Absorption vs. Variable Costing

Gerald M. MyersBUSA 323

School of BusinessPacific Lutheran University

Copyright © 2005Gerald M. Myers

All rights reserved

Absorption costing is required for GAAP

• Absorption costing charges fixed overhead to production

• Fixed overhead is expensed as cost of goods sold is written off against revenues

Absorption costing: how it works• Suppose production is greater than sales.

– We’re adding to finished goods inventory– A pro-rata share of variable and fixed production costs

are held back in finished goods until the product is sold– Less than 100% of the total fixed overhead will be

written off in the current period• Under FIFO, the “old” production costs will be

expensed in the next fiscal period, along with the costs of the new production that is actually sold

Absorption costing: how it works, continued

• But, suppose we have the reverse situation; sales exceeds production and we draw down inventory– Now we’re selling all of the current production,

plus some of whatever we had sitting around on the shelf

– As a result, we’ll write off all of the current year’s fixed overhead, plus some fixed overhead from the previous year

But what happens under variable costing

• Under variable costing, 100% of fixed costs are expensed in the period incurred. Zero (zip, nada) fixed costs are charged to inventory.

Let’s use the Widget Works data to illustrate the difference between absorption and variable costing.

Here’s the original information again.STANDARDS PRICE OR QUANTITY

RATE PER UNIT COSTS VOLUME

Direct material cost/foot $2.50 3.0 Direct material purchased $330,000 110,000 feet

Direct labor cost/DLH $4.50 1.50 Direct material used 105,000 feet

Variable ohd rate/DLH $2.80 Direct labor used $255,000 52,000 DLH

Budgeted fixed overhead $157,500 Variable overhead $147,900Planned output (denominator ) 35,000 units Fixed overhead $160,000Fixed overhead rate/DLH 3.00$ Actual production 36,000 unitsBudgeted unit sales 35,000 Units sold 34,000 unitsBudgeted sales price $29.95 Variable selling & admin exp $2.05Variable selling & admin expenses $2.00 Fixed Selling & admin exp $143,690Fixed selling & admin expenses $140,000 Selling price/unit $29.50

CALCULATION OF TOTAL ACTUAL COSTDirect material purchased $330,000Less: direct material not used

STANDARD COST/UNIT (at standard cost) 5,000 2.50$ (12,500) Direct material $7.50 Direct labor used $255,000Direct labor 6.75 Variable overhead $147,900Variable overhead 4.20 Fixed overhead $160,000Total variable cost $18.45 Total actual costs 880,400$ Fixed overhead 4.50 Total std cost of production 36,000 22.95 826,200$ Absorption cost/unit $22.95 Total variance 54,200$

ACTUAL OUTCOMES

What would a variable costing income statement look like here?

Standard variable costing income statementRevenue $1,003,000Less variable cost of goods sold Material 255,000 Labor 229,500 Variable overhead 142,800 Total variable manufacturing costs 627,300 Less variable S & A expenses 69,700 Contribution margin at standard 306,000$ Adjust for variable cost variances 56,200 Adjusted contribution margin 249,800$ Less fixed costs Overhead 160,000 S & A Expenses 143,690 Net income (53,890)$

But absorption costing net income was...

Hmmm…that’s a difference of $9,000! We’re better off (smaller loss), but where did the $9,000 come from?

Sales revenue 1,003,000$ Cost of goods sold 834,500$ Gross profit @ standard 168,500$ Variable selling & admin exp 69,700$ Fixed selling & admin exp 143,690$ Net income (44,890)$

Absorption and variable costing net income reconciliation

• Recall that we produced 36,000 units and sold 34,000 units. – 2,000 units wound up in inventory– The fixed costs of those 2,000 units is:

• $3.00/DLH * 1.5 DLH/unit * 2,000 units, or $9,000!

• Therefore under absorption costing, $9,000 of fixed overhead is held back in inventory. Under variable costing, that amount is expensed in the period incurred.

This leads directly to the following conclusions. Ceteris paribus,

• when production > sales, absorption costing net income will be greater than variable costing net income due to the current period fixed costs held in inventory.

• when production < sales, absorption costing net income will be less than variable costing net income due to the “old” fixed costs released from inventory.

• when production = sales, absorption costing net income and variable costing net income will be equal.

Now suppose you find yourself in the following situation:

• Your bonus is a function of profit• 4th quarter sales are off; prospects for that

bonus are looking less and less favorable• The factory has excess production capacity• How can you take advantage of this set of

circumstances to improve the likelihood of getting the bonus?

Answer?• Crank up production!

– What doesn’t get sold will just go to inventory.– The variable costs of the unsold output won’t

affect profits anyway– The fixed costs per unit will drop as production

increases. – We’ll write off less fixed overhead resulting in

higher profits, even if total sales are unchanged.

Ethical?• Not really, but it happens.• During a period when its sales were taking a hit in the

1960s, Chrysler Corporation kept building cars for inventory in order to drive up apparent profits.

• They rented cow pastures, vacant lots, any space they could find to store the unsold vehicles

• It got to the point that the rent and security costs (vandalism got to be a serious problem) were a substantial expense.