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Variable Costing: ATool for Management

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Absorption Costing

Treats all manufacturing costs as productcosts, and non-manufacturing costs as period

costsUnit costs consist of direct material and directlabor and both variable and fixedmanufacturing overhead.

Fixed manufacturing overhead is allocated toeach unit of production

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Overview of Absorption andVariable 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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Q uick Check

W hich method will produce the highest valuesfor work in process and finished goodsinventories?a. Absorption costing.b. Variable costing.c. They produce the same values for these

inventories.d. It depends. . .

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W hich method will produce the highest valuesfor work in process and finished goodsinventories?a. Absorption costingb. Variable costing.c. They produce the same values for these

inventories.d. It depends. . .

Q uick Check

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Q uick Check

W hich method will produce the highest retainedearnings? (Hint: Remember the balance sheetequation.)a. Absorption costingb. Variable costingc. There would be no difference in retained

earnings under the two methods.d. It depends ...

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W hich method will produce the highest retainedearnings? (Hint: Remember the balance sheet

equation.)a. Absorption costing, because some fixed costs stay

in inventory until the product is soldb. Variable costing

c. There would be no difference in retainedearnings under the two methods.d. It depends ...

Q uick Check

Assets = Liabilities + Owners Equityo o

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

Unit Cost Computations

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U nit product cost is determined as follows:

Selling and administrative expenses arealways treated as period expenses and

deducted from revenue.

Unit Cost Computations

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A bsorption CostingSales (20,000 $30) 600,000$Less cost of goods sold:

Beginning inventory -$A dd 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.

VariableFixed

Net operating income

Harvey Co. had no beginning inventory, produced25,000 units and sold 20,000 units this year.

Income Comparison of Absorption and Variable Costing

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Harvey Co. had no beginning inventory, produced25,000 units and sold 20,000 units this year.

A bsorption CostingSales (20,000 $30) 600,000$Less cost of goods sold:

Beginning inventory -$A dd 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 (20,000 $3) 60,000$Fixed 100,000 160,000

Net operating income 120,000$

Income Comparison of Absorption and Variable Costing

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

Beginning inventory -$A dd 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$

N ow lets look at variable costing by Harvey Co.Variable

costsonly.

A ll fixedmanufacturing

overhead isexpensed.

Income Comparison of Absorption and Variable Costing

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Q uick Check The net operating income under absorption

costing was $120,000 and under variablecosting it was $90,000 because of higher expenses. W here is the missing $30,000 under absorption costing?a. It has disappeared into an accounting black

hole.

b. It is in ending inventories.c. It represents taxes that have been saved.d. The $30,000 wasnt a real cost, so nothing

is really missing.

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The net operating income under absorptioncosting was $120,000 and under variablecosting it was $90,000 because of higher expenses. W here is the missing $30,000 under absorption costing?a. It has disappeared into an accounting black

hole.

b. It is in ending inventories.c. It represents taxes that have been saved.d. The $30,000 wasnt a real cost, so nothing

is really missing.

Q uick Check

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Lets compare the methods.

Income Comparison of Absorption and Variable Costing

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Reconciliation

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

deferred in inventory(5,000 units $6 per unit) 30,000

Absorption costing net operating income 120,000$

Fixed mfg. overhead $150,000U nits produced 25,000 units= = $6.00 per unit

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

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Harvey Co. Year 2

In its second year of operations, Harvey Co.started with an inventory of 5,000 units,

produced 25,000 units and sold 30,000 units.

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Harvey Co. Year 2

Unit product cost is determined as follows:

No change in Harveyscost structure.

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A bsorption CostingSales (30,000 $30) 900,000$Less cost of goods sold:

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

A dd COGM (25,000 $16 ) 400,000 Goods available for sale 480,000 Less ending inventory - 480,000

Gross margin 420,000 Less selling & admin. exp.

Variable (30,000 $3) 90,000$Fixed 100,000 190,000 Net operating income 230,000$

Harvey Co. Year 2

T hese are the 25,000 unitsproduced in the current period.

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Harvey Co. Year 2Variable

costsonly.

A ll fixedmanufacturingoverhead isexpensed.

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Reconciliation

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

(5,000 units $6 per unit) 30,000A bsorption costing net operating income 230,000$

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

Fixed mfg. overhead $150,000U nits produced 25,000 units= = $6.00 per unit

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Summary

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Comparative Income Effects

Production = SalesN o change in inventory; income the same for both absorption and variable costing

Production > SalesInventories increase; Absorption Incomehigher than Variable Cost income due tomore fixed cost retained in inventory

Production < SalesInventories decrease; Absorption Incomelower than Variable Cost income as morefixed costs are released from inventory