variable costing
DESCRIPTION
This presentation gives an idea about absorption costing and variable costing management system.TRANSCRIPT
Garrison Noreen Brewer 11th Edition Chapter
7McGraw-Hill/Irwin
McGraw-Hill/Irwin
*
Two general approaches are used for valuing inventories and cost of goods sold. One approach, called absorption costing, is generally used for external reporting. The other approach, called variable costing, is preferred by some managers for internal decision making and must be used when an income statement is prepared in the contribution format. This chapter shows how these two methods differ from each other.
Copyright © 2006, The McGraw-Hill Companies, Inc.
McGraw-Hill/Irwin
Product
Costs
Period
Costs
Product
Costs
Period
Costs
*
Absorption costing (also called full costing) charges products with all manufacturing costs, regardless of whether the costs are fixed or variable. The cost of a unit of product consists of all four types of manufacturing costs — direct material, direct labor, variable manufacturing overhead, and fixed manufacturing overhead. Since no distinction is made between variable and fixed costs, absorption costing is not well suited for cost-volume-profit analysis.
Variable costing (also called direct costing) charges products with only the variable manufacturing costs. The cost of a unit of product consists of the three variable manufacturing costs — direct material, direct labor, and variable manufacturing overhead. Variable costing is consistent with the contribution format income statement and it supports cost-volume-profit analysis because of its emphasis on separating variable and fixed costs.
The only difference in the two approaches is the treatment of fixed manufacturing overhead. With absorption costing, fixed manufacturing overhead is a product cost. With variable costing, fixed manufacturing overhead is a period cost. Note that selling and administrative costs are treated as period costs with both absorption costing and variable costing.
Think about the impact of each method on inventory values, and then answer the following question.
Copyright © 2006, The McGraw-Hill Companies, Inc.
McGraw-Hill/Irwin
Quick Check
Which method will produce the highest values for work in process and finished goods inventories?
a. Absorption costing.
b. Variable costing.
inventories.
To answer this question correctly, recall which method includes more manufacturing costs in the unit product cost.
Copyright © 2006, The McGraw-Hill Companies, Inc.
McGraw-Hill/Irwin
Which method will produce the highest values for work in process and finished goods inventories?
a. Absorption costing.
b. Variable costing.
inventories.
*
Unit product costs are in both work in process and finished goods inventories. Absorption costing results in the highest inventory values because it treats fixed manufacturing overhead as a product cost. Using variable costing, fixed manufacturing overhead is expensed as incurred and never becomes a part of the product cost.
Copyright © 2006, The McGraw-Hill Companies, Inc.
McGraw-Hill/Irwin
with the following information available:
Unit Cost Computations
*
Harvey Company makes twenty-five thousand units of a single product. Variable manufacturing costs total ten dollars per unit. Variable selling and administrative expenses are three dollars per unit. Fixed manufacturing overhead for the year is one hundred fifty thousand dollars and fixed selling and administrative expenses for the year are one hundred thousand dollars.
Sheet1
25,000
McGraw-Hill/Irwin
Selling and administrative expenses are
always treated as period expenses and deducted from revenue as incurred.
Unit Cost Computations
*
With variable costing, only the ten dollars per unit variable manufacturing costs (direct material, direct labor, and variable manufacturing overhead) are product costs. With absorption costing, we include fixed manufacturing overhead in product costs. To compute the per unit amount of fixed manufacturing overhead, we divide one hundred fifty thousand dollars of fixed manufacturing overhead by the twenty-five thousand units manufactured.
Selling and administrative expenses are always treated as period expenses and deducted from revenue as incurred.
Sheet1
McGraw-Hill/Irwin
Let’s assume the following additional information for Harvey Company.
20,000 units were sold during the year at a price of $30 each.
There were no units in beginning inventory.
Now, let’s compute net operating
income using both absorption
*
We need some additional information to allow us to prepare income statements for Harvey Company:
Twenty thousand units were sold during the year.
There were no units in beginning inventory.
Now let’s prepare income statements for Harvey Company. We will start with an absorption income statement.
Copyright © 2006, The McGraw-Hill Companies, Inc.
McGraw-Hill/Irwin
*
Harvey had no beginning inventory and sold only twenty thousand of the twenty-five thousand units produced, leaving five thousand units in ending inventory. The sales price is thirty dollars per unit, so sales revenue for the twenty thousand units sold is six hundred thousand dollars. The computation of cost of goods sold on your screen starts with beginning inventory, adds cost of goods manufactured and subtracts ending inventory. We could also compute cost of goods sold directly by multiplying twenty thousand units sold times the sixteen dollar unit cost. We subtract cost of goods sold from sales to get the two hundred eighty thousand dollar gross margin.
We subtract selling and administrative expenses from gross margin to get absorption cost net operating income of one hundred twenty thousand dollars. The sixty thousand dollar variable selling and administrative expense is computed by multiplying twenty thousand units sold times three dollars per unit. The one hundred thousand dollar fixed administrative expense was given earlier.
Sheet1
Beginning inventory
McGraw-Hill/Irwin
*
Now let’s examine a variable cost income statement. Notice that this is a contribution format statement. First, we subtract all variable expenses from sales to get contribution margin. The first variable expense is variable cost of goods sold, which is computed using only the ten dollar per unit variable manufacturing cost. The next variable expense is the variable selling and administrative expense. It is computed as before, twenty thousand units sold at three dollars per unit.
After computing contribution margin, we subtract fixed expenses to get the ninety thousand dollar variable cost net operating income. Note that all of the one hundred fifty thousand dollars of fixed manufacturing overhead is expensed as a lump sum.
Sheet1
50,000
200,000
McGraw-Hill/Irwin
*
The only difference between the two methods is the treatment of fixed manufacturing overhead. Absorption costing treats fixed manufacturing overhead as a product cost using an overhead rate of six dollars per unit. As a result, thirty thousand dollars of fixed manufacturing overhead is left in inventory as a part of the cost of the five thousand unsold units.
Income computed using variable costing expenses all one hundred fifty thousand dollars of the fixed manufacturing overhead as a period expense. None of the fixed manufacturing overhead remains in inventory with variable costing. The variable costing inventory of fifty thousand dollars is computed by multiplying the ten dollar per unit variable product cost times the five thousand unsold units.
Sheet1
McGraw-Hill/Irwin
Reconciliation
Fixed mfg. Overhead $150,000
Units produced 25,000 units
*
The difference between absorption cost net operating income and variable cost net operating income results from the thirty thousand dollars of fixed manufacturing overhead remaining in inventory as a part of cost of the five thousand unsold units using absorption costing. Using variable costing, this thirty thousand dollars is expensed in the period resulting in a net operating income that is thirty thousand dollars less than absorption cost net operating income.
The thirty thousand dollars can be computed by multiplying the five thousand unsold units times the six dollar fixed manufacturing overhead cost per unit.
We can reconcile the difference between the two methods by adding the thirty thousand dollars to the ninety thousand dollar variable cost income to get the one hundred twenty thousand dollar absorption cost net operating income.
Sheet1
$ 90,000
deferred in inventory
30,000
$ 120,000
&A
McGraw-Hill/Irwin
*
In the second year, Harvey Company again makes twenty-five thousand units of the same product, but sells thirty thousand units. Five thousand units are in beginning inventory, left from last year. The sales price is the same as last year, thirty dollars per unit.
Variable manufacturing costs total ten dollars per unit. Variable selling and administrative expenses are three dollars per unit. Fixed manufacturing overhead for the year is one hundred fifty thousand dollars and fixed selling and administrative expenses for the year are one hundred thousand.
Sheet1
McGraw-Hill/Irwin
*
With variable costing, only the ten dollars per unit variable manufacturing costs (direct material, direct labor, and variable manufacturing overhead) are product costs. With absorption costing, we include fixed manufacturing overhead in product costs. To compute the per unit amount of fixed manufacturing overhead, we divide one hundred fifty thousand dollars of fixed manufacturing overhead by the twenty-five thousand units manufactured.
Since there was no change in the per unit variable costs, total fixed costs, or the number of units produced, the unit costs remain unchanged.
Sheet1
McGraw-Hill/Irwin
*
Harvey sold thirty thousand units in the second year, twenty-five thousand units produced in the second year plus five thousand units from beginning inventory. The sales price is again thirty dollars per unit, so sales revenue for the thirty thousand units sold is nine hundred thousand dollars. The computation of cost of goods sold on your screen starts with beginning inventory, adds cost of goods manufactured and subtracts ending inventory. We could also compute cost of goods sold directly by multiplying thirty thousand units sold times the sixteen dollar unit cost. We subtract cost of goods sold from sales to get the four hundred twenty thousand dollar gross margin.
We subtract selling and administrative expenses from gross margin to get absorption cost net operating income of two hundred thirty thousand dollars. The ninety thousand dollar variable selling and administrative expense is computed by multiplying thirty thousand units sold times three dollars per unit. The one hundred thousand dollar fixed administrative expense was given.
Sheet1
Beg. inventory (5,000 × $16)
McGraw-Hill/Irwin
*
Now let’s examine a variable cost income statement for the second year. Again, notice that this is a contribution format statement. First, we subtract all variable expenses from sales to get contribution margin. The first variable expense is variable cost of goods sold, which is computed using only the ten dollar per unit variable manufacturing cost. The next variable expense is the variable selling and administrative expense. It is computed as before, thirty thousand units sold at three dollars per unit.
After computing contribution margin, we subtract fixed expenses to get the two hundred sixty thousand dollar variable cost net operating income. Note that all of the one hundred fifty thousand dollars of fixed manufacturing overhead is expensed as a lump sum.
Sheet1
300,000
McGraw-Hill/Irwin
Reconciliation
Fixed mfg. Overhead $150,000
Units produced 25,000 units
*
The difference between absorption cost net operating income and variable cost net operating income results from the thirty thousand dollars of fixed manufacturing overhead released from beginning inventory using absorption costing. Using variable costing, this thirty thousand dollars was expensed in the first year, never becoming a part of the inventory value.
The thirty thousand dollars can be computed by multiplying the five thousand units from inventory times the six dollar fixed manufacturing overhead cost per unit.
We can reconcile the difference between the two methods by subtracting the thirty thousand dollars from the two hundred sixty thousand dollar variable cost income to get the two hundred thirty thousand dollar absorption cost net operating income.
Sheet1
$ 260,000
(5,000 units × $6 per unit)
30,000
$ 230,000
&A
McGraw-Hill/Irwin
*
For the two-year time period, both methods report the same total income, three hundred fifty thousand dollars, because for the two-year period total sales of fifty thousand units equals total production of fifty thousand units.
Although sales and production may differ in any given year, over an extended period of time sales cannot exceed production, nor can production greatly exceed sales. The shorter the time period, the more the net operating income figures will tend to differ.
Sheet1
McGraw-Hill/Irwin
Summary
*
On your screen is a nice summary of what we have observed from the Harvey Company’s two years:
For year one, Harvey’s production exceeded sales. Fixed manufacturing
overhead was deferred into inventory with absorption costing, so absorption
costing net operating income was greater than variable costing net operating
income.
For year two, Harvey’s production was less than sales. Fixed manufacturing
overhead was released from inventory with absorption costing, so absorption
costing net operating income was less than variable costing net operating
income.
For the two years combined, production equaled sales so absorption
costing net operating income equaled variable costing net operating
income.
Sheet1
McGraw-Hill/Irwin
*
Variable costing and absorption costing are two different approaches for valuing inventories and cost of goods sold. Absorption costing is generally used for external reporting. Variable costing is preferred by some managers for internal decision making and cost-volume-profit analysis.
The shifting of fixed manufacturing overhead between reporting periods using absorption costing can cause net operating income to fluctuate with production decisions, leading to possible confusion and unwise decisions.
Number of units produced annually25,000
Variable costs per unit:
Direct materials, direct labor,
and variable mfg. overhead10$
Fixed mfg. overhead
($150,000 ÷ 25,000 units)6 -
Beginning inventory-$
Gross margin280,000
Variable selling & administrative
320,000$ 80,000$ -$ 400,000$
200,000$ 50,000$ 150,000$ 400,000$
deferred in inventory
Absorption costing net operating income120,000$
Number of units produced25,000
Number of units sold30,000
Units in beginning inventory5,000
Fixed mfg. overhead
($150,000 ÷ 25,000 units)6 -
Beg. inventory (5,000 × $16)80,000$
Add COGM (25,000 × $16)400,000
Goods available for sale480,000
Less ending inventory- 480,000
Variable selling & administrative
Deduct: Fixed manufacturing overhead
costs released from inventory
Absorption costing net operating income230,000$
Costing Method1st Period2nd PeriodTotal
McGraw-Hill/Irwin
*
Two general approaches are used for valuing inventories and cost of goods sold. One approach, called absorption costing, is generally used for external reporting. The other approach, called variable costing, is preferred by some managers for internal decision making and must be used when an income statement is prepared in the contribution format. This chapter shows how these two methods differ from each other.
Copyright © 2006, The McGraw-Hill Companies, Inc.
McGraw-Hill/Irwin
Product
Costs
Period
Costs
Product
Costs
Period
Costs
*
Absorption costing (also called full costing) charges products with all manufacturing costs, regardless of whether the costs are fixed or variable. The cost of a unit of product consists of all four types of manufacturing costs — direct material, direct labor, variable manufacturing overhead, and fixed manufacturing overhead. Since no distinction is made between variable and fixed costs, absorption costing is not well suited for cost-volume-profit analysis.
Variable costing (also called direct costing) charges products with only the variable manufacturing costs. The cost of a unit of product consists of the three variable manufacturing costs — direct material, direct labor, and variable manufacturing overhead. Variable costing is consistent with the contribution format income statement and it supports cost-volume-profit analysis because of its emphasis on separating variable and fixed costs.
The only difference in the two approaches is the treatment of fixed manufacturing overhead. With absorption costing, fixed manufacturing overhead is a product cost. With variable costing, fixed manufacturing overhead is a period cost. Note that selling and administrative costs are treated as period costs with both absorption costing and variable costing.
Think about the impact of each method on inventory values, and then answer the following question.
Copyright © 2006, The McGraw-Hill Companies, Inc.
McGraw-Hill/Irwin
Quick Check
Which method will produce the highest values for work in process and finished goods inventories?
a. Absorption costing.
b. Variable costing.
inventories.
To answer this question correctly, recall which method includes more manufacturing costs in the unit product cost.
Copyright © 2006, The McGraw-Hill Companies, Inc.
McGraw-Hill/Irwin
Which method will produce the highest values for work in process and finished goods inventories?
a. Absorption costing.
b. Variable costing.
inventories.
*
Unit product costs are in both work in process and finished goods inventories. Absorption costing results in the highest inventory values because it treats fixed manufacturing overhead as a product cost. Using variable costing, fixed manufacturing overhead is expensed as incurred and never becomes a part of the product cost.
Copyright © 2006, The McGraw-Hill Companies, Inc.
McGraw-Hill/Irwin
with the following information available:
Unit Cost Computations
*
Harvey Company makes twenty-five thousand units of a single product. Variable manufacturing costs total ten dollars per unit. Variable selling and administrative expenses are three dollars per unit. Fixed manufacturing overhead for the year is one hundred fifty thousand dollars and fixed selling and administrative expenses for the year are one hundred thousand dollars.
Sheet1
25,000
McGraw-Hill/Irwin
Selling and administrative expenses are
always treated as period expenses and deducted from revenue as incurred.
Unit Cost Computations
*
With variable costing, only the ten dollars per unit variable manufacturing costs (direct material, direct labor, and variable manufacturing overhead) are product costs. With absorption costing, we include fixed manufacturing overhead in product costs. To compute the per unit amount of fixed manufacturing overhead, we divide one hundred fifty thousand dollars of fixed manufacturing overhead by the twenty-five thousand units manufactured.
Selling and administrative expenses are always treated as period expenses and deducted from revenue as incurred.
Sheet1
McGraw-Hill/Irwin
Let’s assume the following additional information for Harvey Company.
20,000 units were sold during the year at a price of $30 each.
There were no units in beginning inventory.
Now, let’s compute net operating
income using both absorption
*
We need some additional information to allow us to prepare income statements for Harvey Company:
Twenty thousand units were sold during the year.
There were no units in beginning inventory.
Now let’s prepare income statements for Harvey Company. We will start with an absorption income statement.
Copyright © 2006, The McGraw-Hill Companies, Inc.
McGraw-Hill/Irwin
*
Harvey had no beginning inventory and sold only twenty thousand of the twenty-five thousand units produced, leaving five thousand units in ending inventory. The sales price is thirty dollars per unit, so sales revenue for the twenty thousand units sold is six hundred thousand dollars. The computation of cost of goods sold on your screen starts with beginning inventory, adds cost of goods manufactured and subtracts ending inventory. We could also compute cost of goods sold directly by multiplying twenty thousand units sold times the sixteen dollar unit cost. We subtract cost of goods sold from sales to get the two hundred eighty thousand dollar gross margin.
We subtract selling and administrative expenses from gross margin to get absorption cost net operating income of one hundred twenty thousand dollars. The sixty thousand dollar variable selling and administrative expense is computed by multiplying twenty thousand units sold times three dollars per unit. The one hundred thousand dollar fixed administrative expense was given earlier.
Sheet1
Beginning inventory
McGraw-Hill/Irwin
*
Now let’s examine a variable cost income statement. Notice that this is a contribution format statement. First, we subtract all variable expenses from sales to get contribution margin. The first variable expense is variable cost of goods sold, which is computed using only the ten dollar per unit variable manufacturing cost. The next variable expense is the variable selling and administrative expense. It is computed as before, twenty thousand units sold at three dollars per unit.
After computing contribution margin, we subtract fixed expenses to get the ninety thousand dollar variable cost net operating income. Note that all of the one hundred fifty thousand dollars of fixed manufacturing overhead is expensed as a lump sum.
Sheet1
50,000
200,000
McGraw-Hill/Irwin
*
The only difference between the two methods is the treatment of fixed manufacturing overhead. Absorption costing treats fixed manufacturing overhead as a product cost using an overhead rate of six dollars per unit. As a result, thirty thousand dollars of fixed manufacturing overhead is left in inventory as a part of the cost of the five thousand unsold units.
Income computed using variable costing expenses all one hundred fifty thousand dollars of the fixed manufacturing overhead as a period expense. None of the fixed manufacturing overhead remains in inventory with variable costing. The variable costing inventory of fifty thousand dollars is computed by multiplying the ten dollar per unit variable product cost times the five thousand unsold units.
Sheet1
McGraw-Hill/Irwin
Reconciliation
Fixed mfg. Overhead $150,000
Units produced 25,000 units
*
The difference between absorption cost net operating income and variable cost net operating income results from the thirty thousand dollars of fixed manufacturing overhead remaining in inventory as a part of cost of the five thousand unsold units using absorption costing. Using variable costing, this thirty thousand dollars is expensed in the period resulting in a net operating income that is thirty thousand dollars less than absorption cost net operating income.
The thirty thousand dollars can be computed by multiplying the five thousand unsold units times the six dollar fixed manufacturing overhead cost per unit.
We can reconcile the difference between the two methods by adding the thirty thousand dollars to the ninety thousand dollar variable cost income to get the one hundred twenty thousand dollar absorption cost net operating income.
Sheet1
$ 90,000
deferred in inventory
30,000
$ 120,000
&A
McGraw-Hill/Irwin
*
In the second year, Harvey Company again makes twenty-five thousand units of the same product, but sells thirty thousand units. Five thousand units are in beginning inventory, left from last year. The sales price is the same as last year, thirty dollars per unit.
Variable manufacturing costs total ten dollars per unit. Variable selling and administrative expenses are three dollars per unit. Fixed manufacturing overhead for the year is one hundred fifty thousand dollars and fixed selling and administrative expenses for the year are one hundred thousand.
Sheet1
McGraw-Hill/Irwin
*
With variable costing, only the ten dollars per unit variable manufacturing costs (direct material, direct labor, and variable manufacturing overhead) are product costs. With absorption costing, we include fixed manufacturing overhead in product costs. To compute the per unit amount of fixed manufacturing overhead, we divide one hundred fifty thousand dollars of fixed manufacturing overhead by the twenty-five thousand units manufactured.
Since there was no change in the per unit variable costs, total fixed costs, or the number of units produced, the unit costs remain unchanged.
Sheet1
McGraw-Hill/Irwin
*
Harvey sold thirty thousand units in the second year, twenty-five thousand units produced in the second year plus five thousand units from beginning inventory. The sales price is again thirty dollars per unit, so sales revenue for the thirty thousand units sold is nine hundred thousand dollars. The computation of cost of goods sold on your screen starts with beginning inventory, adds cost of goods manufactured and subtracts ending inventory. We could also compute cost of goods sold directly by multiplying thirty thousand units sold times the sixteen dollar unit cost. We subtract cost of goods sold from sales to get the four hundred twenty thousand dollar gross margin.
We subtract selling and administrative expenses from gross margin to get absorption cost net operating income of two hundred thirty thousand dollars. The ninety thousand dollar variable selling and administrative expense is computed by multiplying thirty thousand units sold times three dollars per unit. The one hundred thousand dollar fixed administrative expense was given.
Sheet1
Beg. inventory (5,000 × $16)
McGraw-Hill/Irwin
*
Now let’s examine a variable cost income statement for the second year. Again, notice that this is a contribution format statement. First, we subtract all variable expenses from sales to get contribution margin. The first variable expense is variable cost of goods sold, which is computed using only the ten dollar per unit variable manufacturing cost. The next variable expense is the variable selling and administrative expense. It is computed as before, thirty thousand units sold at three dollars per unit.
After computing contribution margin, we subtract fixed expenses to get the two hundred sixty thousand dollar variable cost net operating income. Note that all of the one hundred fifty thousand dollars of fixed manufacturing overhead is expensed as a lump sum.
Sheet1
300,000
McGraw-Hill/Irwin
Reconciliation
Fixed mfg. Overhead $150,000
Units produced 25,000 units
*
The difference between absorption cost net operating income and variable cost net operating income results from the thirty thousand dollars of fixed manufacturing overhead released from beginning inventory using absorption costing. Using variable costing, this thirty thousand dollars was expensed in the first year, never becoming a part of the inventory value.
The thirty thousand dollars can be computed by multiplying the five thousand units from inventory times the six dollar fixed manufacturing overhead cost per unit.
We can reconcile the difference between the two methods by subtracting the thirty thousand dollars from the two hundred sixty thousand dollar variable cost income to get the two hundred thirty thousand dollar absorption cost net operating income.
Sheet1
$ 260,000
(5,000 units × $6 per unit)
30,000
$ 230,000
&A
McGraw-Hill/Irwin
*
For the two-year time period, both methods report the same total income, three hundred fifty thousand dollars, because for the two-year period total sales of fifty thousand units equals total production of fifty thousand units.
Although sales and production may differ in any given year, over an extended period of time sales cannot exceed production, nor can production greatly exceed sales. The shorter the time period, the more the net operating income figures will tend to differ.
Sheet1
McGraw-Hill/Irwin
Summary
*
On your screen is a nice summary of what we have observed from the Harvey Company’s two years:
For year one, Harvey’s production exceeded sales. Fixed manufacturing
overhead was deferred into inventory with absorption costing, so absorption
costing net operating income was greater than variable costing net operating
income.
For year two, Harvey’s production was less than sales. Fixed manufacturing
overhead was released from inventory with absorption costing, so absorption
costing net operating income was less than variable costing net operating
income.
For the two years combined, production equaled sales so absorption
costing net operating income equaled variable costing net operating
income.
Sheet1
McGraw-Hill/Irwin
*
Variable costing and absorption costing are two different approaches for valuing inventories and cost of goods sold. Absorption costing is generally used for external reporting. Variable costing is preferred by some managers for internal decision making and cost-volume-profit analysis.
The shifting of fixed manufacturing overhead between reporting periods using absorption costing can cause net operating income to fluctuate with production decisions, leading to possible confusion and unwise decisions.
Number of units produced annually25,000
Variable costs per unit:
Direct materials, direct labor,
and variable mfg. overhead10$
Fixed mfg. overhead
($150,000 ÷ 25,000 units)6 -
Beginning inventory-$
Gross margin280,000
Variable selling & administrative
320,000$ 80,000$ -$ 400,000$
200,000$ 50,000$ 150,000$ 400,000$
deferred in inventory
Absorption costing net operating income120,000$
Number of units produced25,000
Number of units sold30,000
Units in beginning inventory5,000
Fixed mfg. overhead
($150,000 ÷ 25,000 units)6 -
Beg. inventory (5,000 × $16)80,000$
Add COGM (25,000 × $16)400,000
Goods available for sale480,000
Less ending inventory- 480,000
Variable selling & administrative
Deduct: Fixed manufacturing overhead
costs released from inventory
Absorption costing net operating income230,000$
Costing Method1st Period2nd PeriodTotal