Quality and Sustainability Chapter 8 McGraw-Hill/I rwin Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Learning Objective 1 8-2 8-2 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 8-3 Variable Costing A system of cost accounting that only assigns the variable cost of production to products. Fixed Costs Variable Costs Product 8-4 Absorption and Variable Costing Absorption Costing Variable Costing Direct materials Direct labor Product costs Product costs Variable mfg. overhead Fixed mfg. overhead Period costs Period costs Selling & Admin. exp. 8-5 Absorption and Variable Costing Absorption Costing Variable Costing Direct materials Direct labor Product costs Product costs Variable mfg. overhead Fixed mfg. overhead Period costs Period costs Selling & Admin. exp. The difference between absorption and variable costing is the treatment of fixed manufacturing overhead. 8-6 Learning Objective 2 8-7 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 8-8 Absorption and Variable Costing 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 $ Selling & administrative expenses 3 $ Fixed costs per year: Mfg. overhead 150,000 $ Selling & administrative expenses 100,000 $ 8-9 Absorption and Variable Costing Unit product cost is determined as follows: Absorption Costing Variable Costing Direct materials, direct labor, and variable mfg. overhead 10 $ 10 $ Fixed mfg. overhead ($150,000 25,000 units) 6 - Unit product cost 16 $ 10 $ Selling and administrative expenses are always treated as period expenses and deducted from revenue. 8-10 Absorption Costing Income Statements Mellon Co. had no beginning inventory, produced 25,000 units, and sold 20,000 units this year at $30 each. Absorption Costing Sales (20,000 $30) 600,000 $ Less cost of goods sold: Beginning inventory Add COGM Goods available for sale Ending inventory Gross margin Less selling & admin. exp. Variable Fixed Net income 8-11 Absorption Costing Sales (20,000 $30) 600,000 $ Less cost of goods sold: Beginning inventory - $ Add COGM (25,000 $16) 400,000 Goods available for sale 400,000 $ Ending inventory (5,000 $16) 80,000 320,000 Gross margin 280,000 $ Less selling & admin. exp. 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. 8-12 Absorption Costing Sales (20,000 $30) 600,000 $ Less cost of goods sold: Beginning inventory - $ Add COGM (25,000 $16) 400,000 Goods available for sale 400,000 $ Ending inventory (5,000 $16) 80,000 320,000 Gross margin 280,000 $ Less selling & admin. exp. Variable (20,000 $3) 60,000 $ Fixed 100,000 160,000 Net income 120,000 $ 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 Learning Objective 3 8-14 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 - $ Add COGM Goods available for sale Ending inventory Variable cost of goods sold Variable selling & administrative expenses Contribution margin Less fixed expenses: Manufacturing overhead Selling & administrative expenses Net income 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 - $ Add COGM (25,000 $10) 250,000 Goods available for sale 250,000 $ Ending inventory (5,000 $10) 50,000 Variable cost of goods sold 200,000 $ Variable selling & administrative expenses Contribution margin Less fixed expenses: Manufacturing overhead Selling & administrative expenses Net income We exclude the fixed manufacturing overhead. 8-16 Variable Costing Sales (20,000 $30) 600,000 $ Less variable expenses: Beginning inventory - $ Add COGM (25,000 $10) 250,000 Goods available for sale 250,000 $ Ending inventory (5,000 $10) 50,000 Variable cost of goods sold 200,000 $ Variable selling & administrative expenses (20,000 $3) 60,000 260,000 Contribution margin 340,000 $ Less fixed expenses: Manufacturing overhead 150,000 $ Selling & administrative expenses 100,000 250,000 Net income 90,000 $ Variable Costing Income Statements Now lets look at variable costing by Mellon Co. 8-17 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. 8-18 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 $ 8-19 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. 8-20 Learning Objective 4 8-21 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 $ Add: Fixed mfg. overhead costs deferred in inventory (5,000 units $6 per unit) 30,000 Absorption costing net income 120,000 $ Fixed mfg. overhead $150,000 Units produced 25,000 = $6.00 per unit = 8-22 Learning Objective 5 8-23 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. 8-24 Learning Objective 6 8-25 Extending the Example Lets look at the second year of operations for Mellon Company. 8-26 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 $ Selling & administrative expenses 3 $ Fixed costs per year: Mfg. overhead 150,000 $ Selling & administrative expenses 100,000 $ 8-27 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 $ Fixed mfg. overhead ($150,000 25,000 units) 6 - Unit product cost 16 $ 10 $ There has been no change in Mellons cost structure. 8-28 Mellon Co. Year 2 Now lets look at Mellons income statement assuming absorption costing is used. 8-29 Absorption Costing Sales (30,000 $30) 900,000 $ Less cost of goods sold: Beg. inventory (5,000 x $16) 80,000 $ Add COGM (25,000 $16) 400,000 Goods available for sale 480,000 $ Ending inventory - 480,000 Gross margin 420,000 $ Less selling & admin. exp. 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. 8-30 Absorption Costing Sales (30,000 $30) 900,000 $ Less cost of goods sold: Beg. inventory (5,000 x $16) 80,000 $ Add COGM (25,000 $16) 400,000 Goods available for sale 480,000 $ Ending inventory - 480,000 Gross margin 420,000 $ Less selling & admin. exp. 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. 8-31 Mellon Co. Year 2 Next, well look at Mellons income statement assuming variable costing is used. 8-32 Variable Costing Sales (30,000 $30) 900,000 $ Less variable expenses: Beg. inventory (5,000 $10) 50,000 $ Add COGM (25,000 $10) 250,000 Goods available for sale 300,000 $ Ending inventory - Variable cost of goods sold 300,000 $ Variable selling & administrative expenses (30,000 $3) 90,000 390,000 Contribution margin 510,000 $ Less fixed expenses: Manufacturing overhead 150,000 $ Selling & administrative expenses 100,000 250,000 Net income 260,000 $ Mellon Co. Year 2 Excludes fixed manufacturing overhead. 8-33 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). 8-34 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 8-35 Summary Lets see if we can get an overview of what we have done. 8-36 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. 8-37 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. 8-38 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) Inventory decreased from 5,000 units to zero, and $230,000 absorption income was less than $260,000 variable income. 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) For the two-year period, units produced equals units sold, so total absorption income equals total variable income. 8-40 Advantages Management finds it easy to understand. Consistent with CVP analysis. Emphasizes contribution in short-run pricing decisions. Profit for period not affected by changes in fixed mfg. overhead. Impact of fixed costs on profits emphasized. Evaluation of Variable Costing 8-41 Advantages Consistent with long-run pricing decisions that must cover full cost. External reporting and income tax law require absorption costing. Evaluation of Absorption Costing Fixed manufacturing overhead is treated the same as the other product costs, direct material and direct labor. 8-42 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. 8-43 Learning Objective 7 8-44 Costs of Assuring Quality Grade Quality 8-45 Grade refers to the extent of its capabilities in performing an intended purpose, in relation to other products with the same functional use. Quality of design refers to how well it is conceived or designed for its intended use. Quality of conformance refers to the extent to which a product meets the specification of its design. There are four types of quality costs.
Prevention costs are the costs of preventing defects.
Appraisal costs are the costs of determining whether defects exist.
Internal failure costs are the costs of repairing defects found prior to product delivery.
External failure costs are those costs incurred after product delivery.
8-46 Learning Objective 8 8-47 8-47 What is the Optimal Level of Product Quality?
The optimal level of product quality is reached when:
8-48 ISO 9000 Standards ISO 9000 standards require that a company have a well-defined quality control system in place and that the target level of product quality is consistently maintained. These standards have been adopted in the US and other countries.
8-49 Learning Objective 9 8-50 Costs of Environmental Sustainability Sustainable development includes business activity that produces the goods and services needed in the present without limiting the ability of future generations to meet their meets. Environmental costs are the costs of dealing with environmental issues, such as BPs costs in cleaning up the companys spill in the Gulf of Mexico. Environmental cost management is the strategic implantation of systems for identifying, measuring, controlling, and reducing the private environmental costs borne by a company or other organization.
8-51 Environmental costs may be categorized in several ways:
Private environmental costs are those borne by a company or individual. Social environmental costs are those borne by the public at large. Visible environmental costs are those that are known and clearly identified as tied to environmental issues. Hidden social environmental costs cannot be clearly tied to environmental issues.
8-52 Visible and hidden environmental costs may be further classified into one of three types.
Monitoring costs include the costs of monitoring the regulatory environmental as well as monitoring the production process to determine if pollution is being generated. Abatement costs include costs to reduce or eliminate pollution. Remediation costs include on-site and off-site remediation costs. On-site remediation includes costs of reducing or preventing the discharge into the environment of pollutants that have been generated in the production process. Off- site remediation includes the costs of reducing or eliminating pollutants from the environment after they have been discharged.