Variable and absorption costing

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  • 1. Absorption vs. Variable Costing
  • 2. Absorption costing is required for GAAP
    • Absorption costing charges fixed overhead to production
    • Fixed overhead is expensed as cost of goods sold is written off against revenues
  • 3. Absorption costing: how it works
    • Suppose production is greater than sales.
      • We’re adding to finished goods inventory
      • A pro-rata share of variable and fixed production costs are held back in finished goods until the product is sold
      • Less than 100% of the total fixed overhead will be written off in the current period
    • Under FIFO, the “old” production costs will be expensed in the next fiscal period, along with the costs of the new production that is actually sold
  • 4. Absorption costing: how it works, continued
    • But, suppose we have the reverse situation; sales exceeds production and we draw down inventory
      • Now we’re selling all of the current production, plus some of whatever we had sitting around on the shelf
      • As a result, we’ll write off all of the current year’s fixed overhead, plus some fixed overhead from the previous year
  • 5. But what happens under variable costing
    • Under variable costing, 100% of fixed costs are expensed in the period incurred. Zero (zip, nada) fixed costs are charged to inventory.
  • 6. Let’s use the Widget Works data to illustrate the difference between absorption and variable costing. Here’s the original information again.
  • 7. What would a variable costing income statement look like here?
  • 8. But absorption costing net income was... Hmmm…that’s a difference of $9,000! We’re better off (smaller loss), but where did the $9,000 come from?
  • 9. Absorption and variable costing net income reconciliation
    • Recall that we produced 36,000 units and sold 34,000 units.
      • 2,000 units wound up in inventory
      • The fixed costs of those 2,000 units is:
        • $3.00/DLH * 1.5 DLH/unit * 2,000 units, or $9,000!
    • Therefore under absorption costing, $9,000 of fixed overhead is held back in inventory. Under variable costing, that amount is expensed in the period incurred.
  • 10. This leads directly to the following conclusions. Ceteris paribus ,
    • when production > sales, absorption costing net income will be greater than variable costing net income due to the current period fixed costs held in inventory.
    • when production < sales, absorption costing net income will be less than variable costing net income due to the “old” fixed costs released from inventory.
    • when production = sales, absorption costing net income and variable costing net income will be equal.
  • 11. Now suppose you find yourself in the following situation:
    • Your bonus is a function of profit
    • 4th quarter sales are off; prospects for that bonus are looking less and less favorable
    • The factory has excess production capacity
    • How can you take advantage of this set of circumstances to improve the likelihood of getting the bonus?
  • 12. Answer?
    • Crank up production!
      • What doesn’t get sold will just go to inventory.
      • The variable costs of the unsold output won’t affect profits anyway
      • The fixed costs per unit will drop as production increases.
      • We’ll write off less fixed overhead resulting in higher profits, even if total sales are unchanged.
  • 13. Ethical?
    • Not really, but it happens.
    • During a period when its sales were taking a hit in the 1960s, Chrysler Corporation kept building cars for inventory in order to drive up apparent profits.
    • They rented cow pastures, vacant lots, any space they could find to store the unsold vehicles
    • It got to the point that the rent and security costs (vandalism got to be a serious problem) were a substantial expense.