Absorption CostingA system of accounting for costs in which both fixed and variable production costs are considered product costs.FixedCostsVariableCosts

Variable CostingA system of cost accounting that only assigns the variable cost of production to products.FixedCostsVariableCostsProduct

Absorption and Variable Costing

Absorption and Variable CostingThe difference between absorption and variable costing is the treatment of fixed manufacturing overhead.

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Learning Objective2

Absorption and Variable CostingLets put some numbers to an example andsee what we can learn about the differencebetween absorption and variable costing.

Absorption and Variable Costing Mellon Co. produces a single product with the following information available:

Absorption and Variable CostingUnit product cost is determined as follows:Selling and administrative expenses are always treated as period expenses and deducted from revenue.

Absorption Costing Income StatementsMellon Co. had no beginning inventory, produced 25,000 units and sold 20,000 units this year at $30 each.

Absorption Costing Income StatementsMellon Co. had no beginning inventory, produced 25,000 units and sold 20,000 units this year at $30 each.

Absorption Costing Income StatementsMellon Co. had no beginning inventory, produced 25,000 units and sold 20,000 units this year at $30 each.

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Learning Objective3

Variable Costing Income StatementsNow lets look at variable costing by Mellon Co.

Variable Costing Income StatementsNow lets look at variable costing by Mellon Co.We exclude thefixed manufacturingoverhead.

Variable Costing Income StatementsNow lets look at variable costing by Mellon Co.

Comparing Absorption andVariable CostingLets compare the methods.

Comparing Absorption andVariable CostingLets compare the methods.

Comparing Absorption andVariable CostingLets compare the methods.

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Learning Objective4

Reconciling Income Under Absorption and Variable Costing We can reconcile the difference between absorption and variable net income as follows:Fixed mfg. overhead $150,000 Units produced 25,000 = $6.00 per unit =

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Learning Objective5

Cost-Volume-Profit AnalysisCVP 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.

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Learning Objective6

Extending the ExampleLets look at the secondyear ofoperationsfor MellonCompany.

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.

Mellon Co. Year 2Unit product cost is determined as follows:There has been nochange in Mellonscost structure.

Mellon Co. Year 2Now lets look at Mellons income statementassuming absorption costing is used.

Mellon Co. Year 2Units in ending inventory from the previous period.

Mellon Co. Year 225,000 units produced in the current period.

Mellon Co. Year 2Next, well look at Mellons income statementassuming variable costing is used.

Mellon Co. Year 2Excludes fixed manufacturing overhead.

SummaryIn 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).

SummaryFor the two-year period, total absorptionincome and total variable income are the same.

SummaryLets see if we can get an overview of what we have done.

Summary Comparison of Absorption (AC) and Variable Costing (VC)This was the case in the first period when production of 25,000 units was greater than sales of 20,000 units.Inventory increased from zero to 5,000 units and $120,000 absorption income was greater than $90,000 variable income.

Summary Comparison of Absorption (AC) and Variable Costing (VC)In the second period sales of 30,000 units were greater than production of 25,000.

Summary Comparison of Absorption (AC) and Variable Costing (VC)Inventory decreased from 5,000 units to zero,and $230,000 absorption income was less than $260,000 variable income.

Summary Comparison of Absorption (AC) and Variable Costing (VC)For the two-year period, units produced equals units sold, so total absorption incomeequals total variable income.

Evaluation of Variable CostingAdvantagesManagement finds it easy to understand.Consistent withCVP analysis.Emphasizes contribution in short-run pricing decisions.Profit for period notaffected by changesin fixed mfg. overhead.Impact of fixedcosts on profitsemphasized.

Evaluation of Absorption CostingAdvantages

Impact of JIT Inventory MethodsIn a JIT inventory system . . .Production tendsto equal sales . . .So, the difference between variable andabsorption income tends to disappear.

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Learning Objective7

Throughput CostingExample 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 reducedAverage unit cost does not vary with changes in production levels.

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Learning Objective8

Throughput Income SatatementSales Revenue$600,000Throughput cost of goods sold (dir. mat.) 150,000Gross Margin$450,000Less: Operating costsDirect labor100,000Variable mfg overhead 60,000Fixed mfg overhead150,000Variable sales & admin costs 50,000Fixed sales & admin costs125,000Total operating costs 375,000Net Income$ 75,000

End of Chapter 8