Lecture 3

Topic 3: Absorption costing vs Variable Costing & Cost- Volume-Profit Relationships

Ref: LS Appendix to Chapter 7 and Chapter 18

Overview of Absorption and Variable CostingAs we saw in the last lecture, manufacturing costs consist of:Direct materialsDirect labourManufacturing overhead (MOH can be variable or fixed)Under absorption costing, only the fixed MOH which has been attached to the units sold during the period is expensed on the income statement.Under variable costing, the total amount of fixed MOH for the period is expensed.

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Overview of Absorption and Variable CostingVariable CostingAbsorption Costing*

Balance Sheet Costs Inventories Note: Manufacturing Cost FlowsIncome Statement ExpensesPeriod CostsVariable Manufacturing OverheadMaterial PurchasesDirect LabourSelling and AdministrativeFixed Manufacturing Overhead*

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. . .Quick Check *

Lets put some numbers to the issue and see if it will sharpen our understanding.Overview of Absorption and Variable Costing*

Unit Cost CalculationsHarvey Co. produces a single product which sells for $30 per unit.

Number of units produced annually: 25,000 Variable costs per unit: Direct materials, direct labour, and variable manufact. overhead $10 Selling and administrative expenses $ 3 Fixed costs per year: Manufacturing overhead $150,000 Selling & administrative expenses $100,000

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

Sheet1

Absorption CostingVariable Costing

Direct materials, direct labor,

and variable mfg. overhead$10$10

Fixed mfg. overhead

($150,000 25,000 units)60.0

Unit product cost$16$10

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Harvey Co. had no beginning inventory, produced 25,000 units and sold 20,000 units this year.Income Comparison of Absorption and Variable Costing*

Sheet1

Absorption Costing

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

Less cost of goods sold:

Beginning inventory0.0

Add COGM (25,000 $16)400,000

Goods available for sale400,000

Ending inventory (5,000 $16)80,000320,000

Gross profit280,000

Less selling & admin. exp.

Variable

Fixed

Net operating income

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Harvey Co. had no beginning inventory, produced 25,000 units and sold 20,000 units this year.Income Comparison of Absorption and Variable Costing*

Sheet1

Absorption Costing

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

Less cost of goods sold:

Beginning inventory0.0

Add COGM (25,000 $16)400,000

Goods available for sale400,000

Ending inventory (5,000 $16)80,000320,000

Gross profit280,000

Less selling & admin. exp.

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

Fixed100,000160,000

Net operating income$120,000

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Now lets look at variable costing by Harvey Co.Income Comparison of Absorption and Variable Costing*

Sheet1

Variable Costing

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

Less variable expenses:

Beginning inventory0.0

Add COGM (25,000 $10)250,000

Goods available for sale250,000

Less ending inventory (5,000 $10)50,000

Variable cost of goods sold200,000

Variable selling & administrative

expenses (20,000 $3)60,000260,000

Contribution margin340,000

Less fixed expenses:

Manufacturing overhead$150,000

Selling & administrative expenses100,000250,000

Net operating income$90,000

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Quick Check The net operating income under absorption costing was $120,000 and under variable costing it was $90,000 because of higher expenses. Where is the missing $30,000 cost under absorption costing? a. It has disappeared into an accounting black hole.b. It is in ending inventories.c. It represents taxes that have been saved.d. The $30,000 wasnt a real cost, so nothing is really missing.*

The net operating income under absorption costing was $120,000 and under variable costing it was $90,000 because of higher expenses. Where is the missing $30,000 cost under absorption costing? a. It has disappeared into an accounting black hole.b. It is in ending inventories.c. It represents taxes that have been saved.d. The $30,000 wasnt a real cost, so nothing is really missing.Quick Check *

Lets compare the methods.Income Comparison of Absorption and Variable Costing*

Sheet1

Cost of Goods SoldEnding InventoryPeriod ExpenseTotal

Absorption costing

Variable mfg. costs$200,000$50,0000.0$250,000

Fixed mfg. costs120,00030,0000.0150,000

$320,000$80,0000.0$400,000

Variable costing

Variable mfg. costs$200,000$50,0000.0$250,000

Fixed mfg. costs0.00.0150,000150,000

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

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

Sheet1

Variable costing net operating income$90,000

Add: Fixed mfg. overhead costs

deferred in the inventory of FG

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

Absorption costing net operating income$120,000

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Summary*

Sheet1

Relation betweenEffectRelation between

productiononvariable and

and salesiniventoryabsorption income

InventoryAbsorption

Production > Salesincreases>

Variable

InventoryAbsorption

Production < Salesdecreases