The Changing Role of Managerial Accounting in a GLOBAL Business Environment
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The Changing Role of Managerial Accounting in a GLOBAL Business Environment
- 1. ABSORPTION ANDABSORPTION AND VARIABLE COSTINGVARIABLE COSTING Chapter 8Chapter 8
- 2. 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.
- 3. Absorption CostingAbsorption Costing A system of accounting for costs in which both fixed and variable production costs are considered product costs. Fixed Costs Variable Costs Product 8-3
- 4. Variable CostingVariable Costing A system of cost accounting that only assigns the variable cost of production to products. Fixed Costs Variable Costs Product 8-4
- 5. Absorption and Variable CostingAbsorption and Variable Costing Absorption Costing Variable Costing Direct materials Direct labor Product costs Product costs Variable mfg. overhead Fixed mfg. overhead Period costs Period costs Selling & Admin. exp. 8-5
- 6. Absorption and Variable CostingAbsorption and Variable Costing Absorption Costing Variable Costing Direct materials Direct labor Product costs Product costs Variable mfg. overhead Fixed mfg. overhead Period costs Period costs Selling & Admin. exp. The difference between absorption and variable costing is the treatment of fixed manufacturing overhead. 8-6
- 7. Let’s put some numbers to an example and see what we can learn about the difference between absorption and variable costing. Absorption and Variable CostingAbsorption and Variable Costing 8-7
- 8. Absorption and Variable CostingAbsorption and Variable Costing 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$ 8-8
- 9. Absorption and Variable CostingAbsorption and Variable Costing 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
- 10. Absorption CostingAbsorption Costing Statements of Comprehensive IncomeStatements of Comprehensive Income 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 × $30) 600,000$ Less: Ccost of Goods Sold Gross margin Less: selling & admin. exp. Variable Fixed Net income 8-10
- 11. Absorption CostingAbsorption Costing Statements of Comprehensive IncomeStatements of Comprehensive Income Mellon Co. had no beginning inventory, produced 25,000 units and sold 20,000 units this year at $30 each. 8-11 Absorption Costing Sales (20,000 × $30) 600,000$ Less: Cost of Goods Sold (20,000 × $16) (320,000) Gross margin 280,000 Less: selling & admin. exp. Variable Fixed Net income
- 12. Absorption CostingAbsorption Costing Statements of Comprehensive IncomeStatements of Comprehensive Income Mellon Co. had no beginning inventory, produced 25,000 units and sold 20,000 units this year at $30 each. 8-12 Absorption Costing Sales (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 × $3) (60,000) Fixed (100,000) Net income 120,000$
- 13. Variable CostingVariable 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 margin Less fixed expenses: Manufacturing overhead Selling & administrative expenses Net income 8-13
- 14. Variable CostingVariable Costing Statements of Comprehensive IncomeStatements of Comprehensive Income Now let’s look at variable costing by Mellon Co. 8-14 Variable Costing Sales (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 expenses Net income
- 15. Variable CostingVariable Costing Statements of Comprehensive IncomeStatements of Comprehensive Income Now let’s look at variable costing by Mellon Co. 8-15 Variable Costing Sales (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$
- 16. Reconciling Income Under Absorption andReconciling 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= 8-16
- 17. 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. 8-17
- 18. Extending the ExampleExtending the Example Let’s look at the second year of operations for Mellon Company. 8-18
- 19. 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$ 8-19
- 20. Mellon Co. Year 2Mellon Co. Year 2 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 no change in Mellon’s cost structure. 8-20
- 21. Mellon Co. Year 2Mellon Co. Year 2 Now let’s look at Mellon’s income statement assuming absorption costing is used. 8-21
- 22. Absorption Costing Sales (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 2 Units in ending inventory from the previous period. 8-22
- 23. Absorption Costing Sales (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 2 25,000 units produced in the current period. 8-23
- 24. Mellon Co. Year 2Mellon Co. Year 2 Next, we’ll look at Mellon’s income statement assuming variable costingvariable costing is used. 8-24
- 25. Variable Costing Sales (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$ Mellon Co. Year 2Mellon Co. Year 2 Excludes fixed manufacturing overhead. 8-25
- 26. SummarySummary In the first period, production (25,000 units) was greater than sales (20,000). Income Comparison Costing Method 1st Period 2nd Period Total Absorption 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). 8-26
- 27. SummarySummary For the two-year period, total absorption income and total variable income are the same. Income Comparison Costing Method 1st Period 2nd Period Total Absorption 120,000$ 230,000$ 350,000$ Variable 90,000 260,000 350,000 8-27
- 28. SummarySummary Let’s see if we can get an overview of what we have done. 8-28
- 29. 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
- 30. Summary Comparison of Absorption (AC)Summary Comparison of Absorption (AC) and Variable Costing (VC)and Variable Costing (VC) In the second period sales of 30,000 unitsIn the second period sales of 30,000 units were greater than production of 25,000.were greater than production of 25,000. 8-30
- 31. Summary Comparison of Absorption (AC)Summary Comparison of Absorption (AC) and Variable Costing (VC)and Variable Costing (VC) Inventory decreased from 5,000 units to zero, and $230,000 absorption income was less than $260,000 variable income. 8-31
- 32. 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 Summary Comparison of Absorption (AC)Summary Comparison of Absorption (AC) and Variable Costing (VC)and Variable Costing (VC) For the two-year period, units produced equals units sold, so total absorption income equals total variable income. 8-32
- 33. Advantages Management finds itManagement finds it easy to understand.easy to understand. Consistent withConsistent with CVP analysis.CVP analysis. Emphasizes contribution inEmphasizes contribution in short-run pricing decisions.short-run pricing decisions. Profit for period notProfit for period not affected by changesaffected by changes in fixed mfg. overhead.in fixed mfg. overhead. Impact of fixedImpact of fixed costs on profitscosts on profits emphasized.emphasized. Evaluation of Variable CostingEvaluation of Variable Costing 8-33
- 34. Advantages Consistent with long-runConsistent with long-run pricing decisions that mustpricing decisions that must cover full cost.cover full cost. External reportingExternal reporting and income tax lawand income tax law require absorption costingrequire absorption costing.. Evaluation of Absorption CostingEvaluation of Absorption Costing Fixed manufacturing overhead isFixed manufacturing overhead is treated the same as the other producttreated the same as the other product costs, direct material and direct labor.costs, direct material and direct labor. 8-34
- 35. Impact of JIT Inventory MethodsImpact of JIT Inventory Methods In a JIT inventory system . .In a JIT inventory system . . .. Production tendsProduction tends to equal sales . . .to equal sales . . . So, the difference between variable andSo, the difference between variable and absorption income tends to disappear.absorption income tends to disappear. 8-35
- 36. End of Chapter 8End of Chapter 8 The End 8-36
Editor's Notes
- Income is one of many important measures used to evaluate the performance of companies and segments of companies. There are two, commonly used methods for determining product costs and reporting income in a manufacturing firm, depending on the accounting treatment of fixed manufacturing overhead. In absorption costing manufacturing overhead is applied to Work-in-Process Inventory as a product cost along with direct material and direct labor. When the manufactured goods are finished, these product costs flow from Work-in-Process Inventory into Finished-Goods Inventory. Finally, during the accounting period when the goods are sold, the product costs flow from Finished-Goods Inventory into Cost of Goods Sold, an expense account.
- An alternative approach to product costing is called variable costing or direct costing, in which only variable manufacturing overhead is applied to Work-in-Process Inventory as a product cost. The distinction between absorption and variable costing is that fixed costs are included as product costs in absorption costing. Notice that the distinction involves the timing with which fixed manufacturing overhead becomes an expense. Eventually, fixed overhead is expensed under both product-costing systems. Under variable costing, however, fixed overhead is expensed immediately, as it is incurred. Under absorption costing, fixed overhead is inventoried until the accounting period during which the manufactured goods are sold.
- Since the costs of production are stored in inventory accounts until the goods are sold under absorption costing, these costs are said to be inventoried, or inventoriable costs. When using variable costing, only variable costs are inventoried. When using absorption costing, both variable and fixed costs are inventoried.
- Eventually, fixed overhead is expensed under both product-costing systems. Under variable costing, however, fixed overhead is expensed immediately, as it is incurred. Under absorption costing, fixed overhead is inventoried until the accounting period during which the manufactured goods are sold.
- Here is an example of the differences between absorption and variable costing.
- We will assume that Mellon company produces a single product. Mellon’s cost accountant has prepared the schedule shown on the slide.
- Unit product costs are different because absorption costing applies fixed manufacturing costs to the product and variable costing does not.
- We assume that Mellon has no beginning inventory, produced 25,000 units, but sold only 20,000 units.
- We calculate the cost of goods sold, including the fixed costs included in the product costs for absorption costing.
- We finish the income statement by subtracting both variable and fixed selling and administrative expenses. Net income is $120,000.
- Now we prepare a variable costing income statement for Mellon.
- Notice that fixed costs are not included in the cost of the product under variable costing.
- Subtracting the fixed costs from the contribution margin, we get a net income of $90,000 under variable costing.
- If we add the fixed costs remaining in inventory under absorption costing to what has already been expensed as cost of good s sold, we can reconcile the differences between the two types of income statements.
- One of the tools used by managers to plan and control business operations is cost-volume-profit analysis. CVP is easily done with a variable costing income statement because the fixed and variable costs are clearly identified. It is not possible to perform CVP analysis directly from an absorption costing statement because fixed costs are not separated from variable costs.
- Let’s see what happens in Mellon’s second year of operations.
- In this year, Mellon produced 25,000 units, and sold the inventory that remained from the previous year.
- Costs remain the same in the second year.
- Here is Mellon’s absorption costing income statement in the second year.
- Inventory produced last year was sold in the second year.
- 25,000 units were produced in the second year.
- Here is Mellon’s variable costing income statement in the second year.
- Notice that fixed costs of manufacturing are not included in variable costing.
- Again, notice that in the first period production was greater than sales, in the second period, sales were greater than production. Notice that, in the end, after all of the inventory has been sold, the total amount expensed is the same in both statements.
- In the end, both statements become equivalent. Timing differences in expensing fixed costs is the primary reason the statements are different from year to year.
- Let’s see if we can get an overview of what we have done.
- When the amount produced during the period is greater than the amount sold, absorption income will be higher than variable costing net income.
- When the amount produced during the period is less than the amount sold, absorption income will be lower than variable costing net income.
- When the inventory that was left over from the previous year is sold, the fixed costs are expensed at that time, under absorption costing.
- In the end, both statements give the same results, the difference being timing differences in the expensing of fixed costs.
- Some managers find the inconsistency between absorption costing and CVP analysis troubling enough to warrant using variable costing for internal income reporting. Variable costing dovetails much more closely than absorption costing with any operational analyses that require a separation between fixed and variable costs. Proponents of variable costing argue that a product’s variable cost provides a better basis for the pricing decision. They point out that any price above a product’s variable cost makes a positive contribution to covering fixed cost and profit.
- Many managers prefer to use absorption-costing data in cost based pricing decisions. They argue that fixed manufacturing overhead is a necessary cost incurred in the production process. To exclude this fixed cost from the inventoried cost of a product, as is done under variable costing, is to understate the cost of the product. For this reason, most companies that use cost-based pricing base their prices on absorption-costing data. For external reporting purposes, generally accepted accounting principles require that income reporting be based on absorption costing. Federal tax laws also require the use of absorption costing in reporting income for tax purposes.
- In a just-in-time inventory and production management system, all inventories are kept very low. Since finished-goods inventories are minimal, there is little change in inventory from period to period. Thus, in a J I T environment, the income differences under absorption and variable costing generally will be insignificant.
- I hope you have “absorbed” the material in this chapter!