Absorption Costing

vs.
Variable Costing
g

Absorption

Variable

CGS

VC

GP

CM

S&A

FC

NI

NI

ABS

VC

Overview of Absorption
g
and Variable Costing
Absorption
Costing

Product
P
d t
Costs

Variable
Costing
DM

DM

DL

DL

VMOH

Product
Costs

VMOH

FMOH
Period
Costs

VS&A

VS&A

FS&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.
5

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.
6

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
8

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
10

Extended Comparisons of Income Data

Harvey Company Year Two

11

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
12

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
-

$ 90,000
100,000

480,000
420,000

190,000
$ 230,000

These are the 25,000 units

produced in the current period.
13

Variable Costing
Variable
manufacturing
y
costs only.

All fixed
manufacturing
overhead is
expensed.

14

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
15

Comparing the Two Methods

16

Summary of Key Insights

17

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.
18

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.

Under the Tax

R f
Reform
Act
A t off 1986,
1986
absorption costing must be
used when filing income
tax returns.

Since top executives

are usually evaluated based on
external reports to shareholders
shareholders,
they may feel that decisions
sshould
ou d be based o
on
absorption cost income.

19

Advantages of Variable Costing

pp
and the Contribution Approach

Management finds
it more useful.
f l

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

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.
20

Variable versus Absorption Costing

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

Absorption
p
Costing

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

Variable
Costing
21