Absorption Vs Marginal

1. Absorption Vs Marginal Dr. Clive Vlieland-Boddy

2. The Two Main Methods • Absorption costing • Marginal costing

3. Introduction • Before we allocate all manufacturing costs to products regardless of whether they are fixed or variable. This approach is known as absorption costing/full costing • However, only variable costs are relevant to decision-making. This is known as marginal costing/variable costing

4. Throughput Costing • Product costs only include unit level spending for direct costs (i.e. incremental costs) • Materials, commissions, etc. • All other indirect, past or committed costs are treated as period costs • Labor (unless piece-rate), overhead, etc.

5. Variable Costing and Absorption Costing The difference between income reported under these two methods is entirely due to the treatment of fixed manufacturing costs.

6. The only cost of driving my caron a 200 mile trip today is$12 for gasoline. VariableCosting Overview of Absorption and Variable(Marginal) Costing

7. AbsorptionCosting Overview of Absorption and Variable Costing No! You must consider these costs too!

8. Overview of Absorption and Variable Costing Who’s right? How should we treat the carleasing and the insurance?

9. All manufacturingcosts must be assignedto products to properlymatch revenues andcosts. Fixed costs arenot really the costsof any particularproduct. VariableCosting AbsorptionCosting Variable versusAbsorption Costing

10. These are capacitycosts and will beincurred even if nothingis produced. Depreciation,taxes, insurance andsalaries are just asessential to productsas variable costs. VariableCosting AbsorptionCosting Variable versusAbsorption Costing

11. They are the numbers that appear on our external reports. VariableCosting AbsorptionCosting Variable versus Absorption costing Absorption costing product costs are misleading for decision making.

12. Marginal costing and Absorption costing • In marginal costing, fixed production costs are treated as period cost and are written off as they are incurred. • In absorption costing, all costs are absorbed into production and thus operating statements do not distinguish between fixed and variable costs. • The valuation of stock and work in progress contains both fixed and variable elements. • Absorption Inventory values are therefore greater than those calculated using marginal costing

13. ProductCosts Direct Materials ProductCosts Direct Labor Variable Manufacturing Overhead Fixed Manufacturing Overhead PeriodCosts PeriodCosts Variable Selling and Administrative Expenses Fixed Selling and Administrative Expenses Overview of Absorption and Variable Costing AbsorptionCosting VariableCosting

14. What is a Variable Costing System? • A cost accounting system which treats fixed manufacturing overheads as a period cost and values stock on hand at the variable cost of production. • Technique/Method of reporting • Internal Reporting • Contribution Concept I/S Fixed Costs Product B/S Variable Costs

15. What is an Absorption Costing System? • A financial accounting system which values stock on hand at the variable and fixed cost of production. • Technique/Method of reporting • External and Internal Reporting • GAAP, AC108 Fixed Costs I/S Product B/S Variable Costs

16. Quick Check  Which method will produce the highest values for work in process and finished goods inventories? a. Absorption costing. b. Variable costing. c. They produce the same values for these inventories. d. It depends. . .

17. Quick Check  Which method will produce the highest values for work in process and finished goods inventories? a. Absorption costing b. Variable costing. c. They produce the same values for these inventories. d. It depends. . .

18. Quick Check  Which method will produce the highest retained earnings? (Hint: Remember the balance sheet equation.) a. Absorption costing b. Variable costing c. There would be no difference in retained earnings under the two methods. d. It depends ...

19. Assets = Liabilities + Owners’ Equity   Quick Check  Which method will produce the highest inventory valuation and retained earnings? (Hint: Remember the balance sheet equation.) a. Absorption costing, because some fixed costs stay in inventory until the product is sold b. Variable costing c. There would be no difference in retained earnings under the two methods. d. It depends ...

20. Overview of Absorption Vs Variable Costing Let’s put some numbers to theissue and see if it willsharpen our understanding.

21. Unit Cost Computations ABC Corp produces a single product with the following information available:

22. Unit Cost Computations Unit product cost is determined as follows: Selling and administrative expenses arealways treated as period expenses and deducted from revenue.

23. Income Absorption Costing ABC Corp had no beginning inventory, produced 25,000 units and sold 20,000 @ $30 per unit.

24. Income Absorption Costing ABC Corp. had no beginning inventory, produced 25,000 units and sold 20,000 units this year.

25. Variablecostsonly. All fixedmanufacturingoverhead isexpensed. Income Variable Costing Now let’s look at variable costing by ABC Corp.

26. Fixed mfg. overhead $150,000 Units produced 25,000 units = = $6.00 per unit Reconciliation We can reconcile the difference betweenabsorption and variable income as follows:

27. Quick Check  The net operating income under absorption costing was $120,000 and under variable costing it was $90,000 because of higher expenses. Where is the missing $30,000 under absorption costing? a. It has disappeared into an accounting black hole. b. It is in ending inventories. c. It represents taxes that have been saved. d. The $30,000 wasn’t a real cost, so nothing is really missing.

28. Quick Check  The net operating income under absorption costing was $120,000 and under variable costing it was $90,000 because of higher expenses. Where is the missing $30,000 under absorption costing? a. It has disappeared into an accounting black hole. b. It is in ending inventories. c. It represents taxes that have been saved. d. The $30,000 wasn’t a real cost, so nothing is really missing.

29. Let’s look at the second year of operations for ABC Corp. Extending the Example

30. ABC Corp. Year 2 In its second year of operations, ABC Corp. started with an inventory of 5,000 units, produced 25,000 units and sold 30,000 units.

31. ABC Corp. Year 2 Unit product cost is determined as follows: No change in ABC Corp’s Cost Structure.

32. These are the 25,000 units produced in the current period. ABC Corp. Year 2

33. Variablecostsonly. All fixedmanufacturingoverhead isexpensed. ABC Corp. Year 2

34. Fixed mfg. overhead $150,000 Units produced 25,000 units = = $6.00 per unit Reconciliation We can reconcile the difference betweenabsorption and variable income as follows:

35. Summary The difference is inventory movement

36. IF Units Sold < Units produced THEN Variable Costing < Absorption Costing Profits Profits

37. IF Units Sold > Units produced THEN Variable Costing > Absorption Costing Profits Profits

38. Review & Summary

39. Absorption Vs. Variable Costing • Fixed overhead • Is it necessary to produce the product? • Is it related to production volume? • Is it a product or period cost?

40. Absorption Vs. Variable Costing • Which is more useful? • Financial reporting • Absorption Costing required • Decision making • Variable does not distort cost as volume changes • It enables management to focus on variables

41. Argument for Absorption Costing

42. Absorption Costing • It does acknowledge that there are costs of products and that any decision should assemble all these. • Fixed costs are becoming more important as mechanisation reduces labour costs. • Whilst there has to be some degree of estimating absorption of overheads, it is better than ignoring them completely.

43. Key Benefits • It is in Compliance with the GAAP and IFRS • Avoidance of fictitious profit or loss • Absorption costing is better in avoiding the fluctuation of profit being reported in marginal costing

44. Arguments for Marginal Costing

45. Advantages of the Variable Cost Approach • Management finds it easy to understand. • Easier to estimate profitability of products and segments • Can be used for marginal Cost analysis. • Profit is not affected by changes in inventories. • Impact of fixed costs on profits is highlighted • Consistent with CVP analysis.

46. Other Benefits • More relevance to decision-making • Avoidance of profit manipulation • Marginal costing can avoid profit manipulation by adjusting the inventory level • Consideration given to fixed cost • In fact, marginal costing does not ignore fixed costs in setting the selling price. • On the contrary, it provides useful information for break-even analysis that indicates whether fixed costs can be converted with the change in sales volume

47. Exercise

48. Income Analysis Under Variable Costing and Absorption Costing Max Manufacturing Company has no beginning inventory and sales are estimated to be 20,000 units at $75 per unit, regardless of production levels.

49. Total Cost Unit Cost Manufacturing costs: Variable $ 700,000 $35 Fixed 400,000 20 Total costs $1,100,000 $55 Selling and administrative exp. Variable ($5 per unit sold) $ 100,000 Fixed 100,000 Total expenses $ 200,000 Income Analysis Under Variable Costing and Absorption Costing Proposal 1: 20,000 Units to Be Manufactured and Sold

50. Total Cost Unit Cost Manufacturing costs: Variable $ 875,000 $35 Fixed 400,000 16 Total costs $1,275,000 $51 Selling and administrative exp. Variable ($5 per unit sold) $ 100,000 Fixed 100,000 Total expenses $ 200,000 Income Analysis Under Variable Costing and Absorption Costing Proposal 2: 25,000 Units to Be Manufactured; Sell 20,000 Units