Chapter Seventeen

Absorption, Variable, and Throughput Costing

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Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning Objective 1

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Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Absorption Costing
A system of accounting for costs in which both fixed and variable production costs are considered product costs.
Fixed Costs Product Variable Costs

Variable Costing
A system of cost accounting that only assigns the variable cost of production to products.
Fixed Costs Product Variable Costs

Absorption and Variable Costing

Absorption Costing Direct materials Direct labor Variable mfg. overhead Fixed mfg. overhead Period costs Period costs Selling & Admin. exp. Variable Costing

Product costs

Product costs

Absorption and Variable Costing

Absorption Costing Direct materials Direct labor Variable mfg. overhead Fixed mfg. overhead Period costs Period costs Selling & Admin. exp. Variable Costing

Product costs

Product costs

The difference between absorption and variable costing is the treatment of fixed manufacturing overhead.

Learning Objective 2

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Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Absorption and Variable Costing

Lets put some numbers to an example and see what we can learn about the difference between absorption and variable costing.

Absorption and Variable Costing

Mellon Co. produces a single product with the following information available:
Number of units produced annually Variable costs per unit: Direct materials, direct labor and variable mfg. overhead Selling & administrative expenses Fixed costs per year: Mfg. overhead Selling & administrative expenses 25,000

$ $

10 3

$ 150,000 $ 100,000

Absorption and Variable Costing

Unit product cost is determined as follows:
Absorption Costing Direct materials, direct labor, and variable mfg. overhead Fixed mfg. overhead ($150,000 25,000 units) Unit product cost $ 10 6 16 Variable Costing $ 10 10

Selling and administrative expenses are always treated as period expenses and deducted from revenue.

Absorption Costing Income Statements

Mellon Co. had no beginning inventory, produced 25,000 units and sold 20,000 units this year at $30 each. Absorption Costing
Sales (20,000 $30) Less cost of goods sold: Beginning inventory Add COGM Goods available for sale Ending inventory Gross margin Less selling & admin. exp. Variable Fixed Net income $ 600,000

Absorption Costing Income Statements

Mellon Co. had no beginning inventory, produced 25,000 units and sold 20,000 units this year at $30 each. Absorption Costing
Sales (20,000 $30) 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 Gross margin Less selling & admin. exp. Variable Fixed Net income $ 600,000

320,000 $ 280,000

Absorption Costing Income Statements

Mellon Co. had no beginning inventory, produced 25,000 units and sold 20,000 units this year at $30 each. Absorption Costing
Sales (20,000 $30) 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 Gross margin Less selling & admin. exp. $ 60,000 Variable (20,000 $3) Fixed 100,000 Net income $ 600,000

320,000 $ 280,000

160,000 $ 120,000

Learning Objective 3

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Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Variable Costing Income Statements

Now lets look at variable costing by Mellon Co. Variable Costing
Sales (20,000 $30) Less variable expenses: Beginning inventory $ Add COGM Goods available for sale Ending inventory Variable cost of goods sold Variable selling & administrative expenses Contribution margin Less fixed expenses: Manufacturing overhead Selling & administrative expenses Net income $ 600,000 -

Variable Costing Income Statements

Now lets look at variable costing by Mellon We exclude the Variable Costing Co. fixed manufacturing
Sales (20,000 $30) $ 600,000 overhead. Less variable expenses: Beginning inventory $ 250,000 Add COGM (25,000 $10) Goods available for sale $ 250,000 Ending inventory (5,000 $10) 50,000 Variable cost of goods sold $ 200,000 Variable selling & administrative expenses Contribution margin Less fixed expenses: Manufacturing overhead Selling & administrative expenses Net income

Variable Costing Income Statements

Now lets look at variable costing by Mellon Co. Variable Costing
Sales (20,000 $30) Less variable expenses: Beginning inventory Add COGM (25,000 $10) Goods available for sale Ending inventory (5,000 $10) Variable cost of goods sold Variable selling & administrative expenses (20,000 $3) Contribution margin Less fixed expenses: Manufacturing overhead Selling & administrative expenses Net income $ 600,000 $ 250,000 $ 250,000 50,000 $ 200,000 60,000 260,000 $ 340,000

$ 150,000 100,000

250,000 $ 90,000

Comparing Absorption and Variable Costing

Lets compare the methods.
Cost of Goods Sold Absorption costing Variable mfg. costs $ 200,000 Fixed mfg. costs 120,000 $ 320,000 Variable costing Variable mfg. costs $ 200,000 Fixed mfg. costs $ 200,000 Ending Inventory Period Expense Total

Comparing Absorption and Variable Costing

Lets compare the methods.
Cost of Goods Sold Absorption costing Variable mfg. costs $ 200,000 Fixed mfg. costs 120,000 $ 320,000 Variable costing Variable mfg. costs $ 200,000 Fixed mfg. costs $ 200,000 Ending Inventory $ 50,000 30,000 $ 80,000 Period Expense $ $ Total

$ 50,000 $ 50,000

150,000 $ 150,000

Comparing Absorption and Variable Costing

Lets compare the methods.
Cost of Goods Sold Absorption costing Variable mfg. costs $ 200,000 Fixed mfg. costs 120,000 $ 320,000 Variable costing Variable mfg. costs $ 200,000 Fixed mfg. costs $ 200,000 Ending Inventory $ 50,000 30,000 $ 80,000 Period Expense $ $ Total $ 250,000 150,000 $ 400,000

$ 50,000 $ 50,000

150,000 $ 150,000

$ 250,000 150,000 $ 400,000

Learning Objective 4

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Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Reconciling Income Under Absorption and Variable Costing

We can reconcile the difference between absorption and variable net income as follows:
Variable costing net income Add: Fixed mfg. overhead costs deferred in inventory (5,000 units $6 per unit) Absorption costing net income $ 90,000

30,000 120,000

Fixed mfg. overhead $150,000 = Units produced 25,000

= $6.00 per unit

Learning Objective 5

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Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Extending the Example

Lets look at the second year of operations for Mellon Company.

Mellon Co. Year 2

In its second year of operations, Mellon Co. started with an inventory of 5,000 units, produced 25,000 units and sold 30,000 units at $30 each.
Number of units produced annually Variable costs per unit: Direct materials, direct labor and variable mfg. overhead Selling & administrative expenses Fixed costs per year: Mfg. overhead Selling & administrative expenses 25,000

$ $

10 3

$ 150,000 $ 100,000

Mellon Co. Year 2

Unit product cost is determined as follows:
Absorption Costing Direct materials, direct labor, and variable mfg. overhead Fixed mfg. overhead ($150,000 25,000 units) Unit product cost $ 10 6 16 Variable Costing $ 10 10

There has been no change in Mellons cost structure.

Mellon Co. Year 2

Now lets look at Mellons income statement assuming absorption costing is used.

Mellon Co. Year 2

Units in ending inventory from the previous period.
Absorption Costing
Sales (30,000 $30) Less cost of goods sold: Beg. inventory (5,000 x $16) Add COGM (25,000 $16) Goods available for sale Ending inventory Gross margin Less selling & admin. exp. Variable (30,000 $3) Fixed Net income $ 900,000 $ 80,000 400,000 $ 480,000 -

480,000 $ 420,000

$ 90,000 100,000

190,000 $ 230,000

Mellon Co. Year 2

Absorption Costing
Sales (30,000 $30) Less cost of goods sold: Beg. inventory (5,000 x $16) Add COGM (25,000 $16) Goods available for sale Ending inventory Gross margin Less selling & admin. exp. Variable (30,000 $3) Fixed Net income $ 900,000 $ 80,000 400,000 $ 480,000 -

480,000 $ 420,000

$ 90,000 100,000

190,000 $ 230,000

25,000 units produced in the current period.

Mellon Co. Year 2

Next, well look at Mellons income statement assuming variable costing is used.

Mellon Co. Year 2

Variable Costing
Sales (30,000 $30) Less variable expenses: Beg. inventory (5,000 $10) Add COGM (25,000 $10) Goods available for sale Ending inventory Variable cost of goods sold Variable selling & administrative expenses (30,000 $3) Contribution margin Less fixed expenses: Manufacturing overhead Selling & administrative expenses Net income $ 900,000 50,000 250,000 $ 300,000 $ 300,000 90,000 390,000 $ 510,000 $

$ 150,000 100,000

250,000 $ 260,000

Excludes fixed manufacturing overhead.

Summary
Income Comparison
Costing Method Absorption Variable 1st Period $ 120,000 90,000 2nd Period $ 230,000 260,000 Total $ 350,000 350,000

In the first period, production (25,000 units) was greater than sales (20,000). In the second period, production (25,000 units) was less than sales (30,000).

Learning Objective 6

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Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Summary
Income Comparison
Costing Method Absorption Variable 1st Period $ 120,000 90,000 2nd Period $ 230,000 260,000 Total $ 350,000 350,000

For the two-year period, total absorption income and total variable income are the same.

Summary
Lets see if we can get an overview of what we have done.

Summary Comparison of Absorption (AC) and Variable Costing (VC)

Production versus Sales Total Inventory Effect Period Expense Effect Fixed mfg. costs expensed AC Fixed mfg. < costs expensed VC Profit Effect

Produced > Sold

Increase

AC > VC

Fixed mfg. This was the case in the first period Fixed mfg. when production Produced < Sold Decrease costs expensed > costs expensed AC < VC of 25,000 units was greater than sales of 20,000 units. AC VC Fixed zero Fixed units and Inventory increased frommfg. to 5,000mfg. Produced = Sold No change costs expensed = costs expensed AC = $120,000 absorption income was greater than AC VC $90,000 variable income.

VC

Summary Comparison of Absorption (AC) and Variable Costing (VC)

Production versus Sales Total Inventory Effect Period Expense Effect Fixed mfg. costs expensed AC Fixed mfg. costs expensed AC Fixed mfg. < costs expensed VC Fixed mfg. > costs expensed VC Profit Effect

Produced > Sold

Increase

AC > VC

Produced < Sold

Decrease

AC < VC

Fixed mfg. Fixed mfg. In the second period sales of 30,000 units Produced = Sold No change costs expensed = costs expensed AC were greater than production of 25,000. AC VC

= VC

Summary Comparison of Absorption (AC) and Variable Costing (VC)

Production versus Sales Total Inventory Effect Period Expense Effect Fixed mfg. costs expensed AC Fixed mfg. costs expensed AC Fixed mfg. < costs expensed VC Fixed mfg. > costs expensed VC Profit Effect

Produced > Sold

Increase

AC > VC

Produced < Sold

Decrease

AC < VC

Fixed mfg. Fixed mfg. Inventory decreased from 5,000 units to zero, Produced = Sold No change costs expensed = costs expensed AC = VC and $230,000 absorption income was less AC VC than $260,000 variable income.

Summary Comparison of Absorption (AC) and Variable Costing (VC)

Production versus Sales Total Inventory Effect

Period Expense Effect Fixed mfg. costs expensed AC Fixed mfg. < costs expensed VC

Profit Effect

Produced > Sold

Increase

AC > VC

Fixed mfg. For the two-year period, unitsFixed mfg. produced Produced < Sold Decrease equals units sold, costs expensed > costs expensed AC < so total absorption income AC VC equals total variable income. Produced = Sold No change Fixed mfg. Fixed mfg. costs expensed = costs expensed AC VC

VC

AC = VC

Cost-VolumeCost-Volume-Profit Analysis
CVP includes all fixed costs to compute breakeven.
Variable costing and CVP are consistent as both treat fixed costs as a lump sum.

Absorption costing defers fixed costs into inventory.

Absorption costing is inconsistent with CVP because absorption costing treats fixed costs on a per unit basis.

Evaluation of Variable Costing

Management finds it easy to understand. Consistent with CVP analysis.

Advantages

Emphasizes contribution in shortshort-run pricing decisions.

Impact of fixed costs on profits emphasized.

Profit for period not affected by changes in fixed mfg. overhead.

Evaluation of Absorption Costing

Fixed manufacturing overhead is treated the same as the other product costs, direct material and direct labor.

Advantages

Consistent with long-run longpricing decisions that must cover full cost.

External reporting and income tax law require absorption costing.

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.

Learning Objective 7

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Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Throughput Costing
Unit-level spending for direct costs. Product cost

Unit-level costs are incurred every time a unit of product is manufactured and will not be incurred again until the next unit is manufactured.

Throughput Costing
Example In an automated process direct material may be the only unit-level cost and so is the only product cost. All other manufacturing costs are expensed as period costs. Incentive to overproduce is reduced Average unit cost does not vary with changes in production levels.

Advantages

Learning Objective 8

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Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Throughput Income Satatement

Sales Revenue Throughput cost of goods sold (dir. mat.) Gross Margin Less: Operating costs Direct labor 100,000 Variable mfg overhead 60,000 Fixed mfg overhead 150,000 Variable sales & admin costs 50,000 Fixed sales & admin costs 125,000 Total operating costs Net Income $600,000 150,000 $450,000

375,000 $ 75,000

Learning Objective 9

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Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Volume Variances
Variable-costing statement has no volume variance Absorption-costing income statement has volume variance because fixed overhead costs are included in the cost of the product.

End of Chapter 17

The End