2016-17 Term 1

ACCT112 Management Accounting

Week 5a

Absorption Costing & Variable

Costing

2016-17-T1-Aug to Dec 2016

Seminar Outline
Understand the limitations of absorption
costing
Explain how variable costing differs from
absorption costing and compute unit
product costs under each method.
Prepare income statements using variable
costing and absorption costing
Reconcile variable costing and absorption
costing net operating incomes and explain
why the two amounts differ
2016-17-T1-Aug to Dec 2016

Recap: Absorption Costing

Accounting standards require products to be costed
using Absorption Costing for external reporting.
Using absorption costing (also know as full product
costing), the product cost included ALL
manufacturing costs i.e.
Fixed Manu OH fixed
$2
Variable Manu
variable
Full Product
OH $1
Cost or
Direct Labour
variable
Absorption
$10
Cost $18
Direct Material
variable
$5

2016-17-T1-Aug to Dec 2016

Absorption Costing: Example

Budget
Year 1
Year 2
Bgt Total FOH per year
$500,000
$500,000
Bgt Production per year
25,000 units 25,000 units
Bgt FOH per unit (FOHR)
$20
$20
Bgt Var manu cost per unit
comprising
$5
$5
Bgt VOH (VOHR)
$1
$1
DM & DL
$4
$4
Selling price per unit
$30
$30
Actual
Year 1
Year 2
Total FOH incurred during year $500,000
$500,000
Var manu cost per unit
comprising
$5
$5
VOH
$1
$1
DM & DL
$4
$4
Selling price per unit
$30
$30
2016-17-T1-Aug to Dec 2016

Cost of Product using Absorption

Costing
Recap:
Cost of product = Actual DM + Actual DL +
Applied OH

Actual DM, DL per unit

Applied VOH per unit (VOHR x 1
unit)
Applied FOH per unit (FOHR x 1
unit)
Absorption cost per unit

2016-17-T1-Aug to Dec 2016

Year 1
$4

Year 2
$4

$1

$1

$20
$25

$20
$25

Cost of Product using Absorption

Costing
Actual production and
sales data for Year 1, Year 2:
Actual
Beginning Inventory
Production
Sales
Ending Inventory

Year 1
0 unit
12,000 units
10,000 units
2,000 units

Year 2
2,000 units
27,000 units
5,000 units
24,000 units

Sales Qty
COGS ($25/unit x Sales Qty)

10,000 units 5,000 units

$250,000
$125,000

Production Qty
12,000 units 27,000units
Applied FOH (FOHR $20 x
Prodn Qty)
$240,000
$540,000
Actual FOH
$500,000
$500,000
Under-/(Over)-applied FOH
$260,000
($40,000)
As VOHR = $1/unit and Actual VOH = $1/unit, (Actual
VOH Applied VOH) = 0. There is no under- or over2016-17-T1-Aug to Dec 2016
6
applied VOH

Absorption Costing: Income Statement

Year 1
Year 2
10,000 units 5,000 units

Sales
Sales ($30 per unit)

$300,000

$150,000

COGS ($25 per unit)

$250,000
$260,000

$125,000

+ Underapplied FMOH/
- Overapplied FMOH
Adjusted COGS
Profit/(Loss)

$510,000

($40,000)
$85,000

($210,000)

$65,000

Sales in Year 1 were higher than Year 2; but Year 1

reported a loss and Year 2, a profit. Why?

2016-17-T1-Aug to Dec 2016

Absorption Costing: Prodn Volume &

Loss in Year 1 NOT dueProfit
to:
Lower sales qty
Lower selling price per unit
Increase in total actual FOH
Increase in actual VOH per unit, DM, DL
unit an underapplied FOH in Year 1 & overapplied
Whyper
is there
FOH in Year 2?
Year 1
Year 2
Bgt Total FOH per year
$500,000 $500,000
Not
25,000
25,000
because of
Bgt Production per year
units
units
under$20
$20
estimating Bgt FOH per unit (FOHR)
Actual Total FOH per year $500,000 $500,000
FOH$
But
Actual Production per
12,000 27,000unit
because
year
units
s
actual
Applied FOH $20 x Actual
prodn is
Prod
$240,000
$540,000
different
2016-17-T1-Aug to Dec 2016
8
Under-/(Over)-applied

Absorption Costing: Pitfall

Assuming there is no inflation
Actual prodn is more than Bgt prodn ->
Overapplied FOH
substracted from
COGS
-> Lower expenses
Actual prodn is less than Bgt prodn ->
Underapplied FOH
added to COGS
-> Higher
expenses
Create Profit by over-producing

Moreover, over-production results in large

unsold inventory -> manu costs are
inventorised as assets.
2016-17-T1-Aug to Dec 2016

Limitation of Absorption Costing

Absorption Costing is used for external reporting
because it satisfies the matching principle. Fixed
manu overhead is inventorised as an asset and
expensed off as COGS matched to revenue when
the product is sold.
However, using it for internal decision-making e.g.
performance evaluation is misleading. Profit can be
manipulated by over-production.
Companies should not use financial reporting
methods to make internal decisions.
For performance evaluation and short-term
decision-making, companies use variable costing.

2016-17-T1-Aug to Dec 2016

10

Absorption Costing vs Variable Costing

Fixed Manu OH
$20
Variable Manu
OH $1
DM, DL $4
Full Product
Cost or
Absorption
Cost $25

variable
variable

Variable Manu
OH $1
DM, DL $4
Variable
Product Cost $5

2016-17-T1-Aug to Dec 2016

11

Absorption Costing vs Variable Costing

Absorption
Costing

Variable
Costing
Direct Materials

Product
Costs

Product
Costs

Direct Labor
Variable Manufacturing Overhead
Fixed Manufacturing Overhead

Period
Costs

Variable Selling and Administrative Expenses

Fixed Selling and Administrative Expenses

2016-17-T1-Aug to Dec 2016

12

Period
Costs

Differences between Absorption Costing &

Variable Costing
Absorption Costing

Variable Costing

Fixed manufacturing
cost is first captured as a
product cost and
expensed off only when
the good is sold

Fixed manufacturing
cost is expensed off
immediately

Ending inventory (i.e.

unsold goods) includes
Fixed manu cost

Ending inventory does

not include any Fixed
manu cost

Income statement uses

Gross Margin format

Income statement uses

Contribution Margin
format

Distinction between
Distinction between fixed
manufacturing costs and costs and variable costs
non-manufacturing costs (costs classified by
2016-17-T1-Aug to Dec 2016
13
(costs classified by
behaviour)

Formats of Income Statements (Normal

Variable Costing Absorption
Costing) Costing
Revenue
Less ALL Variable
Costs
Variable COGS
(DM+DL+Applied
VOH) x Sales Qty

Revenue
Less Adjusted COGS
COGS before adjustment
(DM+DL+Applied VOH+Applied FOH) x
Sales Qty
+ Underapplied Fixed OH
- Overapplied Fixed OH

Variable Expenses
(Selling & Admin
expenses)
Contribution
Margin
Gross Margin
Less ALL Fixed Costs Less ALL Period Costs/Expenses
Actual Fixed OH
Fixed Expenses
Fixed Expenses
Variable Expenses (Selling & Admin
14
expenses)
Assume there is no under-/over-applied variable

Using Variable Costing for Performance

Eval
Sales Qty
Sales
VC ($5 x Sales Qty)
Contribution Margin
Total FC (expensed off)
Variable Costing Loss
Absorption Costing
(Loss)/Profit

Year 1
Year 2
10,000 units 5,000 units
$300,000
$150,000
50,000
25,000
$250,000
$125,000
$500,000
$500,000
($250,000) ($375,000)
($210,000)

$65,000

Use Absorption Costing or Variable Costing to evaluate

performance?
When Sales , Profit should ; or Loss

When
, Profit should ; or Loss
shouldSales

Costing:
Usingshould
Variable

Income = Total Contribution Margin Total Fixed

Costs
to Dec 2016
15 Costs
= [(SP VC)2016-17-T1-Aug
x Qty Sold]
Total Fixed

Abs Costing or Var Costing for

Decision-Making?

The manufacturing costs of JEK Co. are as follows:

DM
$10 per unit
DL
$15 per unit
VOH
$5 per unit
Total monthly Fixed OH is $50,000 and can
support production of up to 2,500 units per
month.
For the coming month, JEK will be producing
2,000 units and selling them at $100 per unit
($100 is the usual selling price).
There is a special one-off customer order for 500
units. The customer
is willing to pay $40
per
2016-17-T1-Aug to Dec 2016
16
unit.

Var Costing & Abs Costing Profits

Assume:
Bgt costs below are the same as the Actual costs;
and Bgt prodn = Actual prodn
Cost allocation base is production quantity
Year 1

Year 2

Year 3

$300,000

$300,000

$300,000

Var Manu OH per unit

$4

$4

$4

DM per unit

$8

$8

$8

DL per unit

$12

$12

$12

$4

$4

$4

Total FOH

Var S&A cost per unit

Total Fixed S&A cost per
yr
Prodn Qty (Bgt = Actual)

$50,000
$50,000
25,000
units
25,000 units

FOHR ($300,000/25,000) $12/unit

2016-17-T1-Aug to Dec 2016

$12/unit
17

$50,000
25,000
units
$12/unit

Var Costing & Abs Costing Profits

Year 1
$8
$12

Year 2
$8
$12

Actual DM per unit

Actual DL per unit
Applied Var Manu OH per
unit
(VOHR x actual 1 unit)
$4
$4
Variable cost per unit
$24
$24
Applied Fixed Manu OH per
unit
(FOHR x actual 1 unit)
$12
$12
Absorption cost per unit
$36
$36
Actual VOH = $4 x 25,000 units
Applied VOH = $4 x 25,000 units
There is no under-/over-applied VOH

Year 3
$8
$12

Actual Total FOH = $300,000

Applied FOH = $12 x 25,000 units = $300,000
There is no over- or under-applied FOH 18

$4
$24
$12
$36

Var Costing & Abs Costing Profits

Assume FG Inventory, 1 Jan = 0
FG Inventory, 1 Jan
(units)
Production (units)
Sales (units)
FG Inventory, 31 Dec
(units)

Year 1

Year 2

Year 3

0
25,000
25,000

0
25,000
17,500

7,500
25,000
32,500

7,500

2016-17-T1-Aug to Dec 2016

19

Absorption Costing Income Statement

Bgt production (units)
Actual Qty produced
(units)
Actual Qty sold (units)

Year 1
25,000

Year 2
25,000

Year 3
25,000

25,000
25,000

25,000
17,500

25,000
32,500

$1,200,00
0
$840,000 $1,560,000

Sales ($48 per unit)

Less COGS
$900,000
($36/unit x Qty sold)
Gross Margin
$300,000
Less Selling & Admin Expenses
Variable S & A
($4/unit x Qty sold)
$100,000
Fixed S & A
$50,000
Operating Income
$150,000

2016-17-T1-Aug to Dec 2016

$630,000 $1,170,000
$210,000

$390,000

$70,000
$50,000
$90,000

$130,000
$50,000
$210,000

20

H is

Variable Costing Income Statement

Qty sold (units)

25,000

17,500

32,500

Year 1 Year 2 Year 3

$1,200,0 $840,00 $1,560,0
Sales ($48 per unit)
00
0
00
Less Variable
Expenses:
Var COGS ($24
$420,00
per unit)
$600,000
0
$780,000
Var S & A
expenses
$100,000 $70,000 $130,000
Contribution Actual
$350,00
or
Margin
0
$650,000
Applied $500,000
?
Less Fixed
Expenses
2016-17-T1-Aug to Dec 2016 $300,00
21

Year 1: Produced 25,000 units; Sold 25,000 units;

End Inv 0 unit
Absorption Costing Income $150,000 = Variable Costing
Income $150,000
Absorption Costing
Year 1
Balance
Sheet
Year 1
FOH =
$300,0
00
No Ending
inventory

Year 1
Income
Statement
Applied FOH in
COGS $12 x
25,000 units =
$300,000

Variable
Costing
Year 1
Income
Statement
All FOH
expensed
$300,000

Total Expenses =
Total Expenses =
No
difference; thus$300,000
Income is
$300,000

the same

2016-17-T1-Aug to Dec 2016

22

Year 2: BI 0 unit; Prod 25,000 units; Sold 17,500

units; EI 7,500 units

Absorption Costing Income $90,000 is higher than Variable

Costing Income $0 by $90,000
Absorption Costing
Year 2
Balance
Sheet

Year 2
Income Statement
Applied OH in COGS
$12 x 17,500 units
from current
production =
$210,000

Year 2
FOH =
$300,0
00

Variable
Costing
Year 2
Income
Statement

All FOH
expensed
$300,000

FOH in
Ending
inventory
7,500 units x
Absorption$12
Costing
expenses $210,000 < Variable Costing
=
$300,000 $90,000
expenses by $90,000 due to FOH deferred as
2016-17-T1-Aug to Dec 2016
asset in unsold inventory

Asset

Total Expenses =

23

Total Exp =

Year 3: BI 7,500units; Prod 25,000 units; Sold

32,500
units;
EI: 0 is
unit
Absorption Costing
Income
$210,000
lower than Variable
Costing Income $300,000 by $90,000
Absorption Costing
Year 3
Balance
Sheet
Year 2
FOH

Year 3
FOH =
$300,00
0

Variable Costing

Year 3
Income Statement

Year 3
Income
Statement

FOH in Beginning
inventory
expensed in COGS
7,500 units x $12 =
$90,000

Beginning
inventory does
not carry FOH
and thus no
impact on COGS

Applied OH in COGS
25,000 units from
current production x
$12 = $300,000

All FOH expensed

$300,000

No Ending
Inventory
Absorption
Costing expenses $390,000 > Variable Costing
Total Expenses
TotalFOH
Exp =in
expenses $300,000 by $90,000
due =
to $90,000
$390,000
$300,000
Beg Inventory expensed
off as COGS
2016-17-T1-Aug to Dec 2016

24

Comparing Operating Incomes:

Summary

Prod =
2016-17-T1-Aug Sales
to Dec 2016

Prod >
25
Sales

Prod <
Sales

Inventory Levels & Operating Incomes

Production
vs.
Sales
Production
>
Sales
Production
<
Sales
Production
=
Sales

Change in
Inventory
i.e.
Ending Inv
Beg Inv

Profit
Comparison

Inventory

Absorption
>
Variable

Inventory

Absorption
<
Variable

Inventory
Unchanged

Absorption
=
Variable

2016-17-T1-Aug to Dec 2016

26

Reconciling Income under AC & VC:

Summary
Difference in incomes
is always due to:
Fixed Manufacturing Overhead;
Beginning Inventory and
Ending Inventory
Absorption Costing Income
+ FOH in Beginning Inventory expensed in
COGS
FOH in Ending Inventory deferred in BS
= Variable Costing Income
Absorption Var Costing Incomes =
(Ending Inventory Beg Inventory) x FOH per
unit; OR =
(Prod Qty Sales Qty) x FOH per unit
Beg Inv + Prod Qty Sales Qty =
End Inv
(Prod Qty 2016-17-T1-Aug
Sales Qty)
= (End Inv27
to Dec 2016
Beg Inv)

Why use Variable Costing?

Recap: using Variable Costing:
Income = Total Contribution Margin Total Fixed
Costs
= [(SP VC) x Qty Sold] Total Fixed Costs

Consistent with CVP analysis

Advantages

Impact of fixed
costs on profits
emphasized

Net operating income

(not affected by changes in
inventory) is closer to net
cash flow
Easier to estimate profitability
of products and segments.
Profit is not affected
by
changes in
inventories
2016-17-T1-Aug to Dec 2016

28