Full (Absorption) Costing

vs. Variable (Direct) Costing

Overview

Full (Absorption) Costing

Variable (Direct) Costing
Differences Between Full (Absorption)
Costing and Variable (Direct) Costing

Product (Inventoriable) Costing

Accounting for Fixed Overhead
Operating Income

Reconciliation Between Full (Absorption)

Costing and Variable (Direct) Costing
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Full (Absorption) Costing

Under GAAP,

product (inventoriable) cost

= DM + DL + OH
= DM + DL + var OH + fixed OH

Relevance of Fixed Costs

Class Example
Relevance of Fixed Costs?
production capacity
= 10,000 units
selling price
= $20 per unit
variable mfg costs (relevant range = 5,000 to 10,000 units):
direct materials
= $4 per unit
direct labour
= $3 per unit
variable manufacturing overhead
= $1 per unit
fixed manufacturing overhead
= $50,000
variable selling and administrative costs
= $2 per unit
fixed selling and administrative costs
= $15,000

Class Example
Relevance of Fixed Costs?
Current Production = 8,000 units
Current Sales
= 8,000 units
Decision Problem:
Assuming that there are no additional
selling and administrative costs, should
a special order for 1,500 units at a price
of $12 be accepted?
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Class Example Relevance of Fixed Costs?

Relevance of Fixed Costs

Incremental revenue
($1,500 units x $12)
Incremental costs
($1,500 units x ($4+$3+$1))
Net Contribution
Decision: Accept special order.

$18,000
12,000
$6,000

Variable (Direct) Costing

product cost
= variable manufacturing costs
= DM + DL + variable OH
because:
fixed OH is irrelevant in decision making
fixed OH is related to production capacity
but not production activity
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Differences Between
Absorption and Direct Costing

Definition of product cost

Accounting for fixed overhead
Operating income

traditional approach vs. contribution approach

differences in operating income

Definition of Product Cost; Class Example Accounting for Fixed Overhead; Class Example Operating Income ; Reconciliation of Absorption
and Direct Costing Income

Class Example
Absorption vs Direct Costing

production capacity
= 10,000 units
selling price
= $20 per unit
variable mfg costs (relevant range = 5,000 to 10,000 units):
direct materials
= $4 per unit
direct labour
= $3 per unit
variable manufacturing overhead
= $1 per unit
fixed manufacturing overhead
= $50,000
variable selling and administrative costs
= $2 per unit
fixed selling and administrative costs
= $15,000

Class Example
Absorption vs Direct Costing
Current production = 8,000 units
Current sales
= 7,600 units
Product cost??
Accounting for fixed OH??
Operating income??
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Definition of Product Cost

Absorption Costing (GAAP)
product cost = DM + DL + var OH + fixed OH

Direct Costing
product cost = DM + DL + var OH

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Class Example Absorption vs Direct Costing

Definition of Product Cost

Absorption
Costing
Product cost

Manufacturing CGS
Inventory

Direct
Costing

=$4+$3+$1+
= $4+$3+$1
$50,000/8,000
= $14.25 per unit

= $8 per unit

= $14.25 x 7,600

=$8 x 7,600

= $108,300

= $60,800

= $14.25 x 400

= $8 x 400

= $5,700

= $3,200
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Accounting for Fixed OH

Absorption Costing
fixed OH

product costs

inventory in B/S,
if unsold
cost of goods
sold in I/S, if sold

Direct Costing
fixed OH

period costs

expensed in I/S
in period incurred
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Class Example Absorption vs Direct Costing

Class Example Accounting for Fixed Overhead

Absorption Costing
Fixed OH deducted as CGS
= $50,000/8,000 x 7,600
= $47,500
Fixed OH in inventory
= $50,000/8,000 x 400
= $2,500

Direct Costing
Fixed OH deducted as expense
= $50,000

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Operating Income

Absorption Costing

Traditional Approach
Costs/Expenses classified on the basis of Cost
Function (manufacturing vs. non-manufacturing)

Direct Costing

Contribution Approach
Costs/Expenses classified on the basis of Cost
Behaviour (variable vs. fixed)
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Absorption Costing Income

Traditional Approach
Sales
Cost of goods sold (manufacturing)
Gross profits
Selling, general & administrative (SG&A) expenses
Operating income

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Direct Costing Income

Contribution Approach
Sales
Variable costs
Variable cost of goods sold (manufacturing)
Variable SG&A expenses (nonmanufacturing)
Contribution margin
Fixed costs
Fixed manufacturing costs (manufacturing)
Fixed SG&A expenses (nonmanufacturing)
Operating income

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Contribution margin
= sales variable costs
Contribution margin ratio
= contribution margin / sales
Variable cost ratio
= variable cost / sales

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Income Statement
Absorption Costing
(Traditional Approach)
Sales
CGS
Gross profits
SG&A expenses
Operating income

Direct Costing
(Contribution Approach)
Sales
Variable costs
Contribution margin
Fixed costs
Operating income

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Class Example Absorption vs Direct Costing

Class Example -Operating Income

Absorption Costing
Sales
CGS
Gross profits
SG&A expenses
Variable SG&A
Fixed SG&A
SG&A expenses
Operating income

Direct Costing
Sales
Variable costs
Variable mfg CGS
Variable SG&A
Total variable costs
Contribution margin
Fixed costs
Fixed mfg costs
Fixed SG&A
Total fixed costs
Operating income

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Class Example Absorption vs Direct Costing

Class Example -Operating Income

Absorption Costing
Sales
$152,000
CGS
108,300
Gross profits
$43,700
SG&A expenses
Variable SG&A
$15,200
Fixed SG&A
15,000
SG&A expenses
$30,200
Operating income
$13,500

Direct Costing
Sales
$152,000
Variable costs
Variable mfg CGS
$60,800
Variable SG&A
15,200
Total variable costs
$76,000
Contribution margin
$76,000
Fixed costs
Fixed mfg costs
$50,000
Fixed SG&A
15,000
Total fixed costs
$65,000
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Operating income
$11,000

Differences in Absorption &

Direct Costing Income
1. If production > sales,
fixed OH deferred in ending
inventory under absorption costing,
fixed OH deducted as cost of goods
sold under absorption costing <
fixed OH expensed under direct costing
absorption costing income (ACI) >
direct costing income (DCI)

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Differences in Absorption &

Direct Costing Income
2. If production < sales,
fixed OH in beginning inventory
deducted as cost of goods sold
under absorption costing,
fixed OH deducted as cost of goods
sold under absorption costing >
fixed OH expensed under direct costing
absorption costing income (ACI) <
direct costing income (DCI)

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Differences in Absorption &

Direct Costing Income
3. If production = sales,
absorption costing income (ACI) =
direct costing income (DCI)
Assumptions:
FIFO for inventory costing.

No difference in fixed OH per unit between

last and current periods.
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Timing Difference
The difference between absorption and direct
costing income is temporary as it will
reverse from period to period depending on
the relationship between production and
sales units.

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Reconciliation of Absorption
and Direct Costing Income
Absorption Costing

Direct Costing

Fixed OH

Fixed OH

Beg. Inv.

Current
Production

charged to
I/S as cost of
goods sold

charged to
I/S as cost of
goods sold
deferred in
end. inv. in
B/S

Current
Production

expensed
in I/S

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Absorption Costing Income (ACI)

= Income before fixed OH X - Y
Direct Costing Income (DCI)
= Income before fixed OH Y - Z
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Income before fixed OH

= ACI + X + Y
= DCI + Y + Z

(Absorption Costing)
(Direct Costing)

ACI + X = DCI + Z
ACI = DCI + Z - X
DCI = ACI + X - Z
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Reconciliation of Absorption
and Direct Costing Income
Absorption Costing Income
=

Direct
Fixed OH
Costing + in ending
Income
inventory

Fixed OH
in
beginning
inventory

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Reconciliation of Absorption
and Direct Costing Income
Direct Costing Income
Absorption
= Costing Income

Fixed OH
in ending
inventory

Fixed OH
in
+
beginning
inventory

Class Example:
Direct costing income = 13,500 - $2,500 + 0
= $11,000

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