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15 - 1©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Chapter 15
Overhead Application:
Variable and Absorption Costing
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Learning Objective 1
Construct an income statement
using the variable-costing
approach.
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Variable Versus Absorption Costing
This chapter compares twomethods of product costing.
Variable-Costing Absorption-Costing
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Variable Versus Absorption Costing
The differences between variable-costing and absorption-costing methods are based on the treatment of fixed manufacturing overhead.
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Variable Versus Absorption Costing
Variable costing excludes fixed manufacturingoverhead from inventoriable costs.
Absorption costing treats fixed manufacturingoverhead as inventoriable costs.
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Variable Versus Absorption Costing
Beginning inventory at $3 – $ 90plus cost of goodsmanufactured at standard,170,000 and 140,000 rings 510 420
Available for sale minus 510 510ending inventory, at $3 90* 30^
Variable manufacturingcost of goods sold $420 $480
*30,000 rings × $3 ^10,000 rings × $3
(in thousands of dollars) 2002 2003
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Comparative Income Statement for Variable-Costing Method
Sales, 140,000 and 160,000 rings $700 $800Variable expenses:
Variable manufacturing cost of goods sold 420 480Variable selling expenses, at 5% of dollar sales 35 40
Contribution margin $245 $280Fixed expenses:
Fixed factory overhead 150 150Fixed selling and admin. expenses 65 65
Operating income, variable costing $ 30 $ 65
(in thousands of dollars) 2002 2003
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Objective 2
Construct an income statement
using the absorption-costing
approach.
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Fixed-Overhead Rate
The fixed-overhead rate is the amount offixed manufacturing overhead applied toeach unit of production.
It is determined by dividing the budgetedfixed overhead by the expected volumeof production for the budget period.
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Cost of Goods Sold forAbsorption-Costing Method
Beginning inventory $ – $120Add: Cost of goods manufactured
at standard, of $4* 680 560Available for sale $680 $680Deduct: Ending inventory 120 40Cost of goods sold, at standard $560 $640*Variable cost $3 Fixed cost ($150,000 ÷ $150,000) 1 Standard absorption cost $4
(in thousands of dollars) 2002 2003
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Cost of Goods Sold forAbsorption-Costing Method
Sales $700 $800Cost of goods sold, at standard 560 640Gross profit at standard $140 $160Production-volume variance* 20 F 10 UGross margin or gross profit “actual” $160 $150Selling and administrative expenses 100 105Operating income, variable costing $ 60 $ 45*Based on expected volume of production of 150,000 rings: 2002: (170,000 – 150,000) × $1 = $20,000 F
(in thousands of dollars) 2002 2003
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Comparison of Variable andAbsorption Costing
Absorption unit cost is higher.
Output-level (production-volume) varianceexists only under absorption costing.
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Reconciliation of Variable Costing and Absorption Costing
The difference in income equals thedifference in the total amount offixed manufacturing overheadcharged as expense duringa given year.
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Reconciliation of Variable Costing and Absorption Costing
Under absorption costing, fixed overhead appears in the cost of goods sold and also in the production volume variance.
Under variable costing, fixed overhead is a period cost.
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Learning Objective 3
Compute the production-
volume variance and show
how it should appear in the
income statement.
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Production-Volume Variance
A production-volume variance is a variancethat appears whenever actual productiondeviates from the expected volume ofproduction used in computing thefixed overhead rate.
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Production-Volume Variance
Actual volume
– Expected volume
× Fixed overhead rate
= Production-volume variance
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Volume Variance
Applied fixed overhead – Budgeted fixed overhead= Production-volume variance
In practice, theproduction-volumevariance is usuallycalled simply thevolume variance.
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Other Variances
The fixed-overhead flexible budget variance(also called the fixed-overhead spendingvariance or simply the budget variance)is the difference between actual fixedoverhead and budgeted fixed overhead.
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Learning Objective 4
Differentiate among the three
alternative cost bases of an
absorption-costing system:
actual, normal, and standard.
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Practical Capacity
Maximum, or full capacity, used as the expected activity level in calculating the fixed-overhead rate, is often called practical capacity.
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Normal Costing
Normal costing is a costing system thatapplies actual direct materials and actualdirect-labor costs to products or services butuses budgeted rates for applying overhead.
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Actual, Normal, and Standard Costing
ActualCostingNormalCostingStandardCosting
Variable FixedDirect Direct factory factorymaterials labor overhead overheadActual Actual Actual Actualcosts costs costs costsActual Actual Budgeted ratescosts costs × actual inputsStandard prices or rates × standard inputsallowed for actual output achieved
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Actual, Normal, and Standard Costing
Favorable Variance Unfavorable Variance
Both normal absorption costing and
standard absorption costing generate
production-volume variances.
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Learning Objective 5
Explain why a company might
prefer to use a variable-costing
approach.
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Why Use Variable Costing?
One reason is that absorption-costingincome is affected by productionvolume while variable-costingincome is not.
Another reason is based on whichsystem the company believesgives a better signal aboutperformance.
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Flexible-Budget Variances
All variances other than the production-volumevariance are essentially flexible-budget variances.
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Flexible-Budget Variances
Flexible-budget variances measurecomponents of the differencesbetween actual amounts andthe flexible-budget amountsfor the output achieved.
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Flexible-Budget Variances
Flexible budgets are primarilydesigned to assist planning andcontrol rather than product costing.
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Learning Objective 6
Identify the two methods for
disposing of the standard
cost variances at the end
of a year and give the
rationale for each.
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Disposition of Standard-Cost Variances
There are two methods for disposing of thestandard cost variances at the end of a year:
An adjustment to income of the current year.
An assignment to both inventory and costof goods sold by proration.
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Disposition of Standard-Cost Variances
One view is that in standard costing the “standards” are viewed as currently attainable.
Therefore, variances are not inventoriable and should be treated as adjustments to the income of the period instead of being added to inventories.
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Disposition of Standard-Cost Variances
Another view favors assigning the variances to the inventories and cost of goods sold related to the production during the period the variances arose.
This is often called prorating the variances.
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Learning Objective 7
Understand how product-
costing systems affect
operating income.
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Product-Costing Systems Affect Operating Income
Managers’ performance measures and rewards are most often based on operating income.
As a result, managers are motivated to take actions that improve current operating income.
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Product-Costing Systems Affect Operating Income
Absorption- and variable-costing systemsaffect operating income because of theirtreatment of fixed factory overhead.
Absorption-costing systems, both normaland standard, generate production-volumevariances that also affect income.
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Effects of Sales and Production on Reported Income
Production > Sales
Variable costing income is lowerthan absorption income.
Production < Sales
Variable costing income is higherthan absorption income.
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Summary Comments
The difference between income reportedunder these two methods is entirely due tothe treatment of fixed manufacturing costs.
Under absorption costing, these costs aretreated as assets (inventory) until theassociated goods are sold.