Absorption and Variable Costing

Chapter 8 Absorption and Variable Costing

Learning Objective1

Product Absorption Costing A system of accounting for costs in which both fixed and variable production costs are considered product costs. Fixed Costs Variable Costs

Variable Costing A system of cost accounting that only assigns the variable cost of production to products. Fixed Costs Product Variable Costs

Absorption and Variable Costing

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

Absorption and Variable Costing 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 Costing Mellon Co. produces a single product with the following information available:

Absorption and Variable Costing Unit product cost is determined as follows: Selling and administrative expenses are always treated as period expenses and deducted from revenue.

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

Variable Costing Income Statements Now let’s look at variable costing by Mellon Co.

Variable Costing Income Statements Now let’s look at variable costing by Mellon Co. We exclude the fixed manufacturing overhead.

Variable Costing Income Statements Now let’s look at variable costing by Mellon Co.

Comparing Absorption andVariable Costing Let’s compare the methods.

Reconciling Income Under Absorption and Variable Costing We can reconcile the difference between absorption and variable net income as follows: Fixed mfg. overhead$150,000 Units produced 25,000 = = $6.00 per unit

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.

Extending the Example Let’s look at the second year of operations for Mellon Company.

Mellon 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.

Mellon Co. Year 2 Unit product cost is determined as follows: There has been no change in Mellon’s cost structure.

Mellon Co. Year 2 Now let’s look at Mellon’s income statement assuming absorption costing is used.

Mellon Co. Year 2 Units in ending inventory from the previous period.

Mellon Co. Year 2 25,000 units produced in the current period.

Mellon Co. Year 2 Next, we’ll look at Mellon’s income statement assuming variable costing is used.

Mellon Co. Year 2 Excludes fixed manufacturing overhead.

Summary In the first period, production (25,000 units) was greater than sales (20,000). In the second period, production (25,000 units) was less than sales (30,000).

Summary For the two-year period, total absorption income and total variable income are the same.

Summary Let’s see if we can get an overview of what we have done.

Summary Comparison of Absorption (AC) 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.

Summary Comparison of Absorption (AC) and Variable Costing (VC) In the second period sales of 30,000 units were greater than production of 25,000.

Summary Comparison of Absorption (AC) and Variable Costing (VC) Inventory decreased from 5,000 units to zero, and $230,000 absorption income was less than $260,000 variable income.

Summary Comparison of Absorption (AC) and Variable Costing (VC) For the two-year period, units produced equals units sold, so total absorption income equals total variable income.

Evaluation of Variable Costing Management finds it easy to understand. Consistent with CVP analysis. Emphasizes contribution in short-run pricing decisions. Advantages Impact of fixed costs on profits emphasized. Profit for period not affected by changes in fixed mfg. overhead.

Fixed manufacturing overhead istreated the same as the other productcosts, direct material and direct labor. Consistent with long-runpricing decisions that mustcover full cost. External reportingand income tax lawrequire absorption costing. Evaluation of Absorption Costing Advantages

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.

Advantages Throughput Costing ExampleIn 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.

Throughput Income Satatement Sales 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

The End End of Chapter 8

Absorption and Variable Costing