Absorption Costing vs.

Variable Costing g

Absorption S CGS GP S&A NI

ABS

Variable S VC CM FC NI
VC

Overview of Absorption g and Variable Costing

Absorption Costing
DM DM DL VMOH

Variable Costing Product Costs

Product P d t Costs

DL VMOH

FMOH
Period Costs
VS&A FS&A VS&A FS&A

Period C t Costs

Unit Cost Computations

Harvey Company produces a single product g information available: with the following

Unit Cost Computations

Unit p product cost is determined as follows:

Under absorption p costing g, S&A expenses p are always treated as period expenses and deducted from revenue as incurred.
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Income Comparison of Absorption and Variable Costing

Lets assume the following additional information for Harvey Company Company.
20,000 units were sold during the year at a price of $30 each. each There were no units in beginning inventory.

Now, let lets s compute net operating income using both absorption and variable costing.
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Absorption Costing

Variable Costing
Variable manufacturing f t i Variable Costing costs only.

Sales (20,000 $30) Less variable expenses: Beginning inventory $ Add COGM (25,000 $10) 250,000 Goods available for sale 250 000 250,000 Less ending inventory (5,000 $10) 50,000 Variable cost of goods sold 200,000 V i bl selling Variable lli & administrative d i i t ti expenses (20,000 $3) 60,000 Contribution margin Less fixed expenses: Manufacturing overhead $ 150,000 Selling & administrative expenses 100,000 Net operating income

$ 600,000

All fixed g manufacturing overhead is expensed.

260,000 340,000

250,000 $ 90,000
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Comparing the Two Methods

Comparing the Two Methods

We can reconcile W il the th difference diff between b t absorption and variable income as follows:
Variable costing net operating income $ 90,000

Add: FMOH deferred in inventory (5,000 units $6 per unit) 30,000 Absorption costing net operating income $ 120 120,000 000

FMOH Units produced

$150,000 = $6.00 $6 00 per unit 25,000 units

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Extended Comparisons of Income Data Harvey Company Year Two

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Unit Cost Computations

Since there was no change in the variable costs per unit, total fixed costs, or the number of units it produced, d d the th unit it costs t remain i unchanged. h d
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Absorption Costing
Absorption Costing
Sales (30,000 $30) Less cost of g goods sold: Beg. inventory (5,000 $16) Add COGM (25,000 $16) Goods available for sale Less ending inventory Gross margin Less selling & admin. exp. Variable (30,000 $3) Fixed Net operating income $ 900,000 $ 80,000 400,000 480 000 480,000 -

480,000 420,000

$ 90,000 100,000

190,000 $ 230,000

These are the 25,000 units produced in the current period.

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Variable Costing
Variable manufacturing y costs only.

All fixed manufacturing overhead is expensed.

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Comparing the Two Methods

We can reconcile W il the th difference diff between b t absorption and variable income as follows:
Variable costing net operating income $ 260,000

Deduct: FMOH costs released from inventory (5,000 units $6 per unit) 30,000 Absorption costing net operating income $ 230,000

FMOH Units produced

$150,000 = $6.00 $6 00 per unit 25,000 units

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Comparing the Two Methods

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Summary of Key Insights

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CVP Analysis, Decision Making p costing g and Absorption

Absorption costing does not support CVP analysis because it essentially treats fixed manufacturing g overhead as a variable cost by y assigning a per unit amount of the fixed overhead to each unit of production. p
Treating fixed manufacturing overhead as a variable cost can: Lead to faulty pricing decisions and keep-or-drop decisions. Produce positive net operating income even when the number of units sold is less than the breakeven point.
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External Reporting and Income Taxes

To conform T f to t GAAP requirements, absorption costing must be used for external financial reports in the United States.

Since top executives are usually evaluated based on external reports to shareholders shareholders, they may feel that decisions should s ou d be based o on absorption cost income.

Under the Tax R f Reform Act A t of f 1986, 1986 absorption costing must be used when filing income tax returns.

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Advantages of Variable Costing pp and the Contribution Approach

Consistent with CVP analysis. Net operating income i closer is l t to net cash flow. Consistent with standard costs and flexible budgeting.

Management finds it more useful. f l

Advantages
Easier to estimate profitability of products and segments. Impact of fixed costs on p profits emphasized. Profit is not affected by changes in inventories.
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Variable versus Absorption Costing

Fixed Fi d manufacturing f t i costs must be assigned to products to properly match revenues and costs.

Fixed manufacturing costs are capacity costs and will be incurred even if nothing is produced.

Absorption p Costing

Variable Costing
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