Variable costing & absorption costing

Variable costing & absorption costing

1. Topics to be covered Variable Costing Absorption Costing

2. Comparison Between Variable Costing & Absorption Costing

3. Variable Costing Absorption Costing This would usually include direct materials, direct labor, and the variable portion of manufacturing overhead. Fixed manufacturing overhead is not treated as a product cost under this method . Absorption costing treats all manufacturing costs as product costs, regardless of whether they are variable or fixed.

4. Variable Costing—An Example A company that produces light recreational aircraft. Data concerning the company’s operations appear below: Per Aircraft Per Month Selling price. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $100,000 Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $19,000 Direct labor. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . …. $5,000 Variable manufacturing overhead . . . . . . . . . . . . . . . . $1,000 Fixed manufacturing overhead . . . . . . . . . . . . . . . . . . $70,000 Variable selling and administrative expenses. . . . . . . $10,000 Fixed selling and administrative expenses. . . . . . . . . $20,000 January February March Beginning inventory . . . . . . . . . . . . . . . . . . . . . . . 0 0 1 Units produced . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 2 4 Units sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 1 5 Ending inventory . . . . . . . . . . . . . . . . . . . . . . . . . . 0 1 0

5. Variable Costing Unit Product Cost Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $19,000 Direct labor. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 Variable manufacturing overhead . . . . . . . . . . . . . . . . . . . . . . 1,000 Variable costing unit product cost . . . . . . . . . . . . . . . . . . . . . . $25,000 Variable Costing Cost of Goods Sold January February March Variable production cost (a). . . . . . . . . $25,000 $25,000 $25,000 Units sold (b) . . . . . . . . . . . . . . . . . . . . . 1 1 5 Variable cost of goods sold (a) × (b). . . $25,000 $25,000 $125,000 Selling and Administrative Expenses January February March Variable selling and administrative expense (@ $10,000 per unit sold). . . . . . . . . . . . . . . $10,000 $10,000 $50,000 Fixed selling and administrative expense . . . . 20,000 20,000 20,000 Total selling and administrative expense . . . . . $30,000 $30,000 $70,000

6. Variable Costing Contribution Format Income Statements January February March Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $100,000 $100,000 $500,000 Variable expenses: Variable cost of goods sold. . . . . . . . . . . . 25,000 25,000 125,000 Variable selling and administrative expense . . . . . . . . . . . . . . . . . . . . . . . . 10,000 10,000 50,000 Total variable expenses . . . . . . . . . . . . . . . 35,000 35,000 175,000 Contribution margin . . . . . . . . . . . . . . . . . 65,000 65,000 325,000 Fixed expenses: Fixed manufacturing overhead . . . . .. 70,000 70,000 70,000 Fixed selling and administrative expense . . . 20,000 20,000 20,000 Total fi xed expenses . . . . . . . . . . . . . . . . . 90,000 90,000 90,000 Net operating income (loss). . . . . . . . . . $ (25,000) $ (25,000) $235,000

7. Income Statement of Absorption Costing Absorption costing uses a gross margin income statement, which starts with revenues and subtracts cost of goods sold to derive gross margin, then subtracts non-manufacturing costs to derive operating income. Gross margin income statements separate manufacturing costs from non-manufacturing costs.

8. Review Problem : Dexter Corporation produces and sells a single product, a wooden hand loom for weaving small items such as scarves. Selected cost and operating data relating to the product for two years are given below: Selling price per unit . . . . . . . . . . . . . . . . . . . . . . $50 Manufacturing costs: Variable per unit produced: Direct materials . . . . . . . . . . . . . . . . . . . . . . $11 Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . $6 Variable manufacturing overhead . . . . . . . . . $3 Fixed manufacturing overhead per year . . . . . . $120,000 Selling and administrative expenses: Variable per unit sold . . . . . . . . . . . . . . . . . . . . $4 Fixed per year . . . . . . . . . . . . . . . . . . . . . . . . . $70,000 Year 1 Year 2 Units in beginning inventory . . . . . . . . . . . 0 2,000 Units produced during the year . . . . . . . . 10,000 6,000 Units sold during the year . . . . . . . . . . . . 8,000 8,000 Units in ending inventory . . . . . . . . . . . . . 2,000 0

9. Required 1. Assume the company uses absorption costing. a. Compute the unit product cost in each year. b. Prepare an income statement for each year . Solution 1. a. Under absorption costing, all manufacturing costs, variable and fixed, are included in unit product costs: Year 1 Year 2 Direct materials . . . . . . . . . . . . . . . . . . . . . . . $11 $11 Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . 6 6 Variable manufacturing overhead . . . . . . . . . . 3 3 Fixed manufacturing overhead ($120,000 4 10,000 units) . . . . . . . . . . . . . 12 ($120,000 4 6,000 units) . . . . . . . . . . . . . . 20 Absorption costing unit product cost . . . . . . . $ 32 $ 40

10. b. The absorption costing income statements follow : Sales (8,000 units 3 $50 per unit) . . . . . . . . . . . . . . . . . . . . . $400,000 $400,000 Cost of goods sold (8,000 units 3 $32 per unit); (2,000 units 3 $32 per unit) 1 (6,000 units 3 $40 per unit) . . . . . . . . . . . . . . . . . . . . . . . . 256,000 304,000 Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144,000 96,000 Selling and administrative expenses (8,000 units 3 $4 per unit 1 $70,000) . . . . . . . . . . . . . . . . 102,000 102,000 Net operating income (loss) . . . . . . . . . . . . . . . . . . . . . . . . . $ 42,000 $ (6,000) Year 1 Year 2

11. Reconciling The Differences In Net Operating Income Under Variable Costing And Absorption Costing Income reported under variable costing and absorption costing are different. It is only the different value of inventory under the two costing income statements that changes the amount of the net income. As the size of inventory increases or decreases during the year, the reported income differs under variable and absorption costing.

12. This results from the fixed overheads that are included in the inventory valuation under absorption costing but are expended immediately under variable costing. Under absorption costing this period's factory overheads are postponed to the next year whereas under variable costing it is expended during the same year.

13. Comparative Income Effects- Absorption Costing &Variable Costing Relation between Production and Sales for the Period Effects on Inventories Relation between the Absorption & Variable Costing net income Units Produced = Units Sold No change in inventories Absorption costing net operating income = Variable costing net operating income Units Produced > Units Sold Inventories Increase Absorption costing net operating income > Variable costing net operating income Units Produced < Units Sold Inventories decrease Absorption costing net operating income < Variable costing net operating income

14. Net income will tend to be higher under AC since fixed manufacturing overhead cost will be deferred inventory costing. Net income will be tend to be lower under AC since fixed manufacturing overhead cost will be released in inventory under absorption costing.

15. Example Company prepares variable costing income statement for the use of internal management and absorption costing income statement for the use of external parties like creditors, banks, tax authorities etc. The company manufactures a product that is sold for $80. The variable and fixed cost data is given below: Direct materials: $30.00 Direct labor:$19.00 Factory over head: Variable cost: $6.00 Fixed cost ($45,000/9000 units): $5.00

16. Marketing, general and administrative: Variable cost (per unit sold): $4.00 Fixed cost (per month): $28,000 During the month of June, 9,000 units were produced and 7,500 units were sold. The opening inventory was 2,000 units. Required: Reconcile the variable costing and absorption costing net operating incomes.

17. Solution: Computation of units in ending inventory

18. Income Statement Absorption Costing

19. Variable Costing

20. Reconciliation of net operating income:

21. TOPICS Uses & Limitations of Absorption Costing Uses & Limitations of Variable Costing

22. Uses of Absorption Costing & Variable Costing Absorption Costing: External financial reports Variable Costing: Internal financial reports

23. Example

24. Absorption Costing Advantages : 1. Increase profit 2. F uller picture of a product’s  cost 3. Accounting tools 4. GAAP Compliant 5. Accounts for all p roduction c osts 6. S maller companies Disadvantages 1. Mislead when analyzing profitability. 2. N ot as useful for internal decision-making purposes   3. Doesn't Help Improve Operational Efficiency 4. Not Useful for Comparison of Product Lines 5. Need of computation of unit fixed cost 6. Profit is not easily calculated

25. Variable Costing Advantages : 1. S urplus income 2. Clearer picture of the actual incremental cost 3. Determine contribution margin ratios 4. Break-even points 5. Prevents inflating profit 6. Easy to understand and use 7. No need of computation of unit fixed cost 8. Profit is calculated easily Disadvantages : 1. Show less profit 2. External reporting purpose . 3. Not accepted by GAPP