Traditional (Absorption) IS vs. Contribution (Variable) IS

Traditional Approach (costs organized by function)

Sales $60,000 Less CGS Gross Profit Less Operating Expenses: Selling

Administrative Net Income *Contains both variable and fixed elements since this is the income statement for a manufacturing company. If this were a merchandising company, then the cost of goods sold would be entirely variable.

Contribution Approach (costs organized by behavior)

Sales $60,000 Less Variable Expenses: Contribution Margin Less Fixed Expenses: Net Income

Absorption Costing

V a ria ble Costing

Overview of Absorption and Variable Costing

32

Variable vs. Absorption Costing

Variable Costing Under variable costing, only those costs of production that vary with out put are treated as product costs.

• These costs usually consist of DM, DL, and VMOH. • FMOH is not treated as a product cost under variable

costing. Rather, it is treated as a period cost and deducted in full each year from revenues.

• Variable costing may be used by companies internally for

planning and for controlling operations. However, variable costing is not generally considered acceptable for audited external reports and tax reporting.

Absorption Costing Absorption costing treats all production costs as product costs.

• Unit product cost under the absorption costing method consists of DM, DL, and both VMOH and FMOH.

• Under absorption costing a portion of the FMOH is

allocated to each unit of product.

3

SummaryRelation between Effect Relation between

production on variable andYear and sales iniventory absorption income

Inventory Absorption 1st Production > Sales increases by >

year 25,000 > 20,000 5,000 units. Variable Inventory Absorption

2nd Production < Sales decreases < year 25,000 < 30,000 to zero. Variable Both Absorption years Production = Sales No change =

combined 50,000 = 50,000 Variable

134

Advantages of the Contribution Approach

Advantages

Management finds it easy to understand.

Consistent withCVP analysis.

Net income is closerto net cash flow.

Profit is not affected bychanges in inventories.

Impact of fixedcosts on profitsemphasized.

Consistent with standardcosts and flexible budgeting.

Easier to estimate profitabilityof products and segments.

145

Absorption versus Variable Costing

Depreciation, taxes, insurance and salariesare just as essential to

products as variable costs.

AbsorptionCosting

VariableCosting

These are capacitycosts and will be

incurred if nothingis produced.

All manufacturing costsmust be assigned toproducts to properly

match revenues and costs.

Fixed costs arenot really the costs

of any particularproduct.

156

Variable vs. Absorption Costing P9-20 The Zwatch Company manufactures trendy, high-quality moderately priced watches. As Zwatch’s senior financial analyst, you are asked to recommend a method of inventory costing. The CFO will use your recommendation to construct Zwatch’s 2004 income statement. The following data are for the year ended December 31, 2004:

Beginning inventory, January 1, 2004 85,000 units Ending inventory, December 31, 2004 34,500 units 2004 sales 345,400 units Selling price (to distributor) $22.00 per unit Variable mnfc cost per unit, incl. DM $5.10 per unit Variable operating cost per unit sold $1.10 per unit sold Fixed mnfc. Overhead $1,440,000 Denominator-level machine-hours 6,000 Standard production rate 50 units per machine-hour Fixed operating costs $1,080,000

Assume standard costs per unit are the same for units in beginning inventory and units produced during the year. Also, assume no price, spending, or efficiency variances.

1. Prepare income statements under variable and absorption costing for the year ended December 31, 2004.

2. What is Zwatch’s operating income under each costing method (in percentage terms)?

3. Explain the difference in operating income between the two methods. 4. Which costing method would you recommend to the CFO? Why?

7

Absorption and Variable Costing P9-21 (CMA) Osawa, Inc., planned and actually manufactured 200,000 units of its single product in 2004, its first year of operation. Variable manufacturing costs was $20 per unit produced. Variable operating cost was $10 per unit sold. Planned and actual fixed manufacturing costs were $600,000. Planned and actual fixed operating costs totaled $400,000 in 2004. Osawa sold 120,000 units of product in 2004 at $40 per unit.

1. Osawa’s 2004 operating income using absorption costing is: a. $440,000 b. $200,000 c. $600,000 d. $840,000 e. None of these.

2. Osawa’s 2004 operating income using variable costing is: a. $800,000 b. $440,000 c. $200,000 d. $600,000 e. None of these.

8

Comparison of Actual-Costing Methods P9-23

The Rehe Company sells its razors at $3 per unit. The company uses a FIFO actual-costing system. A new FMOH overhead rate is computed each year by dividing the actual FMOH cost by the actual production units. The following simplified data are related to its first two years of operation:

2003 2004 Sales 1,000 units 1,200 units Production 1,400 units 1,000 units Costs: Variable manufacturing $700 $500 Fixed manufacturing $700 $700 Variable operating $1,000 $1,200 Fixed operating $400 $400

1. Prepare income statements based on variable costing for each of the two years. 2. Prepare income statements based on absorption costing for each of the two years. 3. Prepare a numerical reconciliation and explanation of the difference between

operating income for each year under absorption costing and variable costing. 4. Critics have claimed that a widely used accounting system has led to undesirable

buildups of inventory levels. a. Is variable costing or absorption costing more likely to lead to such

buildups? Why? What can be done to counteract undesirable inventory buildups?

9

HORNGREN/DATAR/FOSTER, COST ACCOUNTING 11E

Problem 9-23

B C D E F G HData Input Section: Rehe Company

Year 2003 Year 2004Unit data:

Sales 1,000 1,200 Production 1,400 1,000 Beginning inventory - 400 Ending inventory 400 200

Cost data:Variable manufacturing 700$ 500$ Fixed manufacturing 700 700 Variable marketing and administration 1,000 1,200 Fixed marketing and administration 400 400

Selling price per razor 3.00$ Output Section: Rehe CompanyPart 1. Variable Costing

Year 2003 Year 2004Sales 3,000$ 3,600$ Variable expenses:

Beginning inventory - 200 Variable manufacturing costs 700 500 Available for sale 700 700 Ending inventory 200 100

Variable manufacturing cost of goods sold 500 600 Variable marketing costs 1,000 1,200

Total variable costs 1,500 1,800 Contribution margin 1,500 1,800 Fixed expenses:

Manufacturing costs 700 700 Marketing costs 400 400

Total fixed expenses 1,100 1,100 Operating income 400$ 700$

continued

HORNGREN/DATAR/FOSTER, COST ACCOUNTING 11E

Problem 9-23

B C D E F G HPart 2. Rehe Company

Absorption CostingYear 2003 Year 2004

Sales 3,000$ 3,600$ Cost of goods sold:

Beginning inventory - 400 Variable manufacturing cost 700 500 Fixed manufacturing cost 700 700 Available for sale 1,400 1,600 Deduct ending inventory 400 240

Cost of goods sold: 1,000 1,360 Gross margin 2,000 2,240 Marketing costs:Variable marketing and administration costs 1,000 1,200 Fixed marketing and administration costs 400 400 Total 1,400 1,600 Operating income 600$ 640$

Part 3. Year 2003 Year 2004Variable costing:

Operating income 400$ 700$ Ending inventory 200 100

Absorption costing:Operating income 600$ 640$ Ending inventory 400 240 Fixed manufacturing overhead

In beginning inventory 0 200In ending inventory 200 140

The All-Fixed Company in 2004 P9-32 (R. Marple, adapted) It is the end of 2004. The All-Fixed Company began operations in January 2003. The company is so named because it has no variable costs. All its costs are fixed; they do not vary with output. The All-Fixed Company is located on the bank of a river and its own hydroelectric plant to supply power, light, and heat. The company manufactures a synthetic fertilizer from air and river water and sells its product at a price that is not expected to change. It has a small staff of employees, all hired on a fixed annual salary. The output of the plant can be increased or decreased by adjusting a few dials on a control panel. The following data are for the operations of the All-Fixed Company: 2003 2004a

Sales 10,000 tons 10,000 tons Production 20,000 tons ------------- Selling price $30 per ton $30 per ton Costs (all fixed): Manufacturing $280,000 $280,000 Operating $ 40,000 $ 40,000

a Management adopted the policy, effective January 1, 2004, of producing only as much product as needed to fill sales orders. During 2004, sales were the same as for 2003 and were filled entirely from inventory at the start of 2004.

1. Prepare income statements with one column for 2003, one column for 2004, and one column for the two years together, using (a) variable costing and (b) absorption costing?

2. What is the breakeven point under (a) variable costing and (b) absorption costing? 3. What inventory costs would be carried on the balance sheet on December 31,

2003 and 2004, under each method? 4. Assume that the performance of the top manager of the company is evaluated and

rewarded largely on the basis of reported operating income. Which costing method would the manager prefer? Why?

10

1

9-32 (40 min.) The All-Fixed Company in 2004. This problem always generates active classroom discussion. 1. The treatment of fixed manufacturing overhead in absorption costing is affected primarily by what denominator level is selected as a base for allocating fixed manufacturing costs to units produced. In this case, is 10,000 tons per year, 20,000 tons, or some other denominator level the most appropriate base? We usually place the following possibilities on the board or overhead projector and then ask the students to indicate by vote how many used one denominator level versus another. Incidentally, discussion tends to move more clearly if variable-costing income statements are discussed first, because there is little disagreement as to computations under variable costing.

a. Variable-Costing Income Statement:

2003 2004 Together Revenues (and contribution margin) $300,000 $300,000 $600,000 Fixed costs: Manufacturing costs $280,000 Operating costs 40,000 320,000 320,000 640,000 Operating income $ (20,000) $ (20,000) $ (40,000) b. Absorption-Costing Income Statement:

The ambiguity about the 10,000- or 20,000-unit denominator level is intentional. IF YOU WISH, THE AMBIGUITY MAY BE AVOIDED BY GIVING THE STUDENTS A SPECIFIC DENOMINATOR LEVEL IN ADVANCE. Alternative 1. Use 20,000 units as a denominator; fixed manufacturing overhead per unit is $280,000 ÷ 20,000 = $14.

2

9-32 (Cont’d.)

2003

2004

Together

Revenues $300,000 $ 300,000 $600,000 Manufacturing costs at $14 280,000 -- 280,000 Deduct ending inventory 140,000 -- -- Cost of goods sold 140,000 140,000* 280,000 Underallocated manuf. overhead-- output level variance -- 280,000 280,000 Operating costs 40,000 40,000 80,000 Total costs 180,000 460,000 640,000 Operating income $120,000 $(160,000) $( 40,000)

* Inventory carried forward from 2003 and sold in 2004. Alternative 2. Use 10,000 units as a denominator; fixed manufacturing overhead per unit is $280,000 ÷ 10,000 = $28.

2003 2004 Together Revenues $300,000 $300,000 $600,000 Manufacturing costs at $28 560,000 -- 560,000 Deduct ending inventory 280,000 -- -- Cost of goods sold 280,000 280,000* 560,000 Underallocated manuf. overhead-- output level variance -- 280,000 -- Overallocated manuf. overhead -- output level variance (280,000) -- -- Operating costs 40,000 40,000 80,000 Total costs 40,000 600,000 640,000 Operating income $260,000 $(300,000) $ (40,000)

*Inventory carried forward from 2003 and sold in 2004. Note that operating income under variable costing follows sales and is not affected by inventory changes. Note also that students will understand the variable-costing presentation much more easily than the alternatives presented under absorption costing.

2. costing

ableunder varipointBreakeven

= per tonmargin on Contributi

costs Fixed = $30

$320,000

= 10,667 tons per year or 21,333 for two years.

3

9-32 (Cont’d.) If the company could sell 667 more tons per year at $30 each, it could get the extra $20,000 contribution margin needed to break even. Most students will say that the breakeven point is 10,667 tons per year under both absorption costing and variable costing. The logical question to ask a student who answers 10,667 tons for variable costing is: "What operating income do you show for 2003 under absorption costing?" If a student answers $120,000 (alternative 1 above), or $260,000 (alternative 2 above), ask: "But you say your breakeven point is 10,667 tons. How can you show an operating income on only 10,000 tons sold during 2003?" The answer to the above dilemma lies in the fact that operating income is affected by both sales and production under absorption costing. Given that sales would be 10,000 tons in 2003, solve for the production level that will provide a breakeven level of zero operating income. Using the formula in the chapter, sales of 10,000 units, and a fixed manufacturing overhead rate of $14 (based on $280,000 ÷ 20,000 units denominator level = $14): Let P = Production level

Breakevensales

in units =

marginon contributiUnit

producedUnits

unitsin sales

Breakeven

rateoverhead

manuf. Fixed

income operatingTarget

costsfixed Total

⎥⎥⎥

⎦

⎤

⎢⎢⎢

⎣

⎡

⎟⎟⎟

⎠

⎞

⎜⎜⎜

⎝

⎛−×

⎟⎟⎟

⎠

⎞

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⎝

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⎠

⎞

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⎛

10,000 tons = 30$

)000‚10(14$0$000‚320$ P−++

$300,000 = $320,000 + $140,000 – $14P $14P = $160,000 P = 11,429 units (rounded) Proof: Gross margin, 10,000 × ($30 – $14) $160,000 Output level variance, (20,000 – 11,429) × $14 $120,000 Marketing and administrative costs 40,000 160,000 Operating income $ 0

4

9-32 (Cont’d.) Given that production would be 20,000 tons in 2003, solve for the breakeven unit sales level. Using the formula in the chapter and a fixed manufacturing overhead rate of $14 (based on a denominator level of 20,000 units): Let N = Breakeven sales in units

N = marginon contributiUnit

producedUnits

Nrate

overheadmanuf. Fixed

income operatingTarget

costsfixed Total

⎥⎥⎥

⎦

⎤

⎢⎢⎢

⎣

⎡

⎟⎟⎠

⎞⎜⎜⎝

⎛−×

⎟⎟⎟

⎠

⎞

⎜⎜⎜

⎝

⎛+

⎟⎟⎟

⎠

⎞

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⎝

⎛+⎟⎟

⎠

⎞⎜⎜⎝

⎛

N = 30$

)000‚20N(14$0$000‚320$ -++

$30N = $320,000 + $14N – $280,000 $16N = $40,000 N = 2,500 units Proof: Gross margin, 2,500 × ($30 – $14) $40,000 Output level MOH variance $ 0 Marketing and administrative costs 40,000 40,000 Operating income $ 0 We find it helpful to put the following comparisons on the board: Variable costing breakeven = f(sales) = 10,667 tons Absorption costing breakeven = f(sales and production) = f(10,000 and 11,429) = f(2,500 and 20,000) 3. Absorption costing inventory cost: Either $140,000 or $280,000 at the end of 2003 and zero at the end of 2004. Variable costing: Zero at all times. This is a major criticism of variable costing and focuses on the issue of the definition of an asset. Operating income is affected by both production and sales under absorption costing. Hence, most managers would prefer absorption costing because their performance in any given reporting period, at least in the short run, is influenced by how much production is scheduled near the end of a period.