Absorption Costing vs Variable (Marginal) Costing

1. Absorption Costing vs Variable (Marginal) Costing

2. Costing Comparison • Variable costing is a method of inventory costing in which only variable manufacturing costs are included as inventoriable costs • Absorption costing is a method of inventory costing in which all variable manufacturing costs and all fixed manufacturing costs are included as inventoriable costs

3. 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 Absorptionand Variable Costing AbsorptionCosting VariableCosting

4. 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. . .

5. Unit Cost Computations Harvey Company produces a single productwith the following information available:

6. Unit Cost Computations Unit product cost is determined as follows: Selling and administrative expenses arealways treated asperiod expensesand deducted from revenue as incurred.

7. Income Comparison ofAbsorption and Variable Costing Let’s assume the following additional information for Harvey Company. • 20,000 units were sold during the year at a price of $30 each. • There were no units in beginning inventory. Now, let’s compute net operatingincome using both absorptionand variable costing.

8. Absorption Costing

9. Variablemanufacturing costs only. All fixedmanufacturingoverhead isexpensed. Variable Costing

10. 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:

11. Example 1 (done) HMV Company produces a single product. Number of units produced annually …….. 25,000 Variable costs per unit: DM, DL and Variable Mfg OH ………… RM10 Selling & Admin. expenses …………… RM3 Fixed costs per year: Fixed manufacturing OH ……………… RM150,000 Fixed selling & admin. expense ……… RM100,000 Required: Determine product cost using, (i) Absorption costing (ii) Marginal costing

12. Example 1 (continued) • If HMV Company had no beginning inventory, produced 25,000 units, and sold 20,000 units for the period, prepare Income Statement using: (i) Absorption Costing (ii) Marginal Costing (Assume selling price is RM30 per unit)

13. Example 1 (continued) • Prepare Reconciliation Statement of net incomes.

14. Example 2 – Fluctuating Sales Dutch Company produces a single product. Number of units produced annually …….. 5,000 Variable costs per unit: DM, DL and Variable Mfg OH ………… RM5 Selling & Admin. expenses …………… RM1 Fixed costs per year: Fixed manufacturing OH ……………… RM15,000 Fixed selling & admin. expense ……… RM21,000

15. Example 2 (continued) • Additional information: Year 1 Year 2 Year 3 Units in beginning inventory -0- -0- 1,000 Units produced ……………. 5,000 5,000 5,000 Units sold ………………….. 5,000 4,000 6,000 Units in ending inventory … -0- 1,000 -0-

16. Example 2 (continued) Required: (a) Determine product cost using, (i) Absorption Costing (ii) Marginal Costing (b) For the year 1, year 2 and year 3, prepare Income Statement using: (i) Absorption Costing (ii) Marginal Costing (Assume selling price is RM15 per unit) (c) Prepare Reconciliation Statement of net incomes for the year 1, year 2 and year 3.

17. Example 3 – Fluctuating Production • Suppose all of the facts are the same as in the previous Example 2 of Dutch Company except that production and sales are as follows: Year 1 Year 2 Year 3 Units in beginning inventory -0- -0- 1,000 Units produced ……………. 5,000 6,000 4,000 Units sold ………………….. 5,000 5,000 5,000 Units in ending inventory … -0- 1,000 -0-

18. Example 3 (continued) Required: (a) Determine product cost using, (i) Absorption Costing (ii) Marginal Costing (b) For the year 1, year 2 and year 3, prepare Income Statement using: (i) Absorption Costing (ii) Marginal Costing (Assume selling price is RM15 per unit) (c) Prepare Reconciliation Statement of net incomes for the year 1, year 2 and year 3.

19. Since top executivesare usually evaluated based on external reports to shareholders,they may feel that decisionsshould be based on absorption cost income. External Reporting and Income Taxes To conform toGAAP requirements,absorption costing must be used forexternal financial reports in the United States. Under the TaxReform Act of 1986,absorption costing must beused when filing income tax returns.

20. Consistent with CVP analysis. Management findsit more useful. Net operating income is closer tonet cash flow. Consistent with standardcosts and flexible budgeting. Easier to estimate profitabilityof products and segments. Impact of fixed costs on profits emphasized. Profit is not affected bychanges in inventories. Advantages of Variable Costingand the Contribution Approach Advantages

21. THE END ADVISE & REMINDER: Now, your reading time….it’s your responsibility to read relevant chapters in the main text and additional recommended references !