Managerial Accounting Somnath Das INVENTORY VALUATION METHODS: ABSORPTION vs. VARIABLE COSTING The distinction between absorption and variable costing is based on the treatment of fixed overhead. Under absorption costing, fixed overhead is assigned to units of inventory and shows up in the income statement as part of the CGS when the units are sold. When units are produced and not sold, fixed overhead stays in finished goods inventory Absorption costing includes fixed manufacturing overhead in inventoriable costs Under variable costing, no fixed overhead is assigned to inventory. Fixed overhead is a period expense which enters the income statement as a line-item every period regardless of the number of units sold. Variable costing excludes fixed manufacturing overhead from inventoriable costs. NOTE: 1. Exhibit 9-1, page 301, presents variable costing and absorption costing income statements for Radius Company for 19_7. Go through the construction of these income statements. 2. Comparison of Standard Variable and Standard Absorption Costing (Refer to Stassen Company illustration (Exhibit 9-2, page 303) in the text). Format (Technical) Differences Absorption costing makes a primary classification of costs according to manufacturing and non-manufacturing functions, emphasizing the gross margin (that is, Sales - CGS) available to cover all fixed and variable selling and administrative expenses. Direct costing makes a primary classification of costs into variable and fixed categories, emphasizing the contribution margin (that is, sales - variable costs) available to cover all fixed costs. Report Formats The formats for profit reporting under direct costing and absorption costing are different. Absorption Costing Direct Costing Revenues Revenues - - Cost of Goods Sold Variable Manufacturing ------------------ - Gross Margin Variable S&A - ------------------- Variable S&A Contribution Margin - - Fixed S&A Fixed Manufacturing ----------------- - Profit Fixed S&A ======= ------------------- Profit ======== The figures under the two approaches will not always be the same. Interpretation of the Difference The difference between the two income-measurement approaches is essentially the difference in the timing of the charge to expense for fixed factory-overhead cost. In the absorption-costing method, fixed factory overhead is first charged to inventory; thus, it is not charged to expense until the period in which the inventory is sold and included in cost of goods sold (an expense). In contrast, in the variable-costing method, fixed factory overhead is charged to expense immediately, and only variable manufacturing costs are included in product inventories. Therefore, if inventories increase during a period (i.e., production exceeds sales), the variable-costing method will generally report less operating income than will the absorption-costing method; when inventories decrease, the opposite effect will take place. Example 1 Assume the following (per unit) Direct Materials 2.5 lbs @ $4.00 $10.00 Direct Labor .5 hr @ $16.00 $ 8.00 VOH .5 hr @ $4.00 $ 2.00 FOH $40,000 $ 2.50 Actual Output 16,000 units Variable S&A $6.00 per unit Fixed S&A $60,000 Selling price $40 What do the income statements look like if actual sales equal 16,000 units? Absorption Costing Direct Costing Revenue (40)(16000) 640,000 Revenue (40)(16000) 640,000 Cogs (22.50)(16000) 360,000 Vbl Mfg (20)(16000) 320,000 GM (17.50)(16000) 280,000 Vbl S+A (6)(16000) 96,000 Vbl S+A (6)(16000) 96,000 CM 224,000 Fx S+A 60,000 Fx Mfg 40,000 Profit 124,000 Fx S+A 60,000 Profit 124,000 - Note: When sales equals production, profit under absorption costing and direct costing are equal. Example 2 Assume sales of 12,000 units. What is the profit under each costing method? Absorption Costing Direct Costing Revenue (40)(12000) 480,000 Revenue (40)(12000) 480,000 Cogs (22.50)(12000) 270,000 Vbl Mfg (20)(12000) 240,000 GM (17.50)(12000) 210,000 Vbl S+A (6)(12000) 72,000 Vbl S+A (6)(12000) 72,000 CM (14)(12000) 168,000 Fx S+A 60,000 Fx Mfg 40,000 Profit 78,000 Fx S+A 60,000 Profit 68,000 - Note: When production exceeds sales, absorption profit exceeds direct profit. Example 3 Assume sales of 18,000 units. What is the profit under each costing method? Absorption Costing Direct Costing Revenue (40)(18000) 720,000 Revenue (40)(18000) 720,000 Cogs (22.50)(18000) 405,000 Vbl Mfg (20)(18000) 360,000 GM (17.50)(18000) 315,000 Vbl S+A (6)(18000) 108,000 Vbl S+A (6)(18000) 108,000 CM (14)(18000) 252,000 Fx S+A 60,000 Fx Mfg 40,000 Profit 147,000 Fx S+A 60,000 Profit 152,000 - Note: When sales exceed production, direct profit exceeds absorption profit. Comparison of Income Statements Absorption unit cost is higher. Output-level (production-volume) variance exists only under absorption costing. Absorption costing uses business functions to classify (manufacturing, marketing, administration). Variable costing uses cost behavior to classify. Explaining Differences in Operating Income: Analysis of Profit Difference 1. General formula (Formula 1, page 304 in text). Absorption Profit - Direct Profit = (FOH per unit) * (units produced units sold) = (FOH per unit) * (change in inventories) Example 2 78,000 - 68,000 = 2.50(16,000 - 12,000) = 10,000 Example 3 147,000 - 152,000 = 2.50(16,000 - 18,000) = -5,000 2. If all variances are written off as period expenses, no change in work-in-process inventory, and no change in the budgeted fixed manufacturing overhead rate (Formula 3, page 305 in text :IGNORE for Now- Remember to Integrate after we have done Variance Analysis). Effects of sales and production on reported income (See Exhibit 9-4, page 307.) Production > Sales var. costing income lower than absorption income Production < Sales var. costing income higher than absorption income Under absorption costing, changes in operating income are tied to both sales and production Under variable costing, changes in reported operating income are tied only to sales Breakeven Points and Variable Costing and Absorption Costing A. Income manipulation is possible under absorption costing via altering production and changingthe denominator level used in establishing the budgeted overhead rate. The formula to compute breakeven under absorption costing can be found on page 307. Operating income is a function of both sales and production; thus, solve for BEP by fixing sales and solving for production, or fixing production and solving for sales B. With variable costing, breakeven is a function of sales alone. There is only one break-even point. Divide fixed costs by the unit contribution margin to determine the break-even number of units. Throughput Costing A. Throughput costing treats all costs except those related to variable direct materials as period costs. Only direct materials costs are inventoriable. B. Exhibit 9-5 presents a throughput costing income statement using the Stassen Company example. Capsule Comparison of Inventory-Costing Methods A. Exhibit 9-6, page 310, presents twelve different methods of costing inventory by looking at different combinations of variable, absorption, and throughput costing and actual, normal, extended-normal, and standard costing. B. Currently variable and throughput costing cannot be used for external reporting or tax purposes. Performance Measures and Absorption Costing Question: Why do many managers prefer direct costing statements for internal purposes? A. Undesirable buildups of inventories 1. Increased year-end production reduced output level (production volume) variance [deferred fixed cost] increased operating income 2. Proposals for revising performance evaluation: a. Use variable costing. b. Change time period used to evaluate performance. c. Use non-financial performance measures as well as financial ones. Alternative Denominator-Level Concepts -- in determining the fixed manufacturing overhead rate. A. Theoretical and practical capacity -- based on the capacity of the plant to supply product. 1. Theoretical capacity is based on producing a maximum efficiency for 100% of the time. 2. Practical capacity reduces theoretical capacity for unavoidable operating interruptions. B. Normal utilization and master-budget utilization -- based on the demand for product. 1. Normal utilization is based on the average demand over a 2 or 3-year period. 2. Master-budget utilization for the coming budget period is based on the expected current utilization. Effect on Financial Statements (Refer to Exhibit 9-7, page 316) A. IRS requires use of the master-budget utilization level for tax purposes.
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