Absorption Costing vs. Variable Costing

1 Absorption Costing Costingg1 AbsorptionVariableSSCGSVCGPCMS&AFCNIABSN IVC2 Overview of Absorptionand Variable CostinggVariableCostingAbsorptionCosting DMDLP roductPdtDMDLDLVMOHC ostsProductCostsDLVMOHVS&APeriodCtPeriod VS&AFMOHFS&ACostsPeriodCostsFS&A3 Unit cost ComputationsHarvey Company produces a single productwith the following information available:g4 Unit cost ComputationsUnitproduct cost is determined as follows:pUnderabsorption Costing , S&A expenses arepg,palways treated asperiod expenses anddeducted from revenue as Comparison ofAbsorption and Variable CostingAbsorption and Variable CostingLet s assume the following additional information for Harvey Companyinformation for Harvey Company.

2 20,000 units were sold during the year at a price of $30 each$30 each. There were no units in beginning , let s compute net operating income usingNow, let s compute net operating income usingboth Absorption and Variable Costing7 Variable CostingVariableftiVariable CostingSales (20,000 $30)600,000$Less Variable expenses:manufacturingcosts Variable expenses: Beginning inventory-$ Add COGM (25,000 $10)250,000 Goods available for sale250 000 All fixedmanufacturingGoods available for sale250,000 Less ending inventory (5,000 $10)50,000 Variable cost of goods sold200,000 Vibl lli &diittigoverhead selling& administrative expenses (20,000 $3)60,000 260,000 Contribution margin340,000 Less fixed expenses: Manufacturing overhead150,000$ Selling & administrative expenses100,000 250,000 Net operating income90,000$ 8 Comparing the Two Methods9 Comparing the Two MethodsWil th diffb tWe can reconcilethedifferencebetweenabsorption and Variable income as follows.

3 Variable Costing net operating income90,000$ Add: FMOH deferred in inventory (5,000 units $6 per unit) 30,000 Absorption Costing net operating income120 000$Ab so r p ti o n co sti n g n e t o p e r a ti n g i n co m e120,000$FMOH$150,000 == $6 00 per unitUnits produced 25,000 units==$ per unit10 Extended Comparisons of Income Data Harvey Company Year Two11 Unit cost ComputationsSince there was no change in the Variable costsper unit, total fixed costs, or the number ofitdd thittihdunits produced,the unit costs remain CostingAbsorption CostingAbsorption CostingSales (30,000 $30)900,000$Less cost of goods sold:g Beg.

4 Inventory (5,000 $16)80,000$ Add COGM (25,000 $16)400,000 Goods available for sale480 000 Goods available for sale480,000 Less ending inventory- 480,000 Gross margin420,000 Less selling & admin. exp. Variable (30,000 $3)90,000$ Fixed100,000190,000 Fixed100,000190,000 Net operating income230,000$These are the 25,000 unitsThese are the 25,000 unitsproduced in the current CostingVariablemanufacturingcosts fixedmanufacturingmanufacturingoverhead the Two MethodsWil th diffb tWe can reconcilethedifferencebetweenabsorption and Variable income as follows: Variable Costing net operating income260,000$ De duct.

5 FMOH costs relea se d from inventory (5,000 units $6 per unit) 30,000 Absorption Costing net operating income230,000$ FMOH$150,000 == $6 00 per unitUnits produced 25,000 units==$ per unit15 Comparing the Two Methods16 Summary of Key Insights17 CVP Analysis, Decision Makingand Absorption costingpgAbsorption Costing does not support CVPA bsorption Costing does not support CVPanalysis because it essentially treats fixed manufacturing overhead as a Variable cost bygyassigning a per unit amount of the fixed overhead to each unit of fixed manufacturing overhead as avariable cost can: Variable cost can: Lead to faulty pricing decisions and keep-or-dropdecisions.

6 Produce positive net operating income evenwhen the number of units sold is less than thebreakeven Reporting and Income TaxesTftTo conformtoGAAP requirements, Absorption Costing must be used forabsorption Costing must be used forexternal financial reports in theUnited the TaxR fA t f 1986 ReformAct of 1986, Absorption Costing must beused when filing incomeused when filing incometax top executivesare usually evaluated based onexternal reports to shareholdersexternal reports to shareholders,they may feel that decisionsshould be based onabsorption cost ou d be based oabsorption cost of Variable Costingand the Contribution ApproachppConsistent withManagement findsitf lConsistent withCVP operating incomeil tit more closertonet cash with standardcosts and flexible to estimate profitabilityProfit is not affected byImpact of fixedcosts on profitsof products and is not affected bychanges in versus Absorption CostingFi df t iFixed manufacturingcosts must be assignedto products to properlyFixed manufacturingcosts are capacity coststo products to properlymatch revenues are capacity costsand will be

7 Incurredeven if nothing iseven if nothing