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

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Absorption and Variable Costing Absorption and Variable Costing

Chapter 8

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

McGraw-Hill/Irwin

Learning Objective

1

Learning Objective

1

8-3

Absorption and Variable CostingAbsorption and Variable Costing

Absorption Costing

Variable Costing

Direct materialsDirect labor Product costs

Product costs Variable mfg. overhead

Fixed mfg. overheadPeriod costs

Period costs Selling & Admin. exp.

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

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

McGraw-Hill/Irwin

Learning Objective

2

Learning Objective

2

8-5

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$Selling & administrative expenses 100,000$

Absorption and Variable CostingAbsorption and Variable Costing

8-6

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$

Absorption and Variable CostingAbsorption and Variable Costing

Selling and administrative expenses are always treated as period expenses and

deducted from revenue.

8-7

Absorption CostingSales (20,000 × $30) 600,000$ Less cost of goods sold: Beginning inventory -$ Add COGM (25,000 × $16) 400,000 Goods available for sale 400,000$ Ending inventory (5,000 × $16) 80,000 320,000 Gross margin 280,000$ Less selling & admin. exp. Variable (20,000 × $3) 60,000$ Fixed 100,000 160,000 Net income 120,000$

Mellon Co. had no beginning inventory, produced 25,000 units and sold 20,000 units this year at $30 each.

Absorption CostingAbsorption Costing Income Statements Income Statements

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

McGraw-Hill/Irwin

Learning Objective

3

Learning Objective

3

8-9

Variable CostingSales (20,000 × $30) 600,000$ Less variable expenses: Beginning inventory -$ Add COGM (25,000 × $10) 250,000 Goods available for sale 250,000$ Ending inventory (5,000 × $10) 50,000 Variable cost of goods sold 200,000$ Variable selling & administrative expenses (20,000 × $3) 60,000 260,000 Contribution margin 340,000$ Less fixed expenses: Manufacturing overhead 150,000$ Selling & administrative expenses 100,000 250,000 Net income 90,000$

Variable Costing Variable Costing Income StatementsIncome Statements

Now let’s look at variable costing by Mellon Co.

8-10

Cost of Goods Sold

Ending Inventory

Period 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 Absorption andComparing Absorption andVariable CostingVariable Costing

Let’s compare the methods.

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

McGraw-Hill/Irwin

Learning Objective

4

Learning Objective

4

8-12

Reconciling Income Under Reconciling Income Under Absorption and Variable CostingAbsorption and Variable Costing

We can reconcile the difference between absorption and variable net income as follows:

Variable costing net income 90,000$ Add: Fixed mfg. overhead costs deferred in inventory (5,000 units × $6 per unit) 30,000 Absorption costing net income 120,000$

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

= $6.00 per unit =

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

McGraw-Hill/Irwin

Learning Objective

5

Learning Objective

5

8-14

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.

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

McGraw-Hill/Irwin

Learning Objective

6

Learning Objective

6

8-16

Advantages

Management finds it Management finds it easy to understand.easy to understand.

Consistent withConsistent withCVP analysis.CVP analysis.

Emphasizes contribution inEmphasizes contribution in short-run pricing decisions short-run pricing decisions..

Profit for period notProfit for period notaffected by changesaffected by changes

in fixed mfg. overhead.in fixed mfg. overhead.

Impact of fixedImpact of fixedcosts on profitscosts on profitsemphasized.emphasized.

Evaluation of Variable CostingEvaluation of Variable Costing

8-17

AdvantagesConsistent with long-runConsistent with long-run

pricing decisions that mustpricing decisions that mustcover full cost.cover full cost.

External reportingExternal reportingand income tax lawand income tax law

require absorption costingrequire absorption costing.

Evaluation of Absorption CostingEvaluation of Absorption Costing

Fixed manufacturing overhead isFixed manufacturing overhead istreated the same as the other producttreated the same as the other productcosts, direct material and direct labor.costs, direct material and direct labor.

8-18

Impact of JIT Inventory MethodsImpact of JIT Inventory Methods

In a JIT inventory system . . .In a JIT inventory system . . .

Production tendsProduction tendsto equal sales . . .to equal sales . . .

So, the difference between variable andSo, the difference between variable andabsorption income tends to disappear.absorption income tends to disappear.

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

McGraw-Hill/Irwin

Learning Objective

7

Learning Objective

7

8-20

Throughput CostingThroughput Costing

Productcost

Unit-levelspending fordirect costs.

Unit-level costs are incurred every time a unit ofproduct is manufactured and will not be incurred

again until the next unit is manufactured.

8-21

Throughput CostingThroughput Costing

Example

In an automated process direct material may bethe only unit-level cost and so is the only product cost.

All other manufacturing costs are expensed as period costs.

Incentive to overproduceis reduced

Average unit cost doesnot vary with changesin production levels.

Advantages

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

McGraw-Hill/Irwin

Learning Objective

8

Learning Objective

8

8-23

Throughput Income SatatementThroughput Income SatatementSales Revenue $600,000

Throughput cost of goods sold (dir. mat.) 150,000

Gross Margin $450,000

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 375,000

Net Income $ 75,000

8-24

End of Chapter 17End of Chapter 17

The End