the changing role of managerial accounting in a global business environment

ABSORPTION AND ABSORPTION AND VARIABLE COSTING VARIABLE COSTING

Chapter 8Chapter 8

Learning Objectives

• Explain the accounting treatment of fixed manufacturing overhead under absorption and variable costing.

• Prepare an income statement under absorption costing.• Prepare an income statement under variable costing. • Reconcile reported income under absorption and variable

costing.• Explain the implications of absorption and variable costing

for cost-volume-profit analysis.• Evaluate absorption and variable costing.• Explain the rationale behind throughput costing.• Prepare an income statement under throughput costing.

Absorption CostingAbsorption 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 CostingVariable 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 CostingAbsorption 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 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 variable costing 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.


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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$Selling & administrative expenses 100,000$

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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$

Selling and administrative expenses are always treated as period expenses and

deducted from revenue.8-9

Absorption CostingAbsorption Costing Statements of Comprehensive Income Statements of Comprehensive Income

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

Absorption CostingSales (20,000 × $30) 600,000$ Less: Ccost of Goods Sold Gross marginLess: selling & admin. exp. Variable FixedNet income

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Absorption CostingSales (20,000 × $30) 600,000$ Less: Cost of Goods Sold (20,000 × $16) (320,000) Gross margin 280,000 Less: selling & admin. exp. Variable FixedNet income



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Absorption CostingSales (20,000 × $30) 600,000$ Less: Cost of Goods Sold (20,000 × $16) (320,000) Gross margin 280,000 Less: selling & admin. exp. Variable (20,000 × $3) (60,000) Fixed (100,000) Net income 120,000$

Variable Costing Variable Costing Statements of Comprehensive IncomeStatements of Comprehensive Income

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

Sales (20,000 × $30) 600,000$ Less variable expenses: Variable cost of goods sold Variable selling & administrative expenses Contribution marginLess fixed expenses: Manufacturing overhead Selling & administrative expensesNet income

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

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Variable CostingSales (20,000 × $30) 600,000$ Less variable expenses: Variable cost of goods sold (20,000 × $10) (200,000) Variable selling & administrative (20,000 × $3) (60,000) expenses Contribution margin 340,000$ Less fixed expenses: Manufacturing overhead Selling & administrative expensesNet income


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

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Variable CostingSales (20,000 × $30) 600,000$ Less variable expenses: Variable cost of goods sold (20,000 × $10) (200,000) Variable selling & administrative (20,000 × $3) (60,000) expenses Contribution margin 340,000$ Less fixed expenses: Manufacturing overhead (150,000) Selling & administrative expenses (100,000) Net income 90,000$

Reconciling Income Under Absorption and Reconciling Income Under Absorption and Variable CostingVariable Costing

We can reconcile the difference between absorption and variable net income as follows:

Variable costing net income 90,000$ Absorption costing net income 120,000 Add: Fixed mfg. overhead costs deferred in inventory (5,000 units × $6 per unit) (30,000)$

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

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Cost-Volume-Profit AnalysisCost-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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Extending the ExampleExtending the Example

Let’s look at the second

year ofoperationsfor MellonCompany.

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Mellon Co. Year 2Mellon Co. Year 2

In 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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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$

There has been nochange in Mellon’s

cost structure.8-20


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 2Mellon 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$


25,000 units produced in the current period.8-23


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

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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$


Excludes fixed manufacturing overhead.8-25

SummarySummary

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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SummarySummary

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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SummarySummary

Let’s see if we can get an overview of what we have done.

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Summary Comparison of Absorption (AC) Summary Comparison of Absorption (AC) and Variable Costing (VC)and Variable Costing (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.8-29


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

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

than $260,000 variable income.8-31

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


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

equals total variable income.

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Advantages

Management finds it Management finds it easy to understand.easy to understand.

Consistent withConsistent withCVP analysis.CVP analysis.

Emphasizes contribution inEmphasizes contribution in short-run pricing decisions. short-run pricing decisions.

Profit for period notProfit for period notaffected by changesaffected by changes

in fixed mfg. overhead.in fixed mfg. overhead.

Impact of fixedImpact of fixedcosts on profitscosts on profitsemphasized.emphasized.

Evaluation of Variable CostingEvaluation of Variable Costing

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AdvantagesConsistent with long-runConsistent with long-run

pricing decisions that mustpricing decisions that mustcover full cost.cover full cost.

External reportingExternal reportingand income tax lawand income tax law

require absorption costingrequire absorption costing..

Evaluation of Absorption CostingEvaluation of Absorption Costing

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

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Impact of JIT Inventory MethodsImpact of JIT Inventory Methods

In a JIT inventory system . .In a JIT inventory system . . . .

Production tendsProduction tendsto equal sales . . .to equal sales . . .

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

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End of Chapter 8End of Chapter 8

The End

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the changing role of managerial accounting in a global business environment

Economy & Finance