Absorption Costing & Variable Costing

| Introduction | Product Costing | ABC | Absorption & Variable Costing | Allocating Support Costs | Allocating Joint Costs | Part II | Part III |

Source:

Textbook: Managerial Accounting, Creating Value in a Dynamic Business Environment (Fifth edition), Ronald W. Hilton

Notes: Management Accounting A, 2003 Semester 1, University of Sydney

Web: http://www.mhhe.com/business/accounting/garrison/Student/olc/garrison9emgracct_s/index.htm

General

Two income-reporting alternatives

• Absorption Costing
• Variable Costing

Difference (1) : Accounting treatment of fixed manufacturing overhead

Absorption Costing: All manufacturing overhead costs are applied to (or absorbed by) the manufactured goods.

Variable Costing: Only variable overhead costs is applied to Work in process inventory as product cost, while fixed overhead costs are expenses as period costs.

Difference (2) : Timing with with fixed manufacturing overhead becomes an expense

Finally, fixed overhead is expensed in both costing system.

However,

Variable costing: Fixed overhead is expensed immediately

Absorption costing: Fixed overhead is inventoried until the accounting period during which the manufactured goods are sold.

Illustration of the concept of both costing (page 813)

Illustration of the Income statement of both costing (page 814 - 815)

Reconciliation of income under absorption and variable costing (Page 816)

Cost of Goods Sold under AC

- Variable manufacturing costs under VC

- Fixed Manufacturing costs under VC

= Difference in net come of Absorption and variable costing

An alternative way,

Net Income in AC

+ Fixed cost in opening inventory under AC

- Fixed cost in ending inventory under AC

= Net Income in VC

Shortcut way

Difference in FOH under AC and VC = Change in inventory (units) X Predetermined fixed overhead rate per unit

Difference in FOH under AC and VC = Value of Absorption costing income - Variable costing income

Comparison of Net income under AC & VC when inventory changes (Notes)

When Produced > Sold, Inventory Increase,

FOH in AC < FOH in VC,    Profit in AC > Profit in VC

When Produced < Sold, Inventory decrease,

FOH in AC > FOH in VC, Profit in AC < Profit in VC

When Produced = Sold, Inventory keeps constant,

FOH in AC = FOH in VC, Profit in AC = Profit in VC

Cost-Volume-Profit Analysis (CVP) (Page 817)    | top |

CVP includes all fixed costs to compute breakeven ( = FC / Unit contribution margin) in units

Variable costing highlights the separation between fixed and variable costs, as do CVP analysis and breakeven calculations. Both of these techniques account for fixed manufacturing overhead as a lump sum.

In contrast, absorption costing is inconsistent with CVP analysis because fixed overhead is applied to goods as product cost on a per-unit basis.

Evaluation of absorption and variable costing (Page 818)    | top |

Advantages of Absorption costing

• Fixed MOH is treated as the same as other product costs, e.g. DM, DL
• Consistent with long-run pricing decisions that must cover full cost
• External reporting and income tax law require AC

Advantages of Variable costing

• Management find it easy to understand
• Consistent with CVP analysis
• Emphasis contribution in short-run pricing decisions
• Profit for period not affected by changes in fixed manufactured overhead

Balance sheet Difference (Problem 19.34)

Two components would be affected,

• Inventory value - AC cost of inventory > VC cost of inventory
• Retained Earnings - AC > VC

Controversy of Absorption Costing & Variable Costing (Page 817 - 818)    | top |

Pricing

AC - using variable costing, understate the cost

VC - Variable cost provides a better basis for the pricing decision because it makes a positive contribution to covering fixed cost and profit

Definition of an asset

AC - Inventory should be valued at full cost of production because the cost has future service potential, the inventory can be sold in the future to generate sales revenue.

VC - Fixed cost component of AC does not have future service potential, reason is that fixed manufacturing overhead costs during the current period will not prevent these costs from having to be incurred in the next period. Fixed overhead costs will be incurred every period, regardless of production levels.