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					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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