Chapter 5: Absorpion/Vaiable Costing Bere Chapter 5 Absorption Costing and Variable Costing Learning goals ‘© Describe the major differences between absorption and variable costing. © Recast absorption income statement into variable costing statements. # Reconcile the differences between absorption costing net income and variable costing net income. © Construct income statements having standard costs and variances. 86(Chapter 5: Absorption/Voviasle Costing ABSORPTION COSTING VS. VARIABLE COSTING Absorption Costing cost accumulation and reporting method that treats the costs of all manufacturing components (direct material, direct labor, variable overhead, and fixed overhead) as inventonable or product costs itis the traditional approach to product costing used for external financial statements and tax returns ‘Absorption costing is also known as full costing since all types of manufacturing costs are included as product cost. ‘2. Absorption costing presents expenses on an income statement according to their functional classifications. A functional classification is @ group of costs that were all incurred for the same principle purpose. Examples include cost of goods sold, selling ‘expenses, and administrative expenses. 0. Total variable product costs increase with each additional product made or each additional service rendered and aro therefore considered to be product costs and are inventoried until the product or service is sold ©. Fixed overhead does not vary with units of production or level of service; it provides the manufacturing capacity necessary for production to occur. Production could not take place without the incurrence of fixed overhead, so fixed overhead is considered to be a product cost under absorption costing . Absorption costing is perceived to furnish external parties with a more informative picture of earnings, as compared to variable costing Product Costs: Direct Materials Direct Labor Variable Manufacturing Overhead Fixed Manufacturing Overhead Period Costs: Variable Selling and Administrative Expense Fixed Selling and Administrative Expense 87(Chapter 5; Absorption Veviable Costing Variable Costing ‘= a.cost accumulation and reporting method that includes only variable production costs (direct material, direct labor, and variable overhead) as inventoriable or product costs; + treats fixed overhead as a period cost, + itis also known as direct costing; "itis not acceptable for extemal reporting and tax returns, ‘2. Variable costing treats fixed overhead as a period cost while absorption costing treats fixed overhead as a product cost. b. Avvariable costing income statement presents expenses according to cost behavior (variable and fixed), although it may present expenses by functional classification within the behavioral categories ©. Gost of goods sold is more appropriately called variable cost of goods sold since itis composed of only the variable production costs related to the units sold. Product Costs: Direct Materials Direct Labor Variable Manufacturing Overhead Fixed Manufacturing Overhead Variable Selling and Administrative Expense Fixed Selling and Administrative Expense Product contribution margin ‘+ the difference between selling price and variable cost of goods sold and indicates how much revenue is available to cover all period costs and to potentially provide net income. Product contribution margin is commonly called manufacturing margin. Total contribution margin + the difference between revenue and all variable costs regardless of the area of incurrence (production or nonproduction) = The accounting profession has unofficially disallowed the use of variable costing as a generally accepted inventory valuation method for external reporting purposes,Chopler 5: Absorplion/Veriable Costing To illustrate the two approaches, consider the following problem: ‘Assume that a certain company produced 10,000 units and sold 9,000 units of a product . The company is selling the product at P25/unit. Unit costs are P4 for direct material, PS for direct labor, and P8 for variable factory overhead. In addition, the company incurred fixed factory overhead of P10,000, variable selling expense of P2,000 and fixed selling expense of P3,000, ‘The company had no beginning inventory. Under absorption costing, income statement will be presented this way: Sales (P25 x 9,000) 225,000 Beginning inventory 0 Cost of goods manufactured (P19 x 10,000) 180,000, Cost of goods available for sale ¥180,000 Ending inventory (P19 x 1000) 49.000 171.0 Gross Margin P 54,000 Fixed seling expense 3,000 Variable selling expense 2,000 5.00 Net Income 49,000 Income statement for variable costing will be presented this way: Sales (P25 x 9,000) 225,000 Beginning inventory ° Variable cost of manufacturing (P18 x 10,000) 180,000 180,000 Ending Inventory (P18 x 1000) 48,000 Variable cost of goods sold (182,000) Manufacturing contribution margin * 63,000 Variable seling expense 2000) Contribution margin 1,000 Fixed factory overhead (10,000) Fixed selling 3.000) Net Income 48,000 Under absorption costing, the product cost is P19 per unit, consisting ofthe variable cost ‘components direct material + direct labor + variable factory overhead (P4 + P6 + P8 = P18) and 1 of allocated fied factory overhead (P10,000/10,000 unis). Variable costing, on the other hand, will have a product cost of P18 (direct material + direct labor + variable factory overhead). To reconcile the difference in net income between the two approaches: Absorption costing income 49,000 Production 40,000 Sales 9,000 Ending inventory 7,000 x Fixed factory overhead (P10,000/10,000) 1 1,000) Variable costing income 48,000 ‘Since Production > Sales, we know that income under absorption costing approach will be ‘greater than the income under variable costing, The fixed factory overhead portion of the ending 89Chapter §: Absorption Variable Casting inventory is, therefore, deducted from the absorption costing income to arrive at the variable costing income. Had there been beginning inventory, the fixed factory overhead portion of that beginning inventory will be added to the income under absorption costing to reconcile it with variable costing income. ‘Absorption costing Income + Fixed factory overhead of beginning inventory - Fixed factory overhead of ending inventory Variable costing income HBR x ‘Comparison of the Two Approaches The primary difference between variable and absorption costing is that under variable costing the fixed manufacturing ovethead is charged as an expense in the current period. The result is that absorption costing will show a higher net income number than variable costing whenever units produced exceed units sold, The reason: the cost ofthe ending inventory is higher under aosorption costing than under variable costing 1. Absorption costing income will equal variable costing income if production is equal to sales. 2. Absorption costing income will be greater than variable costing income if production is greater than sales. 'b. Some fixed overhead cost is deferred as part of inventory cost on the balance sheet under absorption costing. ©. The total amount of fixed overhead cost is expensed as a period cost under variable costing, 2. Absorption costing income will be less than variable costing income if production is less than sales. a. Absorption costing expenses all of the current period xed overhead cost as well as releasing some fixed overhead cost from beginning inventory where it had been eferred from a prior period b. Variable costing shows on the income statement only current period fixed overhead, so that the additional fixed overhead released from beginning inventory makes absorption costing income lower. The process of deferring and releasing fixed overhead costs into and from inventory ‘makes it possible to manipulate income under absorption costing by adjusting levels. of production relative to sales. This leads some to believe that variable costing might bbe more useful for external reporting purposes than absorption costing d._ For intemal reporting purposes, variable costing provides managers information ‘about the behavior of the various product and period costs. 90Chapter 5: Absorption /Veviable Costing Summary of Relationships 1. Production Sales Ending Inventory Beginning Inventory Absorption Income Variable/Direct Costing Income 2. Produetion Sales ending Inventory Beginning Inventory Absorption Income Variable/Direct Costing Income 3. Production Sales Ending Inventory Beginning Inventory Absorption Income Variable/Direct Costing Income Limitations and Problems of Absorption Costing ‘One of the problems with absorption costing is that management may be tempted to ‘overproduce in a given period in order to increase net income, Therefore, to avoid this ‘overproduction, variable costing is often used internally to evaluate management decision- making Limitations and Problems of Variable Costing ‘The use of variable costing is consistent with cost-volume-profit and incremental analysis. b._ Net income computed under variable costing is unaffected by changes In production levels. ©. Net income computed under variable costing is closely tied to changes in sales levels giving a more realistic assessment of a company's success or failure. . The presentation of fixed and variable cost components on the face of the variable costing income statement makes it easier to identify these costs and understand their effect on the business o1 ee