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Product Costing Systems: Concepts and Design Issues


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Learning Objective 1

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The Meaning of Cost


The use of valuable resources, in order to achieve a stated purpose. In accounting, cost is reported in monetary terms.

Product Costs Related to the purchase or manufacture of goods for resale. Assigned to inventory and cost of goods sold.
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Period Costs Related to selling and administrative operations. Recognized as expenses in the same time period.

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Learning Objective 3

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Comparing Service, Retail and Manufacturing Companies


Service firms . . . Provide a service that is
consumed when produced.

Retailers . . . Buy finished goods. Sell finished goods.


MegaLoMart

Have no inventories.

Manufacturers . . . Buy raw materials. Produce and sell finished goods.


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Manufacturing Companies
The 3 major categories of manufacturing costs:
Manufacturing Overhead
Indirect material Indirect labor Other overhead

Direct Materials Raw materials, components, and other parts that can be traced to a specific product.
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Direct Labor Payments and benefits for those employees who convert direct materials into finished product.

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Manufacturing Companies
Prime Costs include:

Direct Materials

Direct Labor

Manufacturing Overhead

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Manufacturing Companies
Conversion Costs include:

Direct Materials

Direct Labor

Manufacturing Overhead

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Stages of Production and the Flow of Costs


Add: = Raw Materials Beg. Inventory Purchases Raw Materials Available for Production Raw Materials Transferred to Production Ending Inventory
Add: Work-In-Process Beg. WIP Inventory Raw Materials Transferred In Direct Labor Manufacturing Overhead Total Manufacturing Costs Incurred Cost of Goods Completed and Transferred to Finished Goods Ending WIP Inventory
Add: Finished Goods Beg. Inventory Cost of Goods Completed and Transferred from WIP Goods Available for Sale Cost of Goods Sold Ending Inventory

Less:

= Less: =

= Less:

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Stages of Production and the Flow of Costs - Example


Raw Materials Beg. Inventory Purchases Raw Materials Available for Production Raw Materials Transferred to Production Ending Inventory

Add: =

Axel Electronics makes toasters. On February 1, Axel has $15,000 of raw material on hand. Axels purchase and transfers to the production floor are indicated below.
Date Feb 3 Feb 10 Feb 15 Feb 20 Feb 22 Feb 27 Cost of Purchases $ 8,000 12,000 14,000 9,000 16,000
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Less:

What is Ending Inventory in February?


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Cost of Transfers $ 5,000 11,000 7,000 6,000

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Stages of Production and the Flow of Costs - Example


Raw Materials $15,000 43,000 $58,000 45,000 $13,000

Add: = Less: =

Axel Electronics makes toasters. On February 1, Axel has $15,000 of raw material on hand. Axels purchase and transfers to the production floor are indicated below.
Date Feb 3 Feb 10 Feb 15 Feb 20 Feb 22 Feb 27 Cost of Purchases $ 8,000 12,000 14,000 9,000 16,000
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Now lets look at Work-in-Process.


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Cost of Transfers $ 5,000 11,000 7,000 6,000

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Stages of Production and the Flow of Costs - Example


Raw Materials $15,000 43,000 $58,000 45,000 $13,000
Work-In-Process Beg. WIP Inventory Raw Materials Transferred In Direct Labor Manufacturing Overhead Total Manufacturing Costs Incurred Cost of Goods Completed and Transferred to Finished Goods Ending WIP Inventory

Add: = Less: =

Add:

What is the amount of cost transferred to Finished Goods in February?


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Less:

On February 1, Axel had WIP of $30,000 on the factory floor. During February, Axel paid $92,000 in direct labor wages. Overhead is applied at 150% of direct labor. On 2/28, $22,000 is still in WIP.

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Stages of Production and the Flow of Costs - Example 150 % of $92,000


Add: = Less: = Raw Materials $15,000 43,000 $58,000 45,000 $13,000

Add:

= Less: =

Work-In-Process $30,000 45,000 92,000 138,000 $305,000 283,000 $22,000

Now lets look at Finished Goods.


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Transferred to Finished Goods

On February 1, Axel had WIP of $30,000 on the factory floor. During February, Axel paid $92,000 in direct labor wages. Overhead is applied at 150% of direct labor. On 2/28, $22,000 is still in WIP.

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Stages of Production and the Flow of Costs - Example


Raw Materials $15,000 43,000 $58,000 45,000 $13,000

Add: = Less: =

Add:

= Less: =

Work-In-Process $30,000 45,000 92,000 138,000 $305,000 283,000 $22,000

Add:

= Less: =

Finished Goods Beg. Inventory Cost of Goods Completed and Transferred from WIP Goods Available for Sale Cost of Goods Sold Ending Inventory

On February 1, Axel had Finished Goods of $125,000 on hand. At the end of February, a physical inventory count revealed $96,000 in Finished Goods still on hand. What was Cost of Goods Sold for February?
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Stages of Production and the Flow of Costs - Example Cost of goods sold
Add: = Less: = Raw Materials $15,000 43,000 $58,000 45,000 $13,000

Add:

= Less: =

Work-In-Process $30,000 45,000 92,000 138,000 $305,000 283,000 $22,000

Add: = Less: =

Finished Goods $125,000 283,000 $408,000 312,000 $96,000

On February 1, Axel had Finished Goods of $125,000 on hand. At the end of February, a physical inventory count revealed $96,000 in Finished Goods still on hand. What was Cost of Goods Sold for February?
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Learning Objective 2

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Schedule of Cost of Goods Manufactured

Lets look at a Schedule of Cost of Goods Manufactured for CollegePak Company.

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Schedule of Cost of Goods Manufactured


CollegePak Company Schedule of Cost of Goods Manufactured Raw material used Direct labor Total manufacturing overhead Total manufacturing costs Add: Work-in-process inventory, January 1 Subtotal Deduct: Work-in-process inventory, December 31 Cost of goods manufactured
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850,000 700,000 1,850,000

$ 3,400,000 350,000 $ 3,750,000 400,000 $ 3,350,000

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Schedule of Cost of Goods Computation of Cost of Raw Material Used Raw-material inventory, January 1 $ Manufactured Add: Purchases of raw materials
Raw material available for use Deduct: Raw material inventory, December 31 Raw material used

200,000 800,000 1,000,000 150,000

$ 850,000

CollegePak Company Schedule of Cost of Goods Manufactured Raw material used Direct labor Total manufacturing overhead Total manufacturing costs Add: Work-in-process inventory, January 1 Subtotal Deduct: Work-in-process inventory, December 31 Cost of goods manufactured
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850,000 700,000 1,850,000

$ 3,400,000 350,000 $ 3,750,000 400,000 $ 3,350,000

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Schedule of Cost of Goods Manufactured


Include all direct labor costs incurred during the CollegePak Company current period.
Schedule of Cost of Goods Manufactured Raw material used Direct labor Total manufacturing overhead Total manufacturing costs Add: Work-in-process inventory, January 1 Subtotal Deduct: Work-in-process inventory, December 31 Cost of goods manufactured
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850,000 700,000 1,850,000

$ 3,400,000 350,000 $ 3,750,000 400,000 $ 3,350,000

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Schedule of Cost of Goods Manufactured


Beginning work-inprocess inventory is carried over from the CollegePak Company prior period. Schedule of Cost of Goods Manufactured
Raw material used Direct labor Total manufacturing overhead Total manufacturing costs Add: Work-in-process inventory, January 1 Subtotal Deduct: Work-in-process inventory, December 31 Cost of goods manufactured
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850,000 700,000 1,850,000

$ 3,400,000 350,000 $ 3,750,000 400,000 $ 3,350,000

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Schedule of Cost of Goods Manufactured


Ending work-in-process inventory contains the cost of unfinished goods, CollegePak Company and is reported in the current assets section of the balance sheet. Schedule of Cost of Goods Manufactured
Raw material used Direct labor Total manufacturing overhead Total manufacturing costs Add: Work-in-process inventory, January 1 Subtotal Deduct: Work-in-process inventory, December 31 Cost of goods manufactured
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850,000 700,000 1,850,000

$ 3,400,000 350,000 $ 3,750,000 400,000 $ 3,350,000

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Income Statement for a Manufacturer

Now lets look at an income statement for CollegePak.

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Income Statement for a Manufacturer

CollegePak Company Income Statement For the Year Ended December 31, 20X2 Sales revenue Less: Cost of goods sold Gross margin Selling and administrative expenses Operating profit before taxes
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$ 4,500,000 2,810,000 $ 1,690,000 1,440,000 $ 250,000

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Income Statement for a Manufacturer


CollegePak Company Schedule of Cost of Goods Sold For the Year Ended December 31, 20X2 Finished-goods inventory, Jan. 1 Add: Cost of goods manufactured Cost of goods available for sale CollegePak Company Deduct Finished-goods inventory, Dec. 31 $ 920,000 3,350,000 4,270,000 1,460,000

Income Statement Cost of goods sold $ 2,810,000 For the Year Ended December 31, 20X2 Sales revenue Less: Cost of goods sold Gross margin Selling and administrative expenses Operating profit before taxes
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$ 4,500,000 2,810,000 $ 1,690,000 1,440,000 $ 250,000

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Production Costs in the Service Sector

A service provider cannot inventory its services. The costs of providing the service can be identified and measured, just as occurs in manufacturing industries. Managing and tracking the costs associated with valuechain activities can point to opportunities for improvement.

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Cost Drivers
An activity is any discrete task that an organization undertakes to make or deliver a good or service. A cost driver is some characteristic of the activity that causes costs to be incurred.
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Number of computers made by Dell in a day

Number of flights by Southwest Airlines in a given market

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Learning Objective 4

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Cost Behavior
Cost behavior means how a cost will react to changes in the level of business activity.

Total variable costs change when activity level changes. Total fixed costs remain unchanged when activity level changes.

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Total Variable Cost Example


Your total long distance telephone bill is based on how many minutes you talk.
Total Long Distance Telephone Bill

Minutes Talked
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Variable Cost Per Unit Example


The cost per long distance minute talked is constant. For example, 5 cents per minute.
Per Minute Telephone Charge

Minutes Talked
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Total Fixed Cost Example


Your monthly basic telephone bill probably does not change when you make more local calls.
Monthly Basic Telephone Bill

Number of Local Calls


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Fixed Cost Per Unit Example


The average cost per local call decreases as more local calls are made.
Monthly Basic Telephone Bill per Local Call

Number of Local Calls


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Cost Behavior Summary

Summary of Variable and Fixed Cost Behavior


Cost Variable In Total Changes proportionately with changes in activity within the relevant range. Remains the same even when activity changes within the relevant range. Per Unit Remains constant for each additional unit as long as activity is in the relevant range. The per unit amount changes each time the level of activity changes due to the fixed nature of the related costs.

Fixed

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Cost Hierarchy
Unit-level Costs
Directly traceable to the decision to produce the level of output

Costs that are incurred for every unit of product manufactured or service produced.

Includes direct material, direct labor, utilities to run equipment, other overhead directly related to the production process. All unit level costs are variable, but not all variable costs are unit level costs.
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Cost Hierarchy
Batch-level Costs
Costs that are incurred for batch of product manufactured or service produced.

Includes setup costs, material-handling costs related to delivering raw material to the production line, etc.

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Cost Hierarchy
Product-level Costs
Costs that are incurred for each line of product or service.

Includes design costs for product lines and marketing costs for each product line.

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Cost Hierarchy
Facility-level Costs
Costs that are incurred to maintain the organizations overall facility and infrastructure.

Includes production managers salary, plant depreciation, and insurance on the facility and equipment.

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Learning Objective 5

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Committed and Discretionary Costs


Committed
Long-term obligations, difficult to change in the short term.

Discretionary
Easier to alter in the short term by current managerial decisions.

Rental and/or Lease Financing of Buildings and equipment


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Advertising and Research and Development


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Opportunity Costs
The potential benefit that is given up when one alternative is selected over another.

If you were not attending college, you could be earning $20,000 per year. Your opportunity cost of attending college for one year is $20,000.

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Sunk Costs
Past payments for resources that cannot be changed by any current or future decision.

Sunk costs should not be considered in decisions.


Example: You bought an automobile for $12,000 two years ago. Whatever you do with the automobile in the future, you cannot nullify the original transaction. If it has a trade-in value, that value would become an opportunity cost in your future decisions.

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Traceability of Resources
Direct Costs

Indirect Costs

Costs that can be traced easily and conveniently to a product or department. Example: Cost of paint in the paint department of an automobile assembly plant.

Costs that need to be allocated, before they can be assigned to a product or department. Example: Cost of national advertising for an airline is indirect to a given flight or route.

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Learning Objective 6

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Absorption (Full) Costing


A system of accounting for costs in which both fixed and variable production costs are included in product costs.

Fixed Costs Product Variable Costs


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Variable Costing
A system of cost accounting that assigns only the variable cost of production to products.

Fixed Costs Product Variable Costs


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Learning Objective 7

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Absorption Costing vs. Variable Costing


Absorption Costing Direct materials Direct labor Variable mfg. overhead Fixed mfg. overhead Period costs Period costs Selling & admin. exp. Variable Costing

Product costs

Product costs

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Absorption and Variable Costing


Lets see what we can learn about the differences between absorption and variable costing by looking at a numerical example.

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Absorption Costing vs. Variable Costing - Example


Howell, Inc. produces a single product with a sales price of $40 and the following cost information:

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Absorption Costing vs. Variable Costing - Example


Unit product cost is determined as follows:

Selling and administrative expenses are always treated as period expenses and deducted from revenue as they are incurred.
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Absorption Costing vs. Variable Costing - Example


Howell, Inc. had no beginning inventory, produced 30,000 units and sold 28,000 units this year.
Absorption Costing
Sales (28,000 $40) Less cost of goods sold: Beginning inventory $ Add COGM (30,000 $19) 570,000 Goods available for sale 570,000 Ending inventory (2,000 $19) 38,000 Gross margin Less selling & admin. exp. Variable (28,000 x $4) $ 112,000 Fixed 250,000 Net income
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$ 1,120,000

532,000 588,000

362,000 226,000

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Absorption Costing vs. Variable Costing - Example


Sales (28,000 $40) Less variable expenses: Beginning inventory $ Add COGM (30,000 $12) 360,000 Goods available for sale 360,000 Ending inventory (2,000 $12) 24,000 Variable cost of goods sold 336,000 Variable selling & administrative expenses (28,000 $4) 112,000 Contribution margin Less fixed expenses: Manufacturing overhead $ 210,000 Selling & administrative expenses 250,000 Net income
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Variable costs only.

Variable Costing
$ 1,120,000

All fixed manufacturing overhead is expensed.


448,000 672,000

460,000 212,000

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Comparing Absorption and Variable Costing


Lets compare the methods.
Cost of Goods Sold Absorption costing Variable mfg. costs $ 336,000 Fixed mfg. costs 196,000 $ 532,000 Variable costing Variable mfg. costs $ 336,000 Fixed mfg. costs $ 336,000 Ending Inventory $ 24,000 14,000 $ 38,000 Period Expense $ $ Total $ 360,000 210,000 $ 570,000

$ 24,000 $ 24,000

210,000 $ 210,000

$ 360,000 210,000 $ 570,000

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Reconciling Income
We can reconcile the difference between absorption and variable net income as follows:

Variable costing net income Add: Fixed mfg. overhead costs deferred in inventory (2,000 units $7 per unit) Absorption costing net income

$ 212,000

14,000 $ 226,000

Fixed mfg. overhead $210,000 = Units produced 30,000


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= $7.00 per unit

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Extending the Example

Lets look at the second year of operations for Howell, Inc.

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Howell Inc., Year 2


In its second year of operations, Howell started with an inventory of 2,000 units, produced 30,000 units and sold 32,000 units at $40 each.

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Howell Inc., Year 2


Unit product cost is determined as follows:

There has been no change in Howells cost structure.


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Howell Inc., Year 2


Units in ending inventory from the previous period.
Absorption Costing
Sales (32,000 $40) Less cost of goods sold: Beg. inventory (2,000 x $19) Add COGM (30,000 $19) Goods available for sale Ending inventory Gross margin Less selling & admin. exp. Variable (32,000 $4) Fixed Net income $ 1,280,000 $ 38,000 570,000 $ 608,000 $ $ 128,000 250,000 $

608,000 672,000

378,000 294,000

30,000 units produced in the current period.


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Howell Inc., Year 2


Variable Costing
Sales (32,000 $40) Less variable expenses: Beg. inventory (2,000 $12) Add COGM (30,000 $12) Goods available for sale Ending inventory Variable cost of goods sold Variable selling & administrative expenses (32,000 $4) Contribution margin Less fixed expenses: Manufacturing overhead Selling & administrative expenses Net income $ 1,280,000 $ 24,000 360,000 $ 384,000 $ 384,000 128,000 $ $ 210,000 250,000 $ 512,000 768,000

460,000 308,000

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Summary
Income Comparison
Costing Method Absorption Variable 1st Period $ 226,000 212,000 2nd Period $ 294,000 308,000 Total $ 520,000 520,000

In the first period, production (30,000 units) was greater than sales (28,000). In the second period, production (30,000 units) was less than sales (32,000). For the two-year period, total absorption income and total variable income are the same.
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Summary

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Learning Objective 8

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Variable versus Absorption Costing


All manufacturing costs must be assigned to products to properly match revenues and costs.

Fixed costs are not really the costs of any particular product.

Absorption Costing
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Variable Costing
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Variable versus Absorption Costing


Depreciation, taxes, insurance and salaries are just as essential to products as variable costs.

These are capacity costs and will be incurred even if nothing is produced.

Absorption Costing
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Variable Costing
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Variable versus Absorption Costing


Absorption costing product costs are misleading for decision making. They are the numbers that appear on our external reports.

Variable Costing
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Absorption Costing
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Variable versus Absorption Costing Absorption Costing


Cost of goods sold decreases because production exceeds sales, leaving a portion of fixed manufacturing costs in inventory.
Variable cost Fixed manufacturing overhead Units sold $10 $100,000 10,000

Units Total Variable Produced Cost 10,000 $100,000 12,000 $120,000 14,000 $140,000 16,000 $160,000 18,000 $180,000 20,000 $200,000
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Fixed Total Average Manufacturing Manufacturing Manufacturing Overhead Cost Cost $100,000 $200,000 $ 20.00 $100,000 $220,000 $ 18.33 $100,000 $240,000 $ 17.14 $100,000 $260,000 $ 16.25 $100,000 $280,000 $ 15.56 $100,000 $300,000 $ 15.00

Cost of Goods Sold $ 200,000 $ 183,333 $ 171,429 $ 162,500 $ 155,556 $ 150,000

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Variable versus Absorption Costing


COGS for 10,000 units
$200,000

Absorption Costing Cost of goods sold decreases because production exceeds sales, leaving a portion of fixed manufacturing costs in inventory.

COGS

$150,000

$100,000
0 0 0 0 0 0 10 ,0 0 14 ,0 0 18 ,0 0 22 ,0 0 26 ,0 0 30 ,0 0 34 ,0 0 0

Number of units produced


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Throughput Costing
Unit-level spending for direct costs
Indirect, past or committed costs Unit-level costs are incurred every time a unit of product is manufactured and will not be incurred again until the next unit is manufactured.
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Product cost

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Throughput Costing
Example In an automated process direct material may be the only unit-level cost and so is the only product cost. All other manufacturing costs are expensed as period costs. Incentive to overproduce is reduced Average unit cost does not vary with changes in production levels.

Advantages
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Learning Objective 9

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Intentional Overproduction of Inventory

Absorption costing: Excess inventory would include more fixed production costs, so that gross income for the period would be artificially higher. An unethical manager would have an incentive to produce for inventory at the end of a period, in order to obtain a better looking bottom line. Throughput costing: No such incentive would exist, since fixed production costs would be charged against operating income for the period.

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End of Chapter 2

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