# Absorption Costing vs.

Variable Costing g

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Absorption S CGS GP S&A NI
ABS

Variable S VC CM FC NI
VC

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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 Costs C t 3 Unit Cost Computations Harvey Company produces a single product g with the following information available: 4 .

Unit Cost Computations Unit product cost is determined as follows: p Under absorption costing. let’s compute net operating income using let s both absorption and variable costing. 5 Income Comparison of Absorption and Variable Costing Let’s assume the following additional information for Harvey Company Company. S&A expenses are p g.  20.000 units were sold during the year at a price of \$30 each each. 6 . Now.  There were no units in beginning inventory. p always treated as period expenses and deducted from revenue as incurred.

000 \$ 90.000 × \$10) 250.000 × \$10) 50.000 Goods available for sale 250.Absorption Costing 7 Variable Costing Variable manufacturing f t i Variable Costing costs only.000 × \$3) 60.000 8 .000 Contribution margin Less fixed expenses: Manufacturing overhead \$ 150.000 250.000 340. 260.000 250 000 Less ending inventory (5. Sales (20.000 Variable cost of goods sold 200.000 Net operating income \$ 600.000 All fixed g manufacturing overhead is expensed.000 × \$30) Less variable expenses: Beginning inventory \$ Add COGM (25.000 Variable lli V i bl selling & administrative d i i t ti expenses (20.000 Selling & administrative expenses 100.

Comparing the Two Methods 9 Comparing the Two Methods We W can reconcile the difference between il th diff b t absorption and variable income as follows: Variable costing net operating income \$ 90.000 units 10 .000 FMOH Units produced = \$150.000 units × \$6 per unit) 30.000 = \$6.000 Absorption costing net operating income \$ 120 000 120.00 per unit \$6 00 25.000 Add: FMOH deferred in inventory (5.

Extended Comparisons of Income Data Harvey Company Year Two 11 Unit Cost Computations Since there was no change in the variable costs per unit. it d d th it t i h d 12 . the unit costs remain unchanged. or the number of units produced. total fixed costs.

000 \$ 90.000 × \$16) Goods available for sale Less ending inventory Gross margin Less selling & admin.000 480 000 - 480.Absorption Costing Absorption Costing Sales (30.000 × \$16) Add COGM (25. All fixed manufacturing overhead is expensed. inventory (5.000 190.000 420.000 \$ 80.000 × \$30) Less cost of goods sold: g Beg. Variable (30.000 These are the 25. 14 .000 100.000 units produced in the current period.000 480.000 × \$3) Fixed Net operating income \$ 900. 13 Variable Costing Variable manufacturing y costs only. exp.000 \$ 230.000 400.

000 units × \$6 per unit) 30.000 = \$6.000 units 15 Comparing the Two Methods 16 .000 Absorption costing net operating income \$ 230.00 per unit \$6 00 25.000 Deduct: FMOH costs released from inventory (5.000 FMOH Units produced = \$150.Comparing the Two Methods We W can reconcile the difference between il th diff b t absorption and variable income as follows: Variable costing net operating income \$ 260.

18 .Summary of Key Insights 17 CVP Analysis. • Produce positive net operating income even when the number of units sold is less than the breakeven point. p Treating fixed manufacturing overhead as a variable cost can: • Lead to faulty pricing decisions and keep-or-drop decisions. Decision Making p g and Absorption costing Absorption costing does not support CVP analysis because it essentially treats fixed manufacturing overhead as a variable cost by g y assigning a per unit amount of the fixed overhead to each unit of production.

Under the Tax Reform Act of 1986. Consistent with standard costs and flexible budgeting. Since top executives are usually evaluated based on external reports to shareholders shareholders. they may feel that decisions s ou d should be based o on absorption cost income. R f A t f 1986 absorption costing must be used when filing income tax returns. Management finds it more useful. Net operating income is l i closer t to net cash flow. 19 Advantages of Variable Costing pp and the Contribution Approach Consistent with CVP analysis.External Reporting and Income Taxes To T conform to f t GAAP requirements. Impact of fixed costs on profits p emphasized. f l Advantages Easier to estimate profitability of products and segments. absorption costing must be used for external financial reports in the United States. Profit is not affected by changes in inventories. 20 .

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 21 .