Group 4

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

Source: Managerial Accounting /Garrison-Noreen-

Brewer/McGraw-Hill International Edition
 Variable
Variablecosting
costingincome
incomestatements
statementsareareeasier
easier
to
tounderstand
understandbecause
becausenetnetoperating
operating
income
incomeisisonly
onlyaffected
affectedbybychanges
changesin inunit
unit sales.
sales.This
This
produces
producesnet netoperating
operatingincome
incomefigures
figuresthat
thatare
are
more
moreconsistent
consistent with
with managers’
managers’expectations.
expectations.

Source: Managerial Accounting /Garrison-Noreen-

Brewer/McGraw-Hill International Edition
 CVP Analysis, Decision Making
and Variable Costing
Variable Costing harmonizes well with CVP analysis
because it essentially treats fixed manufacturing
overhead as a period cost.

Treating
Treatingfixed
fixedmanufacturing
manufacturingoverhead
overheadasasaa
variable
variablecost
cost can:
can:
•• Lead
Leadto
to faulty
faultypricing
pricingdecisions
decisions and
and keep-or-drop
keep-or-drop
decisions.
decisions.
•• Produce
Produceaahigher
highernet
netoperating
operatingincome
incomecompared
comparedtoto variable
variable
costing
costing

Source: Managerial Accounting /Garrison-Noreen-

Brewer/McGraw-Hill International Edition
 Consistent with
CVP analysis.
Management finds Net operating income
it more useful. is closer to
net cash flow.
Consistent with standard
costs and flexible budgeting.
Advantages
Easier to estimate profitability
Impact of fixed of products and segments.
costs on profits
emphasized. Profit is not affected by
changes in inventories.
Source: Managerial Accounting /Garrison-Noreen-
Brewer/McGraw-Hill International Edition
DISADVANTAGES OF VARIABLE
COSTING
Inconsistent with the Tax
regulation and GAAP
requirements
Inconsistent with how
executives are evaluated
by investors

DISADVANTAGES
understated inventory - lower
net operating income

Overheads that are essential to producing

a product do not form part of the product
cost
Under Absorption Costing
 To
To conform
conform to to
GAAP
GAAP requirements,
requirements,
absorption
absorption costing
costing must
must be be used
used for
for
external
external financial
financial reports
reports in
in the
the Under
Under the
the Tax
Tax
United
United States.
States. Reform
Reform Act
Act of
of 1986,
1986,
absorption
absorption costing
costing must
must be
be
used
used when
when filling
filling out
out
Since
Since top
top executives
executives income
income tax
tax returns.
returns.
are
are typically
typically evaluated
evaluated based
based onon
earnings
earnings reported
reported toto shareholders
shareholders
in
in external
external reports,
reports, they
they may
may feel
feel that
that
decisions
decisions should
should bebe based
based onon
absorption
absorption costing
costing data.
data.
Source: Managerial Accounting /Garrison-Noreen-
Brewer/McGraw-Hill International Edition
IFRS # 2 Inventories
International Accounting Standard (IAS) 2
Inventories...The cost of inventories shall comprise all
costs of purchase, costs of conversion and other
costs incurred in bringing the inventories to their
present location and condition

Sources : Wiley IFRS 2008 : Interpretation and Application of International Financial Reporting Standards - Barry J. Epstein,
Eva K. Jermakowicz and IAS 2 Inventories
US Treasury Reg section 1.263A-1T

Also known as Uniform Capitalization (UNICAP)

Itemizes the direct and indirect costs that must be capitalized.
Direct materials, direct labor, and certain types of overhead
costs are required to be capitalized. In the regulations, overhead
costs have typically been placed into three categories.
Under pre-1986 Act law, "category I" costs were capitalized;
"category II" costs were expended; and "category III" costs were
capitalized for tax purposes if they were capitalized for financial
reporting purposes.
Under the new law, all category I and category III costs (except
the costs of strikes and idle time) and certain types of category
II costs must be capitalized.
UNICAP Summary

IRS.GOV -
http://www.irs.gov/businesses/small/industries/article/0,,id=97675,00.html
Absorption Costing
Advantages
Widely accepted – method
used for external reporting
Recognises the importance of
fixed costs in production
Stock is not undervalued –
ensures that costs are fully
recovered
Identifies the profitability of
different products and services
Disadvantages
Not useful for management to
use to make decisions,
planning and control
Portion of fixed cost is carried
over to subsequent period as
part of closing stock
Hard to distinguish between
variable and fixed cost
Net profit varies with sales
and stock values – variability
of profit will cause confusion
Cost per unit changes from
period to period due to
existence of fixed overhead
Cost Behaviour
Absorption Variable Costing
Costing

Cost of Good Sold High Low

Ending Inventories High Low
Gross Margin Low High
Net Operating Income High Low
Normal Corporate Income Taxes High Low
Minimum Corporate Income Tax Low High
Unit Cost High Low
Break Even Point Low High
Bridging the GAP for Labor Costs
Fixed Variable
Paid by result or per X
piece
Paid on daily / weekly or X
monthly without quota
Paid on daily / weekly or X X
monthly, with overtime
premiums , without
quota
Paid on daily / weekly or X
monthly - with quota
Paid on daily / weekly or X X
monthly, with overtime
premiums, with quota
 In a JIT inventory system . . .

Production
tends to equal
sales . . .

So, the difference between variable and

absorption income tends to be minimal or zero.
Source: Managerial Accounting /Garrison-Noreen-
Brewer/McGraw-Hill International Edition
Source: Managerial Accounting /Garrison-Noreen-
Brewer/McGraw-Hill International Edition
Impact on Lean Production
The difference in net operating income between
absorption and variable costing occur because of the
changes in the number of units in the inventory. Under
Lean Production, goods are produced to customers’ orders
and the goal is to eliminate finished goods inventories
entirely and reduce work-in-process almost entirely, thus,
the differences in net operating income will be very
minimal.
Just-in-time production
Questions?