Absorption costing

Group no-4
Apparel Production-6
National Institute Of Fashion
Technology
Mumbai
 Absorption costing
• Costing method which involves or
“absorbs” all the costs necessary to
produce the product into its saleable
form.
The layman’s language
The only cost of driving my car
on a 200 mile trip today is
$12 for gasoline.

Variable
Costing
No! You must consider these costs too!
Cost Per month Per day
Car payment $ 300.00 $ 10.00
Insurance 60.00 2.00

Absorption
Costing
 Two Costing Methods

Absorption Costing
✔ Used for external financial
reporting
✔ Includes direct materials, direct
labor, variable factory overhead,
and fixed factory overhead as
part of total product cost
 Two Costing Methods

Variable Costing
✔ Used for internal planning
and decision making
✔ Does not include fixed factory
overhead as a product cost
Absorption Costing Compared to
Variable Costing
Absorption Costing
Cost of Goods Manufactured

Direct Direct Variable Fixed

Materials Labor Factory OH Factory OH

Cost of Goods Manufactured Period Expense

Variable Costing
 Overview of Absorption and
Variable Costing
Absorption Variable
Costing Costing
Direct Materials
Product
Product Direct Labor
Costs
Costs Variable Manufacturing Overhead

Fixed Manufacturing Overhead

Period
Period Variable Selling and Administrative Expenses
Costs
Costs Fixed Selling and Administrative Expenses
• An example of income comparisons
using variable and absorption costings
 Unit Cost Computations
ABC Co. produces a single product with
the following information available:
Number of units produced annually 25,000
Variable costs per unit:
Direct materials, direct labor,
and variable mfg. overhead $ 10
Selling & administrative expenses $ 3

Fixed costs per year:

Manufacturing overhead $ 150,000
Selling & administrative expenses $ 100,000
 Unit Cost Computations
Unit product cost is determined as follows:
Absorption Variable
Costing Costing
Direct materials, direct labor,
and variable mfg. overhead $ 10 $ 10
Fixed mfg. overhead
($150,000 ÷ 25,000 units) 6 -
Unit product cost $ 16 $ 10

Selling and administrative expenses are

always treated as period expenses and
deducted from revenue.
 Income Comparison of
Absorption and Variable Costing
ABC Co. had no beginning inventory, produced
25,000 units and sold 20,000 units this year.
Absorption Costing
Sales (20,000 × $30) $ 600,000
Less cost of goods sold:
Beginning inventory $ -
Add COGM (25,000 × $16) 400,000
Goods available for sale 400,000
Ending inventory (5,000 × $16) 80,000 320,000
Gross margin 280,000
Less selling & admin. exp.
Variable
Fixed
Net operating income
 Income Comparison of
Absorption and Variable Costing
ABC Co. had no beginning inventory, produced
25,000 units and sold 20,000 units this year.
Absorption Costing
Sales (20,000 × $30) $ 600,000
Less cost of goods sold:
Beginning inventory $ -
Add COGM (25,000 × $16) 400,000
Goods available for sale 400,000
Ending inventory (5,000 × $16) 80,000 320,000
Gross margin 280,000
Less selling & admin. exp.
Variable (20,000 × $3) $ 60,000
Fixed 100,000 160,000
Net operating income $ 120,000
 Income Comparison of
Absorption and Variable Costing
Now let’s look at variable costing by ABC Co.
Variable
Variable Costing
Sales (20,000 × $30)
costs $ 600,000
Less variable expenses: only.
Beginning inventory $ - All fixed
Add COGM (25,000 × $10) 250,000 manufacturing
Goods available for sale 250,000
Less ending inventory (5,000 × $10) 50,000
overhead is
Variable cost of goods sold 200,000 expensed.
Variable selling & administrative
expenses (20,000 × $3) 60,000 260,000
Contribution margin 340,000
Less fixed expenses:
Manufacturing overhead $ 150,000
Selling & administrative expenses 100,000 250,000
Net operating income $ 90,000
 Income Comparison of
Absorption and Variable Costing
Let’s compare the methods.
Cost of
Goods Ending Period
Sold Inventory Expense Total
Absorption costing
Variable mfg. costs $ 200,000 $ 50,000 $ - $ 250,000
Fixed mfg. costs 120,000 30,000 - 150,000
$ 320,000 $ 80,000 $ - $ 400,000

Variable costing
Variable mfg. costs $ 200,000 $ 50,000 $ - $ 250,000
Fixed mfg. costs - - 150,000 150,000
$ 200,000 $ 50,000 $ 150,000 $ 400,000
 Reconciliation
We can reconcile the difference between
absorption and variable income as follows:

Variable costing net operating income $ 90,000

Add: Fixed mfg. overhead costs
deferred in inventory
(5,000 units × $6 per unit) 30,000
Absorption costing net opearting income $ 120,000

Fixed mfg. overhead $150,000

= = $6.00 per unit
Units produced 25,000 units
Extending the Example
Let’s look at the
second year
of operations
for ABC
Company.
 ABC Co. Year 2
In its second year of operations, ABC Co.
started with an inventory of 5,000 units,
produced 25,000 units and sold 30,000 units.
Number of units produced annually 25,000
Variable costs per unit:
Direct materials, direct labor
variable mfg. overhead $ 10
Selling & administrative
expenses $ 3
Fixed costs per year:
Manufacturing overhead $ 150,000
Selling & administrative
expenses $ 100,000
 ABC Co. Year 2
Unit product cost is determined as follows:

Absorption Variable
Costing Costing
Direct materials, direct labor,
and variable mfg. overhead $ 10 $ 10
Fixed mfg. overhead
($150,000 ÷ 25,000 units) 6 -
Unit product cost $ 16 $ 10

No change in ABC’s
cost structure.
 ABC Co. Year 2
Now let’s look at ABC’s income statement
assuming absorption costing is used.
 ABC Co. Year 2
Absorption Costing
Sales (30,000 × $30) $ 900,000
Less cost of goods sold:
Beg. inventory (5,000 × $16) $ 80,000
Add COGM (25,000 × $16) 400,000
Goods available for sale 480,000
Less ending inventory - 480,000
Gross margin 420,000
Less selling & admin. exp.
Variable (30,000 × $3) $ 90,000
Fixed 100,000 190,000
Net operating income $ 230,000

These are the 25,000 units

produced in the current period.
 ABC Co. Year 2
Next, we’ll look at ABC’s income statement
assuming is used.
 ABC Co. Year
Variable
2
costs Variable Costing
Sales (30,000 × $30) only. $ 900,000
Less variable expenses:
Beg. inventory (5,000 × $10) $ 50,000
Add COGM (25,000 × $10) 250,000 All fixed
Goods available for sale 300,000 manufacturing
Less ending inventory - overhead is
Variable cost of goods sold 300,000 expensed.
Variable selling & administrative
expenses (30,000 × $3) 90,000 390,000
Contribution margin 510,000
Less fixed expenses:
Manufacturing overhead $ 150,000
Selling & administrative expenses 100,000 250,000
Net operating income $ 260,000
 Reconciliation
We can reconcile the difference between
absorption and variable income as follows:

Variable costing net operating income $ 260,000

Deduct: Fixed manufacturing overhead
costs released from inventory
(5,000 units × $6 per unit) 30,000
Absorption costing net operating income $ 230,000

Fixed mfg. overhead $150,000

= = $6.00 per unit
Units produced 25,000 units
 Summary
Income Comparison

Costing Method 1st Period 2nd Period Total

Absorption $ 120,000 $ 230,000 $ 350,000
Variable 90,000 260,000 350,000
 IF Units Sold < Units produced

THEN Variable Costing < Absorption Costing

Income Income
 IF Units Sold > Units produced

THEN Variable Costing > Absorption Costing

Income Income
• when production > sales, absorption costing
net income will be greater than variable
costing net income due to the current period
fixed costs held in inventory.
• when production < sales, absorption costing
net income will be less than variable costing
net income due to the “old” fixed costs
released from inventory.
• when production = sales, absorption costing
net income and variable costing net income
will be equal.
 Variable versus
Absorption Costing
They are the Absorption
numbers that costing product costs
appear on our are misleading for
external
reports. decision making.

Absorption Variable
Costing Costing
 Absorption Costing
Cost of goods sold decreases because production
exceeds sales, leaving a portion of fixed
manufacturing costs in inventory.
Variable cost $10
Fixed manufacturing overhead $100,000
Units sold 10,000

Fixed Total Average

Units Total Variable Manufacturing Manufacturing Manufacturing Cost of
Produced Cost Overhead Cost Cost Goods Sold
10,000 $100,000 $100,000 $200,000 $ 20.00 $ 200,000
12,000 $120,000 $100,000 $220,000 $ 18.33 $ 183,333
14,000 $140,000 $100,000 $240,000 $ 17.14 $ 171,429
16,000 $160,000 $100,000 $260,000 $ 16.25 $ 162,500
18,000 $180,000 $100,000 $280,000 $ 15.56 $ 155,556
20,000 $200,000 $100,000 $300,000 $ 15.00 $ 150,000
 Absorption Costing
Cost of goods sold decreases because production
exceeds sales, leaving a portion of fixed
manufacturing costs in inventory.

COGS for 10,000 units

$200,000
COGS

$150,000

$100,000
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6
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3
Number of units produced
 Impact of JIT Inventory
Methods
In a JIT inventory system . . .

Production
tends to equal
sales . . .

So, the difference between variable and

absorption income tends to disappear.
Management’s Use of Costing Methods
Variable costing reports and absorption
costing reports are useful in the following
situations:
1. Controlling costs
2. Pricing products
3. Planning production
4. Analyzing market segments
5. Analyzing contribution margins
Accounting Reports and
Management Decisions
ACCOUNTING REPORTS

Absorption Costing and Variable Costing

MANAGEMENT
 MANAGEMENT

DECISIONS

Analyzing Analyzing
Controlling Planning
Pricing Market Contribution
Costs Production
Segments Margins

ACTUAL PLANNED
THANK YOU