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Copyright

2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Absorption andVariable Costing

Chapter 8

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Copyright


LearningObjective

1

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Absorption Costing

1-3

A system of accounting for costs in whichboth fixed and variable production costs

are considered product costs.

FixedCosts

VariableCosts

Product

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Variable Costing

1-4

A system of cost accounting that onlyassigns the variable cost of production to

products.

FixedCosts

VariableCosts

Product

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Absorption and Variable Costing

1-5

Absorption

Costing

Variable

Costing

Direct materials

Direct labor Product costsProduct costs Variable mfg. overhead

Fixed mfg. overhead

Period costs

Period costs Selling & Admin. exp.

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1-6

Absorption

Costing

Variable

Costing

Direct materials

Direct labor Product costsProduct costs Variable mfg. overhead

Fixed mfg. overhead

Period costs

Period costs Selling & Admin. exp.

The difference between absorption and variablecosting is the treatment of fixed manufacturing overhead.

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LearningObjective

2

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1-8

Lets put some numbers to an example andsee what we can learn about the differencebetween absorption and variable costing.

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1-9

Mellon Co. produces a single product withthe following information available:

Number of units produced annually 25,000

Variable costs per unit:Direct materials, direct labor

and variable mfg. overhead 10$

Selling & administrative

expenses 3$

Fixed costs per year:Mfg. overhead 150,000$


expenses 100,000$

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1-10

Unit product cost is determined as follows:

Absorption

Costing

Variable

CostingDirect materials, direct labor, and

variable mfg. overhead 10$ 10$

Fixed mfg. overhead

($150,000 25,000 units) 6 -

Unit product cost 16$ 10$

Selling and administrative expenses arealways treated as period expenses and

deducted from revenue.

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Absorption CostingIncome Statements

1-11

Mellon Co. had no beginning inventory, produced25,000 units and sold 20,000 units this year at $30

each. Absorption Costing

Sales (20,000 $30) 600,000$Less cost of goods sold:

Beginning inventory

Add COGM

Goods available for sale

Ending inventory

Gross marginLess selling & admin. exp.

Variable

Fixed

Net income

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1-12

Mellon Co. had no beginning inventory, produced25,000 units and sold 20,000 units this year at $30

each. Absorption Costing


Beginning inventory -$

Add COGM (25,000 $16) 400,000

Goods available for sale 400,000$

Ending inventory (5,000 $16) 80,000 320,000

Gross margin 280,000$Less selling & admin. exp.

Variable

Fixed

Net income

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1-13

Mellon Co. had no beginning inventory, produced25,000 units and sold 20,000 units this year at $30each.

Absorption Costing


Beginning inventory -$

Add COGM (25,000 $16) 400,000


Ending inventory (5,000 $16) 80,000 320,000

Gross margin 280,000$Less selling & admin. exp.

Variable (20,000 $3) 60,000$

Fixed 100,000 160,000

Net income 120,000$

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LearningObjective

3

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Variable CostingIncome Statements

1-15

Now lets look at variable costing by Mellon Co.

Variable CostingSales (20,000 $30) 600,000$

Less variable expenses:

Beginning inventory -$Add COGM

Goods available for sale

Ending inventory

Variable cost of goods sold

Variable selling & administrative

expenses

Contribution margin

Less fixed expenses:

Manufacturing overhead

Selling & administrative expenses

Net income

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1-16



Less variable expenses: Beginning inventory -$

Add COGM (25,000 $10) 250,000


Ending inventory (5,000 $10) 50,000

Variable cost of goods sold 200,000$


expenses

Contribution margin


Manufacturing overhead

Selling & administrative expenses

Net income

We exclude thefixed manufacturing

overhead.

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1-17



Less variable expenses:

Beginning inventory -$Add COGM (25,000 $10) 250,000


Ending inventory (5,000 $10) 50,000



expenses (20,000 $3) 60,000 260,000

Contribution margin 340,000$


Manufacturing overhead 150,000$

Selling & administrative expenses 100,000 250,000

Net income 90,000$

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Comparing Absorption andVariable Costing

1-18

Lets compare the methods.Cost of

Goods

Sold

Ending

Inventory

Period

Expense Total

Absorption costing

Variable mfg. costs 200,000$

Fixed mfg. costs 120,000

320,000$

Variable costing

Variable mfg. costs 200,000$ Fixed mfg. costs -

200,000$

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1-19


Goods

Sold

Ending

Inventory

Period

Expense Total

Absorption costing

Variable mfg. costs 200,000$ 50,000$ -$

Fixed mfg. costs 120,000 30,000 -

320,000$ 80,000$ -$

Variable costing

Variable mfg. costs 200,000$ 50,000$ -$Fixed mfg. costs - - 150,000

200,000$ 50,000$ 150,000$

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1-20


Goods

Sold

Ending

Inventory

Period

Expense Total

Absorption costing

Variable mfg. costs 200,000$ 50,000$ -$ 250,000$

Fixed mfg. costs 120,000 30,000 - 150,000

320,000$ 80,000$ -$ 400,000$

Variable costing

Variable mfg. costs 200,000$ 50,000$ -$ 250,000$Fixed mfg. costs - - 150,000 150,000

200,000$ 50,000$ 150,000$ 400,000$

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Learning

Objective4

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Reconciling Income UnderAbsorption and Variable Costing

1-22

We can reconcile the difference betweenabsorption and variable net income as

follows:Variable costing net income 90,000$Add: Fixed mfg. overhead costs

deferred in inventory

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

Absorption costing net income 120,000$

Fixed mfg. overhead $150,000Units produced 25,000

= $6.00 per unit=

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Learning

Objective5

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Cost-Volume-Profit Analysis

1-24

CVP includes all fixed costs to computebreakeven.

Variable costing and CVP are consistent as bothtreat fixed costs as a lump sum.

Absorption costing defers fixed costs intoinventory.

Absorption costing is inconsistent with CVPbecause absorption costing treats fixed costs ona per unit basis.

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Copyright


Learning

Objective6

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Extending the Example

1-26

Lets look at

the secondyear of

operationsfor MellonCompany.

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Mellon Co. Year 2

1-27

In its second year of operations, Mellon Co. started withan inventory of 5,000 units, produced 25,000 units and

sold 30,000 units at $30 each.

Number of units produced annually 25,000

Variable costs per unit:Direct materials, direct labor

and variable mfg. overhead 10$


expenses 3$

Fixed costs per year:

Mfg. overhead 150,000$


expenses 100,000$

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Mellon Co. Year 2

1-28

Unit product cost is determined asfollows:

Absorption

Costing

Variable

CostingDirect materials, direct labor,

and variable mfg. overhead 10$ 10$

Fixed mfg. overhead

($150,000 25,000 units) 6 -

Unit product cost 16$ 10$

There has been nochange in Mellons

cost structure.

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Mellon Co. Year 2

1-29

Now lets look at Mellons income statementassuming absorption costing is used.

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Mellon Co. Year 2

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Absorption CostingSales (30,000 $30) 900,000$

Less cost of goods sold:

Beg. inventory (5,000 x $16) 80,000$

Add COGM (25,000 $16) 400,000Goods available for sale 480,000$

Ending inventory - 480,000

Gross margin 420,000$

Less selling & admin. exp.

Variable (30,000 $3) 90,000$

Fixed 100,000 190,000

Net income 230,000$

Units in ending inventory from the previous period.

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Mellon Co. Year 2

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Absorption CostingSales (30,000 $30) 900,000$

Less cost of goods sold:

Beg. inventory (5,000 x $16) 80,000$

Add COGM (25,000 $16) 400,000Goods available for sale 480,000$

Ending inventory - 480,000

Gross margin 420,000$

Less selling & admin. exp.

Variable (30,000 $3) 90,000$

Fixed 100,000 190,000

Net income 230,000$

25,000 units produced in the current period.

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Mellon Co. Year 2

1-32

Next, well look at Mellons income statementassuming variable costing is used.

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Mellon Co. Year 2

1-33

Variable CostingSales (30,000 $30) 900,000$Less variable expenses:

Beg. inventory (5,000 $10) 50,000$

Add COGM (25,000 $10) 250,000


Ending inventory -



expenses (30,000 $3) 90,000 390,000

Contribution margin 510,000$

Less fixed expenses: Manufacturing overhead 150,000$

Selling & administrative expenses 100,000 250,000

Net income 260,000$

Excludes fixed manufacturing overhead.

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Summary

1-34

In the first period, production (25,000 units)

was greater than sales (20,000).

Income Comparison

Costing Method 1st Period 2nd Period Total

Absorption 120,000$ 230,000$ 350,000$

Variable 90,000 260,000 350,000

In the second period, production (25,000 units)was less than sales (30,000).

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Summary

1-35

For the two-year period, total absorption

income and total variable income are the same.

Income Comparison

Costing Method 1st Period 2nd Period Total

Absorption 120,000$ 230,000$ 350,000$

Variable 90,000 260,000 350,000

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Summary

1-36

Lets see if we can get an overviewof what we have done.

S C i f Ab ti

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Summary Comparison of Absorption(AC) and Variable Costing (VC)

1-37

Production versus

Sales

Total

Inventory

Effect Period Expense Effect Profit Effect

Fixed mfg. Fixed mfg.

Produced > Sold Increase costs expensed < costs expensed AC > VC

AC VC

This was the case in the first period when production

of 25,000 units was greater than sales of 20,000 units.

Inventory increased from zero to 5,000 units and$120,000 absorption income was greater than

$90,000 variable income.

S C i f Ab ti

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1-38

Production versus

Sales

Total

Inventory




AC VC


Produced < Sold Decrease costs expensed > costs expensed AC < VC

AC VC

In the second period sales of 30,000 units

were greater than production of 25,000.

S C i f Ab ti

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1-39

Production versus

Sales

Total

Inventory




AC VC


Produced < Sold Decrease costs expensed > costs expensed AC < VCAC VC

Inventory decreased from 5,000 units to zero,and $230,000 absorption income was less

than $260,000 variable income.

S C i f Ab ti

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1-40

Production versus

Sales

Total

Inventory




AC VC


Produced < Sold Decrease costs expensed > costs expensed AC < VC

AC VC


Produced = Sold No change costs expensed = costs expensed AC = VCAC VC

For the two-year period, units producedequals units sold, so total absorption income

equals total variable income.

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Evaluation of Variable Costing

1-41

Advantages

Management finds iteasy to understand.

Consistent withCVP analysis.

Emphasizes contribution inshort-run pricing decisions.

Profit for period notaffected by changes

in fixed mfg. overhead.

Impact of fixedcosts on profitsemphasized.

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Evaluation of Absorption Costing

1-42

AdvantagesConsistent with long-run

pricing decisions that mustcover full cost.

External reportingand income tax law

require absorption costing.

Fixed manufacturing overhead istreated the same as the other productcosts, direct material and direct labor.

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Impact of JIT Inventory Methods

1-43

In a JIT inventory system . ..

Production tendsto equal sales . . .

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

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Copyright


Learning

Objective7

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Throughput Costing

1-45

Example

In an automated process direct material may bethe only unit-level cost and so is the only product cost.

All other manufacturing costs are expensed as period costs.

Incentive to

overproduceis reduced

Average unit cost does

not vary with changesin production levels.

Advantages

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Learning

Objective8

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Throughput Income Statement

1-47

Sales Revenue $600,000Throughput cost of goods sold (dir. mat.) 150,000

Gross Margin $450,000

Less: Operating costs

Direct labor 100,000

Variable mfg overhead 60,000

Fixed mfg overhead 150,000

Variable sales & admin costs 50,000

Fixed sales & admin costs 125,000

Total operating costs 375,000

Net Income $ 75,000

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End of Chapter 8

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Chapter 08 n