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Absorption, Variable, and Throughput Costing

17 ChapterSeventeen

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Absorption Costing

A system of accounting for costs in which both fixed and variable production costs

are considered product costs.

FixedCosts

VariableCosts

Product

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Variable Costing

A system of cost accounting that only assigns the variable cost of production to

products.

FixedCosts

VariableCosts

Product

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Absorption and Variable Costing

Absorption Costing

Variable Costing

Direct materialsDirect labor Product costs

Product costs Variable mfg. overhead

Fixed mfg. overheadPeriod costs

Period costs Selling & Admin. exp.

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Absorption and Variable Costing

Absorption Costing

Variable Costing

Direct materialsDirect labor Product costs

Product costs Variable mfg. overhead

Fixed mfg. overheadPeriod costs

Period costs Selling & Admin. exp.

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

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

Absorption and Variable Costing

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Mellon Co. produces a single product with the 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$Selling & administrative expenses 100,000$

Absorption and Variable Costing

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Unit product cost is determined as follows:

Absorption Costing

Variable Costing

Direct materials, direct labor, and variable mfg. overhead 10$ 10$ Fixed mfg. overhead ($150,000 ? 25,000 units) 6 - Unit product cost 16$ 10$

Absorption and Variable Costing

Selling and administrative expenses are always treated as period expenses and

deducted from revenue.

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17-9Absorption CostingIncome Statements

Absorption CostingSales (20,000 � $30) 600,000$ Less cost of goods sold: Beginning inventory Add COGM Goods available for sale Ending inventoryGross marginLess selling & admin. exp. Variable FixedNet income

Mellon Co. had no beginning inventory, produced 25,000 units and sold 20,000 units this year at $30 each.

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Absorption CostingSales (20,000 ? $30) 600,000$ Less cost of goods sold: 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 FixedNet income

Absorption CostingIncome Statements

Mellon Co. had no beginning inventory, produced 25,000 units and sold 20,000 units this year at $30 each.

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Absorption CostingSales (20,000 ? $30) 600,000$ Less cost of goods sold: 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 (20,000 ? $3) 60,000$ Fixed 100,000 160,000 Net income 120,000$

Mellon Co. had no beginning inventory, produced 25,000 units and sold 20,000 units this year at $30 each.

Absorption CostingIncome Statements

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17-12Variable Costing Income Statements

Now let’s look at variable costing by Mellon Co.Variable Costing

Sales (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 marginLess fixed expenses: Manufacturing overhead Selling & administrative expensesNet income

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17-13Variable Costing Income Statements

Now let’s look at variable costing by Mellon Co.Variable Costing

Sales (20,000 ? $30) 600,000$ Less variable expenses: Beginning inventory -$ Add COGM (25,000 ? $10) 250,000 Goods available for sale 250,000$ Ending inventory (5,000 ? $10) 50,000 Variable cost of goods sold 200,000$ Variable selling & administrative expenses Contribution marginLess fixed expenses: Manufacturing overhead Selling & administrative expensesNet income

We exclude thefixed manufacturing

overhead.

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Variable CostingSales (20,000 ? $30) 600,000$ Less variable expenses: Beginning inventory -$ Add COGM (25,000 ? $10) 250,000 Goods available for sale 250,000$ 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 income 90,000$

Variable Costing Income Statements

Now let’s look at variable costing by Mellon Co.

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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$

Comparing Absorption andVariable Costing

Let’s compare the methods.

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17-16Comparing Absorption andVariable Costing

Let’s compare the methods.Cost of 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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Cost of 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$

Comparing Absorption andVariable Costing

Let’s compare the methods.

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17-18Reconciling Income Under Absorption and Variable CostingWe can reconcile the difference between

absorption 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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Extending the Example

Let’s look at the second

year ofoperationsfor MellonCompany.

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Mellon Co. Year 2In its second year of operations, Mellon Co. started with an

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$ Selling & administrative expenses 3$

Fixed costs per year:Mfg. overhead 150,000$Selling & administrative expenses 100,000$

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Mellon Co. Year 2

Unit product cost is determined as follows: Absorption

Costing Variable Costing

Direct materia ls, 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 Mellon’s

cost structure.McGraw-Hill/Irwin

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Mellon Co. Year 2

Now let’s look at Mellon’s income statementassuming absorption costing is used.

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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 ? $16) 400,000 Goods available for sale 480,000$ 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$

Mellon Co. Year 2Units in ending inventory from the previous period.

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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 ? $16) 400,000 Goods available for sale 480,000$ 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$

Mellon Co. Year 2

25,000 units produced in the current period.

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Mellon Co. Year 2

Next, we’ll look at Mellon’s income statementassuming variable costing is used.

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Mellon Co. Year 2Variable Costing

Sales (30,000 ? $30) 900,000$ Less variable expenses: Beg. inventory (5,000 ? $10) 50,000$ Add COGM (25,000 ? $10) 250,000 Goods available for sale 300,000$ Ending inventory - Variable cost of goods sold 300,000$ Variable selling & administrative 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$

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Variable CostingSales (30,000 ? $30) 900,000$ Less variable expenses: Beg. inventory (5,000 ? $10) 50,000$ Add COGM (25,000 ? $10) 250,000 Goods available for sale 300,000$ Ending inventory - Variable cost of goods sold 300,000$ Variable selling & administrative 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$

Mellon Co. Year 2

Excludes fixed manufacturing overhead.McGraw-Hill/Irwin

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Summary

In the first period, production (25,000 units)was greater than sales (20,000).

Income Comparison

Costing Method 1st Period 2nd Period TotalAbsorption 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

For the two-year period, total absorptionincome and total variable income are the same.

Income Comparison

Costing Method 1st Period 2nd Period TotalAbsorption 120,000$ 230,000$ 350,000$ Variable 90,000 260,000 350,000

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SummaryLet’s see if we can get an overview of

what we have done.

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17-31Summary Comparison of Absorption (AC) and Variable Costing (VC)

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.McGraw-Hill/Irwin

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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

Fixed mfg. Fixed mfg.Produced < Sold Decrease costs expensed > costs expensed AC < VC

AC VC

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

In the second period sales of 30,000 units were greater than production of 25,000.

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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

Fixed mfg. Fixed mfg.Produced < Sold Decrease costs expensed > costs expensed AC < VC

AC VC

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

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

than $260,000 variable income.McGraw-Hill/Irwin

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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

Fixed mfg. Fixed mfg.Produced < Sold Decrease costs expensed > costs expensed AC < VC

AC VC

Fixed mfg. Fixed mfg.Produced = Sold No change costs expensed = costs expensed AC = VC

AC VC

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

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

equals total variable income.

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Cost-Volume-Profit Analysis

☯CVP includes all fixed costs to compute breakeven.

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

☯Absorption costing defers fixed costs into inventory.

Absorption costing is inconsistent with CVP because absorption costing treats fixed costs on a per unit basis.

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Advantages

Management finds it easy 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.

Evaluation of Variable Costing

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AdvantagesConsistent with long-run

pricing decisions that mustcover full cost.

External reportingand income tax law

require absorption costing.

Evaluation of 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

In a JIT inventory system . . .

Production tendsto equal sales . . .

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

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Throughput Costing

Productcost

Unit-levelspending fordirect costs.

Unit-level costs are incurred every time a unit ofproduct is manufactured and will not be incurred

again until the next unit is manufactured.

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Throughput Costing

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 tooverproduceis reduced

Average unit cost doesnot vary with changesin production levels.

Advantages

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End of Chapter 17

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