Chapter 8

Absorption and
Variable Costing

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning
Objective
1

McGraw-Hill/Irwin

Copyright 2011 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
1-3

Variable Costing
A system of cost accounting that only
assigns the variable cost of production to
products.
Fixed
Costs
Product
Variable
Costs
1-4

Absorption and Variable Costing

Absorption
Costing

Product costs

Variable
Costing
Direct materials
Direct labor
Variable mfg. overhead

Product costs

Fixed mfg. overhead

Period costs
Period costs

Selling & Admin. exp.

1-5

Absorption and Variable Costing

Absorption
Costing

Product costs

Variable
Costing
Direct materials
Direct labor
Variable mfg. overhead

Product costs

Fixed mfg. overhead

Period costs
Period costs

Selling & Admin. exp.

The difference between absorption and variable

costing is the treatment of fixed manufacturing overhead.
1-6

Learning
Objective
2

McGraw-Hill/Irwin

Copyright 2011 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.

1-8

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

$ 150,000
$ 100,000
1-9

Absorption and Variable Costing

Unit product cost is determined as follows:

Direct materials, direct labor, and

variable mfg. overhead
Fixed mfg. overhead
($150,000 25,000 units)
Unit product cost

Absorption
Costing

Variable
Costing

10

10

6
16

10

Selling and administrative expenses are

always treated as period expenses and
deducted from revenue.
1-10

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

1-11

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

1-12

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 (20,000 $3)
$ 60,000
Fixed
100,000
Net income

$ 600,000

320,000
$ 280,000

160,000
$ 120,000

1-13

Learning
Objective
3

McGraw-Hill/Irwin

Copyright 2011 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
-

1-15

Variable Costing
Income Statements
Now lets look at variable costing by Mellon Co.
We exclude the
Variable
Costing
fixed manufacturing
$ 600,000
overhead.

Sales (20,000 $30)

Less variable expenses:
Beginning inventory
$
Add COGM (25,000 $10)
250,000
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

1-16

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

$ 150,000
100,000

260,000
$ 340,000

250,000
$ 90,000

1-17

Comparing Absorption and

Variable Costing
Lets compare the methods.
Cost of
Goods
Sold

Ending
Inventory

Period
Expense

Total

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

1-18

Comparing Absorption and

Variable Costing
Lets compare the methods.
Cost of
Goods
Sold

Ending
Inventory

Period
Expense

Absorption costing
Variable mfg. costs $ 200,000
Fixed mfg. costs
120,000
$ 320,000

$ 50,000
30,000
$ 80,000

Variable costing
Variable mfg. costs $ 200,000
Fixed mfg. costs
$ 200,000

$ 50,000
$ 50,000

Total

150,000
$ 150,000

1-19

Comparing Absorption and

Variable Costing
Lets compare the methods.
Cost of
Goods
Sold

Ending
Inventory

Period
Expense

Absorption costing
Variable mfg. costs $ 200,000
Fixed mfg. costs
120,000
$ 320,000

$ 50,000
30,000
$ 80,000

Variable costing
Variable mfg. costs $ 200,000
Fixed mfg. costs
$ 200,000

$ 50,000
$ 50,000

150,000
$ 150,000

Total
$ 250,000
150,000
$ 400,000

$ 250,000
150,000
$ 400,000

1-20

Learning
Objective
4

McGraw-Hill/Irwin

Copyright 2011 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

Fixed mfg. overhead

$150,000
=
Units produced
25,000

90,000

30,000
120,000

= $6.00 per unit

1-22

Learning
Objective
5

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Cost-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.
1-24

Learning
Objective
6

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Extending the Example

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

1-26

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

$ 150,000
$ 100,000
1-27

Mellon Co. Year 2

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

Absorption
Costing

Variable
Costing

10

10

6
16

10

There has been no

change in Mellons
cost structure.
1-28

Mellon Co. Year 2

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

1-29

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
-

$ 90,000
100,000

480,000
$ 420,000

190,000
$ 230,000

1-30

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
-

$ 90,000
100,000

480,000
$ 420,000

190,000
$ 230,000

25,000 units produced in the current period.

1-31

Mellon Co. Year 2

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

1-32

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

$ 150,000
100,000

390,000
$ 510,000

250,000
$ 260,000

Excludes fixed manufacturing overhead.

1-33

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).
1-34

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.

1-35

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

1-36

Summary Comparison of Absorption

(AC) and Variable Costing (VC)
Production versus
Sales

Produced > Sold

Total
Inventory
Effect

Increase

Period Expense Effect

Fixed mfg.
costs expensed
AC

Fixed mfg.
< costs expensed
VC

Profit Effect

AC > VC

mfg.
mfg.
This was the case in theFixed
first
period Fixed
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 mfg.
Fixed mfg.
Inventory increased from
zero to 5,000
units and
Produced = Sold No change
costs expensed = costs expensed
AC =
$120,000 absorption income
was greater
than
AC
VC
$90,000 variable income.

VC

1-37

Summary Comparison of Absorption

(AC) and Variable Costing (VC)

Production versus
Sales

Produced > Sold

Produced < Sold

Total
Inventory
Effect

Period Expense Effect

Profit Effect

Increase

Fixed mfg.
costs expensed
AC

Fixed mfg.
< costs expensed
VC

AC > VC

Decrease

Fixed mfg.
costs expensed
AC

Fixed mfg.
> costs expensed
VC

AC < VC

Fixedsales
mfg.
Fixed mfg.units
In the second period
of 30,000
Produced = Sold No change
costs expensed = costs expensed
AC
were greater than production
ofVC25,000.
AC

= VC
1-38

Summary Comparison of Absorption

(AC) and Variable Costing (VC)
Production versus
Sales

Produced > Sold

Produced < Sold

Total
Inventory
Effect

Period Expense Effect

Profit Effect

Increase

Fixed mfg.
costs expensed
AC

Fixed mfg.
< costs expensed
VC

AC > VC

Decrease

Fixed mfg.
costs expensed
AC

Fixed mfg.
> costs expensed
VC

AC < VC

Fixed
mfg. 5,000
Fixed
mfg. to zero,
Inventory decreased
from
units
Produced = Sold No change
costs expensed = costs expensed
AC = VC
and $230,000 absorption
income
was
less
AC
VC
than $260,000 variable income.
1-39

Summary Comparison of Absorption

(AC) and Variable Costing (VC)

Production versus
Sales

Produced > Sold

Total
Inventory
Effect

Increase

Period Expense Effect

Fixed mfg.
costs expensed
AC

Fixed mfg.
< costs expensed
VC

Profit Effect

AC > VC

For the two-year period,

produced
Fixed mfg. unitsFixed
mfg.
Produced < Sold
Decrease
> costs expensed
AC <
equals units
sold, costs
so expensed
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
1-40

Evaluation of Variable Costing

Management finds it
easy to understand.

Advantages

Impact of fixed
costs on profits
emphasized.

Consistent with
CVP analysis.

Emphasizes contribution in
short-run pricing decisions.

Profit for period not

affected by changes
in fixed mfg. overhead.
1-41

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

pricing decisions that must
cover full cost.

External reporting
and income tax law
require absorption costing.
1-42

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.
1-43

Learning
Objective
7

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

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
1-45

Learning
Objective
8

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Throughput Income Statement

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
1-47

End of Chapter 8

The End
1-48