Absorption Costing or Full Costing System: Definition and explanation: Absorption costing is a costing system which treats all costs of production as product costs, regardless weather they are variable or fixed. The cost of a unit of product under absorption costing method consists of direct materials, direct labor and both variable and fixed overhead. Absorption costing allocates a portion of fixed manufacturing overhead cost to each unit of product, along with the variable manufacturing cost. Because absorption costing includes all costs of production as product costs, it is frequently referred to as full costing method. Variable, Direct or Marginal Costing: Definition and explanation: Variable costing is a costing system under which those costs of production that vary with output are treated as product costs. This would usually include direct materials, direct labor and variable portion of manufacturing overhead. Fixed manufacturing cost is not treated as a product costs under variable costing. Rather, fixed manufacturing cost is treated as a period cost and, like selling and administrative expenses, it is charged off in its entirety against revenue each period. Consequently the cost of a unit of product in inventory or cost of goods sold under this method does not contain any fixed overhead cost. Variable costing is some time referred to as direct costing or marginal costing. To complete this summary comparison of absorption and variable costing, we need to consider briefly the handling of selling and administrative expenses. These expenses are never treated as product costs, regardless of the costing method in use. Thus under either absorption or variable costing, both variable and fixed selling and administrative expenses are always treated as period costs and deducted from revenues as incurred. The concepts explained so for are illustrated below Absorption Costing Product cost Period cost Cost classifications—Absorption versus variable costing Direct materials Direct Labor Variable Manufacturing overhead Fixed manufacturing overhead Variable selling and administrative expenses Fixed selling and administrative expenses Variable Costing Product cost Period cost Unit Cost Computation/Calculation: To illustrate the computation/calculation of unit product costs under both absorption and variable costing consider the following example. Example: A small company that produces a single product has the following cost structure. Number of units produced Variable costs per unit: Direct materials Direct labor 6,000 $2 $4 Variable manufacturing overhead Variable selling and Administrative expenses Fixed costs per year: Fixed manufacturing overhead Fixed selling and administrative expenses $1 $3 $30,000 $10,000 Required: 1. Compute the unit product cost under absorption costing method. 2. Compute the unit product cost under variable / marginal costing method. Unit product Cost Absorption Costing Method Direct materials Direct labor Variable manufacturing overhead Total variable production cost Fixed manufacturing overhead Unit product cost Unit product Cost Variable Costing Method Direct materials Direct labor Variable manufacturing overhead Unit product cost $2 $4 $1 -------$7 $5 -------$12 ===== $2 $4 $1 -------$7 ===== (The $30,000 fixed manufacturing overhead will be charged off in total against income as a period expense along with selling and administrative expenses.) Under the absorption costing, notice that all production costs, variable and fixed, are included when determining the unit product cost. Thus if the company sells a unit of product and absorption costing is being used, then $12 (consisting of $7 variable cost and $5 fixed cost) will be deducted on the income statement as cost of goods sold. Similarly, any unsold units will be carried as inventory on the balance sheet at $12 each. Under variable costing, notice that all variable costs of production are included in product costs. Thus if the company sells a unit of product, only $7 will be deducted as cost of goods sold, and unsold units will be carried in the balance sheet inventory account at only $7. Reference: Accountingformanagement.com The income statements prepared under absorption costing and variable costing usually produce different net operating income figures. This difference can be quite large. Here we will explain the basic reason of this difference in income. The explanation for this difference needs two separate income statements one under absorption costing and other under variable costing. We will prepare two income statements that will produce different income figures and then explain the reasons of difference. Consider the following example: Example: Following data relates to a manufacturing company: Number of units produced each year Variable cost per unit: Direct materials Direct labor Variable Manufacturing Overhead Variable selling and Administrative expenses 6,000 $2 $4 $1 $3 Fixed costs per year: Fixed manufacturing overhead Fixed selling and administrative expenses $30,000 $10,000 Units in beginning inventory Units produced Units Sold Units in ending inventory Selling price per unit Selling and administrative expenses: Variable per unit Fixed per year 0 6,000 5,000 1,000 $20 $3 $10,000 Required: 1. Prepare income statements using: a. Absorption costing system b. Variable costing system 2. Prepare a reconciliation schedule Absorption Costing Income Statement Sales (5,000 units×$20 per unit) Less cost of goods sold: Beginning inventory Add Cost of goods manufactured (6,000 units×$12 per unit) Goods available for sale Less ending inventory Cost of goods sold Gross Margin ($100,000 – $60,000) Less selling and administrative expenses $100,000 ---------$0 $72,000 ---------$72,000 $12,000 ---------$60,000 ---------$40,000 ---------- Variable selling and administrative expenses (5,000 × $3 per unit) Fixed selling and administrative expenses Net operating income ($40,000 – $25,000) $15,000 $10,000 --------$25,000 ---------$15,000 ======== Variable Costing Income Statement Sales (5,000 units×$20 per unit) Less variable expenses: Variable cost of goods sold: Beginning inventory Add variable manufacturing costs (1,000 units×$7 per unit) Goods available for sale Less ending inventory (1,000 units×$7 per unit) Variable cost of goods sold variable selling and administrative expenses (5,000 units × $3 per unit) Contribution margin ($100,000 − $50,000) Less fixed expenses: Fixed manufacturing overhead Fixed selling and administrative expenses Net operating Income ($50,000 − $40,000) $100,000 $0 $42,000 ----------$42,000 $7,000 --------$35,000 $15,000 --------50,000 ---------50,000 ---------$30,000 $10,000 --------$40,000 --------$10,000 ======= The income statements prepared above have different net operating income figures. Now we will explain why net operating income is different under both the costing systems. Explanation: Several points can be noted from the income statements prepared above: Under absorption costing if inventories increase then some of the fixed manufacturing costs of the current period will not appear on the income statement as part of cost of goods sold. Instead, these costs are deferred to a future period and are carried on the balance sheet as part of the inventory account. Such a deferral of cost is known as fixed manufacturing overhead deferred in inventory. The process involved can be explained by referring to income statements prepared above. During the current period 6,000 units have been produced but only 5,000 units have been sold leaving 1,000 unsold units in the ending inventory. Under the absorption costing system each unit produced was assigned $5 in fixed overhead cost. Therefore each unit going into inventory at the end of the period has $5 in fixed manufactured overhead cost attached to it, or a total of $5,000 for 1,000 units (1,000 × $5). This fixed manufacturing overhead cost of the current period deferred in inventory to the next period, when hopefully these units will be taken out of inventory and sold. This deferral of $5,000 of fixed manufacturing overhead costs can be clearly seen by analyzing the ending inventory under the absorption costing method: Variable manufacturing costs (1,000 units × $7 per unit) Fixed manufacturing overhead costs (1,000 units × $5 per unit) Total ending inventory value $7,000 $5,000 --------$12,000 ======= In summary, under absorption costing, of the $30,000 in fixed manufacturing overhead costs incurred during the period, only $25,000 (5,000 x $5 per unit) has been included in the cost of goods sold. The remaining $5,000 (1,000 units not sold at $5 per unit) has been deferred in inventory to the next period. Under variable costing method the entire $30,000 in fixed manufacturing overhead costs has been treated as an expense of the current period (see the bottom portion of the variable costing income statement). The ending inventory figure under the variable costing method is $5,000 lower than it is under the absorption costing method. The reason is that under variable costing; only the variable manufacturing costs are assigned to units of product and therefore included in the inventory: Variable manufacturing costs (1,000 units × $7 per unit) $7,000 The $5,000 difference in ending inventories explains the difference in net operating income reported between the two costing methods. Net operating is $5,000 higher under absorption costing since, as explained above, $5,000 of fixed manufacturing overhead cost has been deferred in inventory to the next period under that costing method. Hopefully, when the units relating to this $5,000 fixed cost will be sold in the next period the cost attached to these units will be included in the cost of goods sold of the next period. This is called fixed manufacturing overhead cost released from inventory. The absorption costing system makes no distinction between fixed and variable costs; therefore, it is not well suited for CVP computations, which are important for good planning and control. To generate data for cost volume profit (CVP) analysis, it would be necessary to spend considerable time reworking and reclassifying costs on the absorption statement. The variable costing approach to costing units of product works very well with the contribution approach to the income statement, since both concepts are based on the idea of classifying costs by behavior. The variable costing data could be immediately used in cost volume profit (CVP) calculations. Reference: Accountingformanagement.com Questions: 1. Differentiate between direct costs and direct costing. 2. Distinguish between period costs and product costs. 3. Why does the direct costing or variable costing theorist exclude fixed manufacturing costs from inventories? 4. In the process of determining a proper sales price, what kind of cost figures are likely to be most helpful? 5. Why is it said that an income statement prepared by the direct costing procedure is more helpful to management than an income statement prepared by the absorption costing method? 6. Why should the chart of accounts be expanded when direct costing is used? 7. A manufacturing concern follows the practice of charging the cost of direct materials and direct labor to work in process but charges off all indirect costs (factory overhead) directly to income summary. State the effects of this procedure on the concern's financial statements and comment on the acceptability of the procedure for use in preparing financial statements. 8. Has the Internal Revenue Service approved direct costing for tax purposes? 9. A speaker remarked that even though direct costing has attractive merits, there are certain items that should be concerned before converting the present system. What hidden dangers or disadvantages are present in direct costing? 10. List the arguments for and against the use of direct costing. Answers: 1. Direct costs are direct materials, direct labor, and other costs directly assignable to a product. 2. 3. 4. 5. 6. 7. 8. 9. Direct costing or variable costing is a procedure by which only prime costs plus variable factory overhead are assignable to a product or inventory; all fixed costs are considered period costs. Period costs are costs charged against the income of the current period. In direct costing, the fixed factory overhead as well as selling and administrative expenses are treated as period costs. Expenses that apply to the production of goods are called product costs. Variable manufacturing costs are typical product costs in direct costing and are charged against income when the units to which they relate are sold. Fixed manufacturing costs are the expenses of maintaining capacity; such expenses occur with the passage of time and not with the utilization of the facilities. There is no way to prove that one type of cost figure is going to be more helpful than another in the determination of the sales price. The sales price must exceed all costs of every kind before a profit is realized, but this does not mean that some sales of a single product or sales of products could not be made at a price which recovers at least the variable costs or makes a contribution to the recovery of fixed expenses. The absorption or conventional cost approach to pricing looks at the long run total cost recovery. The marginal costing or direct costing approach looks at the short run profit contribution aspect of immediate sales. It seems probable that direct costing is more appropriate in making short run decisions with regard to production schedules and pricing products offered for sales, provided the total cost recovery in the long run is kept in mind. An income statement prepared by the direct costing method presents cost of goods sold figures with variable costs only. These variable costs, based on the number of units sold, facilitate computing a contribution margin figure. Thus the direct costing income statement is preferred by the management because it follows management's decision making processes more closely that the statement based on absorption costing. Under a direct costing plan, all variable expenses are channeled into the fixed category at the time the expenses are incurred. This procedure means that the chart of accounts has to be expanded to take care of the new accounts needed. The cost to manufacture usually includes the sum of direct materials, direct labor, and applicable indirect factory costs. Consequently, by omitting indirect factory costs from work in process (WIP) the concern is understanding inventory accounts in comparison with concerns which follow the usual practice. At any particular time, then, its financial position (balance sheet) is incorrectly stated because: (a) work in process and finished goods are understated; (b) current assets are understated and so is the net working capital—and therefore the current ratio is understated; (c) total assets are under stated; (d) stockholder's equity is understated—particularly the retained earnings amount. Of at least equal importance is the effect on the recorded results of operations. Unless the sum of the work in process and finished goods accounts happens to be the same at each balance sheet date, costs and revenue will not be matched in the usual manner, resulting in a corresponding distortion of reported income. Thus, if these inventories at the end of the year exceed the corresponding totals at the beginning of the year, Profits will be understated; if these inventories are below those at the beginning of the year, profits will be overstated. It is not accepted accounting practice to omit all factory overhead from inventories. While the costs of idle facilities, excessive spoilage, and certain other variances and usual items may be treated as period costs, the usual indirect costs are considered assignable to the production of the period. These indirect factory costs are ordinarily not as easily assignable to products as are the direct cost; but at the time they are incurred, they are recoverable from future revenues. Therefore, they should be added to the direct costs and flow through inventories. The Internal Revenue Service (IRS) does not permit the use of direct costing for tax purposes because it does not clearly reflect income. The hidden dangers or disadvantages present in direct costing are: (a) A change to direct costing will prohibit a comparison with the company's accounting information for any prior year unless past periods are changed to a direct costing basis. (b) A seasonal business which produces for six months and sells its entire production in the next six months would show a sizeable loss for the first six months and a sizeable profit for the last six months. (c) Those who use direct costing figures must understand the difference between conventional gross profit on sales and contribution to fixed costs and profits and realize the limitations of the contribution theory. (d) In planning price and sales policies, the full cost to develop, produce, and market a product must be known. Using direct costs and looking at marginal contributions only would certainly be fallacious when new extensive use of existing expensive equipment or expansion of facilities. (e) Direct costing might bring unsatisfactory management action when sales outrun production and inventories are being drawn on. Under these conditions, direct cost profits are higher than under absorption costing. The opposite is true when sales lag behind production. (f) When used as the sole vehicle for the management decisions, direct costing can lead to a disregard for the need to recover fixed costs. 10. Arguments for the use of direct costing include the following: (a) For profit planning purposes, management requires cost volume profit relationship data which are more readily available from direct cost statement than from absorption costing. (b) Since fixed factory overhead is absorbed as a period cost, increasing or reducing production and differences in the number of units produced versus the number sold do not affect the per unit production cost. (c) Direct costing reports are more easily understood by management because the statements follow management's decision making process more closely than do absorption costing statements. (d) Reporting the total fixed cost for the period in the income statement directs management's attention to the relationship of this cost to profits. (e) The elimination of allocated joint fixed cost permits a more objective appraisal of income contributions according to products, sales areas, kinds of customers, etc. Cost volume relationships are highlighted. (f) The similarity of the underlying concepts of direct costing, flexible budgets, break even analysis, and standard costs facilitates the adoption and use of these methods for reporting, cost control and financial planning. (g) Direct costing provides a means of costing inventory that is similar to management's concept of inventory cost as the current out of pocket expenditures necessary to produce or replace the inventory. (i) The computation of product costs is simpler and more reliable under direct costing because a basis of allocating the fixed cost, which involves estimates and personal judgment, is eliminated. (j) A "true and proper" profit results from direct costing because only variable costs should be identified with production. Fixed costs occur with the passage of time. Arguments against the use of direct costing include the following: (a) Separation of costs into fixed and variable costs might be difficult, especially when such costs are semi variable in nature. Moreover, all costs—including fixed costs—are variable at some level of production and in the long run. (b) Long-range pricing of products and other long range policy decisions require a knowledge of complete manufacturing cost which would require additional separate computations to allocate fixed overhead. (c) The pricing of inventories by the direct costing method is not acceptable for income tax computation purposes. (d) Direct costing has not been recognized as conforming with generally accepted accounting principles (GAAP) applied in the preparation of financial statements for stockholders and general public. (e) Profits determined by direct costing are not "true and proper" because of the exclusion of fixed production costs which are a part of total production costs and inventory. Production would not be possible without plant facilities, equipment, etc. To disregard these fixed costs violates the general principle of matching costs with revenues. (f) The elimination of fixed costs from inventory results in a lower figure and consequent reduction of reported working capital for financial analysis purposes. The decrease in working capital may also weaken the borrowing position.