Absorption & Variable Costing
Absorption & Variable Costing
Absorption & Variable Costing
Group One
Objectives
1. Explain how vaiable costing differs from After and compute unit product studying this absorption costin costs underchapter, you should each method 2. Prepare incomebe able to: using both variable statement and absorption costing. 3. Reconcile variable costing and absorption costing net operating incomes and explain why the two amounts differ. 4. Understand the advantages and disadvantages of both variable and absorption costing.
Period Cost
Costs incurred with the passage of time
Interest on loan, insurance premiums coverage
Absorption Costing
Variable Costing
Product Costs
Product Costs
Period Costs
Variable Selling and Administrative Expenses Fixed Selling and Administrative Expenses
Period Costs
Two Costing Methods Variable Costing Used for internal planning and decision making Does not include fixed factory overhead as a product cost
Summary of Differences
Period Expense
Variable Costing
Selling and administrative expenses are always treated as period expenses and deducted from revenue as incurred.
Now, lets compute net operating income using both absorption and variable costing.
Absorption Costing
Variable Costing
Sales (20,000 $30) Less variable expenses: Beginning inventory $ Add COGM (25,000 $10) 250,000 Goods available for sale 250,000 Less ending inventory (5,000 $10) 50,000 Variable cost of goods sold 200,000 Variable selling & administrative expenses (20,000 $3) 60,000 Contribution margin Less fixed expenses: Manufacturing overhead $ 150,000 Selling & administrative expenses 100,000 Net operating income
$ 600,000
250,000 $ 90,000
Reconciliation
We can reconcile the difference between absorption and variable income as follows:
Variable costing net operating income $ 90,000 Add: Fixed mfg. overhead costs deferred in inventory (5,000 units $6 per unit) 30,000 Absorption costing net operating income $ 120,000
Fixed mfg. Overhead $150,000 = = $6.00 per unit Units produced 25,000 units
Since there was no change in the variable costs per unit, total fixed costs, or the number of units produced, the unit costs remain unchanged.
Absorption Costing
Absorption Costing
Sales (30,000 $30) Less cost of goods sold: Beg. inventory (5,000 $16) Add COGM (25,000 $16) Goods available for sale Less ending inventory Gross margin Less selling & admin. exp. Variable (30,000 $3) Fixed Net operating income $ 900,000 $ 80,000 400,000 480,000 -
480,000 420,000
$ 90,000 100,000
190,000 $ 230,000
Variable Costing
Reconciliation
We can reconcile the difference between absorption and variable income as follows:
Variable costing net operating income $ 260,000 Deduct: Fixed manufacturing overhead costs released from inventory (5,000 units $6 per unit) 30,000 Absorption costing net operating income $ 230,000
Fixed mfg. Overhead $150,000 = = $6.00 per unit Units produced 25,000 units
Income Comparison
Summary
Since the number of units produced increased in this example, while the fixed manufacturing overhead remained the same, the absorption unit cost is less.
$ 750,000
250,000 $ 175,000
Since the number of units produced decreased in the second year, while the fixed manufacturing overhead remained the same, the absorption unit cost is now higher.
425,000 325,000
$ 75,000 100,000
175,000 $ 150,000
These are the 20,000 units produced in the current period at the higher unit cost of $17.50 each.
Variable Costing:
Income Comparison
Conclusions
Net operating income is not affected by changes in production using variable costing.
Net operating income is affected by changes in production using absorption costing even though the number of units sold is the same each year.
Opponents of absorption costing argue that shifting fixed manufacturing overhead costs between periods can lead to misinterpretations and faulty decisions.
Those who favor variable costing argue that the income statements are easier to understand because net operating income is only affected by changes in unit sales. The resulting income amounts are more consistent with managers expectations.
Since top executives are usually evaluated based on external reports to shareholders, they may feel that decisions should be based on absorption cost income.
Under the Tax Reform Act of 1986, absorption costing must be used when filing income tax returns.
Advantages of Variable Costing Consistent with CVP analysis. and the Contribution Approach
Advantages
Easier to estimate profitability of products and segments. Impact of fixed costs on profits emphasized. Profit is not affected by changes in inventories.
Variable versus Absorption Fixed manufacturing costs must be assigned Costing Fixed manufacturing
to products to properly match revenues and costs. costs are capacity costs and will be incurred even if nothing is produced.
Absorption Costing
Variable Costing
So, the difference between variable and absorption income tends to disappear.