absorption & variable costing

7/30/2019 Absorption & Variable Costing

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Absorption & Variable CostingGroup One


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1. Explain how vaiable costing differs fromabsorption costin and compute unit productcosts under each method

2. Prepare income statement using both variableand absorption costing.3. Reconcile variable costing and absorption

costing net operating incomes and explainwhy the two amounts differ.

4. Understand the advantages anddisadvantages of both variable andabsorption costing.

Objectives

After studying thischapter, you should

be able to:


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Review: Product vs Period Cost Product Cost

Traced directly to the product Denim for jeans, labor to sew the pants.. Direct

Materials, Direct Labor

Period Cost Costs incurred with the passage of time Interest on loan, insurance premiums coverage


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Overview of Absorptionand Variable Costing

Direct Materials

Direct Labor

Variable Manufacturing Overhead

Fixed Manufacturing Overhead

Variable Selling and Administrative Expenses

Fixed Selling and Administrative Expenses

VariableCosting

AbsorptionCosting

ProductCosts

PeriodCosts

ProductCosts

PeriodCosts


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Two Costing Methods

Used for external financialreporting

Includes direct materials, directlabor, variable factory overhead,

and fixed factory overhead aspart of total product cost

Absorption Costing


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Two Costing Methods

Variable Costing

Used for internal planningand decision making

Does not include fixed factoryoverhead as a product cost


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Selling and Administrative Never treated as product cost Variable and fixed selling and

administrative expenses are treatedperiod costs and expensed are

incurred


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Summary of Differences


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Absorption Costing Compared toVariable Costing

Variable Costing

Absorption Costing

Cost of Goods Manufactured

Cost of Goods Manufactured

DirectMaterials

DirectLabor

VariableFactory OH

FixedFactory OH

Period Expense


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Unit Cost Computations


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Selling and administrative expenses arealways treated as period expenses and deducted from revenue as incurred.


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Income Comparison of Absorptionand Variable Costing

Lets assume the following additional information for HarveyCompany. 20,000 units were sold during the year at a price of $30 each. There were no units in beginning inventory.

Now, lets compute net operatingincome using both absorptionand variable costing.


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Absorption Costing


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Variable CostingSales (20,000 $30) 600,000$Less variable expenses:

Beginning inventory -$

Add COGM (25,000 $10) 250,000 Goods available for sale 250,000 Less ending inventory (5,000 $10) 50,000 Variable cost of goods sold 200,000 Variable selling & administrative

expenses (20,000 $3) 60,000 260,000 Contribution margin 340,000 Less fixed expenses:

Manufacturing overhead 150,000$Selling & administrative expenses 100,000 250,000

Net operating income 90,000$

Variablemanufacturingcosts only.

All fixedmanufacturing

overhead isexpensed.

Variable Costing


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Income Comparison of Absorption and Variable CostingLets compare the methods.


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Reconciliation

Variable costing net operating income 90,000$Add: Fixed mfg. overhead costsdeferred in inventory(5,000 units $6 per unit) 30,000

Absorption costing net operating income 120,000$

Fixed mfg. Overhead $150,000Units produced 25,000 units= = $6.00 per unit

We can reconcile the difference betweenabsorption and variable income as follows:


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Extended Comparison of Income DataHarvey Company Year Two


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Since there was no change in the variable costsper unit, total fixed costs, or the number of

units produced, the unit costs remain unchanged.


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Variable Costing

All fixedmanufacturingoverhead isexpensed.

Variablemanufacturing

costs only.


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Reconciliation

Variable costing net operating income 260,000$Deduct: Fixed manufacturing overheadcosts released from inventory

(5,000 units $6 per unit) 30,000

Absorption costing net operating income 230,000$

We can reconcile the difference betweenabsorption and variable income as follows:

Fixed mfg. Overhead $150,000Units produced 25,000 units= = $6.00 per unit


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Income Comparison


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Effect of Changes in Productionon Net Operating Income

In the previous example,25,000 units were produced each year,

but sales increased from 20,000 units in year one to 30,000 units in year two.

In this revised example,production will differ each year while

sales will remain constant.

Lets revise the Harvey Company example.


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Effect of Changes in ProductionHarvey Company Year One


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Unit Cost Computations for Year One

Since the number of units produced increasedin this example, while the fixed manufacturing overhead

remained the same, the absorption unit cost is less.


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Absorption Costing: Year One


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Variable CostingSales (25,000 $30) 750,000$Less variable expenses:

Beginning inventory -$

Add COGM (30,000 $10) 300,000 Goods available for sale 300,000 Less ending inventory (5,000 $10) 50,000 Variable cost of goods sold 250,000 Variable selling & administrative

expenses (25,000 $3) 75,000 325,000 Contribution margin 425,000 Less fixed expenses:

Manufacturing overhead 150,000$Selling & administrative expenses 100,000 250,000


Variable Costing: Year OneVariablemanufacturing

costs only.




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Effect of Changes in ProductionHarvey Company Year Two


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Absorption CostingSales (25,000 $30) 750,000$Less cost of goods sold:

Beg. inventory (5,000 $15 ) 75,000$

Add COGM (20,000 $17.50 ) 350,000 Goods available for sale 425,000 Less ending inventory - 425,000

Gross margin 325,000 Less selling & admin. exp.

Variable (25,000 $3) 75,000$Fixed 100,000 175,000


Absorption Costing: Year Two

These are the 20,000 units produced in the current

period at the higher unit cost of $17.50 each.


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Variable Costing: Year Two



Variablemanufacturing

costs only.


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Income Comparison

Net operating income is not affected by changes inproduction using variable costing.

Net operating income is affected by changes in productionusing absorption costing even though the number of units

sold is the same each year.

Conclusions


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Impact on the ManagerOpponents of absorption costing argue that shiftingfixed manufacturing overhead costs between periodscan lead to misinterpretations and faulty decisions.

Those who favor variable costing argue that the incomestatements are easier to understand because net operatingincome is only affected by changes in unit sales. The

resulting income amounts are more consistent withmanagers expectations.


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CVP Analysis, Decision Makingand Absorption costing

Absorption costing does not support CVP analysis because itessentially treats fixed manufacturing overhead as a

variable cost by assigning a per unit amount of the fixedoverhead to each unit of production.

Treating fixed manufacturing overhead as avariable cost can:

Lead to faulty pricing decisions and keep/dropdecisions.

Produce positive net operating income evenwhen the number of units sold is less than the

breakeven point.


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External Reporting and Income TaxesTo conform to

GAAP requirements,absorption costing must be used for

external financial reports in theUnited States. Under the Tax

Reform Act of 1986,absorption costing must be

used when filing incometax returns.

Since top executives

are usually evaluated based onexternal reports to shareholders,

they may feel that decisionsshould be based on

absorption cost income.


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Advantages of Variable Costingand the Contribution Approach

Advantages

Management findsit more useful.

Consistent withCVP analysis.Net operating income

is closer tonet cash flow.

Profit is not affected by

changes in inventories.

Consistent with standardcosts and flexible budgeting.

Impact of fixedcosts on profits

emphasized.

Easier to estimate profitabilityof products and segments.


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VariableCosting

Variable versus AbsorptionCosting

AbsorptionCosting

Fixed manufacturingcosts must be assignedto products to properlymatch revenues and

costs.

Fixed manufacturingcosts are capacity costs

and will be incurredeven if nothing is

produced.


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Impact of JIT InventoryMethodsIn a JIT inventory system . . .

Productiontends to equal

sales . . .

So, the difference between variable andabsorption income tends to disappear.

absorption & variable costing

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