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McGraw-Hill/Irwin
Absorption and
Variable Costing
Chapter 8
Learning
Objective
1
8-3
Absorption Costing
A system of accounting for costs in which
both fixed and variable production costs
are considered product costs.
Fixed
Costs
Variable
Costs
Product
8-4
Variable Costing
A system of cost accounting that only
assigns the variable cost of production to
products.
Fixed
Costs
Variable
Costs
Product
8-5
Absorption and Variable Costing
Absorption
Costing
Variable
Costing
Direct materials
Direct labor Product costs
Period costs
Period costs Selling & Admin. exp.
8-6
Absorption and Variable Costing
Absorption
Costing
Variable
Costing
Direct materials
Direct labor Product costs
Period costs
Period costs Selling & Admin. exp.
The difference between absorption and variable
costing is the treatment of fixed manufacturing overhead.
Learning
Objective
2
8-8
Lets put some numbers to an example and
see what we can learn about the difference
between absorption and variable costing.

Absorption and Variable Costing
8-9
Mellon Co. produces a single product with
the following information available:
Number of units produced annually 25,000
Variable costs per unit:
Direct materials, direct labor
and variable mfg. overhead 10 \$
expenses 3 \$
Fixed costs per year:
expenses 100,000 \$
Absorption and Variable Costing
8-10
Unit product cost is determined as follows:
Absorption
Costing
Variable
Costing
Direct materials, direct labor, and
variable mfg. overhead 10 \$ 10 \$
(\$150,000 25,000 units) 6 -
Unit product cost 16 \$ 10 \$
Absorption and Variable Costing
always treated as period expenses and
deducted from revenue.
8-11
Absorption Costing
Income Statements
Absorption Costing
Sales (20,000 \$30) 600,000 \$
Less cost of goods sold:
Beginning inventory
Goods available for sale
Ending inventory
Gross margin
Variable
Fixed
Net income
Mellon Co. had no beginning inventory, produced
25,000 units and sold 20,000 units this year at \$30
each.
8-12
Absorption Costing
Sales (20,000 \$30) 600,000 \$
Less cost of goods sold:
Beginning inventory - \$
Goods available for sale 400,000 \$
Ending inventory (5,000 \$16) 80,000 320,000
Gross margin 280,000 \$
Variable
Fixed
Net income
Absorption Costing
Income Statements
Mellon Co. had no beginning inventory, produced
25,000 units and sold 20,000 units this year at \$30
each.
8-13
Absorption Costing
Sales (20,000 \$30) 600,000 \$
Less cost of goods sold:
Beginning inventory - \$
Goods available for sale 400,000 \$
Ending inventory (5,000 \$16) 80,000 320,000
Gross margin 280,000 \$
Variable (20,000 \$3) 60,000 \$
Fixed 100,000 160,000
Net income 120,000 \$
Mellon Co. had no beginning inventory, produced
25,000 units and sold 20,000 units this year at \$30
each.
Absorption Costing
Income Statements
Learning
Objective
3
8-15
Variable Costing
Income Statements
Now lets look at variable costing by Mellon
Co.
Variable Costing
Sales (20,000 \$30) 600,000 \$
Less variable expenses:
Beginning inventory - \$
Goods available for sale
Ending inventory
Variable cost of goods sold
expenses
Contribution margin
Less fixed expenses:
Net income
8-16
Variable Costing
Income Statements
Now lets look at variable costing by Mellon
Co.
Variable Costing
Sales (20,000 \$30) 600,000 \$
Less variable expenses:
Beginning inventory - \$
Goods available for sale 250,000 \$
Ending inventory (5,000 \$10) 50,000
Variable cost of goods sold 200,000 \$
expenses
Contribution margin
Less fixed expenses:
Net income
We exclude the
fixed manufacturing
8-17
Variable Costing
Sales (20,000 \$30) 600,000 \$
Less variable expenses:
Beginning inventory - \$
Goods available for sale 250,000 \$
Ending inventory (5,000 \$10) 50,000
Variable cost of goods sold 200,000 \$
expenses (20,000 \$3) 60,000 260,000
Contribution margin 340,000 \$
Less fixed expenses:
Selling & administrative expenses 100,000 250,000
Net income 90,000 \$
Variable Costing
Income Statements
Now lets look at variable costing by Mellon
Co.
8-18
Cost of
Goods
Sold
Ending
Inventory
Period
Expense Total
Absorption costing
Variable mfg. costs 200,000 \$
Fixed mfg. costs 120,000
320,000 \$
Variable costing
Variable mfg. costs 200,000 \$
Fixed mfg. costs -
200,000 \$
Comparing Absorption and
Variable Costing
Lets compare the methods.
8-19
Comparing Absorption and
Variable Costing
Lets compare the methods.
Cost of
Goods
Sold
Ending
Inventory
Period
Expense Total
Absorption costing
Variable mfg. costs 200,000 \$ 50,000 \$ - \$
Fixed mfg. costs 120,000 30,000 -
320,000 \$ 80,000 \$ - \$
Variable costing
Variable mfg. costs 200,000 \$ 50,000 \$ - \$
Fixed mfg. costs - - 150,000
200,000 \$ 50,000 \$ 150,000 \$
8-20
Cost of
Goods
Sold
Ending
Inventory
Period
Expense Total
Absorption costing
Variable mfg. costs 200,000 \$ 50,000 \$ - \$ 250,000 \$
Fixed mfg. costs 120,000 30,000 - 150,000
320,000 \$ 80,000 \$ - \$ 400,000 \$
Variable costing
Variable mfg. costs 200,000 \$ 50,000 \$ - \$ 250,000 \$
Fixed mfg. costs - - 150,000 150,000
200,000 \$ 50,000 \$ 150,000 \$ 400,000 \$
Comparing Absorption and
Variable Costing
Lets compare the methods.
Learning
Objective
4
8-22
Reconciling Income Under
Absorption and Variable Costing
We can reconcile the difference between
absorption and variable net income as
follows:
Variable costing net income 90,000 \$
deferred in inventory
(5,000 units \$6 per unit) 30,000
Absorption costing net income 120,000 \$
Units produced 25,000
= \$6.00 per unit =
Learning
Objective
5
8-24
Cost-Volume-Profit Analysis
CVP includes all fixed costs to compute
breakeven.
Variable costing and CVP are consistent as both
treat fixed costs as a lump sum.
Absorption costing defers fixed costs into
inventory.
Absorption costing is inconsistent with CVP
because absorption costing treats fixed costs on
a per unit basis.
Learning
Objective
6
8-26
Extending the Example
Lets look at
the second
year of
operations
for Mellon
Company.
8-27
Mellon Co. Year 2
In its second year of operations, Mellon Co. started with
an inventory of 5,000 units, produced 25,000 units and
sold 30,000 units at \$30 each.
Number of units produced annually 25,000
Variable costs per unit:
Direct materials, direct labor
and variable mfg. overhead 10 \$
expenses 3 \$
Fixed costs per year:
expenses 100,000 \$
8-28
Mellon Co. Year 2
Unit product cost is determined as
follows:
Absorption
Costing
Variable
Costing
Direct materials, direct labor,
and variable mfg. overhead 10 \$ 10 \$
(\$150,000 25,000 units) 6 -
Unit product cost 16 \$ 10 \$
There has been no
change in Mellons
cost structure.
8-29
Mellon Co. Year 2
Now lets look at Mellons income statement
assuming absorption costing is used.
8-30
Absorption Costing
Sales (30,000 \$30) 900,000 \$
Less cost of goods sold:
Beg. inventory (5,000 x \$16) 80,000 \$
Goods available for sale 480,000 \$
Ending inventory - 480,000
Gross margin 420,000 \$
Variable (30,000 \$3) 90,000 \$
Fixed 100,000 190,000
Net income 230,000 \$
Mellon Co. Year 2
Units in ending inventory from the previous period.
8-31
Absorption Costing
Sales (30,000 \$30) 900,000 \$
Less cost of goods sold:
Beg. inventory (5,000 x \$16) 80,000 \$
Goods available for sale 480,000 \$
Ending inventory - 480,000
Gross margin 420,000 \$
Variable (30,000 \$3) 90,000 \$
Fixed 100,000 190,000
Net income 230,000 \$
Mellon Co. Year 2
25,000 units produced in the current period.
8-32
Mellon Co. Year 2
Next, well look at Mellons income statement
assuming variable costing is used.
8-33
Variable Costing
Sales (30,000 \$30) 900,000 \$
Less variable expenses:
Beg. inventory (5,000 \$10) 50,000 \$
Goods available for sale 300,000 \$
Ending inventory -
Variable cost of goods sold 300,000 \$
expenses (30,000 \$3) 90,000 390,000
Contribution margin 510,000 \$
Less fixed expenses:
Selling & administrative expenses 100,000 250,000
Net income 260,000 \$
Mellon Co. Year 2
8-34
Summary
In the first period, production (25,000 units)
was greater than sales (20,000).
Income Comparison
Costing Method 1st Period 2nd Period Total
Absorption 120,000 \$ 230,000 \$ 350,000 \$
Variable 90,000 260,000 350,000
In the second period, production (25,000 units)
was less than sales (30,000).
8-35
Summary
For the two-year period, total absorption
income and total variable income are the same.
Income Comparison
Costing Method 1st Period 2nd Period Total
Absorption 120,000 \$ 230,000 \$ 350,000 \$
Variable 90,000 260,000 350,000
8-36
Summary
Lets see if we can get an overview
of what we have done.
8-37
Summary Comparison of
Absorption (AC) and Variable
Costing (VC)
Production versus
Sales
Total
Inventory
Effect Period Expense Effect Profit Effect
Fixed mfg. Fixed mfg.
Produced > Sold Increase costs expensed < costs expensed AC > VC
AC VC
Fixed mfg. Fixed mfg.
Produced < Sold Decrease costs expensed > costs expensed AC < VC
AC VC
Fixed mfg. Fixed mfg.
Produced = Sold No change costs expensed = costs expensed AC = VC
AC VC
This was the case in the first period when production
of 25,000 units was greater than sales of 20,000 units.
Inventory increased from zero to 5,000 units and
\$120,000 absorption income was greater than
\$90,000 variable income.
8-38
Production versus
Sales
Total
Inventory
Effect Period Expense Effect Profit Effect
Fixed mfg. Fixed mfg.
Produced > Sold Increase costs expensed < costs expensed AC > VC
AC VC
Fixed mfg. Fixed mfg.
Produced < Sold Decrease costs expensed > costs expensed AC < VC
AC VC
Fixed mfg. Fixed mfg.
Produced = Sold No change costs expensed = costs expensed AC = VC
AC VC
Summary Comparison of
Absorption (AC) and Variable
Costing (VC)
In the second period sales of 30,000 units
were greater than production of 25,000.
8-39
Production versus
Sales
Total
Inventory
Effect Period Expense Effect Profit Effect
Fixed mfg. Fixed mfg.
Produced > Sold Increase costs expensed < costs expensed AC > VC
AC VC
Fixed mfg. Fixed mfg.
Produced < Sold Decrease costs expensed > costs expensed AC < VC
AC VC
Fixed mfg. Fixed mfg.
Produced = Sold No change costs expensed = costs expensed AC = VC
AC VC
Summary Comparison of
Absorption (AC) and Variable
Costing (VC)
Inventory decreased from 5,000 units to zero,
and \$230,000 absorption income was less
than \$260,000 variable income.
8-40
Production versus
Sales
Total
Inventory
Effect Period Expense Effect Profit Effect
Fixed mfg. Fixed mfg.
Produced > Sold Increase costs expensed < costs expensed AC > VC
AC VC
Fixed mfg. Fixed mfg.
Produced < Sold Decrease costs expensed > costs expensed AC < VC
AC VC
Fixed mfg. Fixed mfg.
Produced = Sold No change costs expensed = costs expensed AC = VC
AC VC
Summary Comparison of
Absorption (AC) and Variable
Costing (VC)
For the two-year period, units produced
equals units sold, so total absorption income
equals total variable income.
8-41
Management finds it
easy to understand.
Consistent with
CVP analysis.
Emphasizes contribution in
short-run pricing decisions.
Profit for period not
affected by changes
Impact of fixed
costs on profits
emphasized.
Evaluation of Variable Costing
8-42
Consistent with long-run
pricing decisions that must
cover full cost.
External reporting
and income tax law
require absorption costing.
Evaluation of Absorption Costing
treated the same as the other product
costs, direct material and direct labor.
8-43
Impact of JIT Inventory Methods
In a JIT inventory system . . .
Production tends
to equal sales . . .
So, the difference between variable and
absorption income tends to disappear.
Learning
Objective
7
8-45
Throughput Costing
Example

In an automated process direct material may be
the only unit-level cost and so is the only product cost.

All other manufacturing costs are expensed as period costs.
Incentive to
overproduce
is reduced
Average unit cost does
not vary with changes
in production levels.
Learning
Objective
8
8-47
Throughput Income Satatement
Sales Revenue \$600,000
Throughput cost of goods sold (dir. mat.) 150,000
Gross Margin \$450,000
Less: Operating costs
Direct labor 100,000