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© 2006 McGraw-Hill Ryerson Ltd..
Variable vs. Absorption Costing: A Tool for
Management
Chapter Seven
© 2006 McGraw-Hill Ryerson Ltd..
Learning Objectives
1. Explain how variable costing differs from absorption costing and compute unit product costs under each method.
2. Prepare income statements using both variable and absorption costing.
3. Reconcile variable costing and absorption costing operating incomes, and explain why the two amounts differ.
After studying this chapter, you should be able to:
© 2006 McGraw-Hill Ryerson Ltd..
Learning Objectives
4. Explain the advantages and disadvantages of both variable and absorption costing.
5. Explain how the use of JIT reduces the difference in reported operating income under the variable and absorption costing methods.
After studying this chapter, you should be able to:
© 2006 McGraw-Hill Ryerson Ltd..
Overview of Absorptionand Variable Costing
Direct Materials
Direct Labour
Variable Manufacturing Overhead
Fixed Manufacturing Overhead
Variable Selling and Administrative Expenses
Fixed Selling and Administrative Expenses
VariableCosting
AbsorptionCosting
ProductCosts
PeriodCosts
ProductCosts
PeriodCosts
© 2006 McGraw-Hill Ryerson Ltd..
Quick Check
Which method will produce the highest values for work in process and finished goods inventories?
a. Absorption costing.
b. Variable costing.
c. They produce the same values for these inventories.
d. It depends. . .
Which method will produce the highest values for work in process and finished goods inventories?
a. Absorption costing.
b. Variable costing.
c. They produce the same values for these inventories.
d. It depends. . .
© 2006 McGraw-Hill Ryerson Ltd..
Which method will produce the highest values for work in process and finished goods inventories?
a. Absorption costing.
b. Variable costing.
c. They produce the same values for these inventories.
d. It depends. . .
Which method will produce the highest values for work in process and finished goods inventories?
a. Absorption costing.
b. Variable costing.
c. They produce the same values for these inventories.
d. It depends. . .
Quick Check
© 2006 McGraw-Hill Ryerson Ltd..
Harvey Company produces a single productwith the following information available:
Unit Cost Computations
© 2006 McGraw-Hill Ryerson Ltd..
Unit product cost is determined as follows:
Selling and administrative expenses arealways treated as period expenses and
deducted from revenue as incurred.
Unit Cost Computations
© 2006 McGraw-Hill Ryerson Ltd..
Income Comparison ofAbsorption and Variable Costing
Let’s assume the following additional information for Harvey Company. 20,000 units were sold during the year at a price of
$30 each. There were no units in beginning inventory.
Now, let’s compute net operatingincome using both absorptionand variable costing.
© 2006 McGraw-Hill Ryerson Ltd..
Absorption Costing
© 2006 McGraw-Hill Ryerson Ltd..
Variable CostingSales (20,000 × $30) 600,000$ 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 × $3) 60,000 260,000 Contribution margin 340,000 Less fixed expenses: Manufacturing overhead 150,000$ Selling & administrative expenses 100,000 250,000 Net operating income 90,000$
Variable CostingSales (20,000 × $30) 600,000$ 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 × $3) 60,000 260,000 Contribution margin 340,000 Less fixed expenses: Manufacturing overhead 150,000$ Selling & administrative expenses 100,000 250,000 Net operating income 90,000$
Variablemanufacturing
costs only.
All fixedmanufacturing
overhead isexpensed.
Variable Costing
© 2006 McGraw-Hill Ryerson Ltd..
Income Comparison ofAbsorption and Variable Costing
Let’s compare the methods.
© 2006 McGraw-Hill Ryerson Ltd..
Reconciliation
Variable costing net operating income 90,000$ Add: Fixed mfg. overhead costs deferred in inventory (5,000 units × $6 per unit) 30,000 Absorption costing net operating income 120,000$
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 Units produced 25,000 units
= = $6.00 per unit
We can reconcile the difference betweenabsorption and variable income as follows:
© 2006 McGraw-Hill Ryerson Ltd..
Extended Comparison of Income Data Harvey Company Year Two
© 2006 McGraw-Hill Ryerson Ltd..
Unit Cost Computations
Since there was no change in the variable costsper unit, total fixed costs, or the number of
units produced, the unit costs remain unchanged.
© 2006 McGraw-Hill Ryerson Ltd..
Absorption CostingSales (30,000 × $30) 900,000$ Less cost of goods sold: Beg. inventory (5,000 × $16) 80,000$ Add COGM (25,000 × $16) 400,000 Goods available for sale 480,000 Less ending inventory - 480,000 Gross margin 420,000 Less selling & admin. exp. Variable (30,000 × $3) 90,000$ Fixed 100,000 190,000 Net operating income 230,000$
Absorption CostingSales (30,000 × $30) 900,000$ Less cost of goods sold: Beg. inventory (5,000 × $16) 80,000$ Add COGM (25,000 × $16) 400,000 Goods available for sale 480,000 Less ending inventory - 480,000 Gross margin 420,000 Less selling & admin. exp. Variable (30,000 × $3) 90,000$ Fixed 100,000 190,000 Net operating income 230,000$
Absorption Costing
These are the 25,000 unitsproduced in the current period.
© 2006 McGraw-Hill Ryerson Ltd..
Variable Costing
All fixedmanufacturing
overhead isexpensed.
Variablemanufacturing
costs only.
© 2006 McGraw-Hill Ryerson Ltd..
Reconciliation
Variable costing net operating income 260,000$ Deduct: Fixed manufacturing overhead costs released from inventory (5,000 units × $6 per unit) 30,000 Absorption costing net operating income 230,000$
We can reconcile the difference betweenabsorption and variable income as follows:
Fixed mfg. Overhead $150,000 Units produced 25,000 units
= = $6.00 per unit
© 2006 McGraw-Hill Ryerson Ltd..
Income Comparison
© 2006 McGraw-Hill Ryerson Ltd..
Summary
© 2006 McGraw-Hill Ryerson Ltd..
Effect of Changes in Productionon Net Operating Income
Let’s revise the Harvey Company example.Let’s revise the Harvey Company example.
In the previous example,25,000 units were produced each year,
but sales increased from 20,000 units in yearone to 30,000 units in year two.
In this revised example,production will differ each year while
sales will remain constant.
© 2006 McGraw-Hill Ryerson Ltd..
Effect of Changes in ProductionHarvey Company Year One
© 2006 McGraw-Hill Ryerson Ltd..
Unit product cost is determined as follows:
Unit Cost Computations for Year One
Since the number of units produced increasedin this example, while the fixed manufacturing overhead
remained the same, the absorption unit cost is less.
Since the number of units produced increasedin this example, while the fixed manufacturing overhead
remained the same, the absorption unit cost is less.
© 2006 McGraw-Hill Ryerson Ltd..
Absorption Costing: Year One
© 2006 McGraw-Hill Ryerson Ltd..
Variable CostingSales (25,000 × $30) 750,000$ Less variable expenses: Beginning inventory -$ Add COGM (30,000 × $10) 300,000 Goods available for sale 300,000 Less ending inventory (5,000 × $10) 50,000 Variable cost of goods sold 250,000 Variable selling & administrative expenses (25,000 × $3) 75,000 325,000 Contribution margin 425,000 Less fixed expenses: Manufacturing overhead 150,000$ Selling & administrative expenses 100,000 250,000 Net operating income 175,000$
Variable CostingSales (25,000 × $30) 750,000$ Less variable expenses: Beginning inventory -$ Add COGM (30,000 × $10) 300,000 Goods available for sale 300,000 Less ending inventory (5,000 × $10) 50,000 Variable cost of goods sold 250,000 Variable selling & administrative expenses (25,000 × $3) 75,000 325,000 Contribution margin 425,000 Less fixed expenses: Manufacturing overhead 150,000$ Selling & administrative expenses 100,000 250,000 Net operating income 175,000$
Variable Costing: Year One
Variablemanufacturing
costs only.
All fixedmanufacturing
overhead isexpensed.
© 2006 McGraw-Hill Ryerson Ltd..
Effect of Changes in ProductionHarvey Company Year Two
© 2006 McGraw-Hill Ryerson Ltd..
Unit product cost is determined as follows:
Unit Cost Computations for Year Two
Since the number of units produced decreased in thesecond year, while the fixed manufacturing overhead
remained the same, the absorption unit cost is now higher.
Since the number of units produced decreased in thesecond year, while the fixed manufacturing overhead
remained the same, the absorption unit cost is now higher.
© 2006 McGraw-Hill Ryerson Ltd..
Absorption CostingSales (25,000 × $30) 750,000$ Less cost of goods sold: Beg. inventory (5,000 × $15) 75,000$ Add COGM (20,000 × $17.50) 350,000 Goods available for sale 425,000 Less ending inventory - 425,000 Gross margin 325,000 Less selling & admin. exp. Variable (25,000 × $3) 75,000$ Fixed 100,000 175,000 Net operating income 150,000$
Absorption CostingSales (25,000 × $30) 750,000$ Less cost of goods sold: Beg. inventory (5,000 × $15) 75,000$ Add COGM (20,000 × $17.50) 350,000 Goods available for sale 425,000 Less ending inventory - 425,000 Gross margin 325,000 Less selling & admin. exp. Variable (25,000 × $3) 75,000$ Fixed 100,000 175,000 Net operating income 150,000$
Absorption Costing: Year Two
These are the 20,000 units produced in the currentperiod at the higher unit cost of $17.50 each.
© 2006 McGraw-Hill Ryerson Ltd..
Variable Costing: Year Two
All fixedmanufacturing
overhead isexpensed.
Variablemanufacturing
costs only.
© 2006 McGraw-Hill Ryerson Ltd..
Income Comparison
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.
Conclusions
© 2006 McGraw-Hill Ryerson Ltd..
Impact on the Manager
Opponents of absorption costing argue that shiftingfixed manufacturing overhead costs between periodscan lead to misinterpretations and faulty decisions.
Opponents of absorption costing argue that shiftingfixed manufacturing overhead costs between periodscan lead to misinterpretations and faulty decisions.
Those who favor variable costing argue that the incomestatements are easier to understand because net operating
income is only affected by changes in unit sales. Theresulting income amounts are more consistent with
managers’ expectations.
Those who favor variable costing argue that the incomestatements are easier to understand because net operating
income is only affected by changes in unit sales. Theresulting income amounts are more consistent with
managers’ expectations.
© 2006 McGraw-Hill Ryerson Ltd..
CVP Analysis, Decision Makingand Absorption costing
Absorption costing does not support CVP analysis because it essentially treats fixed
manufacturing overhead as a variable cost by assigning a per unit amount of the fixed
overhead to each unit of production.
Treating fixed manufacturing overhead as a variable cost can:
• Lead to faulty pricing decisions and keep/drop decisions.
• Produce positive net operating income even when the number of units sold is less than the breakeven point.
Treating fixed manufacturing overhead as a variable cost can:
• Lead to faulty pricing decisions and keep/drop decisions.
• Produce positive net operating income even when the number of units sold is less than the breakeven point.
© 2006 McGraw-Hill Ryerson Ltd..
External Reporting and Income Taxes
Though GAAP allow the use of either method, absorption costing
Is the predominant method used in Canada.
Though GAAP allow the use of either method, absorption costing
Is the predominant method used in Canada.
Either variable orabsorption costing can beused when filing income
tax returns.
Either variable orabsorption costing can beused when filing income
tax returns.Since top executivesare usually evaluated based on
external reports to shareholders,they may feel that decisions
should be based on absorption cost income.
Since top executivesare usually evaluated based on
external reports to shareholders,they may feel that decisions
should be based on absorption cost income.
© 2006 McGraw-Hill Ryerson Ltd..
Advantages of Variable Costingand the Contribution Approach
Advantages
Management findsit more useful.
Consistent withCVP analysis.
Net operating income is closer to
net cash flow.
Profit is not affected bychanges in inventories.
Consistent with standardcosts and flexible budgeting.
Impact of fixedcosts on profitsemphasized.
Easier to estimate profitabilityof products and segments.
© 2006 McGraw-Hill Ryerson Ltd..
VariableCosting
Variable versus Absorption Costing
AbsorptionCosting
Fixed manufacturingcosts must be assignedto products to properlymatch revenues and
costs.
Fixed manufacturing costs are capacity costs
and will be incurredeven if nothing is
produced.
© 2006 McGraw-Hill Ryerson Ltd..
Variable Costing and theTheory of Constraints (TOC)
Companies involved in TOC use a form of variable costing, but treating direct labour as a fixed cost for three reasons: Many companies have a commitment to guarantee
workers a minimum number of paid hours.
TOC emphasizes the role of direct labour in continuous improvement. Fluctuating levels of direct labour can devastate morale and defeat the role of employees in continuous improvement efforts.
Direct labour is usually not the constraint.
Companies involved in TOC use a form of variable costing, but treating direct labour as a fixed cost for three reasons: Many companies have a commitment to guarantee
workers a minimum number of paid hours.
TOC emphasizes the role of direct labour in continuous improvement. Fluctuating levels of direct labour can devastate morale and defeat the role of employees in continuous improvement efforts.
Direct labour is usually not the constraint.
© 2006 McGraw-Hill Ryerson Ltd..
Impact of JIT Inventory Methods
In a JIT inventory system . . .
Productiontends to equal
sales . . .
So, the difference between variable andabsorption income tends to disappear.
© 2006 McGraw-Hill Ryerson Ltd..
Review Problem
Contrasting Variable and
Absorption Costing
© 2006 McGraw-Hill Ryerson Ltd..
Review Problem
Dexter Company produces and sells a single product, a wooden hand loom for weaving small items such as scarves. Selected cost and operating data relating to the product for two years are given below:
© 2006 McGraw-Hill Ryerson Ltd..
Review Problem
1. Assume that the company uses absorption costing.
a. Compute the unit product cost in each year.
b. Prepare an income statement for each year.
2. Assume that the company uses variable costing.
a. Compute the unit product cost in each year.
b. Prepare an income statement for each year.
3. Reconcile the variable costing and absorption costing operating incomes.
© 2006 McGraw-Hill Ryerson Ltd..
End of Chapter 7