Costing ComparisonVariable costing is a method of inventory costing in which only variable manufacturing costs are included as inventoriable costsAbsorption costing is a method of inventory costing in which all variable manufacturing costs and all fixed manufacturing costs are included as inventoriable costs

Overview of Absorptionand Variable CostingVariable CostingAbsorption Costing

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. . .

Unit Cost ComputationsHarvey Company produces a single product with the following information available:

Unit Cost ComputationsUnit product cost is determined as follows:Selling and administrative expenses are always treated as period expenses and deducted from revenue as incurred.

Income Comparison ofAbsorption and Variable CostingLets 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, lets compute net operating income using both absorption and variable costing.

Absorption Costing

Variable Costing

ReconciliationWe can reconcile the difference between absorption and variable income as follows:

Example 1 (done)HMV Company produces a single product.Number of units produced annually .. 25,000Variable costs per unit: DM, DL and Variable Mfg OH RM10 Selling & Admin. expenses RM3Fixed costs per year: Fixed manufacturing OH RM150,000 Fixed selling & admin. expense RM100,000Required: Determine product cost using,(i) Absorption costing(ii) Marginal costing

Example 1 (continued)If HMV Company had no beginning inventory, produced 25,000 units, and sold 20,000 units for the period, prepare Income Statement using: (i) Absorption Costing (ii) Marginal Costing

(Assume selling price is RM30 per unit)

Example 1 (continued)Prepare Reconciliation Statement of net incomes.

Example 2 Fluctuating SalesDutch Company produces a single product.Number of units produced annually .. 5,000Variable costs per unit: DM, DL and Variable Mfg OH RM5 Selling & Admin. expenses RM1Fixed costs per year: Fixed manufacturing OH RM15,000 Fixed selling & admin. expense RM21,000

Example 2 (continued)Additional information: Year 1 Year 2 Year 3Units in beginning inventory -0- -0- 1,000Units produced . 5,000 5,000 5,000Units sold .. 5,000 4,000 6,000Units in ending inventory -0- 1,000 -0-

Example 2 (continued)Required:(a) Determine product cost using,(i) Absorption Costing(ii) Marginal Costing(b) For the year 1, year 2 and year 3, prepare Income Statement using: (i) Absorption Costing(ii) Marginal Costing(Assume selling price is RM15 per unit)(c) Prepare Reconciliation Statement of net incomes for the year 1, year 2 and year 3.

Example 3 Fluctuating ProductionSuppose all of the facts are the same as in the previous Example 2 of Dutch Company except that production and sales are as follows: Year 1 Year 2 Year 3Units in beginning inventory -0- -0- 1,000Units produced . 5,000 6,000 4,000Units sold .. 5,000 5,000 5,000Units in ending inventory -0- 1,000 -0-

Example 3 (continued)Required:(a) Determine product cost using, (i) Absorption Costing (ii) Marginal Costing(b) For the year 1, year 2 and year 3, prepare Income Statement using: (i) Absorption Costing (ii) Marginal Costing (Assume selling price is RM15 per unit)(c) Prepare Reconciliation Statement of net incomes for the year 1, year 2 and year 3.

External Reporting and Income TaxesTo conform to GAAP requirements, absorption costing must be used for external financial reports in the United States.Under the Tax Reform Act of 1986, absorption costing must be used when filing income tax returns.

Advantages of Variable Costingand the Contribution ApproachAdvantages

THE ENDADVISE & REMINDER: Now, your reading time.its your responsibility to read relevant chapters in the main text and additional recommended references !

Two general approaches are used for valuing inventories and cost of goods sold. One approach, called absorption costing, is generally used for external reporting. The other approach, called variable costing, is preferred by some managers for internal decision making and must be used when an income statement is prepared in the contribution format. This chapter shows how these two methods differ from each other.Absorption costing (also called full costing) charges products with all manufacturing costs, regardless of whether the costs are fixed or variable. The cost of a unit of product consists of all four types of manufacturing costs direct material, direct labor, variable manufacturing overhead, and fixed manufacturing overhead. Since no distinction is made between variable and fixed costs, absorption costing is not well suited for cost-volume-profit analysis. Variable costing (also called direct costing) charges products with only the variable manufacturing costs. The cost of a unit of product consists of the three variable manufacturing costs direct material, direct labor, and variable manufacturing overhead. Variable costing is consistent with the contribution format income statement and it supports cost-volume-profit analysis because of its emphasis on separating variable and fixed costs. The only difference in the two approaches is the treatment of fixed manufacturing overhead. With absorption costing, fixed manufacturing overhead is a product cost. With variable costing, fixed manufacturing overhead is a period cost. Note that selling and administrative costs are treated as period costs with both absorption costing and variable costing.Think about the impact of each method on inventory values, and then answer the following question.

To answer this question correctly, recall which method includes more manufacturing costs in the unit product cost. Harvey Company makes twenty-five thousand units of a single product. Variable manufacturing costs total ten dollars per unit. Variable selling and administrative expenses are three dollars per unit. Fixed manufacturing overhead for the year is one hundred fifty thousand dollars and fixed selling and administrative expenses for the year are one hundred thousand dollars.

With variable costing, only the ten dollars per unit variable manufacturing costs (direct material, direct labor, and variable manufacturing overhead) are product costs. With absorption costing, we include fixed manufacturing overhead in product costs. To compute the per unit amount of fixed manufacturing overhead, we divide one hundred fifty thousand dollars of fixed manufacturing overhead by the twenty-five thousand units manufactured.Selling and administrative expenses are always treated as period expenses and deducted from revenue as incurred.

We need some additional information to allow us to prepare income statements for Harvey Company: Twenty thousand units were sold during the year. There were no units in beginning inventory.Now lets prepare income statements for Harvey Company. We will start with an absorption income statement.

Harvey had no beginning inventory and sold only twenty thousand of the twenty-five thousand units produced, leaving five thousand units in ending inventory. The sales price is thirty dollars per unit, so sales revenue for the twenty thousand units sold is six hundred thousand dollars. The computation of cost of goods sold on your screen starts with beginning inventory, adds cost of goods manufactured and subtracts ending inventory. We could also compute cost of goods sold directly by multiplying twenty thousand units sold times the sixteen dollar unit cost. We subtract cost of goods sold from sales to get the two hundred eighty thousand dollar gross margin.We subtract selling and administrative expenses from gross margin to get absorption cost net operating income of one hundred twenty thousand dollars. The sixty thousand dollar variable selling and administrative expense is computed by multiplying twenty thousand units sold times three dollars per unit. The one hundred thousand dollar fixed administrative expense was given earlier.

Now lets examine a variable cost income statement. Notice that this is a contribution format statement. First, we subtract all variable expenses from sales to get contribution margin. The first variable expense is variable cost of goods sold, which is computed using only the ten dollar per unit variable manufacturing cost. The next variable expense is the variable selling and administrative expense. It is computed as before, twenty thousand units sold at three dollars per unit.After computing contribution margin, we subtract fixed expenses to get the ninety thousand dollar variable cost net operating income. Note that all of the one hundred fifty thousand dollars of fixed manufacturing overhead is expensed as a lump sum.

The difference between absorption cost net operating income and variable cost net operating income results from the thirty thousand dollars of fixed manufacturing overhead remaining in inventory as a part of cost of the five thousand unsold units using absorption costing. Using variable costing, this thirty thousand dollars is expensed in the period resulting in a net operating income that is thirty thousand dollars less than absorption cost net operating income.The thirty thousand dollars can be computed by multiplying the five thousand unsold units times the six dollar fixed manufacturing overhead cost per unit.We can reconcile the difference between the two methods by adding the thirty thousand dollars to the ninety thousand dollar variable cost income to get the one hundred twenty thousand dollar absorption cost net operating income.

To conform to GAAP requirements, absorption costing must be used for external financial reports in the United States. Since top executives are usually evaluated based on earnings reported to shareholders in external reports, they may feel that decisions should be based on absorption cost income. Under the Tax Reform Act of 1986, absorption costing must be used when filing income tax returns.

The advantages of variable costing and the contribution approach include: The data required for cost-volume-profit analysis can be taken directly from a contribution format income statement. Profits move in the same direction as sales assuming other things remain the same. Managers often assume that unit product costs are variable. Under variable costing, this assumption is true. The impact of fixed costs on profits is emphasized because fixed costs appear explicitly on the contribution format income statement. Variable costing data make it easier to estimate the profitability of products, customers, and other business segments. Variable costing ties in with cost control methods such as standard costs and flexible budgeting. Variable costing net operating income is closer to net cash flow than absorption costing net operating income.