Absorption and Variable Costing

1.

Absorption and Variable Costing
McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

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

3. Variable Costing

A system of cost accounting that only assigns
the variable cost of production to products.
Fixed
Costs
Product
Variable
Costs

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.

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.

6. 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.

7. 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. 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.

9. Absorption Costing Income Statements

ABSORPTION
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
8-9

10. Absorption Costing Income Statements

ABSORPTION
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

11. Absorption Costing Income Statements

ABSORPTION
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

12. Variable Costing Income Statements

VARIABLE
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
-

13. Variable Costing Income Statements

VARIABLE
Now let’s look at variable costing by Mellon Co.
We exclude the fixed
manufacturing
Variable
Costingoverhead.
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
$ 600,000

14. Variable Costing Income Statements

VARIABLE
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

15. Comparing Absorption and Variable Costing

COMPARING
Let’s compare the methods.
Cost of
Goods
Sold
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
Ending
Inventory
Period
Expense
Total

16. Comparing Absorption and Variable Costing

COMPARING
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

17. Comparing Absorption and Variable Costing

COMPARING
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

18. Reconciling Income Under Absorption and Variable Costing

RECONCILING INCOME
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
Units produced
$150,000
=
25,000
$
90,000
$
30,000
120,000
= $6.00 per unit

19. Extending the Example

Let’s look at
the second
year of
operations
for Mellon
Company.

20. 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

21. 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.
8-21

22. Absorption Costing Income Statement Mellon Co. Year 2

ABSORPTION
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

23. Absorption Costing Income Statement Mellon Co. Year 2

ABSORPTION
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.

24. VARIABLE Costing Income Statement Mellon Co. Year 2

VARIABLE
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
Excludes fixed manufacturing overhead.
390,000
$ 510,000
250,000
$ 260,000

25. 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).

26. 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.

27. SUMMARY

28. Effect of Changes in Production on Net Operating Income

CHANGES IN PRODUCTION
Let’s revise the Mellon Company example
In the previous example, 25,000 units were
produced each year, but sales increased from
20,000 units in year one to 30,000 units in year
two.
In this revised example, production will differ
each year while sales will remain constant.

29. Effect of Changes in Production Mellon co, year 1

30. Unit Cost Computations for Year One

YEAR ONE
Since the number of units produced increased in this
example, while the fixed manufacturing overhead
remained the same, the absorption unit cost is less.

31. Absorption Costing Income Statements, year 1

ABSORPTION

32. Variable Costing Income Statements, year 1

VARIABLE

33. Effect of Changes in Production Mellon co, year 2

34. Unit Cost Computations for Year two

YEAR TWO
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.

35. Absorption Costing Income Statements, year 2

ABSORPTION

36. Variable Costing Income Statements, year 2

VARIABLE

37. Summary 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.

38. Impact on the Manager

• 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.

39. Evaluation of Variable Costing and the contribution approach

CONTRIBUTION
Management finds it
easy to understand
Advantages
Impact of fixed
costs on profits
emphasized
Consistent with
CVP analysis
Net operating income
is closer to net cash flow.
Emphasizes contribution in
short-run pricing decisions
Profit for period not
affected by changes
in inventories
8-39

40. 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
8-40