Introductory Management Accounting Variable Costing Vs Absorption Costing

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Introductory Management Accounting Variable
Costing Vs Absorption Costing

• Topic 7- Ch. 7 (Appendix) L/S

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Learning Objectives

• Prepare a profit and loss statement using either
  variable or absorption costing
• Reconcile the differences between variable and
  absorption costing
• Describe how changes in sales and/or production
  levels affect net income under absorption and
  variable costing

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Review

• Costing systems
• Measuring costs
• Manufacturing overheads

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Costing Systems

• Major sources of variation in conventional
  costing systems stem from
• The way costs are measured
• The focus of the costing system
• The method used to allocate manufacturing
  overhead to products
• The cost included in product (or service) costs
• Different costs for different purposes

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Measuring costs

• Actual costing
• Actual costs assigned to products
• Normal costing
• Actual direct material labour and predetermined
  overhead
• Standard costing
• Budgeted direct materials direct labour cost
  and predetermined overhead rate

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Costing Systems

• Job costing
• Costs are assigned to individual jobs
• Process costing
• Costs are traced to processes/departments and
  averaged across units produced
• Hybrid costing
• Combinations of two or more costing systems

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Allocating Manufacturing Overheads

• The number of overhead rates
• Plant wide manufacturing overhead rate
• Departmental overhead rates
• The measure of cost driver volume
• Budget volume
• Normal volume
• Theoretical capacity
• Practical capacity

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Selecting which costs to include

• External reporting purposes
• Product costs must include a share of fixed
  manufacturing overhead costs, and no
  non-manufacturing costs
• Management decision-making purposes
• A product cost may exclude fixed manufacturing
  overhead (variable costing) /or
• Include non-manufacturing costs

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Variable Costing and Absorption Costing

• Variable Costing- only variable manufacturing
  costs assigned to products
• Direct materials, direct labour and variable
  manufacturing overhead
• Absorption costing- all manufacturing costs are
  assigned to products
• Direct materials, direct labour, variable and
  fixed manufacturing overhead

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Calculating profit under variable costing

• Contribution (margin) statement- highlights the
  variable and fixed costs of the business
• Total contribution margin (CM) Total sales
  revenue less total variable costs
• Variable cost of goods sold- total direct
  materials, direct labour and variable overhead
  assigned to units sold.

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Calculating profit under absorption costing

• Profit statement separates manufacturing from
  non-manufacturing costs
• Use of gross margin
• Consistent with external reporting requirements

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Absorption costing illustrated

• Manufacturing costs become either COGS or
  Inventory

DM
DL
Fixed O/Heads
Variable O/Heads
WIP
Inventory
B/Sheet
PL
COGS
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Variable costing illustrated

• Only variable manufacturing costs assigned to
  products

DM
DL
Fixed O/Heads
Variable O/Heads
WIP
Inventory
B/Sheet
PL
COGS
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Absorption and Variable Costing

• Berry Co. produces a single product with the
  following information available

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Absorption and Variable Costing

• Unit product cost is determined as follows

Selling and administrative expenses are always
treated as period expenses (not product costs).
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Absorption Costing Income Statements

• Berry Co. had no beginning inventory, produced
  25,000 units and sold 20,000 units this year.

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Variable Costing Income Statements

• Variable costing by Berry Co.

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What has happened?

• Why has absorption costing a profit of 120,000
  which is 30,000 higher than the 90,000 reported
  under variable costing?

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Was it magic?

• The basic information was the identical for both
  methods of calculating profit

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No! Nothing magical!

• The 30,000 had been released as a period cost
  under variable costing (income statement).
• The 30,000 was hiding in the absorption
  costing valuation of ending inventory (balance
  sheet)

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Comparing Absorption andVariable Costing-
Comparison

• Lets compare the methods.

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Reconciling Income Under Absorption Variable
Costing

• We can reconcile the difference between
  absorption and variable net income as follows

Fixed mfg. overhead 150,000 Units
produced 25,000
6.00 per unit

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Extending the Example
Lets look at the second year of operations for
Berry Company.
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Berry Co. Year 2

• In its second year of operations, Berry Co.
  started with an inventory of 5,000 units,
  produced 25,000 units and sold 30,000 units.

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Berry Co. Year 2

• Unit product cost is determined as follows

There has been no change in Berrys cost
structure.
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Berry Co. Year 2
Now lets look at Berrys income
statement assuming absorption costing is used.
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Berry Co. Year 2
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Berry Co. Year 2
Next, well look at Berrys income
statement assuming variable costing is used.
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Berry Co. Year 2
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What has happened? Why has absorption
costing a profit of 230,000 which is 30,000
lower than the 260,000 reported under variable
costing?
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Summary
In the first period, production (25,000
units) was greater than sales (20,000).
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Summary
In the second period, production (25,000
units) was less than sales (30,000).
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Summary
For the two-year period, total absorption income
and total variable income are the same.
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Comparison of Absorption Variable Costing
This was the case in the first period when
production of 25,000 units was greater than
sales of 20,000 units.
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Comparison of Absorption Variable Costing
Inventory increased from zero to 5,000 units and
absorption income (120,000) was greater than
variable income (90,000).
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Comparison of Absorption Variable Costing
In the second period sales of 30,000 units were
greater than production of 25,000units.
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Comparison of Absorption Variable Costing
Inventory decreased from 5,000units to zero, and
absorption income 230,000 was less than variable
income 260,000.
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Comparison of Absorption Variable Costing
For the two-year period, units produced equals
units sold, so total absorption income equals
total variable income.
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Reconciling profit under variable and absorption
costing

• When inventory increases or decreases during the
  period
• Difference in fixed overhead expensed under
  absorption and variable costing equals the change
  in inventory multiplied by the predetermined
  overhead rate per unit
• Over the long term, differences in profits
  between the two methods will diminish

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Variable or absorption costing?

• Valuing inventory
• Only absorption costing is allowed for external
  reporting purposes
• Providing relevant cost information
• Variable costing- useful for short-term decisions
• Absorption costing- useful for long-term decisions

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Variable costing

• Profit information from variable costing
• Classification of fixed and variable costs
  simplifies predictions of the effects of changes
  in sales on profit
• Link between sales performance and profit
  performance is easily understandable
• Highlights the impact of fixed costs on profits
  by isolating them

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Absorption costing

• Profit information from absorption costing
• No direct relationship between sales and profit
  so
• Provides a poor basis for planning and control
• May encourage managers to increase inventories to
  drive profits up
• Meets the requirements for external reporting

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Evaluation of Variable Costing
Consistent with CVP analysis.
Management finds it easy to understand.
Emphasises contribution in short-run pricing
decisions.
Advantages
Profit for period not affected by changes in
fixed mfg. overhead.
Impact of fixed costs on profits emphasised.
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Evaluation of Absorption Costing
Fixed manufacturing overhead istreated the same
as the other productcosts, direct material and
direct labour.
Consistent with long-runpricing decisions that
mustcover full cost.
Advantages
External reportingand income tax lawrequire
absorption costing.
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Absorption and variable costing compared

• Absorption
  
  Variable
  
  Costing Costing

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Lecture example

• See the Worksheet
• Quality Packaging P/L produces a range of
  packaging products. The companys Drum plant
  produces and sell a high-quality stainless steel
  drum for packaging. The Drum plant uses normal
  absorption costing and sells its drums at cost
  plus 25 mark-up.

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Lecture example

• Additional information
• FG inventory- start 10,000 units
• FG inventory end 15,000 units
• Sales revenue 5,062,500
• Sales units 135,000 units
• Applied fixed M/OH 700,000
• Selling Admin. Costs
• Fixed 200,000
• Variable 270,000

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Lecture example

• Reconstruct the profit statement using
• Absorption costing
• Variable costing
• Reconcile the difference between the two profits
• (Based on Problem 7.40 L/S text 2nd ed.)