reporting
profitability was also assessed and it was revealed that the change in sales over the
time period of the study also affected the direct costing reported profits. Because the
accountants do not have a theoretical base with reliability for deciding between the
two accounting systems, it is important to know about the affect of these methods
on the corporate profits.

As mentioned above, the accounting conventions have not much known importance
because both methods are being supported by these principles. The effective use of
inventory control procedures was also observed in the companies in this study, as
the profits with marginal costing show more profit for most of the years of the study
due to less stock.

The low level of fixed costs produced less increase in the direct costing profits.
Viewing this, it is likely that companies using full costing should be having a lower
fixed cost percentage than the companies using direct costing. This study also points
out the fact that for modern industrial machinery manufacturing companies, the stock
does not constitute a major part of their total assets. Hence the importance of stock
had reduced as an asset in these companies. In this study the fixed costs were
considered as fixed over the time period of the study which is inconsistent with some
of the previous studies. It is suitable to match fixed costs to an accounting period and
included in profit and loss account as these are period costs (Green 1960).
30
According to Horngren (1962), companies do not want to change their inventory
valuation procedure due to opposition from the internal revenue department. As most
of the companies use marginal costing for internal decision making by the managers
and it is difficult to run two different systems of costing at a time in a company. So
this empirical research supports the views of Horngren (1962).

The views of Inland Revenue emphasise on the inventory valuation method. The
Inland Revenue has been interested in the inventory valuation method because this
affects the profitability of the companies and hence the taxation. According to the
results of this study Inland Revenue lost a considerable amount of tax income during
most of the years of study because of use of absorption costing by the companies.

Although the Inland Revenue showed reluctance in defining principles to follow for
computing taxable profits and generally it looks to be supporting the full costing. But
this study shows the negative effect of full costing on the taxable profits due to the
fall in the inventory levels. This study focussed more on the use of marginal costing
for external reporting. Direct costing is considered more appropriate for internal
reporting than the absorption costing by accountants and accounting bodies.

According to a report issued by ICAEW in 1961 marginal costing is a good

technique for decision making and understanding different cost behaviour. Work-in-
progress valuation and finished stock was also discussed in the report. This study
ignored the work- in-progress and finished goods for inventory valuation. It was
considered that the companies followed UK GAAP throughout the time period of the
study. The report by ICAEW did not clearly present the treatment of fixed costs.

The main issue of for choice of accounting method is the treatment of fixed cost.
The accounting bodies like ICAEW is supportive of full costing for external reporting.
However, it accepted the importance of direct costing for internal purposes.

This study shows the importance of direct costing in external reporting. The role of
ICAEW was criticised in the past for supporting the absorption costing method for
stock valuation. Its exposure draft ED6 was criticised by different companies. A
31
feeling of great danger arises because ICAEW are now extolling absorption costing
for excluding marginal costing (Chloride Electrical Storage Co. Ltd, 1972).The results
of this studies are consistent with the views of these companies representatives.

Because of more automation in the modern industries, the scope marginal costing in
external reporting has increased. An accounting standard IAS2 was issued in 1976,
for inventory and work in progress. This standard emphasise on the use of
absorption costing for inventory valuation. This study enlightened the need for a
review of these accounting standards because of the changes in the industries
procedures and stock controlling operations.

In view of this study and many of the previous studies, it is obvious that there is a
wide scope for discussion about these two accounting methods for inventory
valuation and external reporting. There are advantages and disadvantages for both
systems. Like direct costing is considered better for internal purposes but on the
other hand full costing is supported for external usage in the accounting world.

In fact, until now no one of the method has a clear superiority over the other. And
accounting principles favour both methods. Also there are arguments against both
the methods. The rise in stock values and therefore decline in profits with direct
costing, at the end of this study period, also raise question for the future of the direct
costing in external reporting. Therefore the importance of the choice of the
accounting method has been more important because of the new developments in
the industries. The results of this study point towards this aspect.

5.2 Recommendations

Tests should be carried out to search for the better method for practical application
and for measuring the financial performance. The effects of these accounting
methods on the reported profits might be investigated more directly by getting
information of the actual fixed costs of inventory from companies and then
comparing the reported actual absorption and marginal cost profits of each company.

32
This could be done on both a case study and a survey basis.

This research represents only a starting step for further research required to assure
the impact of these methods on profit reporting currently. This study indicated the
importance of choice between these methods. It is possible that the influence of
stock adjustment on measuring profitability increases with the decrease in the length
of accounting period. Therefore, the profit statements for short period of time e.g.
interim reports etc should be used to assess the influence.

The Inland Revenue should think for a way to increase its tax income in industries
using stock control and modern manufacturing methods. Also at this point of time it is
very necessary to review the international accounting standards in the light of the
new production and processes adopted by companies. The choice of the accounting
systems assumes greater importance at present. The fixed costs should be
mentioned as a note to the accounts to facilitate users of accounting information to
compute profit on both basis.

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