Full (Absorption) Costing vs.

Variable (Direct) Costing

Overview

Full (Absorption) Costing Variable (Direct) Costing Differences Between Full (Absorption) Costing and Variable (Direct) Costing

Product (Inventoriable) Costing Accounting for Fixed Overhead Operating Income

Reconciliation Between Full (Absorption) Costing and Variable (Direct) Costing

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Full (Absorption) Costing

Under GAAP, product (inventoriable) cost = DM + DL + OH = DM + DL + var OH + fixed OH

Relevance of Fixed Costs

Class Example Relevance of Fixed Costs?

production capacity = 10,000 units selling price = $20 per unit variable mfg costs (relevant range = 5,000 to 10,000 units): direct materials = $4 per unit direct labour = $3 per unit variable manufacturing overhead = $1 per unit fixed manufacturing overhead = $50,000 variable selling and administrative costs = $2 per unit fixed selling and administrative costs = $15,000

Class Example Relevance of Fixed Costs?

Current Production = 8,000 units Current Sales = 8,000 units Decision Problem: Assuming that there are no additional selling and administrative costs, should a special order for 1,500 units at a price of $12 be accepted?
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Class Example Relevance of Fixed Costs?

Relevance of Fixed Costs

Incremental revenue ($1,500 units x $12) $18,000

Class Example Relevance of Fixed Costs?

Relevance of Fixed Costs

Incremental revenue ($1,500 units x $12) Incremental costs ($1,500 units x ($4+$3+$1)) $18,000

12,000

Class Example Relevance of Fixed Costs?

Relevance of Fixed Costs

Incremental revenue ($1,500 units x $12) Incremental costs ($1,500 units x ($4+$3+$1)) Net Contribution Decision: Accept special order. $18,000

12,000
$6,000

Variable (Direct) Costing

product cost = variable manufacturing costs = DM + DL + variable OH because: fixed OH is irrelevant in decision making fixed OH is related to production capacity but not production activity
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Differences Between Absorption and Direct Costing

Definition of product cost Accounting for fixed overhead Operating income

traditional approach vs. contribution approach differences in operating income

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Class Example Absorption vs Direct Costing

Definition of Product Cost; Class Example Accounting for Fixed Overhead; Class Example Operating Income ; Reconciliation of Absorption and Direct Costing Income

production capacity = 10,000 units selling price = $20 per unit variable mfg costs (relevant range = 5,000 to 10,000 units): direct materials = $4 per unit direct labour = $3 per unit variable manufacturing overhead = $1 per unit fixed manufacturing overhead = $50,000 variable selling and administrative costs = $2 per unit fixed selling and administrative costs = $15,000

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Class Example Absorption vs Direct Costing

Current production = 8,000 units Current sales = 7,600 units
Product cost?? Accounting for fixed OH?? Operating income??
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Definition of Product Cost

Absorption Costing (GAAP) product cost = DM + DL + var OH + fixed OH

Direct Costing product cost = DM + DL + var OH

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Class Example Absorption vs Direct Costing

Definition of Product Cost

Absorption Costing Product cost Direct Costing

Manufacturing CGS
Inventory

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Class Example Absorption vs Direct Costing

Definition of Product Cost

Absorption Costing Product cost =$4+$3+$1+ $50,000/8,000 = $14.25 per unit Direct Costing

Manufacturing CGS
Inventory

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Class Example Absorption vs Direct Costing

Definition of Product Cost

Absorption Costing Product cost Direct Costing =$4+$3+$1+ = $4+$3+$1 $50,000/8,000 = $14.25 per unit = $8 per unit

Manufacturing CGS
Inventory

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Class Example Absorption vs Direct Costing

Definition of Product Cost

Absorption Costing Product cost Direct Costing =$4+$3+$1+ = $4+$3+$1 $50,000/8,000 = $14.25 per unit = $8 per unit

Manufacturing CGS
Inventory

= $14.25 x 7,600 = $108,300

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Class Example Absorption vs Direct Costing

Definition of Product Cost

Absorption Costing Product cost Direct Costing =$4+$3+$1+ = $4+$3+$1 $50,000/8,000 = $14.25 per unit = $8 per unit

Manufacturing CGS
Inventory

= $14.25 x 7,600 = $108,300

=$8 x 7,600 = $60,800

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Class Example Absorption vs Direct Costing

Definition of Product Cost

Absorption Costing Product cost Direct Costing =$4+$3+$1+ = $4+$3+$1 $50,000/8,000 = $14.25 per unit = $8 per unit

Manufacturing CGS
Inventory

= = = =

$14.25 x 7,600 $108,300 $14.25 x 400 $5,700

=$8 x 7,600 = $60,800

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Class Example Absorption vs Direct Costing

Definition of Product Cost

Absorption Costing Product cost Direct Costing =$4+$3+$1+ = $4+$3+$1 $50,000/8,000 = $14.25 per unit = $8 per unit

Manufacturing CGS
Inventory

= = = =

$14.25 x 7,600 $108,300 $14.25 x 400 $5,700

=$8 x 7,600 = $60,800 = $8 x 400 = $3,200

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Accounting for Fixed OH

Absorption Costing fixed OH product costs inventory in B/S, if unsold cost of goods sold in I/S, if sold expensed in I/S in period incurred
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Direct Costing
fixed OH period costs

Class Example Absorption vs Direct Costing

Class Example Accounting for Fixed Overhead

Absorption Costing Fixed OH deducted as CGS Direct Costing Fixed OH deducted as expense

Fixed OH in inventory

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Class Example Absorption vs Direct Costing

Class Example Accounting for Fixed Overhead

Absorption Costing Fixed OH deducted as CGS = $50,000/8,000 x 7,600 = $47,500 Fixed OH in inventory Direct Costing Fixed OH deducted as expense

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Class Example Absorption vs Direct Costing

Class Example Accounting for Fixed Overhead

Absorption Costing Fixed OH deducted as CGS = $50,000/8,000 x 7,600 = $47,500 Fixed OH in inventory = $50,000/8,000 x 400 = $2,500 Direct Costing Fixed OH deducted as expense

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Class Example Absorption vs Direct Costing

Class Example Accounting for Fixed Overhead

Absorption Costing Fixed OH deducted as CGS = $50,000/8,000 x 7,600 = $47,500 Fixed OH in inventory = $50,000/8,000 x 400 = $2,500 Direct Costing Fixed OH deducted as expense = $50,000

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Operating Income

Absorption Costing

Traditional Approach Costs/Expenses classified on the basis of Cost Function (manufacturing vs. non-manufacturing) Contribution Approach Costs/Expenses classified on the basis of Cost Behaviour (variable vs. fixed)
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Direct Costing

Absorption Costing Income

Traditional Approach
Sales Cost of goods sold (manufacturing) Gross profits Selling, general & administrative (SG&A) expenses Operating income

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Direct Costing Income

Contribution Approach Sales Variable costs Variable cost of goods sold (manufacturing) Variable SG&A expenses (nonmanufacturing) Contribution margin Fixed costs

Fixed manufacturing costs (manufacturing) Fixed SG&A expenses (nonmanufacturing) Operating income

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Contribution margin = sales variable costs Contribution margin ratio = contribution margin / sales Variable cost ratio = variable cost / sales

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Income Statement
Absorption Costing (Traditional Approach) Sales CGS Gross profits SG&A expenses Operating income
Direct Costing (Contribution Approach) Sales Variable costs Contribution margin

Fixed costs Operating income

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Class Example Absorption vs Direct Costing

Class Example -Operating Income

Absorption Costing Direct Costing

Sales CGS Gross profits SG&A expenses Variable SG&A Fixed SG&A SG&A expenses Operating income

Sales Variable costs Variable mfg CGS Variable SG&A Total variable costs Contribution margin Fixed costs Fixed mfg costs Fixed SG&A Total fixed costs Operating income

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Class Example Absorption vs Direct Costing

Class Example -Operating Income

Absorption Costing Direct Costing

Sales CGS Gross profits SG&A expenses Variable SG&A Fixed SG&A SG&A expenses Operating income

$152,000 108,300 $43,700

$15,200 15,000 $30,200 $13,500

Sales Variable costs Variable mfg CGS Variable SG&A Total variable costs Contribution margin Fixed costs Fixed mfg costs Fixed SG&A Total fixed costs Operating income

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Class Example Absorption vs Direct Costing; Reconciliation of Absorption and Direct Costing Income

Class Example -Operating Income

Absorption Costing Direct Costing

Sales CGS Gross profits SG&A expenses Variable SG&A Fixed SG&A SG&A expenses Operating income

$152,000 108,300 $43,700

$15,200 15,000 $30,200 $13,500

Sales Variable costs Variable mfg CGS Variable SG&A Total variable costs Contribution margin Fixed costs Fixed mfg costs Fixed SG&A Total fixed costs Operating income

$152,000
$60,800 15,200 $76,000 $76,000 $50,000 15,000 $65,000
33 $11,000

Differences in Absorption & Direct Costing Income

1. If production > sales, fixed OH deferred in ending inventory under absorption costing, fixed OH deducted as cost of goods sold under absorption costing < fixed OH expensed under direct costing absorption costing income (ACI) > direct costing income (DCI)

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Differences in Absorption & Direct Costing Income

2. If production < sales, fixed OH in beginning inventory deducted as cost of goods sold under absorption costing, fixed OH deducted as cost of goods sold under absorption costing > fixed OH expensed under direct costing
absorption costing income (ACI) < direct costing income (DCI)

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Differences in Absorption & Direct Costing Income

3. If production = sales,
absorption costing income (ACI) = direct costing income (DCI) Assumptions: FIFO for inventory costing. No difference in fixed OH per unit between last and current periods.
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Timing Difference
The difference between absorption and direct costing income is temporary as it will reverse from period to period depending on the relationship between production and sales units.

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Reconciliation of Absorption and Direct Costing Income

Absorption Costing Fixed OH
Beg. Inv. X charged to I/S as cost of goods sold charged to I/S as cost of goods sold deferred in end. inv. in B/S

Direct Costing Fixed OH

Y Current Production

Current Production
Z

expensed in I/S

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Absorption Costing Income (ACI) = Income before fixed OH X - Y Direct Costing Income (DCI)

= Income before fixed OH Y - Z

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Income before fixed OH = ACI + X + Y = DCI + Y + Z ACI + X = DCI + Z ACI = DCI + Z - X DCI = ACI + X - Z
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(Absorption Costing) (Direct Costing)

Reconciliation of Absorption and Direct Costing Income

Absorption Costing Income = Fixed OH Direct Fixed OH in Costing + in ending beginning Income inventory inventory

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Reconciliation of Absorption and Direct Costing Income

Direct Costing Income Absorption = Costing Income
Class Example: Direct costing income = 13,500 - $2,500 0 = $11,000

Class Example -Operating Income

Fixed OH Fixed OH in in ending + beginning inventory inventory

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