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

Absorption andVariable Costing

Chapter 8

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LearningObjective

1

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8-3

Absorption and Variable Costing

Absorption

Costing

Variable

Costing

Direct materials

Direct labor Product costsProduct costs Variable mfg. overhead

Fixed mfg. overhead

Period costs

Period costs Selling & Admin. exp.

The difference between absorption and variablecosting is the treatment of fixed manufacturing overhead.

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LearningObjective

2

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8-5

Mellon Co. produces a single product withthe following information available:

Number of units produced annually 25,000

Variable costs per unit:Direct materials, direct labor

and variable mfg. overhead 10$

Selling & administrative

expenses 3$

Fixed costs per year:Mfg. overhead 150,000$

Selling & administrative

expenses 100,000$


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8-6

Unit product cost is determined as follows:

Absorption

Costing

Variable

CostingDirect materials, direct labor, and

variable mfg. overhead 10$ 10$

Fixed mfg. overhead

($150,000 25,000 units) 6 -

Unit product cost 16$ 10$


Selling and administrative expenses arealways treated as period expenses and

deducted from revenue.

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8-7

Absorption Costing

Sales (20,000 $30) 600,000$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) 80,000 320,000

Gross margin 280,000$Less selling & admin. exp.

Variable (20,000 $3) 60,000$

Fixed 100,000 160,000

Net income 120,000$

Mellon Co. had no beginning inventory, produced25,000 units and sold 20,000 units this year at $30each.

Absorption CostingIncome Statements

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8/24Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

LearningObjective

3

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8-9

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$

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 income 90,000$

Variable CostingIncome Statements

Now lets look at variable costing by MellonCo.

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8-10

Cost of

Goods

Sold

Ending

Inventory

Period

Expense Total

Absorption costing Variable mfg. costs 200,000$ 50,000$ -$ 250,000$

Fixed mfg. costs 120,000 30,000 - 150,000

320,000$ 80,000$ -$ 400,000$

Variable costing

Variable mfg. costs 200,000$ 50,000$ -$ 250,000$Fixed mfg. costs - - 150,000 150,000

200,000$ 50,000$ 150,000$ 400,000$

Comparing Absorption andVariable Costing

Lets compare the methods.

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LearningObjective

4

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Reconciling Income UnderAbsorption and Variable Costing

We can reconcile the difference betweenabsorption and variable net income as

follows:Variable costing net income 90,000$Add: Fixed mfg. overhead costs

deferred in inventory

(5,000 units $6 per unit) 30,000

Absorption costing net income 120,000$

Fixed mfg. overhead $150,000Units produced 25,000

= $6.00 per unit=

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LearningObjective

5

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Cost-Volume-Profit Analysis

CVP includes all fixed costs to computebreakeven.

Variable costing and CVP are consistent as bothtreat fixed costs as a lump sum.

Absorption costing defers fixed costs intoinventory.

Absorption costing is inconsistent with CVPbecause absorption costing treats fixed costs ona per unit basis.

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LearningObjective

6

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Advantages

Management finds iteasy to understand.

Consistent withCVP analysis.

Emphasizes contribution inshort-run pricing decisions.

Profit for period notaffected by changes

in fixed mfg. overhead.

Impact of fixedcosts on profitsemphasized.

Evaluation of Variable Costing

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AdvantagesConsistent with long-run

pricing decisions that mustcover full cost.

External reportingand income tax law

require absorption costing.

Evaluation of Absorption Costing

Fixed manufacturing overhead istreated the same as the other productcosts, direct material and direct labor.

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Impact of JIT Inventory Methods

In a JIT inventory system . . .

Production tendsto equal sales . . .

So, the difference between variable andabsorption income tends to disappear.

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Learning

Objective7

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Throughput Costing

Product

cost

Unit-levelspending for

direct costs.

Unit-level costs are incurred every time a unit of

product is manufactured and will not be incurredagain until the next unit is manufactured.

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Throughput Costing

Example

In an automated process direct material may bethe only unit-level cost and so is the only product cost.

All other manufacturing costs are expensed as period costs.

Incentive to

overproduceis reduced

Average unit cost does

not vary with changesin production levels.

Advantages

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Learning

Objective8

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Throughput Income Satatement

Sales Revenue $600,000Throughput cost of goods sold (dir. mat.) 150,000

Gross Margin $450,000

Less: Operating costs

Direct labor 100,000

Variable mfg overhead 60,000

Fixed mfg overhead 150,000

Variable sales & admin costs 50,000

Fixed sales & admin costs 125,000

Total operating costs 375,000

Net Income $ 75,000

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End of Chapter 17

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