Chapter 8 Absorption and Variable Costing McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. Learning Objective 1 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. Absorption Costing A system of accounting for costs in which both fixed and variable production costs are considered product costs. Fixed Costs Product Variable Costs 8-3 Variable Costing A system of cost accounting that only assigns the variable cost of production to products. Fixed Costs Product Variable Costs 8-4 Absorption and Variable Costing A b so rp tio n V a ria b le C o stin g C o stin g D ire ct m a te ria ls D ire ct la b o r P ro d u ct co sts P ro d u ct co sts V a ria b le m fg . o ve rh e a d F ix e d m fg . o ve rh e a d P e rio d co sts P e rio d co sts S e llin g & A d m in . e x p . 8-5 Absorption and Variable Costing A b so rp tio n V a ria b le C o stin g C o stin g D ire ct m a te ria ls D ire ct la b o r P ro d u ct co sts P ro d u ct co sts V a ria b le m fg . o ve rh e a d F ix e d m fg . o ve rh e a d P e rio d co sts P e rio d co sts S e llin g & A d m in . e x p . The difference between absorption and variable costing is the treatment of fixed manufacturing overhead. 8-6 Learning Objective 2 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. 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. 8-8 Absorption and Variable Costing Mellon Co. produces a single product with the following information available: 25,000 N u m b e r o f u n its p ro d u ce d a n n u a lly V a ria b le co sts p e r u n it: D ire ct m a te ria ls, d ire ct la b o r a n d va ria b le m fg . o ve rh e a d $ 10 $ 3 S e llin g & a d m in istra tive e x p e n se s F ix e d co sts p e r ye a r: M fg . o ve rh e a d $ 150,000 S e llin g & a d m in istra tive e x p e n se s $ 100,000 8-9 Absorption and Variable Costing Unit product cost is determined as follows: A b so rp tio n V a ria b le C o stin g C o stin g D ire ct m a te ria ls, d ire ct la b o r, a n d va ria b le m fg . o ve rh e a d $ 10 $ 10 F ix e d m fg . o ve rh e a d ($150,000 ÷ 25,000 u n its) U n it p ro d u ct co st 6 $ 16 $ 10 Selling and administrative expenses are always treated as period expenses and deducted from revenue. 8-10 Absorption Costing Income Statements Mellon Co. had no beginning inventory, produced 25,000 units and sold 20,000 units this year at $30 each. Ab so rp tio n C o stin g S a le s (20,000 × $30 ) $ 600,000 L e ss co st o f g o o d s so ld : B e g in n in g in ve n to ry Add CO G M G o o d s a va ila b le fo r sa le En d in g in ve n to ry G ro ss m a rg in L e ss se llin g & a d m in . e x p . V a ria b le F ix e d N e t in co m e 8-11 Absorption Costing Income Statements Mellon Co. had no beginning inventory, produced 25,000 units and sold 20,000 units this year at $30 each. Ab so rp tio n C o stin g S a le s (20,000 × $30) $ 600,000 L e ss co st o f g o o d s so ld : B e g in n in g in ve n to ry A d d C O G M (25,000 × $16) G o o d s a va ila b le fo r sa le En d in g in ve n to ry (5,000 × $16) G ro ss m a rg in $ 400,000 $ 400,000 80,000 320,000 $ 280,000 L e ss se llin g & a d m in . e x p . V a ria b le F ix e d N e t in co m e 8-12 Absorption Costing Income Statements Mellon Co. had no beginning inventory, produced 25,000 units and sold 20,000 units this year at $30 each. Ab so rp tio n C o stin g S a le s (20,000 × $30) $ 600,000 L e ss co st o f g o o d s so ld : B e g in n in g in ve n to ry $ A d d C O G M (25,000 × $16) G o o d s a va ila b le fo r sa le 400,000 $ 400,000 En d in g in ve n to ry (5,000 × $16) 80,000 G ro ss m a rg in 320,000 $ 280,000 L e ss se llin g & a d m in . e x p . V a ria b le (20,000 × $3) F ix e d N e t in co m e $ 60,000 100,000 160,000 $ 120,000 8-13 Learning Objective 3 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. Variable Costing Income Statements Now let’s look at variable costing by Mellon Co. Variab le C o stin g S a le s (20,000 × $30) $ 600,000 L e ss va ria b le e x p e n se s: B e g in n in g in ve n to ry $ - Add CO G M G o o d s a va ila b le fo r sa le En d in g in ve n to ry V a ria b le co st o f g o o d s so ld V a ria b le se llin g & a d m in istra tive e x p e n se s C o n trib u tio n m a rg in L e ss fix e d e x p e n se s: M a n u fa ctu rin g o ve rh e a d S e llin g & a d m in istra tive e x p e n se s N e t in co m e 8-15 Variable Costing Income Statements Now let’s look at variable costing by Mellon Co. We exclude the S a le s (20,000 × $30) L e ss va ria b le e x p e n se s: B e g in n in g in ve n to ry A d d C O G M (25,000 × $10) G o o d s a va ila b le fo r sa le En d in g in ve n to ry (5,000 × $10) V a ria b le co st o f g o o d s so ld Variab le C o stin g fixed manufacturing $ 600,000 overhead. $ 250,000 $ 250,000 50,000 $ 200,000 V a ria b le se llin g & a d m in istra tive e x p e n se s C o n trib u tio n m a rg in L e ss fix e d e x p e n se s: M a n u fa ctu rin g o ve rh e a d S e llin g & a d m in istra tive e x p e n se s N e t in co m e 8-16 Variable Costing Income Statements Now let’s look at variable costing by Mellon Co. Variab le C o stin g S a le s (20,000 × $30) $ 600,000 L e ss va ria b le e x p e n se s: B e g in n in g in ve n to ry A d d C O G M (25,000 × $10) G o o d s a va ila b le fo r sa le En d in g in ve n to ry (5,000 × $10) V a ria b le co st o f g o o d s so ld $ 250,000 $ 250,000 50,000 $ 200,000 V a ria b le se llin g & a d m in istra tive e x p e n se s (20,000 × $3) 60,000 C o n trib u tio n m a rg in 260,000 $ 340,000 L e ss fix e d e x p e n se s: M a n u fa ctu rin g o ve rh e a d S e llin g & a d m in istra tive e x p e n se s N e t in co m e $ 150,000 100,000 250,000 $ 90,000 8-17 Comparing Absorption and Variable Costing Let’s compare the methods. C o st o f Goods En d in g P e rio d S o ld In ve n to ry Ex p e n se T o ta l A b so rp tio n co stin g V a ria b le m fg . co sts F ix e d m fg . co sts $ 200,000 120,000 $ 320,000 V a ria b le co stin g V a ria b le m fg . co sts F ix e d m fg . co sts $ 200,000 $ 200,000 8-18 Comparing Absorption and Variable Costing Let’s compare the methods. Cost of Goods Sold Ending Inventory Period Expense Absorption costing Variable mfg. costs $ 200,000 Fixed mfg. costs 120,000 $ 320,000 $ 50,000 30,000 $ 80,000 $ Variable costing Variable mfg. costs $ 200,000 Fixed mfg. costs $ 200,000 $ 50,000 $ 50,000 $ $ Total - 150,000 $ 150,000 8-19 Comparing Absorption and Variable Costing Let’s compare the methods. Cost of Goods Sold Ending Inventory Period Expense Absorption costing Variable mfg. costs $ 200,000 Fixed mfg. costs 120,000 $ 320,000 $ 50,000 30,000 $ 80,000 $ Variable costing Variable mfg. costs $ 200,000 Fixed mfg. costs $ 200,000 $ 50,000 $ 50,000 $ $ - 150,000 $ 150,000 Total $ 250,000 150,000 $ 400,000 $ 250,000 150,000 $ 400,000 8-20 Learning Objective 4 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. Reconciling Income Under Absorption and Variable Costing We can reconcile the difference between absorption and variable net income as follows: V a ria b le co stin g n e t in co m e $ 90,000 A d d : F ix e d m fg . o ve rh e a d co sts d e fe rre d in in ve n to ry (5,000 u n its × $6 p e r u n it) A b so rp tio n co stin g n e t in co m e Fixed mfg. overhead $150,000 = Units produced 25,000 30,000 $ 120,000 = $6.00 per unit 8-22 Learning Objective 5 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. 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. 8-24 Learning Objective 6 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. Extending the Example Let’s look at the second year of operations for Mellon Company. 8-26 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. N u m b e r o f u n its p ro d u ce d a n n u a lly 25,000 V a ria b le co sts p e r u n it: D ire ct m a te ria ls, d ire ct la b o r a n d va ria b le m fg . o ve rh e a d $ 10 $ 3 S e llin g & a d m in istra tive e x p e n se s F ix e d co sts p e r ye a r: M fg . o ve rh e a d $ 150,000 S e llin g & a d m in istra tive e x p e n se s $ 100,000 8-27 Mellon Co. Year 2 Unit product cost is determined as follows: A b so rp tio n V a ria b le C o stin g C o stin g D ire ct m a te ria ls, d ire ct la b o r, a n d va ria b le m fg . o ve rh e a d $ 10 $ 10 F ix e d m fg . o ve rh e a d ($150,000 ÷ 25,000 u n its) U n it p ro d u ct co st 6 $ 16 $ 10 There has been no change in Mellon’s cost structure. 8-28 Mellon Co. Year 2 Now let’s look at Mellon’s income statement assuming absorption costing is used. 8-29 Mellon Co. Year 2 Units in ending inventory from the previous period. Ab so rp tio n C o stin g S a le s (30,000 × $30) $ 900,000 L e ss co st o f g o o d s so ld : B e g . in ve n to ry (5,000 x $16) $ A d d C O G M (25,000 × $16) G o o d s a va ila b le fo r sa le 80,000 400,000 $ 480,000 En d in g in ve n to ry - G ro ss m a rg in 480,000 $ 420,000 L e ss se llin g & a d m in . e x p . V a ria b le (30,000 × $3) F ix e d N e t in co m e $ 90,000 100,000 190,000 $ 230,000 8-30 Mellon Co. Year 2 Ab so rp tio n C o stin g S a le s (30,000 × $30) $ 900,000 L e ss co st o f g o o d s so ld : B e g . in ve n to ry (5,000 x $16) $ A d d C O G M (25,000 × $16) G o o d s a va ila b le fo r sa le 80,000 400,000 $ 480,000 En d in g in ve n to ry - G ro ss m a rg in 480,000 $ 420,000 L e ss se llin g & a d m in . e x p . V a ria b le (30,000 × $3) F ix e d N e t in co m e $ 90,000 100,000 190,000 $ 230,000 25,000 units produced in the current period. 8-31 Mellon Co. Year 2 Next, we’ll look at Mellon’s income statement assuming variable costing is used. 8-32 Mellon Co. Year 2 Variab le C o stin g S a le s (30,000 × $30) $ 900,000 L e ss va ria b le e x p e n se s: B e g . in ve n to ry (5,000 × $10) $ A d d C O G M (25,000 × $10) G o o d s a va ila b le fo r sa le 250,000 $ En d in g in ve n to ry V a ria b le co st o f g o o d s so ld 50,000 300,000 - $ 300,000 V a ria b le se llin g & a d m in istra tive e x p e n se s (30,000 × $3) 90,000 C o n trib u tio n m a rg in 390,000 $ 510,000 L e ss fix e d e x p e n se s: M a n u fa ctu rin g o ve rh e a d S e llin g & a d m in istra tive e x p e n se s N e t in co m e $ 150,000 100,000 250,000 $ 260,000 Excludes fixed manufacturing overhead. 8-33 Summary In c o m e C o m p a ris o n C o stin g M e th o d A b so rp tio n V a ria b le 1st P e rio d $ 120,000 90,000 2n d P e rio d $ T o ta l 230,000 $ 350,000 260,000 350,000 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). 8-34 Summary In c o m e C o m p a ris o n C o stin g M e th o d A b so rp tio n V a ria b le 1st P e rio d $ 120,000 90,000 2n d P e rio d $ T o ta l 230,000 $ 350,000 260,000 350,000 For the two-year period, total absorption income and total variable income are the same. 8-35 Summary Let’s see if we can get an overview of what we have done. 8-36 Summary Comparison of Absorption (AC) and Variable Costing (VC) T o ta l P ro d u ctio n ve rsu s In ve n to ry S a le s Effe ct P e rio d Ex p e n se Effe ct F ix e d m fg . P ro d u ce d > S o ld In cre a se co sts e x p e n se d AC P ro fit Effe ct F ix e d m fg . < co sts e x p e n se d AC > V C VC e d m fgperiod . Fwhen ix e d m fgproduction . This was the case in theF ixfirst P ro d u ce d < S o ld D e cre a se co sts e x p e n se d > co sts e x p e n se d AC < V C of 25,000 units was greaterA Cthan sales of 20,000 units. VC F ix e d mzero fg . F ix e d munits fg . Inventory increased from to 5,000 and P ro d u ce d = S o ld N o ch a n g e co sts e x p e n se d = co sts e x p e n se d AC = $120,000 absorption income was greater than AC VC $90,000 variable income. VC 8-37 Summary Comparison of Absorption (AC) and Variable Costing (VC) T o ta l P ro d u ctio n ve rsu s In ve n to ry S a le s Effe ct P e rio d Ex p e n se Effe ct F ix e d m fg . P ro d u ce d > S o ld P ro d u ce d < S o ld In cre a se D e cre a se co sts e x p e n se d F ix e d m fg . < co sts e x p e n se d AC VC F ix e d m fg . F ix e d m fg . co sts e x p e n se d AC P ro fit Effe ct > co sts e x p e n se d AC > V C AC < V C VC F ix e dsales m fg . F ix e d m fg .units In the second period of 30,000 P ro d u ce d = S o ld N o ch a n g e co sts e x p e n se d = co sts e x p e n se d AC were greater than production ofV C25,000. AC = VC 8-38 Summary Comparison of Absorption (AC) and Variable Costing (VC) T o ta l P ro d u ctio n ve rsu s In ve n to ry S a le s Effe ct P e rio d Ex p e n se Effe ct F ix e d m fg . P ro d u ce d > S o ld P ro d u ce d < S o ld In cre a se D e cre a se co sts e x p e n se d F ix e d m fg . < co sts e x p e n se d AC VC F ix e d m fg . F ix e d m fg . co sts e x p e n se d AC P ro fit Effe ct > co sts e x p e n se d AC > V C AC < V C VC F ix efrom d m fg . 5,000F ix e d m fg . to zero, Inventory decreased units P ro d u ce d = S o ld N o ch a n g e co sts e x p e n se d = co sts e x p e n se d AC = V C and $230,000 absorption income was less AC VC than $260,000 variable income. 8-39 Summary Comparison of Absorption (AC) and Variable Costing (VC) T o ta l P ro d u ctio n ve rsu s In ve n to ry S a le s Effe ct P e rio d Ex p e n se Effe ct F ix e d m fg . P ro d u ce d > S o ld In cre a se co sts e x p e n se d P ro fit Effe ct F ix e d m fg . < co sts e x p e n se d AC VC F ix e d m fg . F ix e d m fg . AC > V C For the two-year period, units produced ix e dtotal m fg . F ix e d m fg . income equals units sold, Fso absorption P ro d u ce d < S o ld D e cre a se co sts e x p e n se d > co sts e x p e n se d AC < V C equals total Avariable income. C VC P ro d u ce d = S o ld N o ch a n g e co sts e x p e n se d AC = co sts e x p e n se d AC = V C VC 8-40 Evaluation of Variable Costing Management finds it easy to understand. Advantages Impact of fixed costs on profits emphasized. Consistent with CVP analysis. Emphasizes contribution in short-run pricing decisions. Profit for period not affected by changes in fixed mfg. overhead. 8-41 Evaluation of Absorption Costing Fixed manufacturing overhead is treated the same as the other product costs, direct material and direct labor. Advantages Consistent with long-run pricing decisions that must cover full cost. External reporting and income tax law require absorption costing. 8-42 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. 8-43 Learning Objective 7 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. Throughput Costing Example In an automated process direct material may be the only unit-level cost and so is the only product cost. All other manufacturing costs are expensed as period costs. Incentive to overproduce is reduced Average unit cost does not vary with changes in production levels. Advantages 8-45 Learning Objective 8 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. Throughput Income Satatement Sales Revenue Throughput cost of goods sold (dir. mat.) Gross Margin 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 Net Income $600,000 150,000 $450,000 375,000 $ 75,000 8-47 End of Chapter 8 The End 8-48