Chapter 8
Absorption and
Variable Costing
McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning
Objective
1
8-2
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
Absorption
Costing
Product costs
Variable
Costing
Direct materials
Direct labor
Variable mfg. overhead
Product costs
Fixed mfg. overhead
Period costs
Period costs
Selling & Admin. exp.
8-5
Absorption and Variable Costing
Absorption
Costing
Product costs
Variable
Costing
Direct materials
Direct labor
Variable mfg. overhead
Product costs
Fixed mfg. overhead
Period costs
Period costs
Selling & Admin. exp.
The difference between absorption and variable
costing is the treatment of fixed manufacturing overhead.
8-6
Learning
Objective
2
8-7
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:
Number of units produced annually
Variable costs per unit:
Direct materials, direct labor
and variable mfg. overhead
Selling & administrative
expenses
Fixed costs per year:
Mfg. overhead
Selling & administrative
expenses
25,000
$
10
$
3
$ 150,000
$ 100,000
8-9
Absorption and Variable Costing
Unit product cost is determined as follows:
Direct materials, direct labor, and
variable mfg. overhead
Fixed mfg. overhead
($150,000 ÷ 25,000 units)
Unit product cost
Absorption
Costing
Variable
Costing
$
10
$
10
$
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. Absorption Costing
Sales (20,000 × $30)
Less cost of goods sold:
Beginning inventory
Add COGM
Goods available for sale
Ending inventory
Gross margin
Less selling & admin. exp.
Variable
Fixed
Net income
$ 600,000
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. Absorption Costing
Sales (20,000 × $30)
Less cost of goods sold:
Beginning inventory
$
Add COGM (25,000 × $16)
400,000
Goods available for sale
$ 400,000
Ending inventory (5,000 × $16)
80,000
Gross margin
Less selling & admin. exp.
Variable
Fixed
Net income
$ 600,000
320,000
$ 280,000
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.
Absorption Costing
Sales (20,000 × $30)
Less cost of goods sold:
Beginning inventory
$
Add COGM (25,000 × $16)
400,000
Goods available for sale
$ 400,000
Ending inventory (5,000 × $16)
80,000
Gross margin
Less selling & admin. exp.
Variable (20,000 × $3)
$ 60,000
Fixed
100,000
Net income
$ 600,000
320,000
$ 280,000
160,000
$ 120,000
8-13
Learning
Objective
3
8-14
Variable Costing
Income Statements
Now let’s look at variable costing by Mellon
Co. Variable Costing
Sales (20,000 × $30)
Less variable expenses:
Beginning inventory
$
Add COGM
Goods available for sale
Ending inventory
Variable cost of goods sold
Variable selling & administrative
expenses
Contribution margin
Less fixed expenses:
Manufacturing overhead
Selling & administrative expenses
Net income
$ 600,000
-
8-15
Variable Costing
Income Statements
Now let’s look at variable costing by Mellon
exclude the
Co. We
Variable Costing
fixed manufacturing
$ 600,000
overhead.
Sales (20,000 × $30)
Less variable expenses:
Beginning inventory
$
Add COGM (25,000 × $10)
250,000
Goods available for sale
$ 250,000
Ending inventory (5,000 × $10)
50,000
Variable cost of goods sold
$ 200,000
Variable selling & administrative
expenses
Contribution margin
Less fixed expenses:
Manufacturing overhead
Selling & administrative expenses
Net income
8-16
Variable Costing
Income Statements
Now let’s look at variable costing by Mellon
Co. Variable Costing
Sales (20,000 × $30)
Less variable expenses:
Beginning inventory
Add COGM (25,000 × $10)
Goods available for sale
Ending inventory (5,000 × $10)
Variable cost of goods sold
Variable selling & administrative
expenses (20,000 × $3)
Contribution margin
Less fixed expenses:
Manufacturing overhead
Selling & administrative expenses
Net income
$ 600,000
$
250,000
$ 250,000
50,000
$ 200,000
60,000
$ 150,000
100,000
260,000
$ 340,000
250,000
$ 90,000
8-17
Comparing Absorption and
Variable Costing
Let’s compare the methods.
Cost of
Goods
Sold
Ending
Inventory
Period
Expense
Total
Absorption costing
Variable mfg. costs $ 200,000
Fixed mfg. costs
120,000
$ 320,000
Variable costing
Variable mfg. costs $ 200,000
Fixed mfg. costs
$ 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
8-21
Reconciling Income Under
Absorption and Variable Costing
We can reconcile the difference between
absorption and variable net income as
follows:
Variable costing net income
Add: Fixed mfg. overhead costs
deferred in inventory
(5,000 units × $6 per unit)
Absorption costing net income
Fixed mfg. overhead
$150,000
=
Units produced
25,000
$
90,000
$
30,000
120,000
= $6.00 per unit
8-22
Learning
Objective
5
8-23
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
8-25
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.
Number of units produced annually
Variable costs per unit:
Direct materials, direct labor
and variable mfg. overhead
Selling & administrative
expenses
Fixed costs per year:
Mfg. overhead
Selling & administrative
expenses
25,000
$
10
$
3
$ 150,000
$ 100,000
8-27
Mellon Co. Year 2
Unit product cost is determined as
follows:
Direct materials, direct labor,
and variable mfg. overhead
Fixed mfg. overhead
($150,000 ÷ 25,000 units)
Unit product cost
Absorption
Costing
Variable
Costing
$
10
$
10
$
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.
Absorption Costing
Sales (30,000 × $30)
Less cost of goods sold:
Beg. inventory (5,000 x $16)
Add COGM (25,000 × $16)
Goods available for sale
Ending inventory
Gross margin
Less selling & admin. exp.
Variable (30,000 × $3)
Fixed
Net income
$ 900,000
$ 80,000
400,000
$ 480,000
-
$ 90,000
100,000
480,000
$ 420,000
190,000
$ 230,000
8-30
Mellon Co. Year 2
Absorption Costing
Sales (30,000 × $30)
Less cost of goods sold:
Beg. inventory (5,000 x $16)
Add COGM (25,000 × $16)
Goods available for sale
Ending inventory
Gross margin
Less selling & admin. exp.
Variable (30,000 × $3)
Fixed
Net income
$ 900,000
$ 80,000
400,000
$ 480,000
-
$ 90,000
100,000
480,000
$ 420,000
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
Variable Costing
Sales (30,000 × $30)
Less variable expenses:
Beg. inventory (5,000 × $10)
Add COGM (25,000 × $10)
Goods available for sale
Ending inventory
Variable cost of goods sold
Variable selling & administrative
expenses (30,000 × $3)
Contribution margin
Less fixed expenses:
Manufacturing overhead
Selling & administrative expenses
Net income
$ 900,000
$
50,000
250,000
$ 300,000
$ 300,000
90,000
$ 150,000
100,000
390,000
$ 510,000
250,000
$ 260,000
Excludes fixed manufacturing overhead.
8-33
Summary
Income Comparison
Costing Method
Absorption
Variable
1st Period
$ 120,000
90,000
2nd Period
$ 230,000
260,000
Total
$ 350,000
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
Income Comparison
Costing Method
Absorption
Variable
1st Period
$ 120,000
90,000
2nd Period
$ 230,000
260,000
Total
$ 350,000
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)
Production versus
Sales
Produced > Sold
Total
Inventory
Effect
Increase
Period Expense Effect
Fixed mfg.
costs expensed
AC
Fixed mfg.
< costs expensed
VC
Profit Effect
AC > VC
mfg.
mfg.
This was the case in theFixed
first
period Fixed
when
production
Produced < Sold
Decrease
costs expensed > costs expensed
AC < VC
of 25,000 units was greaterACthan sales of
20,000
units.
VC
Fixed mfg.
Fixed mfg.
Inventory increased from
zero to 5,000
units and
Produced = Sold No change
costs expensed = costs expensed
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)
Production versus
Sales
Produced > Sold
Produced < Sold
Total
Inventory
Effect
Period Expense Effect
Profit Effect
Increase
Fixed mfg.
costs expensed
AC
Fixed mfg.
< costs expensed
VC
AC > VC
Decrease
Fixed mfg.
costs expensed
AC
Fixed mfg.
> costs expensed
VC
AC < VC
Fixedsales
mfg.
Fixed mfg.units
In the second period
of 30,000
Produced = Sold No change
costs expensed = costs expensed
AC
were greater than production
ofVC25,000.
AC
= VC
8-38
Summary Comparison of
Absorption (AC) and Variable
Costing (VC)
Production versus
Sales
Produced > Sold
Produced < Sold
Total
Inventory
Effect
Period Expense Effect
Profit Effect
Increase
Fixed mfg.
costs expensed
AC
Fixed mfg.
< costs expensed
VC
AC > VC
Decrease
Fixed mfg.
costs expensed
AC
Fixed mfg.
> costs expensed
VC
AC < VC
Fixed
mfg. 5,000Fixed
mfg. to zero,
Inventory decreased
from
units
Produced = Sold No change
costs expensed = costs expensed
AC = VC
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)
Production versus
Sales
Produced > Sold
Total
Inventory
Effect
Increase
Period Expense Effect
Fixed mfg.
costs expensed
AC
Fixed mfg.
< costs expensed
VC
Profit Effect
AC > VC
Fixed mfg. unitsFixed
mfg.
For the two-year period,
produced
Produced < Sold
Decrease
> costs expensed
AC <
equals units
sold, costs
so expensed
total
absorption
income
AC
VC
equals total variable income.
Produced = Sold
No change
Fixed mfg.
Fixed mfg.
costs expensed = costs expensed
AC
VC
VC
AC = 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
8-44
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
8-46
Throughput Income Statement
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