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Chapter Overview
A. Overview of Variable and Absorption Costing. At least two methods can be used
in manufacturing companies to value units of product for accounting purposesabsorption
costing and variable costing. These methods differ only in how they treat fixed manufacturing
overhead costs.
1.
Variable Costing. Variable costing includes only variable production costs in product
costs. Direct materials, direct labor and variable manufacturing overhead costs would
ordinarily be included in product costs under variable costing. Fixed manufacturing
overhead is not treated as a product cost under this method. Rather, fixed manufacturing
overhead is treated as a period cost and is charged against income each period.
2.
Absorption Costing. Absorption costing treats all production costs as product costs,
regardless of whether they are variable or fixed. Under absorption costing, a portion of
fixed manufacturing overhead is allocated to each unit of product.
B. Comparison of Absorption and Variable Costing. (Exercises 7-3, 7-5, 7-6, 7-8,
and 7-9.) When comparing absorption costing and variable costing income statements, a
number of points should be noted:
1.
139
2.
Differences in inventories under the two methods. The ending inventory figures under
the variable costing and absorption costing methods are different. Under variable
costing, only the variable manufacturing costs are included in inventory. Under
absorption costing, both variable and fixed manufacturing costs are included in
inventory.
3.
Suitability for CVP analysis. An absorption costing income statement is not well suited
for providing data for CVP computations since it makes no distinction between fixed and
variable costs. In contrast, the variable costing method classifies costs by behavior and is
very useful in setting-up CVP computations.
C. Extended Comparison of Income Data. (Exercises 7-2 and 7-6.) Exhibit 7-3 in the
text presents a comparison of absorption costing and variable costing income statements over
three years in which production is constant but sales vary. Exhibit 7-6 in the text also presents
comparative income statements over three years but holds annual sales constant and varies
annual production. From these Exhibits, several generalizations can be drawn. (All of these
generalizations assume the LIFO inventory flow assumption is being used. The
generalizations may not hold in some rare cases if a company uses an inventory flow
assumption other than LIFO.)
1.
Production equals sales (no change in inventories). When production equals sales,
inventories do not change. If inventories do not change, then there is no change in the
fixed manufacturing overhead costs in inventories under absorption costing. Therefore,
under both costing methods all of the current fixed manufacturing overhead will flow
through to the income statement as an expense. In the case of absorption costing it will
be part of cost of goods sold. In the case of variable costing, it will be a period expense.
2.
3.
4.
Long-term differences in income. Over an extended period of time, the cumulative net
operating income figures reported under absorption costing and variable costing will be
about the same; they will differ only by the amount of fixed manufacturing overhead
cost in ending inventories under absorption costing. Cumulative net operating income
figures will be identical whenever ending inventories are reduced to zero.
5.
Changes in production volume. Variable costing net operating income is not affected
by changes in production volume. On the other hand, absorption costing net operating
140
income is affected by changes in production volume. For any given level of sales, net
operating income under absorption costing will increase as the level of output increases
and hence inventories increase.
D. The Matching Principle. Accountants and managers have been arguing for decades
concerning the relative merits of absorption and variable costing. In practice, absorption
costing is used far more than variable costing even for internal reports. The reasons for this
are not entirely clear, although the perception that absorption costing is required for external
reporting undoubtedly plays a key role. The argument for using absorption costing in external
reports seems to be based on the matching principle.
1.
Argument for absorption costing. Advocates of absorption costing argue that all
manufacturing costs must be assigned to units of product so as to properly match costs
with revenues. They argue that fixed manufacturing overhead costs are essential to the
production process and must be included when costing units of product, regardless of
how the cost behaves.
2.
Argument for variable costing. Advocates of variable costing argue that fixed
manufacturing overhead costs are incurred in order to have the capacity to produce.
Moreover, they will be incurred regardless of whether anything is actually produced.
Since these costs are not caused by any particular unit of product and are incurred to
provide capacity for a particular period, the matching principle would dictate that fixed
manufacturing overhead costs must be expensed in the current period.
E. Advantages of the Contribution Approach. (Exercises 7-4 and 7-7.) There are a
number of advantages to using variable costing (and the contribution approach) in internal
reports and analysis.
1.
More useful for CVP analysis. Variable costing statements provide data that are
immediately useful for CVP analysis since they categorize costs on the basis of their
behavior. In contrast, it is often difficult to rework absorption costing data so that they
can be used in CVP analysis and in decisions.
2.
3.
4.
Fixed costs are more visible. The impact of fixed costs on profits is emphasized
because the total amount of such costs for the period appears separately and is
highlighted in the income statement rather than being buried in cost of goods sold and
ending inventory.
141
5.
6.
Control is facilitated. Variable costing ties in with cost control methods such as flexible
budgets.
7.
However, variable costing is not generally accepted by auditors for external financial reports
and is not permitted by the IRS in the United States and by tax authorities in many other
countries for income tax calculations. There is some question about whether variable costing
is actually prohibited in the United States by official pronouncements and some companies do
use some form of variable costing in their external reports, but absorption costing must be
considered the most generally accepted practice.
F.
Impact of JIT Inventory Methods. When companies use JIT methods for
controlling their operations, the distortions of income that can occur under absorption costing
largely (or completely) disappear.
1.
The cause of distortions in net operating income. Erratic movements in net operating
income under absorption costing and the differences in net operating income between
absorption and variable costing can be traced to changing levels of inventory. When
inventory levels are constant or negligible, absorption costing and variable costing
methods yield the essentially same net operating income.
2.
The JIT solution. Under an ideally functioning JIT system, goods are produced strictly
to customers orders. Finished goods inventories almost disappear and work in process
inventories are kept to a minimum. With little or no inventories, fixed manufacturing
overhead costs cannot be shifted between periods under absorption costing. As a result,
both variable and absorption costing will show essentially the same net operating
income figure, and the net operating income under absorption costing will move in the
same direction as movements in sales.
142
Assignment Materials
Assignment
Exercise 7-1
Exercise 7-2
Exercise 7-3
Exercise 7-4
Exercise 7-5
Exercise 7-6
Exercise 7-7
Exercise 7-8
Exercise 7-9
Problem 7-10
Problem 7-11
Problem 7-12
Problem 7-13
Problem 7-14
Problem 7-15
Problem 7-16
Problem 7-17
Case 7-18
Case 7-19
Case 7-20
Level of
Topic
Difficulty
Variable and absorption unit product costs........................................
Basic
Variable costing income statement; explanation of
difference in net operating income................................................
Basic
Reconciliation of absorption and variable costing net
operating incomes.........................................................................
Basic
Evaluating absorption and variable costing as alternative
costing methods............................................................................
Medium
Variable and absorption costing unit product costs and
income statements.........................................................................
Basic
Variable costing income statement; reconciliation.............................
Basic
Inferring costing method; unit product costs.....................................
Basic
Variable costing unit product cost and income statement;
break-even....................................................................................
Basic
Absorption costing unit product cost and income statement..............
Basic
Variable and absorption costing unit product costs and
income statements; explanation of difference in net
operating income..........................................................................
Basic
Variable costing income statement; reconciliation.............................
Basic
Absorption and variable costing; production constant, sales
fluctuate........................................................................................
Medium
Comprehensive problem with labor fixed..........................................
Medium
Preparation and reconciliation of variable costing statements...........
Medium
Variable costing statements; sales constant, production
varies; JIT impact.........................................................................
Difficult
Incentives created by absorption costing; ethics and the
manager........................................................................................
Difficult
Prepare and interpret statements; changes in both sales and
production; JIT impact..................................................................
Difficult
Absorption and variable costing; uneven production; breakeven analysis; JIT impact..............................................................
Difficult
Ethics and the manager; absorption costing income
statements.....................................................................................
Difficult
The case of the plummeting profits...................................................
Difficult
Suggested
Time
15 min.
30 min.
20 min.
30 min.
30 min.
20 min.
20 min.
30 min.
20 min.
45 min.
30 min.
60 min.
45 min.
45 min.
45 min.
30 min.
75 min.
90 min.
120 min.
90 min.
Essential Problems: Problem 7-10 or Problem 7-13, Problem 7-11, Problem 7-14
Supplementary Problems: Problem 7-12, Problem 7-15, Problem 7-16, Problem 7-17, Case 7-18,
Case 7-19, Case 7-20
Linked problems and exercises:
Exercise 7-9 should be assigned after Exercise 7-8
Exercise 7-2 should be assigned after Exercise 7-1
143
144
Chapter 7
Lecture Notes
Helpful Hint: Before beginning the lecture, show
students the fifth segment from the first tape of the
McGraw-Hill/Irwin Managerial/Cost Accounting video
library. This segment introduces students to many of
the concepts discussed in chapter 7. The lecture notes
reinforce the concepts introduced in the video.
I.
145
i.
146
ii.
147
In Business Insights
To piggyback on the Helpful Hint above, there are
many companies that treat direct labor as a fixed cost.
For example:
Direct Labor A Fixed Cost in China (page 280)
148
149
iii.
iv.
150
151
i. Income
comparison of
absorption and
variable costing
3. The Harvey Company example continued:
v.
Additional assumptions:
1. 20,000 units were sold during the year.
2. The selling price per unit is $30.
3. There is no beginning inventory.
vi.
Absorption costing
1. The unit product cost is $16.
2. The fixed manufacturing overhead cost
deferred in inventory is $30,000 (5,000
units $6 per unit).
3. The net operating income is $120,000.
10
152
11
10
11
154
12
13
15
II.
14
12
iii.
13
iv.
Absorption costing
1. The unit product cost is $16.
2. The fixed manufacturing overhead cost
released from inventory is $30,000.
3. The net operating income is $230,000.
14
v.
15
Additional assumptions/facts:
Variable costing
1. The unit product cost is $10.
2. All $150,000 of fixed manufacturing
overhead cost is expensed in the current
period.
3. The net operating income is $260,000.
156
16
17
157
18
vi.
16
17
18
158
159
In Business Insights
The relationship between production and sales can
have a significant impact on the net operating income
of companies that use absorption costing. For example:
Chainsaw Al Dunlaps Legacy at Sunbeam (page
287)
Al Dunlap was hired to turn around Sunbeam
Corp. with his well-known cost-cutting and
disregard for the welfare of existing employees.
Three years later, Dunlap left a legacy of
questionable accounting practices and excess
inventories.
Dunlaps successors complain that eliminating
those excess inventories has required the
company to keep production levels well under
capacity.
Since Sunbeam uses absorption costing,
liquidating these excess inventories has depressed
the companys profits.
The Perverse Effects of Absorption Costing at
Nissan (page 289)
Nissan North America liked to run its factories at
capacity, regardless of how well cars were
selling, because under absorption costing it
would help the factories generate a profit.
As a consequence, Nissan dealers had to slash
prices and offer big rebates to sell their cars.
According to Fortune magazine, Years of
discounting and distress sales seriously undercut
the value of the Nissan brand. While Toyota
stood for quality, customers came to Nissan to
get a better deal.
160
19
20
161
i. Effect
of
changes
in
production on
net operating
income
2. The Harvey Co. example revisited
x.
19
20
21
22
24
163
23
22
23
xv.
24
25
26
28
165
27
166
26
27
28
28
29
167
30
28
III.
iii.
55
29
169
30
31
170
30
In Business Insights
Absorption costing is also prevalent around the world.
For example:
31
171
32
33
172
32
ix.
33
173
33
34
174
35
33
34
175
35
176
35
177
Chapter 7
Transparency Masters
178
2.
3.
4.
5.
6.
7.
8.
9.
179
TM 7-1
KEY ELEMENTS
ABSORPTION COSTING
Absorption costing was used in earlier chapters and is generally
considered to be required for external financial reports and is
clearly required for tax reporting.
Under absorption costing, product costs include all
manufacturing costs:
Direct materials.
Direct labor.
Variable manufacturing overhead.
Fixed manufacturing overhead.
Under absorption costing, the following costs are treated as
period expenses and are excluded from product costs:
Variable selling and administrative costs.
Fixed selling and administrative costs.
VARIABLE COSTING
Variable costing is an alternative for internal management
reports.
Under variable costing, product costs include only the variable
manufacturing costs:
Direct materials.
Direct labor (unless fixed).
Variable manufacturing overhead.
Under variable costing, the following costs are treated as period
expenses and are excluded from product costs:
Fixed manufacturing overhead.
Variable selling and administrative costs.
Fixed selling and administrative costs.
TM 7-2
CLASSIFICATION OF COSTS UNDER
VARIABLE AND ABSORPTION COSTING
TM 7-3
UNIT PRODUCT COST COMPARISON
Unit product costs differ between variable and absorption
costing.
EXAMPLE: Harvey Company produces a single product.
Number of units produced annually...................
Variable costs per unit:
Direct materials, direct labor, and variable
manufacturing overhead...............................
Selling and administrative expense.................
Fixed costs per year:
Fixed manufacturing overhead........................
Fixed selling & administrative expense............
25,000
$10
$3
$150,00
0
$100,00
0
Absorpti
on
Costing
Variable
Costing
$10
$10
6
$16
0
$10
TM 7-4
INCOME STATEMENT COMPARISON
Harvey Company had no beginning inventory, produced 25,000
units, and sold 20,000 units last year.
Absorption Costing
Sales (20,000 units $30 per unit)........
Less cost of goods sold:
Beginning inventory.............................
Add COGM (25,000 units $16 per
unit)
Goods available for sale........................
Less ending inventory
(5,000 units $16 per unit)...............
Gross margin...........................................
Less selling and administrative expense
(20,000 units $3 per unit +
$100,000).............................................
Net operating income.............................
Variable Costing
Sales (20,000 units $30 per unit)........
Less variable expenses:
Variable cost of goods sold:
Beginning inventory..........................
Add variable manufacturing costs
(25,000 units $10 per unit)..........
Goods available for sale.....................
Less ending inventory
(5,000 $10 per unit)....................
Variable cost of goods sold...................
Variable selling and administrative
expense
(20,000 units $3 per unit)...............
Contribution margin................................
Less fixed expenses:
Fixed manufacturing overhead.............
Fixed selling and administrative
expense.............................................
Net operating income.............................
$600,000
$
400,000
400,000
80,000
320,000
280,000
160,000
$120,000
$600,000
250,000
250,000
50,000
200,000
60,000
260,000
340,000
150,000
100,000
250,000
$ 90,000
TM 7-5
INCOME STATEMENT COMPARISON (contd)
Cost of
Goods
Sold
Absorption costing
Variable manufacturing costs
(20,000 units $10 per
unit)
(5,000 units $10 per unit)
Fixed manufacturing
overhead
(20,000 units $6 per unit)
(5,000 units $6 per unit). .
Total ......................................
Variable costing
Variable manufacturing costs
(20,000 units $10 per
unit)
(5,000 units $10 per unit)
Total.......................................
Ending
Inventor
y
$200,00
0
$50,000
120,000
30,000
$320,00
0
$80,000
$200,00
0
$50,000
$200,00
0
$50,000
$ 90,00
0
30,00
0
$120,00
0
TM 7-6
EXTENDED EXAMPLEFLUCTUATING SALES
EXAMPLE: Holland Company produces a single product.
Number of units produced annually..........
Variable costs per unit:
Direct materials, direct labor, and
variable manufacturing overhead........
Selling and administrative expense........
Fixed costs per year:
5,000
$5
$1
$15,00
Fixed manufacturing overhead...............
0
Fixed selling and administrative
$21,00
expense...............................................
0
Unit product costs are computed as follows:
Absorptio
n
Costing
Direct materials, direct labor, and
variable manufacturing overhead....
Fixed manufacturing overhead
($15,000 5,000 units)..................
Total unit product cost........................
Variabl
e
Costin
g
$5
$5
3
$8
$5
Income statements using both costing methods over a threeyear period are provided on the following transparency. (Note the
computation of the variable cost of goods sold on the variable
costing income statements. The method used is simpler than the
method used in the previous example.)
TM 7-7
FLUCTUATING SALES (contd)
Year 1
Units in beginning inventory............
Units produced.................................
Units sold.........................................
Units in ending inventory.................
Absorption costing
Sales (@ $15 per unit).....................
Less cost of goods sold:
Beginning inventory (@ $8 per
unit)
Add COGM (@ $8 per unit).............
Goods available for sale.................
Less ending inventory (@ $8 per
unit)
Cost of goods sold............................
Gross margin....................................
Less selling and administrative
expense.........................................
Net operating income......................
Variable costing
Sales (@ $15 per unit).....................
Less variable expenses:
Variable COGS (@ $5 per unit).......
Variable selling and administrative
expenses (@ $1 per unit)............
Total variable expenses....................
Contribution margin.........................
Less fixed expenses:
Fixed manufacturing overhead......
Fixed selling and administrative
expense......................................
Total fixed expenses.........................
Net operating income......................
Year 2
0
5,000
0
5,000
Year 3
1,000
5,000
5,000
0
4,000
1,000
6,000
0
$75,000
$60,000
$90,000
0
40,000
40,000
0
40,000
40,000
8,000
40,000
48,000
0
40,000
35,000
8,000
32,000
28,000
0
48,000
42,000
26,000
$ 9,000
25,000
$ 3,000
27,000
$15,000
$75,000
$60,000
$90,000
25,000
20,000
30,000
5,000
30,000
45,000
4,000
24,000
36,000
6,000
36,000
54,000
15,000
15,000
15,000
21,000
36,000
$ 9,000
21,000
36,000
$
0
21,000
36,000
$18,000
TM 7-8
FLUCTUATING SALES (contd)
RECONCILING NET OPERATING INCOME:
Year 1
Variable costing net operating income..... $9,000
Add: Fixed manufacturing overhead cost
deferred in inventory under absorption
costing (1,000 units $3 per unit)........
Deduct: Fixed manufacturing overhead
cost released from inventory under
absorption costing (1,000 units $3
per unit).................................................
Absorption costing net operating income. $9,000
Year 2
Year 3
$
0 $18,000
3,000
(3,000)
$3,000 $15,000
TM 7-9
COMPARATIVE INCOME EFFECTS
VARIABLE AND ABSORPTION COSTING
Relation Between
Production and Sales
Production = Sales
(No change in
inventory)
Production > Sales
(Inventory increases)
Production < Sales
(Inventory decreases)
Relation Between
Variable and Absorption
Costing Net Operating
Incomes
Absorption costing NI =
Variable costing NI
Absorption costing NI >
Variable costing NI *
Absorption costing NI <
Variable costing NI #
TM 7-10
EXTENDED EXAMPLEFLUCTUATING PRODUCTION
EXAMPLE: Suppose all of the facts are the same as in the previous
example of Holland Company except that production and sales
are as follows:
Units
Units
Units
Units
Year 1
Year 2
Year 3
$5.00
$5.00
$5.00
3.00
2.50
$8.00
$7.50
3.75
$8.75
$5.00
$5.00
$5.00
$5.00
$5.00
$5.00
TM 7-11
FLUCTUATING PRODUCTION (contd)
Year 1
Year 2
Year 3
$75,00
0
$75,00
0
0
45,00
0
45,000
7,50
0
37,50
0
37,500
26,00
0
$11,50
0
7,500
Absorption costing
$75,00
Sales (@ $15 per unit)........................
0
Less cost of goods sold:
Beginning inventory.........................
0
40,00
Add COGM.......................................
0
Goods available for sale................... 40,000
Less ending inventory......................
0
40,00
Cost of goods sold..............................
0
Gross margin...................................... 35,000
Less selling and administrative
26,00
expense...........................................
0
$ 9,00
Net operating income.........................
0
35,000
42,500
0
42,500
32,500
26,000
$6,500
Variable costing
$75,00
Sales (@ $15 per unit)........................
0
Less variable expenses:
Variable COGS (@ $5 per unit)......... 25,000
Variable selling and administrative
5,00
expense (@ $1 per unit)................
0
30,00
Total variable expenses......................
0
45,00
Contribution margin...........................
0
Less fixed expenses:
Fixed manufacturing overhead......... 15,000
Fixed selling and administrative
21,00
expense.........................................
0
36,00
Total fixed expenses...........................
0
$ 9,00
Net operating income.........................
0
$75,00
0
$75,00
0
25,000
5,00
0
30,00
0
45,00
0
25,000
15,000
21,00
0
36,00
0
$ 9,00
0
15,000
5,000
30,000
45,000
21,000
36,000
$ 9,000
TM 7-12
FLUCTUATING PRODUCTION (contd)
RECONCILING NET OPERATING INCOME:
Year 1 Year 2
$9,00
0 $9,000
Year 3
$9,000
2,500
(2,500)
$9,00 $11,50
0
0 $6,500
TM 7-13
JIT AND ABSORPTION COSTING
Differences in net operating income between absorption and
variable costing occur when production doesnt equal sales.
Under true JIT, production isnt started until a customer order is
received. As a result, inventories are reduced drastically and
changes in inventories are small.
As a consequence, the difference between absorption and
variable costing net operating incomes is reduced under JIT.
Under JIT, it is also less likely that absorption costing income will
move in the opposite direction from sales due to changes in
inventories.
TM 7-14
ADVANTAGES OF VARIABLE COSTING
+ Variable costing is easy to use with CVP analysis.
+ With variable costing, changes in levels of inventories do not
affect net operating income.
+ Absorption costing unit product costs may be misinterpreted by
managers as variable costs.
+ In variable costing, fixed costs are highlighted rather than
buried in cost of goods sold and inventories.
+ Variable costing is usually easier to understand than absorption
costing.
+ Variable costing is easier to use in controlling costs as will be
discussed in later chapters.
+ Variable costing net operating income is closer to net cash flow
than absorption costing net operating income. This is
particularly important in companies experiencing difficulties
with cash flows.
- But, variable costing is usually not considered acceptable for
external financial reports. If absorption costing must be used for
mandatory external reports is it worth the trouble to maintain a
different costing system for internal reports?