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Absorption And Variable Costing
This chapter compares absorption costing and variable costing. Absorption costing treats fixed manufacturing overhead as a product cost, while variable costing treats it as a period cost. When production equals sales with no inventory changes, net income is the same under both methods. When production exceeds sales, absorption costing nets income is higher as fixed costs are deferred in inventory. When production is less than sales, absorption net income is lower as fixed costs in inventory are released. Over multiple periods with equal total production and sales, total net income is the same under both methods.
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Absorption And Variable Costing
- 1. Chapter 6 Variable Costingand Segment Reporting: Tools for Management 1 HAFIZ HAMID n' HAFIZ BILAL 0092-301-6459582
- 2. HAFIZ BILAL HAFIZ HAMID M.Com2nd University Of Central Punjab HAFIZ HAMID n' HAFIZ BILAL 0092-301-6459582 2
- 3. Presentation Outline AbsorptionCosting v. Variable Costing. A Comparison of Income Data for Absorption Costing and Variable Costing. An Illustration. 3 HAFIZ HAMID n' HAFIZ BILAL 0092-301-6459582
- 4. Absorption Costing v.Variable Costing A. Cost Classifications B. Fixed Manufacturing Overhead C. Format of Income Statement D. Report Usage 4 HAFIZ HAMID n' HAFIZ BILAL 0092-301-6459582
- 5. (A). Cost Classifications AbsorptionCosting Variable Costing Product costs include: > Direct materials > Direct labor > Variable mfg. overhead > Fixed mfg. overhead Product costs include: > Direct materials > Direct labor > Variable mfg. overhead Period costs include: > Selling & admin. expenses Period costs include: > Selling & admin. expenses > Fixed mfg. overhead 5 HAFIZ HAMID n' HAFIZ BILAL 0092-301-6459582
- 6. Overview of Variableand Absorption Costing Direct Materials Direct Labor Variable Manufacturing Overhead Fixed Manufacturing Overhead Variable Selling and Administrative Expenses Fixed Selling and Administrative Expenses Variable Costing Absorption Costing ProductProduct CostsCosts PeriodPeriod CostsCosts ProductProduct CostsCosts PeriodPeriod CostsCosts 6 HAFIZ HAMID n' HAFIZ BILAL 0092-301-6459582
- 7. (B). Fixed ManufacturingOverhead Absorption Costing Variable Costing Fixed manufacturing overhead is treated as a product cost. Fixed manufacturing overhead is treated as a period cost and deducted in full each year from revenues. Balance Sheet Fixed mfg. overhead Fixed mfg. overhead is never an asset. 7 HAFIZ HAMID n' HAFIZ BILAL 0092-301-6459582
- 8. (C). Format ofIncome Statement Full (Absorption) Costing Variable Costing Sales - Cost of goods sold = Gross margin - Selling & admin. expenses = Net income Sales - Variable expenses = Contribution margin - Fixed expenses = Net income Students See Illustration of chapter 6 for detail 8 HAFIZ HAMID n' HAFIZ BILAL 0092-301-6459582
- 9. (D). Report Usage Absorptioncosting is required for external reporting. Variable costing is permitted for internal use only. 9 HAFIZ HAMID n' HAFIZ BILAL 0092-301-6459582
- 10. A Comparison ofIncome Data for Absorption Costing and Variable Costing A. Production = Sales (no change in inventories) B. Production > Sales (inventories increase) C. Production < Sales (inventories decrease) 10 HAFIZ HAMID n' HAFIZ BILAL 0092-301-6459582
- 11. (A) Production =Sales (No change in inventories) Absorption Costing Net Income Variable Costing Net Income If there is no change in inventories, then there is generally no change in the fixed manufacturing overhead costs in inventories under absorption costing. 11 HAFIZ HAMID n' HAFIZ BILAL 0092-301-6459582
- 12. (B) Production >Sales (Inventories increase) Absorption Costing Net Income Variable Costing Net Income If inventories increase, then some of the current fixed manufacturing overhead costs will be deferred in inventories under absorption costing. 12 HAFIZ HAMID n' HAFIZ BILAL 0092-301-6459582
- 13. (C) Production <Sales (Inventories decrease) Absorption Costing Net Income Variable Costing Net Income If inventories decrease, then some of the prior fixed manufacturing overhead costs that had been deferred in inventories under absorption costing, will be released as a current charge against income. 13 HAFIZ HAMID n' HAFIZ BILAL 0092-301-6459582
- 14. An Illustration Sellingprice per unit $2,000 Variable costs per unit: Direct materials $ 600 Direct labor $ 225 Variable manufacturing overhead $ 75 Variable selling and administrative expenses $ 40 Fixed costs per year: Fixed manufacturing overhead $1,200,000 Fixed selling expenses $ 100,000 Fixed administrative expenses $ 500,000 Annual production in units 5,00014 HAFIZ HAMID n' HAFIZ BILAL 0092-301-6459582
- 15. Computetheunitproductcostunderabsorptioncosting. Direct materials 600 Directlabor 225 Variablemanufacturingoverhead 75 Fixedmanufacturingoverhead($1,200,000/ 5,000units) 240 Absorptionunit product cost 1,140 15 HAFIZ HAMID n' HAFIZ BILAL 0092-301-6459582
- 16. Computetheunitproductcostundervariablecosting. Directmaterials 600 Directlabor 225 Variablemanufacturingoverhead75 Variableunitproductcost 900 16 HAFIZ HAMID n' HAFIZ BILAL 0092-301-6459582
- 17. Year 1 Assumption: Production= Sales 5,000 units = 5,000 units 17 HAFIZ HAMID n' HAFIZ BILAL 0092-301-6459582
- 18. Variable Costing IncomeStatement Sales (5,000 units x $2,000) 10,000,000 Less variable expenses Cost of goods sold: Beginning finished goods inventory 0 Cost of goods mfg (5,000 units x $900) 4,500,000 Goods available for sale 4,500,000 Ending fin. goods inventory 0 Cost of goods sold 4,500,000 Selling expense (5,000 units x $40) 200,000 Contribution margin 5,300,000 Less fixed expenses: Manufacturing overhead 1,200,000 Selling expense 100,000 Administrative expense 500,000 Net income 3,500,000 18 HAFIZ HAMID n' HAFIZ BILAL 0092-301-6459582
- 19. Abosorption Costing IncomeStatement Sales (5,000 units x $2,000) 10,000,000 Less cost of goods sold: Beginning finished goods inventory 0 Cost of goods mfg (5,000 units x $1,140) 5,700,000 Goods available for sale 5,700,000 Ending fin. goods inventory 0 Cost of goods sold 5,700,000 Gross margin 4,300,000 Operating expenses: Selling expenses ($100,000 + (5,000 units x $40) 300,000 Administrative expenses 500,000 Net operating income 3,500,000 19 HAFIZ HAMID n' HAFIZ BILAL 0092-301-6459582
- 20. Year 2 Assumption: Production> Sales 5,000 units = 4,800 units 20 HAFIZ HAMID n' HAFIZ BILAL 0092-301-6459582
- 21. Variable Costing IncomeStatement Sales (4,800 units x $2,000) 9,600,000 Less variable expenses Cost of goods sold: Beginning finished goods inventory 0 Cost of goods mfg (5,000 units x $900) 4,500,000 Goods available for sale 4,500,000 Ending fin. goods inventory (200 units x $900) 180,000 Cost of goods sold 4,320,000 Selling expense (4,800 units x $40) 192,000 Contribution margin 5,088,000 Less fixed expenses: Manufacturing overhead 1,200,000 Selling expense 100,000 Administrative expense 500,000 Net income 3,288,000 21 HAFIZ HAMID n' HAFIZ BILAL 0092-301-6459582
- 22. Abosorption Costing IncomeStatement Sales (4,800 units x $2,000) 9,600,000 Less cost of goods sold: Beginning finished goods inventory 0 Cost of goods mfg (5,000 units x $1,140) 5,700,000 Goods available for sale 5,700,000 End. fin. goods inv. (200 units x $1,140) 228,000 Cost of goods sold 5,472,000 Gross margin 4,128,000 Operating expenses: Selling expenses ($100,000 + (4,800 units x $40) 292,000 Administrative expenses 500,000 Net operating income 3,336,000 22 HAFIZ HAMID n' HAFIZ BILAL 0092-301-6459582
- 23. Reconciliation of theoperating income between variable costing and absorption costing Variable costing net income 3,288,000 - Fixed manufacturing overhead released from beginning inventory 0 units x $240 0 + Fixed manufacturing overhead deferred in ending inventory 200 units x $240 48,000 Absorption costing net income 3,336,000 23 HAFIZ HAMID n' HAFIZ BILAL 0092-301-6459582
- 24. Year 3 Assumption: Production< Sales 5,000 units = 5,200 units 24 HAFIZ HAMID n' HAFIZ BILAL 0092-301-6459582
- 25. Variable Costing IncomeStatement Sales (5,200 units x $2,000) 10,400,000 Less variable expenses Cost of goods sold: Beginning fin. goods inv. (200 units x $900) 180,000 Cost of goods mfg (5,000 units x $900) 4,500,000 Goods available for sale 4,680,000 Ending fin. goods inventory 0 Cost of goods sold 4,680,000 Selling expense (5,200 units x $40) 208,000 Contribution margin 5,512,000 Less fixed expenses: Manufacturing overhead 1,200,000 Selling expense 100,000 Administrative expense 500,000 Net income 3,712,000 25 HAFIZ HAMID n' HAFIZ BILAL 0092-301-6459582
- 26. Abosorption Costing IncomeStatement Sales (5,200 units x $2,000) 10,400,000 Less cost of goods sold: Beg. Fin. goods inv. (200 units x $1,140) 228,000 Cost of goods mfg (5,000 units x $1,140) 5,700,000 Goods available for sale 5,928,000 End. fin. goods inv. 0 Cost of goods sold 5,928,000 Gross margin 4,472,000 Operating expenses: Selling expenses ($100,000 + (5,200 units x $40) 308,000 Administrative expenses 500,000 Net operating income 3,664,000 26 HAFIZ HAMID n' HAFIZ BILAL 0092-301-6459582
- 27. Reconciliation of theoperating income between variable costing and absorption costing Variable costing net income 3,712,000 - Fixed manufacturing overhead released from beginning inventory 200 units x $240 48,000 + Fixed manufacturing overhead deferred in ending inventory 0 units x $240 0 Absorption costing net income 3,664,000 27 HAFIZ HAMID n' HAFIZ BILAL 0092-301-6459582
- 28. A Comparison ofIncomes Absorption Net Income Variable Net Income Year 1 (Production = Sales) 3,500,000 3,500,000 Year 2 (Production > Sales) 3,336,000 3,288,000 Year 3 (Production < Sales) 3,664,000 3,712,000 3 Year Totals 10,500,000 10,500,000When total production over the 3 year period = total sales over that period, total net income under the approaches is equal. 28 HAFIZ HAMID n' HAFIZ BILAL 0092-301-6459582
- 29. Summary of KeyInsights 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 29 HAFIZ HAMID n' HAFIZ BILAL 0092-301-6459582
Editor's Notes
- #2 Chapter 6: Variable Costing and Segment Reporting: Tools for Management Two general approaches are used for valuing inventories and cost of goods sold. One approach, called absorption costing, is generally used for external reporting purposes. The other approach, called variable costing, is preferred by some managers for internal decision making and must be used when an income statement is prepared in the contribution format. This chapter shows how these two methods differ from each other. It also explains how to create segmented contribution format income statements.
- #7 Variable costing (also called direct costing or marginal costing) treats only those costs of production that vary with output as product costs. This approach dovetails with the contribution approach income statement and supports CVP analysis because of its emphasis on separating variable and fixed costs. The cost of a unit of product consists of direct materials, direct labor, and variable overhead. Fixed manufacturing overhead, and both variable and fixed selling and administrative expenses are treated as period costs and deducted from revenue as incurred. Absorption costing (also called the full cost method) treats all costs of production as product costs, regardless of whether they are variable or fixed. Since no distinction is made between variable and fixed costs, absorption costing is not well suited for CVP computations. Under absorption costing, the cost of a unit of product consists of direct materials, direct labor, and both variable and fixed overhead. Variable and fixed selling and administrative expenses are treated as period costs and are deducted from revenue as incurred.
- #30 On your screen is a summary of what we have observed from the Harvey Company’s two years: When units produced equal units sold, the two methods report the same net operating income. When units produced are greater units sold, as in year 1 for Harvey, absorption income is greater than variable costing income. When units produced are less than units sold, as in year 2 for Harvey, absorption costing income is less than variable costing income.