Ethics

Ethics on
on the
the Manager;
Manager;
Absorption
Absorption Costing
Costing
Income
Income Statements
Statements

Jenina Rose Bonifacio

Rijen Mombay
PowerPoint Authors: Rica Marcel Presbitero
Susan Coomer Galbreath, Ph.D., CPA
Mary
Charles W. Caldwell, D.B.A., CMAAnn Wingpo
Jon A. Booker, Ph.D., CPA, CIA
Mark
Cynthia J. Rooney, Ph.D., CPA Gally Reboton
McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
 Variable
VS
Costing
Variable costing is a
concept used in managerial
and cost accounting in
which the fixed
manufacturing overhead is
excluded from the product-
cost of production.
Absorption
Costing
Absorption costing,
also known as full
costing, entails
allocating fixed
overhead costs across
all units produced for
the period, resulting
in a per-unit cost.
 OVERVIEW OF
VARIABLE AND ABSORPTION
COSTING

Variable Absorption
Costing Costing
Direct Materials
Product
Direct Labor Product
Costs
Variable Manufacturing Overhead Costs
Fixed Manufacturing Overhead
Period
Variable Selling and Administrative Expenses Period
Costs
Fixed Selling and Administrative Expenses Costs
 UNIT COST COMPUTATIONS

Harvey Company 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:

Manufacturing overhead $ 150,000
Selling & administrative expenses $ 100,000
 UNIT COST COMPUTATIONS

Unit product cost is determined as follows:

Absorption Variable
Costing 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

Under absorption costing, all production

costs, variable and fixed, are included when
determining unit product cost. Under variable
costing, only the variable production costs are
 VARIABLE AND ABSORPTION
COSTING INCOME STATEMENTS

Let’s assume the following additional information

for Harvey Company.
• 20,000 units were sold during the year at a price
of $30 each.
• There is no beginning inventory.

Now, let’s compute net operating

income using both absorption
and variable costing.
 VARIABLE COSTING
CONTRIBUTION FORMAT
INCOME STATEMENT
All fixed
manufacturing
Variable
overhead is
manufacturing
expensed.
costs only.

Variable Costing
Sales (20,000 × $30) $ 600,000
Less variable expenses:
Variable cost of goods sold (20,000 × $10) $ 200,000
Variable selling & administrative
expenses (20,000 × $3) 60,000
Total variable expenses 260,000
Contribution margin 340,000
Less fixed expenses:
Fixed manufacturing overhead $ 150,000
Fixed selling & administrative expenses 100,000 250,000
Net operating income $ 90,000
 ABSORPTION COSTING
INCOME STATEMENT
Unit product

cost.
Absorption

Sales (20,000 × $30) $ 600,000

Less cost of goods sold: (20,000 × $16) 320,000
Gross margin 280,000
Less selling & administrative expenses
Variable (20,000 × $3) $ 60,000
Fixed 100,000 160,000
Net operating income $ 120,000

Fixed manufacturing overhead deferred in

inventory is 5,000 units × $6 = $30,000.
 COMPARING THE TWO
METHODS

Cost of
Goods Ending Period
Sold Inventory 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 THE TWO
METHODS

We can reconcile the difference between

absorption and variable income as follows:
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 $150,000

= = $6 per unit
Units produced 25,000 units
 EXTENDED COMPARISONS OF
INCOME DATA HARVEY
COMPANY – YEAR TWO

Number of units produced 25,000

Number of units sold 30,000
Units in beginning inventory 5,000
Unit sales price $ 30
Variable costs per unit:
Direct materials, direct labor,
and variable mfg. overhead $ 10
Selling & administrative
expenses $ 3
Fixed costs per year:
Manufacturing overhead $ 150,000
Selling & administrative
expenses $ 100,000
 UNIT COST COMPUTATIONS

Absorption Variable
Costing 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

Since the variable costs per unit, total fixed costs,

and the number of units produced remained
unchanged, the unit cost computations also
remain unchanged.
 VARIABLE COSTING
CONTRIBUTION FORMAT
INCOME STATEMENT
All fixed
Variable manufacturing
manufacturing overhead is
costs only. expensed.

Variable Costing
Sales (30,000 × $30) $ 900,000
Less variable expenses:
Variable cost of goods sold (30,000 × $10) $ 300,000
Variable selling & administrative
expenses (30,000 × $3) 90,000 390,000
Total variable expenses
Contribution margin 510,000
Less fixed expenses:
Fixed manufacturing overhead $ 150,000
Fixed selling & administrative expenses 100,000 250,000
Net operating income $ 260,000
 ABSORPTION COSTING
INCOME STATEMENT
Unit product

cost.
Absorption

Sales (30,000 × $30) $ 900,000

Less cost of goods sold: (30,000 × $16) 480,000
Gross margin 420,000
Less selling & administrative expenses
Variable (30,000 × $3) $ 90,000
Fixed 100,000 190,000
Net operating income $ 230,000

Fixed manufacturing overhead released from

inventory is 5,000 units × $6 = $30,000.
 COMPARING THE TWO
METHODS

We can reconcile the difference between

absorption and variable income as follows:
Variable costing net operating income $ 260,000
Deduct: Fixed manufacturing overhead
costs released from inventory
(5,000 units × $6 per unit) 30,000
Absorption costing net operating income $ 230,000

Fixed mfg. overhead $150,000

= = $6 per unit
Units produced 25,000 units
 SUMMARY OF KEY INSIGHTS

Relation between Relation between

production Effect on variable and
and sales inventory absorption income
Units produced Absorption
= No change =
Units sold in inventory Variable
Units produced Absorption
> Inventory >
Units sold increases Variable
Units produced Absorption
< Inventory <
Units sold decreases Variable
 CASE 7-18:

Company:
ContactGlobal
 INTRODUCTION
:
• Guochang Li was hired as the new CEO of
ContactGlobal.
• ContactGlobal produces advanced GPS devices.
• His first priority was to restore employee morale.
• His second priority was to prepare the budget for
the coming year.
• Profit goal of $2,000,000 for the coming year.
• Top managers will receive an incentive ranging $
10,000- $ 25,000 if the target profit was met.
• The bonus would be all-or-nothing.
 CONTACTGLOBAL
BASIC BUDGET DATA
Beginning Inventory, in units 0
Units Produced 400,000
Units Sold 400,000
Ending Inventory, in units 0

Variable cost per unit:

Direct Materials $ 57.20
Direct Labor 15.00
Variable manufaturing Overhead 5.00
Variable selling and administrative 10.00
Total Variable Cost per Unit $ 87.20

Fixed Costs:
Fixed manufacturing overhead $ 6,888,000.00
Fixed selling and administrative 4,560,000.00
Total Fixed Costs: $ 11,448,000.00
 Fixed manufacturing overhead
Fixed Manufacturing Overhead per Unit =
No. of Units to produced
$ 6,888,000.00
=
400,000
Fixed Manufacturing Overhead per Unit = $ 17.22
Product Cost per Unit (Absorption Method)
Direct Materials $ 57.20
Direct Labor 15.00
Variable manufaturing Overhead 5.00
Fixed manufacturing overhead
(6,888,000/400,000 units) 17.22
Product Cost per Unit (Absorption Method)= $ 94.42
 CONTACTGLOBAL
Budgeted Income Statement
(Absorption Method)

Sales (400,000 unit x $ 120 per unit) 48,000,000.00

Cost of Good Sold
Beg. Inventory
Add: Cost of goods manufactured
(400,000 units x $ 94.42 per unit) 37,768,000.00
Goods Available for sale 37,768,000.00
Less: Ending Inventory - 37,768,000.00
Gross Margin 10,232,000.00
Selling and Administrative Expenses
Variable Selling and Administrative
(400,000 units x $ 10 per unit) 4,000,000.00
Fixed Selling and Administrative 4,560,000.00 8,560,000.00
Profit 1,672,000.00
 CONTACTGLOBAL
Budgeted Income Statement
(Variable Costing Method)

Sales (400,000 units x $120.00) $ 48,000,000.00

Less: Variable Costs
Direct Materials (400,000 units x $57.20) $ 22,880,000.00
Direct Labor (400,000 units x $15.00) 6,000,000.00
Variable manufaturing Overhead (400,000
units x $5.00) 2,000,000.00
Variable selling and administrative
(400,000 units x $10.00) 4,000,000.00 $ 34,880,000.00
Gross Margin $ 13,120,000.00
Less:
Fixed manufacturing overhead 6,888,000.00
Fixed selling and administrative 4,560,000.00 11,448,000.00
Profit $ 1,672,000.00
 1. ASSUMING THAT THE COMPANY
DOES NOT BUILD UP ITS INVENTORY
(I.E., PRODUCTION EQUALS SALES)
AND ITS SELLING PRICE AND COST
STRUCTURE REMAIN THE SAME, HOW
MANY UNITS OF GPS DEVICE WOULD
HAVE TO BE SOLD TO MEET THE NET
OPERATING INCOME GOAL OF
$2,000,000?
ANSWER
:

Total Fixed Costs= Fixed Mftg Overhead + Fixed Selling and Admin

CM per unit = Selling price per unit - Variable cost per unit

CM per unit = $120 - 87.20 = $32.80

PROOF:
CONTACTGLOBAL
Budgeted Income Statement
(Variable Costing Method)
Sales (410,000 units x $120.00) $ 49,200,000.00
Less: Variable Costs
Direct Materials (410,000 units x $57.20) $ 23,452,000.00
Direct Labor (410,000 units x $15.00) 6,150,000.00
Variable manufaturing Overhead (410,000
units x $5.00) 2,050,000.00
Variable selling and administrative
(410,000 units x $10.00) 4,100,000.00 $ 35,752,000.00
Gross Margin $ 13,448,000.00
Less:
Fixed manufacturing overhead 6,888,000.00
Fixed selling and administrative 4,560,000.00 11,448,000.00
Profit $ 2,000,000.00
 2. VERIFY YOUR ANSWER TO (1)
ABOVE BY CONSTRUCTING A
REVISED BUDGET AND BUDGETED
ABSORPTION COSTING INCOME
STATEMENT THAT YIELDS A NET
OPERATING INCOME OF $
2,000,000.
ANSWER
:

Solve for Fixed MOH per unit:

Fixed manufacturing overhead

Fixed Manufacturing Overhead per Unit =
No. of Units to produced
$ 6,888,000.00
Fixed Manufacturing Overhead per Unit =
410,000.00
Fixed Manufacturing Overhead per Unit = $ 16.80

Given: Total Fixed Manufacturing Overhead- $ 6,888,000

 ANSWER
:

Solve for Total Product Cost per unit:

Product Cost per Unit

Direct Materials $ 57.20
Direct Labor 15.00
Variable manufaturing Overhead 5.00
Fixed manufacturing overhead
($ 6,888,000/410,000 units) 16.80
Product Cost per Unit $ 94.00
 ANSWER
:
CONTACTGLOBAL
Revised Budgeted Income Statement
(Absorption Method)

Sales (410,000 unit x $ 120 per unit) $ 49,200,000.00

Cost of Good Sold
Beg. Inventory
Add: Cost of goods manufactured
(410,000 units x $ 94.00 per unit) $ 38,540,000.00
Goods Available for sale 38,540,000.00
Less: Ending Inventory - 38,540,000.00
Gross Margin 10,660,000.00
Selling and Administrative Expenses
Variable Selling and Administrative
(410,000 units x $ 10 per unit) 4,100,000.00
Fixed Selling and Administrative 4,560,000.00 8,660,000.00
Net Operating Income $ 2,000,000.00
 3. UNFORTUNATELY, BY OCTOBER OF
THE NEXT YEAR IT HAD BECOME CLEAR
THAT THE COMPANY WOULD NOT BE
ABLE TO MAKE THE $2,000,000 TARGET
PROFIT. IN FACT, IT LOOKED LIKE THAT
THE COMPANY WOULD WIND UP THE
YEAR AS ORIGINALLY PL ANNED, WITH
SALES OF 400,000 UNITS, NO ENDING
INVENTORIES, AND A PROFIT OF
$1,672,000.
 SEVERAL MANAGERS WHO WERE
RELUCTANT TO LOSE THEIR YEAR-END
BONUSES APPROACHED GUOCHANG
AND SUGGESTED THAT THE COMPANY
COULD STILL SHOW A PROFIT OF
$2,000,000. THE MANAGERS POINTED
OUT THAT AT THE PRESENT RATE OF
SALES, THERE WAS ENOUGH CAPACITY
TO PRODUCE TENS OF THOUSANDS OF
GPS DEVICES FOR
 THE WAREHOUSE AND THEREBY SHIFT
FIXED MANUFACTURING OVERHEAD
COSTS TO ANOTHER YEAR. IF SALES ARE
400,000 UNITS FOR THE YEAR AND THE
SELLING PRICE AND COST STRUCTURE
REMAIN THE S AME, HOW MANY UNITS
WOULD HAVE TO BE PRODUCED IN
ORDER TO SHOW A PROFIT OF AT LEAST
$2,000,000 UNDER ABSORPTION
COSTING?
 ANSWER
:

Method No. 1
Desired Profit $ 2,000,000.00
Current Profit (1,672,000.00)
FOH to be deferred $ 328,000.00
Percentage
Fixed manufacturing overhead $ 6,888,000.00 100.00%
Less: FOH to be deferred 328,000.00 4.76%
Remaining Fixed Mftg. Overhead to be charged$ 6,560,000.00 95.24%

Current No. of Units to be produced 400,000

% of FMOH to be charged 95.24%

No. of units should be produced 420,000

ANSWER
:
ANSWER
:

Fixed manufacturing overhead

No. of units should be produced =
Fixed Overhead Costs per Unit
6,888,000.00
16.40
No. of units should be produced 420,000
ANSWER
:

Solve for the Product Cost per Unit:

Product Cost per Unit

Direct Materials $ 57.20
Direct Labor 15.00
Variable manufaturing Overhead 5.00
Fixed manufacturing overhead
($ 6,888,000/420,000 units) 16.40
Product Cost per Unit $ 93.60
4. VERIFY YOUR ANSWER TO (3)
ABOVE BY CONSTRUCTING AN
ABSORPTION COSTING INCOME
STATEMENT.
ANSWER
:

CONTACTGLOBAL
Revised Budgeted Income Statement
(Absorption Method)

Sales (400,000 unit x $ 120 per unit) $ 48,000,000.00

Cost of Good Sold
Beg. Inventory
Add: Cost of goods manufactured
(420,000 units x $ 93.60 per unit) $ 39,312,000.00
Goods Available for sale 39,312,000.00
Less: Ending Inventory (20,000 units x $
93.60 per unit) 1,872,000.00 37,440,000.00
Gross Margin 10,560,000.00
Selling and Administrative Expenses
Variable Selling and Administrative
(400,000 units x $ 10 per unit) 4,000,000.00
Fixed Selling and Administrative 4,560,000.00 8,560,000.00
Net Operating Income $ 2,000,000.00
 5. Do you think Guochang Li
should approve the plan to build
ending inventories in order to
attain target profit?
 ANSWER:

• The 328,000 in the fixed manufacturing

overhead is deferred in the ending inventory.
• Inventories will grow from year to year.
• Inventories tie up capital, requires storage
space and are expose to the risk of
obsolescence -> devastating effect on the net
income wen inventories are cut down
• Ethical and behavioural consideration to be
noted
 ANSWER:

• unfortunate legacy that the previous CEO left

behind which encourages bad business
practices
• Guochang must set a good moral climate for
the business, must decline the request of the
managers.
• Guochang must choose what is morally right
and ignore the temptation of the bonus and
the resentment that this might create to the
managers.
 6. What advice would you give
the board of directors concerning
how they determine bonuses in
the future?
 ANSWER:

• all-or-nothing bonuses should be changed

instead the bonuses should be performance-
based. The company should set target sales
bracket with corresponding incentive
percentage.
• The bonus plan created by the BOD can be
easily manipulated by the managers
• all-or-nothing bonus gave more reason why
the managers were willing to manipulate the
production of inventories.