Chapter 8

Absorption and Variable Costing

McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning Objective 1

McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Absorption and Variable Costing

Absorption Costing Direct materials Direct labor Variable mfg. overhead Fixed mfg. overhead Period costs Period costs Selling & Admin. exp. Variable Costing

Product costs

Product costs

The difference between absorption and variable costing is the treatment of fixed manufacturing overhead.
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Learning Objective 2

McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Absorption and Variable Costing

Mellon Co. produces a single product with the following information available:
Number of units produced annually Variable costs per unit: Direct materials, direct labor and variable mfg. overhead Selling & administrative expenses Fixed costs per year: Mfg. overhead Selling & administrative expenses 25,000

$ $

10 3

$ 150,000 $ 100,000
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Absorption and Variable Costing

Unit product cost is determined as follows:
Absorption Costing Direct materials, direct labor, and variable mfg. overhead Fixed mfg. overhead ($150,000 25,000 units) Unit product cost $ 10 6 16 Variable Costing $ 10 10

Selling and administrative expenses are always treated as period expenses and deducted from revenue.
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Mellon Co. had no beginning inventory, produced 25,000 units and sold 20,000 units this year at $30 each.
Absorption Costing
Sales (20,000 $30) 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 Gross margin Less selling & admin. exp. Variable (20,000 $3) $ 60,000 Fixed 100,000 Net income $ 600,000

Absorption Costing Income Statements

320,000 $ 280,000

160,000 $ 120,000

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Learning Objective 3

McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Variable Costing Income Statements

Now lets look at variable costing by Mellon Co.
Variable Costing
Sales (20,000 $30) Less variable expenses: Beginning inventory Add COGM (25,000 $10) Goods available for sale Ending inventory (5,000 $10) Variable cost of goods sold Variable selling & administrative expenses (20,000 $3) Contribution margin Less fixed expenses: Manufacturing overhead Selling & administrative expenses Net income $ 600,000 $ 250,000 $ 250,000 50,000 $ 200,000 60,000 260,000 $ 340,000

$ 150,000 100,000

250,000 $ 90,000
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Comparing Absorption and Variable Costing

Lets compare the methods.
Cost of Goods Sold 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 Ending Inventory $ 50,000 30,000 $ 80,000 Period Expense $ $ Total $ 250,000 150,000 $ 400,000

$ 50,000 $ 50,000

150,000 $ 150,000

$ 250,000 150,000 $ 400,000

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Learning Objective 4

McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Reconciling Income Under Absorption and Variable Costing

We can reconcile the difference between absorption and variable net income as follows:
Variable costing net income Add: Fixed mfg. overhead costs deferred in inventory (5,000 units $6 per unit) Absorption costing net income $ 90,000

30,000 120,000

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

= $6.00 per unit

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Learning Objective 5

McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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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Learning Objective 6

McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Evaluation of Variable Costing

Management finds it easy to understand. Consistent with CVP analysis.

Advantages

Emphasizes contribution in short-run pricing decisions.

Impact of fixed costs on profits emphasized.

Profit for period not affected by changes in fixed mfg. overhead.

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Evaluation of Absorption Costing

Fixed manufacturing overhead is treated the same as the other product costs, direct material and direct labor.

Advantages

Consistent with long-run pricing decisions that must cover full cost.

External reporting and income tax law require absorption costing.

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Impact of JIT Inventory Methods

In a JIT inventory system . . .

Production tends to equal sales . . .

So, the difference between variable and absorption income tends to disappear.
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Learning Objective 7

McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Throughput Costing
Unit-level spending for direct costs.
Product cost

Unit-level costs are incurred every time a unit of product 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 be the only unit-level cost and so is the only product cost.

All other manufacturing costs are expensed as period costs.

Incentive to overproduce is reduced Average unit cost does not vary with changes in production levels.

Advantages
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Learning Objective 8

McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Throughput Income Satatement

Sales Revenue Throughput cost of goods sold (dir. mat.) Gross Margin 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 Net Income $600,000 150,000 $450,000

375,000 $ 75,000
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End of Chapter 17

The End
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