ACCT 323 Managerial Accounting
Alternative Inventory Costing
Methods
Decision-Making Perspective
Firoz A. Noorani
2024
Differences between
Absorption costing and
Variable costing
 Changes in the
production and sales
level on net income under
absorption versus
variable costing
 Impact on management
decisions and
performance evaluation
 Effect of a normalabsorption costing
method on net income
under absorption costing
and variable costing
(Appendix 8A)

Learning Objectives
Two approaches
to product
costing:
1. Full or
absorption
costing
[External
reporting
GAAP]; and
2. Variable
costing
[Internal
reporting]
ABSORPTION COSTING




Aka full costing, traditional costing, job
costing
Allocates all production costs (both
variable and fixed) to the product
(inventory) and then to COGS when sold
Treats both variable and fixed costs as
product costs (absorbed into inventory
until products are sold)
Components
Required
 DM
by GAAP
 DL
 Variable MOHD
 Fixed MOHD
Key Takeaways & Understanding
VARIABLE COSTING

Aka Direct costing

Considers only variable
manufacturing costs as product
costs.

Fixed MOHD is a period cost and is
expensed in the period incurred

Components
For Internal
purposes
only

DM

DL

Variable MOHD
As such, accounting income will differ between the two methods:

Net income under absorption costing includes all manufacturing costs
(Variable and fixed) associated with the production of units, regardless of
whether they are sold or remain in ending inventory

 Operating income will differ between absorption and variable costing

The difference represents the amount of fixed product costs capitalized as
inventory under absorption costing and expensed as period costs under
variable costing
Absorption costing
Means that ending inventory on the balance
Accounting Income
sheet is higher, while expenses on the income
statement are lower.
Absorption costing results in a higher net
income when production exceeds sales
because fixed costs are spread over more
units
The key difference is FMOH.
Absorption costing will show a higher net income
than variable costing whenever units produced
exceed units sold since FMOH costs are deferred to
a future period as part of the ending inventory cost.
When units produced and sold are the same, net income will be equal under both
costing approaches because there is no difference in ending inventory, hence no
deferral of FMOH to future periods through ending inventory.
When units produced are less than units sold, net income under absorption
costing is less than net income under variable costing because FMOH cost in
beginning inventory is charged to the current year’s income under absorption
costing.
Absorption vs Variable Costing
REVIEW
The choice between
absorption costing and
variable costing can have
significant implications for
decision-making within an
organization:

Production and
Inventory Levels

Budgeting &
Performance
Evaluation

Product Pricing

Tax Implications
Decision-Making Concerns Lighting Division
Lighting Division of Walker
Enterprises



Students to follow the example
of Walker Enterprises
COST INFORMATION FOR LIGHTING DIVISION
Beginning inventory
-0-
Profits not meeting
expectations
Expected sales in units
20,000
Selling price per unit
$15
Expected sales in the
upcoming year are
20,000 units
Variable manufacturing costs per unit
$6
Fixed manufacturing costs (total)
$60,000
Should 20,000 or
30,000 units be
produced
1.
Assuming
absorption costing
2. Assuming variable
costing
Fixed manufacturing overhead costs per unit
Based on 20,000 units produced
$3 per unit ($60,00020,000)
Based on 30,000 units produced
$2 per unit ($60,00030,000)
Total manufacturing cost per unit
Based on 20,000 units produced
$9 per unit ($6 variable + $3 fixed)
Based on 30,000 units produced
$8 per unit ($6 variable + $2 fixed)
Selling and administrative expenses
Variable selling and administrative expenses per unit
$1
Fixed selling and administrative expenses
$15,000
Copyright ©2021 John Wiley & Sons Canada, Ltd.
9
Decision-Making Concerns Lighting Division


Under absorption costing, 30,000 units should be produced (regardless of sales
level).
Ending inventory of 10,000 x $2.00 fixed overhead = $20,000 of fixed
manufacturing overhead is carried on the Balance
Sheet
Produces
30,000 units
but sells only 20,000
units
Net income is $105,000.
ABSORPTION COSTING
Copyright ©2021 John Wiley & Sons Canada, Ltd.
By producing 30,000
units, the division will
have an inventory of
10,000 units. This
excess inventory
causes net income to
increase by $20,000
because $20,000 of
fixed costs (10,000 ×
$2) are not charged to
the current year but
are deferred to future
periods.
10
Decision-Making Concerns Lighting Division



Regardless of production level, income is the same
Fixed costs treated as a period expense.
10,000 units in ending inventory includes only variable costs.
VARIABLE COSTING
Produces 30,000 units
but sells only 20,000
units
Net income is $105,000.
Net income is not affected by
the number of units produced.
Net income is $85,000 whether
20,000 or 30,000 units are
produced.
Because fixed manufacturing
overhead is treated as a period
expense.
Under variable costing, no
fixed manufacturing overhead
is deferred through inventory
buildup.
Therefore, under variable
costing, production does not
increase income; sales do
Copyright ©2021 John Wiley & Sons Canada, Ltd.
11
MASTI Company builds custom hiking poles. In the current year, the company incurred the following
costs:
Variable cost per unit
Direct materials
$6.50
Direct labour
2.75
Variable manufacturing overhead
5.75
Variable selling and admin expenses 3.90
Fixed costs for year
Fixed manufacturing overhead
$285,000
Fixed selling and administrative expenses
240,100
MASTI Company sells the poles for $25. During the current year, the company produced 95,000 poles
and sold 80,000.
Instructions:
A. Assuming MASTI uses variable costing, calculate MASTI’s manufacturing cost per unit for the current
year.
B. Assuming MASTI uses absorption costing, calculate MASTI’s manufacturing cost per unit for the
current year.
EXERCISE
Momentum Bikes production and sales data for the most recent year are as follows (no beginning inventory):
Variable production costs
$85 per bike
Fixed production costs
$530,000
Variable selling & administrative costs
$17 per bike
Fixed selling & administrative costs
$480,000
Selling price
$195 per bike
Production
21,200 bikes
Sales
19,000 bikes
Instructions
a)
Prepare a brief income statement using absorption costing and variable costing.
b)
Calculate the amount to be reported for inventory in the year-end absorption-costing balance sheet.
EXERCISE
During 2022, Gortle Industries is intending to sell 50,000 units for $10 per
unit. Variable manufacturing costs are $3 per unit. Annual fixed
manufacturing overhead is $200,000. Variable selling and administrative
costs are $1 per unit sold, and fixed selling and administrative costs are
$30,000. Allan Wong, the company manager, is trying to decide whether
to produce 50,000 units or 60,000 units in 2022.
Instructions
Prepare an absorption-costing income statement for 2022 for both levels
of production.
Exercise
During 2022, Gortle Industries is intending to sell 50,000 units for $10 per
unit. Variable manufacturing costs are $3 per unit. Annual fixed
manufacturing overhead is $200,000. Variable selling and administrative
costs are $1 per unit sold, and fixed selling and administrative costs are
$30,000. Allan Wong, the company manager, is trying to decide whether
to produce 50,000 units or 60,000 units in 2022.
Instructions
Prepare a variable-costing income statement for 2022 for both levels of
production.
Explain the results.
Exercise
LO4
Variable Costing has advantages relative to Absorption Costing
Management
finds
it is more
useful.
Consistent with
CVP analysis &
Incremental
Analysis
Net operating income
is closer to
net cash flow.
Easier to estimate profitability
of products and segments
Net income calculated under
variable costing is closely tied to
changes in sales and provides a
more realistic assessment of the
company’s success or failure.
Advantages
Net income calculated
under variable costing
is unaffected by
changes in production
levels.
Impact of fixed
costs on profits
emphasized
Consistent with standard
costs and flexible budgeting
Profit is not affected
by changes in
inventories
The presentation of fixed-cost and
variable-cost components on the variablecosting income statement makes it easier
to identify these costs and evaluate their
impact on the company’s profitability
NORMAL COSTING
Is a costing system that combines actual costs for
DM and DL with predetermined overhead
rates (POR).
The POR rates are based on estimated or
budgeted amounts for indirect MOHD.




MOHD costs are applied to production based on the POR multiplied by the actual activity
level – cost driver
The MOHD applied to production is added to DM and DL costs to calculate the total
product cost.
At the end of the period, the actual overhead costs result in Underapplied or Overapplied
MOHD
Underapplied or overapplied MOHD is adjusted at the end of the period to ensure MOHD
costs are accurately reflected in financial statements
NORMAL ABSORPTION COSTING Appendix 8A
NORMAL ABSORPTION COSTING
Normal-Absorption Costing Effect
 Uses a predetermined overhead
rate to allocate MOH to
products
 Normal absorption costing can
be used under both absorption
and variable costing.
 Under absorption costing, if
normal absorption costing is
used, a production volume
variance will occur whenever
production deviates from
budgeted volumes.
 Normal-absorption costing
expenses any volume variances
Appendix
8Acost of goods sold
to the
Cost and production data for Premiums’ Fix-it sealant for the first month of
production and sales
Fix-it selling price:
$20 per unit
Units:
Produced 30,000; sold 20,000; beginning inventory zero
Unit variable costs:
Manufacturing $9 (direct materials $5, direct labour $3, and
variable overhead $1); selling and administrative expenses $2
Fixed costs:
Manufacturing overhead $120,000, based on a budgeted volume of
40,000 units; selling and administrative expenses $15,000


Premium Products expenses the production volume variance to cost of goods sold in the
accounting period in which it occurs. (A production volume variance occurs whenever
actual production deviates from the budgeted production level.)
Production volume variance: when actual production differs from budgeted production level
NORMAL ABSORPTION COSTING Appendix 8A
Mfg cost per unit is $3 higher under normal
absorption costing because:


FMOH costs are based on a predetermined overhead rate under
absorption costing
Under VMOH costing FMOH costs are
a period cost and expensed
NORMAL ABSORPTION
COSTING INCOME STATEMENT
NORMAL ABSORPTION COSTING Premium Products Corp Example
Following PPT illustrates


Absorption Costing versus Variable Costing examples
(copied from textbook – Premium Products example)
Effects on Net Income using Absorption and Variable
costing (copied from textbook – Overbay Inc.)
Students to review the examples in the textbook
for further understanding
Selling Price
$20 per unit Fixed S&A
$15,000
$4 per unit;
$120,000
Direct Mat
$5 per unit Fixed OVHD
Direct Lab
$3 per unit Units produced
30,000
Variable OVHD
$1 per unit Units Sold
20,000
Variable S&A
$2 per unit
Unit in beginning
inventory
REQUIRED
Using the above data for Premium Products, prepare income statements in
both the absorption and variable costing formats
Absorption vs Variable Costing EXAMPLE
0
Variable Mfg costs only
UNIT Product Cost
Ending inventory = (0 + 30,000 – 20,000) =10,000 units
 10,000 x $13 = $130,000
 COGS = 20,000 x $13 = $260,000
 Statement reports ‘Gross Profit’
FMOH is deferred in inventory 10,000 units X $4 = $40,000





All fixed mfg
ovhd is expenses
Ending inventory = (0 + 30,000 – 20,000) =10,000
units
10,000 x $9 = $90,000
COGS = 20,000 x $9 = $180,000
Statement reports ‘Contribution Margin’
Net Income Effects Overbay Inc.– Example
•
Overbay Inc. manufactures special-purpose drones
•
Production and cost information are as presented
2021
Students are to review the
next Overbay Inc. slides
2022
2023
Volume information
Drones in beginning inventory
-0-
-0-
2
Drones produced
10
10
10
Drones sold
10
8
12
Drones in ending inventory
-0-
2
-0-
Financial information
Selling price per drone
$400,000
Variable manufacturing costs per drone
240,000
Fixed manufacturing costs for the year
600,000
Fixed manufacturing costs per drone ($600,00010)
Variable selling and administrative expenses per drone
Fixed selling and administrative expenses
60,000
5,000
80,000
Copyright ©2021 John Wiley & Sons Canada, Ltd.
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Net Income Effects Overbay Inc.– Example
2021
Produced 10
Sold 10
ABSORPTION COSTING
Absorption inventoriable cost per unit:
= ($240,000variable + $60,000fixed) = $300,000
Copyright ©2021 John Wiley & Sons Canada, Ltd.
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Net Income Effects Overbay Inc. Example
2021
Produced 10
Sold 10
VARIABLE COSTING

Inventoriable cost per unit = $240,000variable

Fixed manufacturing cost is a period (expense)cost

No beginning or ending inventory; Absorption Income = Variable Income
Copyright ©2021 John Wiley & Sons Canada, Ltd.
26
Net Income Effects Overbay Inc.– Example
2022
Produced 10 Sold 8
2 Units in Ending inventory
ABSORPTION COSTING
Each unit in ending
inventory includes
$60,000 of FMOH
COGS = Beginning Inventory + Production – Ending Inventory
COGS = $0 + (10 × $300,000) – (2 × $300,000)
COGS = $0 + 3,000,000 – 600,000
COGS = $2,400,000
Copyright ©2021 John Wiley & Sons Canada, Ltd.
$120,000 ($60,000 × 2)
of FMOH costs are
deferred until a future
period
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Net Income Effects Overbay Inc. Example
2022
Produced 10 Sold 8
2 Units in Ending inventory
VARIABLE COSTING
When more units are
produced (10) than
sold (8), NET INCOME
under absorption
costing ($680,000) is
higher than NET
INCOME under
variable costing
($560,000)
Ending inventory reported on Balance Sheet: 2 × $240,000 = $480,000
Copyright ©2021 John Wiley & Sons Canada, Ltd.
28
Net Income Effects Overbay Inc.– Example
2023
Produced 12 Sold 10
0 (zero) 2 Units in Ending inventory
ABSORPTION COSTING
Note:
FMOH costs of $720,000 are expenses in 2023 $120,000 of FMOH incurred in 2022 and included
in beginning inventory, plus $600,000 of FMOH
incurred in 2023.
Copyright ©2021 John Wiley & Sons Canada, Ltd.
29
Net Income Effects Overbay Inc.– Example
2023
Produced 12 Sold 10
0 (zero) 2 Units in Ending inventory
VARIABLE COSTING
Copyright ©2021 John Wiley & Sons Canada, Ltd.
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Net Income Effects Overbay Inc.– Example
WHY ?
The
FMOH
costs are
applied to
the
inventory
Comparing Net Income under the Two
Approaches
Variable costing income is only affected by changes in
unit sales. It is not affected by the number of units
produced. Generally, when sales go up, net operating
income goes up, and vice versa.
Absorption costing income is influenced by changes in
unit sales and units of production. Net operating income
can be increased simply by producing more units even if
those units are not sold.

When production equals sales; no income difference

When production > sales; absorption income >
variable income

When production < sales; absorption income <
variable income
Copyright ©2021 John Wiley & Sons Canada, Ltd.
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