Variable and Absorption Costing

Variable & Absorption Costing

Variable & Absorption Costing

⚫ Variable and absorption costing are two different methods of inventory costing. Under
both variable and absorption costing, all variable manufacturing costs (both direct and
indirect) are inventoriable costs. The only two differences between the two methods are in:

⚫ Their treatment of fixed manufacturing overhead

⚫ The income statement presentation of the different costs

⚫ All other costs except for fixed factory overheads are treated in the same manner under
both of these methods, but they may be reported in a slightly different manner on the
income statement.
Variable & Absorption Costing
⚫ Examples of fixed overhead costs that are specific to a production area (and which are
usually allocated to manufactured goods) are:

Factory rent
Utilities
Production supervisory salaries
Normal scrap
Materials management staff compensation
Quality assurance staff compensation
Depreciation on production equipment
Insurance on production equipment, facilities, and inventory
Variable & Absorption Costing
Fixed Factory Overheads Under Absorption Costing (Full Costing)

⚫Under absorption costing fixed factory overhead costs are allocated to the units produced
during the period according to a predetermined rate.

⚫The predetermined fixed overhead allocation rate is

Budgeted Dollar Amount of Manufacturing Overhead
Budgeted Activity Level

⚫Fixed manufacturing overhead is therefore a product cost under absorption costing.

Variable & Absorption Costing

⚫ Fixed factory overheads are allocated to the units produced as if they were variable costs,
even though they are not variable costs.

⚫ Absorption costing is required by U.S. GAAP for external financial reporting and by the
U.S. taxing authorities for tax reporting.

⚫ (Job-order costing, process costing and in some cases activity-based costing can all be
used with absorption costing for external purposes.)
Variable & Absorption Costing
⚫ Under the absorption costing method, the profit of a company is influenced by the
difference between the level of production and the level of sales.

⚫ When the level of production is higher than the level of sales, some of the fixed
manufacturing overhead costs from this period are included on the balance sheet as
inventory at the year-end.

⚫ As a result, these costs that are in inventory are not included on the income statement as
an expense.
Variable & Absorption Costing
Fixed Factory Overheads Under Variable Costing

⚫ Under variable costing (also called direct costing), fixed factory overheads are a period
cost that are expensed in the period when they are incurred.

⚫ This means that no matter what the level of sales, all of the fixed factory overheads will
be expensed in the period when incurred.

⚫ Variable costing is not GAAP. For external reporting purposes, GAAP requires the use of
absorption costing for fixed manufacturing cost allocation, and therefore variable costing
cannot be used for external financial reporting.
Variable & Absorption Costing
Fixed Factory Overheads Under Variable Costing

⚫ It is important to remember that the only difference in the profit between these two
methods relates to the treatment of fixed factory overheads.

⚫ Under absorption costing, fixed factory overhead costs are included, or absorbed, into
the product cost.

⚫ Under variable costing, they are excluded from the product cost and treated as a
period cost, because they are not variable costs.
Variable & Absorption Costing
Variable & Absorption Costing

⚫ When production and sales are equal in a period (meaning that there is no change in
inventory levels and everything that was produced was sold) there will not be a
difference between the incomes reported under these two methods.

⚫ This is because all of the fixed factory overheads were expensed as a period cost under
the variable method, and all of the fixed factory overheads were “sold” and included
in cost of goods sold under the absorption method.
Variable & Absorption Costing
Variable & Absorption Costing

⚫ If production is greater than sales, the net income calculated under the absorption
method is greater because some of the fixed factory overheads were inventoried under
this method.

⚫ If production is lower than sales, the variable method will result in a greater net
income because the only fixed factory overheads included as an expense in this period
were those that were incurred during the year.
Variable & Absorption Costing
Variable & Absorption Costing

⚫ The following table summarizes the effect of changing inventory levels (production
compared to sales) under the two methods:

Production & Sales Profit

Production = Sales Absorption = Variable

Production > Sales Absorption > Variable
Production < Sales Absorption < Variable
Variable & Absorption Costing
The Income Statement under Absorption Costing

⚫ Under absorption costing we calculate a gross profit by subtracting all variable and fixed
manufacturing costs for goods sold (this being COGS) from revenue. All variable and
fixed nonproduction costs are then subtracted from the gross profit to calculate net
income. The income statement under absorption costing is as follows:
Sales revenue
− Cost of goods sold (variable and fixed manf. costs of items sold)
= Gross profit
− Variable nonmanufacturing costs (expensed)
− Fixed nonmanufacturing costs (expensed)
= Operating Income
Variable & Absorption Costing
The Income Statement under Variable (Direct) Costing

⚫ Under variable costing we calculate a manufacturing contribution margin as under :

Sales revenue
− Variable manufacturing costs of items sold
= Manufacturing contribution margin
− Variable nonmanufacturing costs (expensed)
= Contribution Margin
− All fixed manufacturing costs (expensed)
− All fixed nonmanufacturing costs (expensed)
= Operating Income
Variable & Absorption Costing
Example:
Hardy Corp. uses the FIFO method to track inventory. The records for Hardy include the
following information. For simplicity, assume that the amounts given are both the
budgeted amounts and the actual amounts and thus, there were no variances.

Inventory Year 1 Year 2

Beginning balance, in units -0- 4,200

Production 12,000 10,000
Available for sale 12,000 14,200
Less units sold ( 7,800) (12,000)
Ending balance, in units 4,200 2,200
Variable & Absorption Costing
Hardy Corp. uses the FIFO method to track inventory. The records for Hardy include the
following information. For simplicity, assume that the amounts given are both the
budgeted amounts and the actual amounts and thus, there were no variances.

Other information Year 1 Year 2

Sales ($2.10 per unit) $16,380 $25,200
Variable mfg. costs ($0.90/unit) 10,800 9,000
Fixed mfg. costs 5,000 5,400
Variable selling and admin. costs 2,250 3,750
Fixed selling and admin. costs 2,250 3,750
Variable & Absorption Costing
Year 1 Income Statements
Absorption Costing
Sales (7,800 × $2.10) $ 16,380
Var. Mfg. COGS (7,800 × $0.90) 7,020
Fixed Mfg. COGS ($5,000÷12,000×7,800) 3,250

COGS (10,270)

Gross margin $ 6,110

S&A exp. ($2,250 var. + $2,250 fixed) (4,500)

Operating income $ 1,610

Variable & Absorption Costing
Year 1 Income Statements

Variable (Direct) Costing

Sales (7,800 × $2.10) $ 16,380

Variable Mfg. COGS (7,800 × $0.90) (7,020)
Manufacturing Contribution Margin $ 9,360
Less: Variable S&A (2,250)
Contribution margin $ 7,110
Less: Fixed mfg. costs (5,000)
Fixed S&A (2,250)
Operating income $ (140)
Variable & Absorption Costing
Year 2 Income Statements

Absorption Costing

Sales (12,000 × $2.10) $ 25,200

Variable Mfg. Cost (12,000 × $0.90) 10,800
Fixed Mfg. COGS-Year 1 production (6) 1,750
Fixed Mfg. COGS-Year 2 production (7) 4,212
COGS (16,762)
Gross profit 8,438
S&A expenses (7,500)
Operating income $ 938
Variable & Absorption Costing
⚫ Note 6 - Beginning inventory for Year 2 was 4,200 units, and those units were produced
during Year 1 at Year 1 costs. Each unit had $0.4167 of fixed manufacturing cost attached
to it ($5,000 fixed manufacturing costs in Year 1 ÷ 12,000 units produced in Year 1). Since
the company uses FIFO, those units were the first units sold in Year 2. 4,200 units ×
$0.4167 of fixed manufacturing cost per unit = $1,750 of fixed manufacturing cost from
Year 1 production that was sold in Year 2.

⚫ Note 7 - A total of 12,000 units were sold in Year 2. As noted above, 4,200 of those units
came from Year 1’s production. That means the remainder, or 12,000 – 4,200 = 7,800 units,
came from Year 2’s production. Fixed manufacturing cost per unit during Year 2 was
$5,400 fixed manufacturing costs ÷ 10,000 units produced, or $0.54 per unit. So the fixed
manufacturing cost included in the units that were sold from Year 2’s production is $0.54 ×
7,800 = $4,212.
Variable & Absorption Costing
Year 2 Income Statements

Variable Costing
Sales (12,000 × $2.10) $ 25,200
Variable Mfg.COGS (12,000×$0.90) (10,800)
Manufacturing Contribution margin 14,400
Variable S&A (3,750)
Contribution margin 10,650
Less: Fixed mfg. costs (5,400)
Fixed S&A (3,750)
Operating income $ 1,500
Variable & Absorption Costing
Example

⚫ The following information is for the next four questions: The estimated unit costs for a
company using absorption (full) costing and planning to produce and sell at a level of
12,000 units per month are as follows.
Cost Item Estimated Unit Cost
Direct materials $32
Direct labor 20
Variable manufacturing overhead 15
Fixed manufacturing overhead 6
Variable selling 3
Fixed selling 4
Variable & Absorption Costing
⚫ Question 4: Estimated conversion costs per unit are:

a) $35
b) $41
c) $48
d) $67

⚫ Question 5: Estimated prime costs per unit are:

a) $73
b) $32
c) $67
d) $52
Variable & Absorption Costing
⚫ 4b–

⚫ Conversion costs include direct labor and manufacturing overhead. In this question
the direct labor is $20 per unit and the manufacturing overhead is $21 per unit for a
conversion cost of $41 per unit.

⚫ 5d–

⚫ Prime costs include direct materials and direct labor. In this question, the direct
materials and direct labor are $32 and $20, respectively, for a prime cost per unit of $52.
Variable & Absorption Costing
⚫ Question 6: Estimated total variable costs per unit are:
a) $38
b) $70
c) $52
d) $18

⚫ Question 7: Estimated total costs that would be incurred during a month with a production
level of 12,000 units and a sales level of 8,000 units are:
a) $692,000
b) $960,000
c) $948,000
d) $932,000
Variable & Absorption Costing
⚫ 6 b – Variable costs are direct materials ($32), direct labor ($20), variable
manufacturing overhead ($15), and variable selling expense ($3), for estimated total
variable costs of $70 per unit.

⚫ 7 c – Total estimated costs include both production and nonproduction (here, selling)
costs and both variable and fixed costs. Total estimated manufacturing costs include
manufacturing costs for the total number of units planned to be produced, not sold. Total
estimated costs also include the fixed and variable selling costs that are expensed as
incurred, but for selling costs, the total number of units planned to be sold is used, not the
number of units planned to be produced.
Variable & Absorption Costing
⚫ 7c–

⚫ Total estimated fixed manufacturing overhead must be calculated by multiplying the

estimated fixed manufacturing overhead per unit by the number of units planned to be
produced per month. The estimated total fixed manufacturing overhead was determined
before the estimated unit cost was determined in the planning process, and it does not
change in total with changes in production level. The fixed manufacturing overhead per
unit was then determined by dividing the total estimated fixed manufacturing overhead by
the number of units planned to be produced. So to find the estimated total fixed
manufacturing overhead, multiply the estimated fixed manufacturing overhead per unit ($6)
by the number of units planned to be produced (12,000).

⚫ Estimated total costs are:

Variable & Absorption Costing
⚫ 7c–
⚫ Variable manufacturing cost of $67 per unit in total × 12,000 units planned to be produced: $ 804,000

⚫ Fixed manufacturing overhead of $6 per unit × 12,000 units planned to be produced: 72,000

⚫ Variable selling expense of $3 per unit × 8,000 units sold: 24,000

⚫ Fixed selling expense (12,000 planned sales × the estimated fixed selling cost of $4/unit): 48,000

$948,000

⚫ Note that total fixed selling expense does not change if only 8,000 units are sold instead of 12,000. That is
true because fixed expenses are fixed—they do not change in total with changes in the level of activity.
Variable & Absorption Costing
⚫ Question 8: When a firm prepares financial reports using absorption costing:

a) Profits will always increase with increases in sales.

b) Profits will always decrease with decreases in sales.
c) Profits may decrease with increased sales even if there is no change in selling prices and
costs.
d) Decreased output and constant sales result in increased profits.
Variable & Absorption Costing
⚫ 8c–

⚫ When absorption costing is being used and sales are greater than production,
operating income will be lower than it would be under variable costing, because some of
the fixed costs incurred in a previous period and capitalized in inventory at that time will be
expensed in cost of goods sold along with the current period’s fixed costs. Under variable
costing, only the current period’s fixed costs would have been expensed.
Variable & Absorption Costing
⚫ Question 9: Jansen, Inc. pays bonuses to its managers based on operating income. The
company uses absorption costing, and overhead is applied on the basis of direct labor hours.
To increase bonuses, Jansen's managers may do all of the following except:

a) Produce those products requiring the most direct labor.

b) Defer expenses such as maintenance to a future period.
c) Increase production schedules independent of customer demands.
d) Decrease production of those items requiring the most direct labor.
Variable & Absorption Costing
⚫ 9d–

⚫ If the managers decrease production of any item, fewer costs will be put on the
balance sheet. By putting fewer costs on the balance sheet, more costs will be on the
income statement, reducing operating income and bonuses. All of the choices that include
an increase in production will cause operating income to be higher since some of the costs
of production will be held on the balance sheet as part of unsold finished goods inventory.
Variable & Absorption Costing
⚫ Question 10: Nance Corp began operations in January. The company produced 50,000 units
and sold 45,000 units in its first year of operations. Costs for the year were as follows:
⚫ Fixed Manufacturing Costs $250,000
⚫ Variable Manufacturing Costs 180,000
⚫ Fixed General and Selling Costs 75,000
⚫ Variable General and Selling Costs 80,000

⚫ How would the operating income of Nance compare between the variable method and full
absorption costing methods?
⚫ a) Variable would be $25,000 higher.
⚫ b) Absorption would be $25,000 higher.
⚫ c) Variable would be $32,500 higher.
⚫ d) Absorption would be $32,500 higher.
Variable & Absorption Costing
⚫ 10 b – The difference between the two methods relates only to the fixed manufacturing
overhead costs.
⚫ Because this was the company’s first year of operations and thus beginning inventory was
zero, the amount of the difference can be calculated as follows:

⚫ Fixed manufacturing costs per unit × Change in the level of inventory

⚫ Fixed manufacturing costs divided by 50,000 units produced equals fixed manufacturing cost
per unit of $5. The company produced 50,000 units and sold 45,000 units, so inventory
increased by 5,000 units. Thus, the increase of fixed manufacturing costs in inventory was $5
× 5,000 = $25,000. Because this $25,000 is put into inventory under absorption costing but
expensed under variable costing, operating income under the absorption method would be
$25,000 higher because cost of goods sold would be $25,000 lower than under variable
costing.
Variable & Absorption Costing
⚫ The following information is for the next two questions: Osawa planned to produce and
actually manufactured 200,000 units of its single product in its first year of operations.
Variable manufacturing costs were $30 per unit of product. Planned and actual fixed
manufacturing costs were $600,000, and the selling and administrative costs totaled
$400,000. Osawa sold 120,000 units of product at a selling price of $40 per unit.

⚫ Question 11: Osawa’s operating income using absorption costing is:

⚫ a) $200,000
⚫ b) $440,000
⚫ c) $600,000
⚫ d) $840,000
Variable & Absorption Costing
⚫ 11 b –

⚫ Under absorption costing, the fixed manufacturing costs are allocated to the products
produced.

⚫ The variable costs of production are $30 per unit and the fixed costs per unit are $3 per unit
($600,000 ÷ 200,000 units produced). In total, the cost per unit is $33. Since the sales price
was $40 per unit, this is a gross profit of $7 per unit.

⚫ With 120,000 units sold, gross profit is $840,000 (120,000 × $7). Subtracting from this the
selling and administrative costs of $400,000 results in operating income of $440,000.
Variable & Absorption Costing
⚫ Question 12: Osawa’s operating income using variable costing is:

a) $200,000
b) $440,000
c) $800,000
d) $600,000
Variable & Absorption Costing
⚫ 12 a –

⚫ Under variable costing, the fixed manufacturing costs are expensed. With a selling price
of $40 per unit and a variable cost of $30 per unit, the manufacturing contribution margin is
$10 per unit.

⚫ With sales of 120,000 units, the total contribution margin is $1,200,000.

⚫ Subtracting from this $1,200,000 the fixed manufacturing costs of $600,000 and the selling
and administrative costs of $400,000 results in operating income of $200,000.
To be continued…