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The distinction between absorption and variable costing is based on the  

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? !nder 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

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 fixed manufacturing overhead in inventoriable costs

? !nder 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.

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 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 D 




 
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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.

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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.

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´ Absorption unit cost is higher.

´ Output-level (production-volume) variance exists only under absorption costing.

´ Absorption costing uses '
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 to classify (manufacturing, marketing,

administration).

´ Variable costing uses

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 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 â 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 D 

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´ Production > Sales var. costing income 

) than absorption income

´ Production < Sales var. costing income  than absorption income

´ !nder absorption costing, changes in operating income are tied to both sales

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´ !nder variable costing, changes in reported operating income are tied only to

sales

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A. Income manipulation is possible under absorption costing via altering production and
 changing the 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.


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A. 
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 treats all costs except those related to variable direct

materials as period costs. Only direct materials costs are inventoriable.

B.
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 presents a throughput costing income statement using the Stassen

Company example.

Capsule Comparison of Inventory-Costing Methods

A.
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" 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.

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Question: Why do many managers prefer direct costing statements for internal purposes?
A. !ndesirable 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. !se variable costing.

b. Change time period used to evaluate performance.

c. !se non-financial performance measures as well as financial ones.


 



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(-- in determining the fixed manufacturing overhead

rate.

A. Theoretical and practical capacity -- based on the capacity of the plant to 

product.

1. 
  ( , is based on producing a maximum efficiency for 100% of the

time.

2.    ( , reduces theoretical capacity for unavoidable operating interruptions.

B. Normal utilization and master-budget utilization -- based on the   for product.

1. 
 - 

is based on the average demand over a 2 or 3-year period.

2. c +'& - 

for the coming budget period is based on the expected

current utilization.

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A. IRS requires use of the master-budget utilization level for tax purposes.?