Chapter 08 - Absorption and Variable Costing

CHAPTER 8

ABSORPTION AND VARIABLE COSTING

Learning Objectives

1. Explain the accounting treatment of fixed manufacturing overhead

under absorption and variable costing.

2. Prepare an income statement under absorption costing.

3. Prepare an income statement under variable costing.

4. Reconcile reported income under absorption and variable costing.

5. Explain the implications of absorption and variable costing for cost-

volume-profit analysis.

6. Evaluate absorption and variable costing.

7. Explain the rationale behind throughput costing.

8. Prepare an income statement under throughput costing.

Chapter Overview

I. Product Cost and Fixed Manufacturing Overhead

A. Absorption-costing income statements
B. Variable-costing income statements

II. Reconciliation of Absorption- and Variable-Costing Income

A. No change in inventory levels
B. Increase in inventory levels
C. Decrease in inventory levels

III. Overall Evaluation of Absorption and Variable Costing

IV. Throughput Costing

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Chapter 08 - Absorption and Variable Costing

Key Lecture Concepts

1. PRODUCT COST AND FIXED MANUFACTURING OVERHEAD

Product, or manufacturing, costs are comprised of direct

materials, direct labor, variable manufacturing overhead, and
fixed manufacturing overhead. The basic difference between
absorption and variable costing is the treatment of fixed
manufacturing overhead.

With absorption (full) costing, all costs related to the

manufacture of a good are product costs. Therefore, fixed
manufacturing overhead attaches to the units being made
and is carried in inventory until the product is sold.

Absorption costing results in the preparation of a

traditional income statement.

Absorption costing is considered GAAP and is

acceptable for tax reporting.

Under variable costing, product cost is comprised solely

of variable manufacturing costs. Fixed manufacturing
overhead is viewed as a cost of being ready to produce,
not an actual production cost (i.e., the cost will remain
constant no matter how many units are manufactured).

Fixed manufacturing overhead is treated as a period

cost and expensed immediately.

The income statement highlights cost behavior and

is presented in a contribution margin format.

Variable costing is useful to managers, as it dovetails

nicely with cost-volume-profit analysis.

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Chapter 08 - Absorption and Variable Costing

2. RECONCILIATION OF ABSORPTION- AND VARIABLE-COSTING INCOME

The difference between the two approaches is the timing of

when fixed manufacturing overhead is shown on the income
statement: when the product is sold under absorption costing
and when incurred under variable costing.

The two methods will usually produce different income figures.

No change in inventory: production = sales

Under variable costing, all fixed manufacturing

overhead is expensed. With absorption costing, the
period's fixed overhead flows through to cost of
goods sold.

Absorption-costing net income equals variable-

costing net income.

Increase in inventory: production > sales

Under variable costing, all fixed manufacturing

overhead is expensed. With absorption costing, a
portion of the period's fixed overhead flows through
to cost of goods sold and a portion remains on the
balance sheet in inventory.

Absorption-costing net income is greater than

variable-costing net income.

Decrease in inventory: sales > production

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Chapter 08 - Absorption and Variable Costing

Under variable costing, all fixed manufacturing

overhead is expensed. With absorption costing, as
units manufactured in a prior period are sold, an
amount greater than the current period's fixed
overhead flows through to cost of goods sold.

Absorption-costing net income is less than variable-

costing net income.

The difference between absorption- and variable-costing

income figures can be reconciled as follows:

Income difference = Inventory change in units x

Fixed overhead per unit

The difference is likely to be very small over a lengthy

time period.

3. OVERALL EVALUATION OF ABSORPTION AND VARIABLE COSTING

Pricing decisions

Absorption-cost proponents argue that fixed

manufacturing overhead is a necessary production cost.
Excluding this element from the inventoried cost of a
product will understate the good's cost, which is
troublesome for companies that use cost-based pricing
techniques.

Variable-cost proponents argue that variable cost is better

for pricing decisions. Any price above a good's variable
cost results in a positive contribution margin for the
company.

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Chapter 08 - Absorption and Variable Costing

Many firms use variable costing for internal-reporting purposes.

Given that absorption costing must be employed for external
financial reporting, companies can use both methods by making
several simple end-of-period adjustments.

If a company operates in a just-in-time environment, inventories

are kept very low and there will be little change in inventory
from period to period. Thus, the income differences between
absorption and variable costing will normally be insignificant.

4. THROUGHPUT COSTING

Throughput costing assigns only the unit-level spending for

direct costs as the cost of products or services.

A unit-level cost is incurred every time that a unit of

product is manufactured.

All costs other than the throughput cost are considered to

be operating expenses of the period.

Proponents of throughput costing argue that this

procedure eliminates the incentive to produce excess
inventory because all non-throughput costs are
expensed regardless of manufacturing volume.
Teaching Overview

Students sometimes have difficulty recognizing that the only difference

between absorption costing and variable costing is the treatment of fixed
manufacturing overhead. After they grasp the mechanics, students should
be urged to think about the underlying theoretical and practical differences
between the two approaches.

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Chapter 08 - Absorption and Variable Costing

It is useful to note that the bottom line on an absorption-costing income

statement fluctuates with production levels. I typically construct an exercise
in which a manager is awarded a bonus based on absorption-costing
income, and all the manager does to earn the bonus is step up production
and "hide" fixed manufacturing overhead on the balance sheet. (See the
chapter's Focus on Ethics, for example.) Even with the same sales level as
in the previous period, bottom-line performance is improved and the bonus
is awarded. We then turn to variable costing where income varies with
sales. The students catch on very quickly that variable costing provides
distinct benefits in the area of performance evaluation by eliminating the
impact of inventory changes.

Problem 8-24 is useful to illustrate much of the material presented in this

chapter.

Links to the Text

Homework Grid CHAPTER 8

Learnin Completi Special

Item No. g on Feature
Objectiv Time s*
es (min.)
Exercises:
8-13 1, 4 15
8-18 5 20 C
8-15 1, 4 15
8-17 1, 4 15
8-19 1 10
8-20 1, 6 30 W
8-14 1, 7 25
8-16 1, 4, 7 10
Problems:
8-29 2, 3, 4 45
8-26 7, 8 40
8-23 2, 3, 4, 5 45
8-21 2, 3, 4 45
8-22 7, 8 25
8-24 1, 4 25 I
8-28 1, 2, 3, 35
7, 8
8-27 1, 4 45
8-25 2, 3, 4, 6 40
8-30 7, 8 40
Cases:

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Chapter 08 - Absorption and Variable Costing

8-31 2, 3, 4 35
8-32 1, 6 30
8-33 1, 4 40

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Chapter 08 - Absorption and Variable Costing

* C = Business communication E = Ethics G = Group work I = International

W = Web-based application

Links to the Ancillaries

Video Programs

McGraw-Hill has produced various videos that are relevant to the instruction
of managerial/cost accounting. Information about these videos (including a
description of those applicable to this chapter) appears in Appendix A.

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