Chapter 8

Absorption and
Variable Costing
 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

8-2
 Variable Costing

A system of cost accounting that only

assigns the variable cost of production
to products.

Fixed
Costs
Product
Variable
Costs

8-3
 Absorption and Variable Costing
Absorption Variable
Costing Costing

Direct materials
Direct labor Product costs
Product costs Variable mfg. overhead

Fixed mfg. overhead

Period costs
Period costs Selling & Admin. exp.

8-4
 Absorption and Variable Costing
Absorption Variable
Costing Costing

Direct materials
Direct labor Product costs
Product costs Variable mfg. overhead

Fixed mfg. overhead

Period costs
Period costs Selling & Admin. exp.

The difference between absorption and variable

costing is the treatment of fixed manufacturing overhead.
8-5
 Absorption and Variable Costing

Let’s put some numbers to an example and

see what we can learn about the difference
between absorption and variable costing.

8-6
Absorption and Variable Costing
Mellon 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:
Mfg. overhead $ 150,000
Selling & administrative
expenses $ 100,000

8-7
Absorption and Variable Costing
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.
8-8
 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 x $30) $ 600,000
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

8-9
 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 x $30) $ 600,000
Less cost of goods sold:
Beginning inventory $ -
Add COGM (25,000 x $16) 400,000
Goods available for sale $ 400,000
Ending inventory (5,000 x $16) 80,000 320,000
Gross margin $ 280,000
Less selling & admin. exp.
Variable
Fixed
Net income

8-10
 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 x $30) $ 600,000
Less cost of goods sold:
Beginning inventory $ -
Add COGM (25,000 x $16) 400,000
Goods available for sale $ 400,000
Ending inventory (5,000 x $16) 80,000 320,000
Gross margin $ 280,000
Less selling & admin. exp.
Variable (20,000 x $3) $ 60,000
Fixed 100,000 160,000
Net income $ 120,000

8-11
 Variable Costing
Income Statements
Now let’s look at variable costing by Mellon Co.
Variable Costing
Sales (20,000 x $30) $ 600,000
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

8-12
 Variable Costing
Income Statements
Now let’s look at variable costing by Mellon
We exclude the Co.
fixed manufacturing
Variable Costing
Sales (20,000 x $30) $ 600,000
Less variable expenses: overhead.
Beginning inventory $ -
Add COGM (25,000 x $10) 250,000
Goods available for sale $ 250,000
Ending inventory (5,000 x $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

8-13
 Variable Costing
Income Statements
Now let’s look at variable costing by Mellon Co.

Variable Costing
Sales (20,000 x $30) $ 600,000
Less variable expenses:
Beginning inventory $ -
Add COGM (25,000 x $10) 250,000
Goods available for sale $ 250,000
Ending inventory (5,000 x $10) 50,000
Variable cost of goods sold $ 200,000
Variable selling & administrative
expenses (20,000 x $3) 60,000 260,000
Contribution margin $ 340,000
Less fixed expenses:
Manufacturing overhead $ 150,000
Selling & administrative expenses 100,000 250,000
Net income $ 90,000
8-14
 Comparing 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
Fixed mfg. costs 120,000
$ 320,000

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

8-15
 Comparing 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 $ -
Fixed mfg. costs 120,000 30,000 -
$ 320,000 $ 80,000 $ -

Variable costing
Variable mfg. costs $ 200,000 $ 50,000 $ -
Fixed mfg. costs - - 150,000
$ 200,000 $ 50,000 $ 150,000

8-16
 Comparing 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

8-17
 Reconciling Income Under
Absorption and Variable Costing
We can reconcile the difference between
absorption and variable net income as follows:

Variable costing net income $ 90,000

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

Fixed mfg. overhead $150,000

= = $6.00 per unit
Units produced 25,000
8-18
 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.

8-19
Extending the Example

Let’s look at
the second
year of
operations
for Mellon
Company.

8-20
 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 25,000
Variable costs per unit:
Direct materials, direct labor
and variable mfg. overhead $ 10
Selling & administrative
expenses $ 3
Fixed costs per year:
Mfg. overhead $ 150,000
Selling & administrative
expenses $ 100,000

8-21
 Mellon 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

There has been no

change in Mellon’s
cost structure.

8-22
 Mellon Co. Year 2
Now let’s look at Mellon’s income statement
assuming absorption costing is used.

8-23
 Mellon Co. Year 2
Units in ending inventory from the previous period.
Absorption Costing
Sales (30,000 x $30) $ 900,000
Less cost of goods sold:
Beg. inventory (5,000 x $16) $ 80,000
Add COGM (25,000 x $16) 400,000
Goods available for sale $ 480,000
Ending inventory - 480,000
Gross margin $ 420,000
Less selling & admin. exp.
Variable (30,000 x $3) $ 90,000
Fixed 100,000 190,000
Net income $ 230,000

8-24
 Mellon Co. Year 2
Absorption Costing
Sales (30,000 x $30) $ 900,000
Less cost of goods sold:
Beg. inventory (5,000 x $16) $ 80,000
Add COGM (25,000 x $16) 400,000
Goods available for sale $ 480,000
Ending inventory - 480,000
Gross margin $ 420,000
Less selling & admin. exp.
Variable (30,000 x $3) $ 90,000
Fixed 100,000 190,000
Net income $ 230,000

25,000 units produced in the current period.

8-25
 Mellon Co. Year 2
Next, we’ll look at Mellon’s income statement
assuming variable costing is used.

8-26
 Mellon Co. Year 2
Variable Costing
Sales (30,000 x $30) $ 900,000
Less variable expenses:
Beg. inventory (5,000 x $10) $ 50,000
Add COGM (25,000 x $10) 250,000
Goods available for sale $ 300,000
Ending inventory -
Variable cost of goods sold $ 300,000
Variable selling & administrative
expenses (30,000 x $3) 90,000 390,000
Contribution margin $ 510,000
Less fixed expenses:
Manufacturing overhead $ 150,000
Selling & administrative expenses 100,000 250,000
Net income $ 260,000

Excludes fixed manufacturing overhead.

8-27
 Summary
Income Comparison

Costing Method 1st Period 2nd Period Total

Absorption $ 120,000 $ 230,000 $ 350,000
Variable 90,000 260,000 350,000

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).

8-28
 Summary
Income Comparison

Costing Method 1st Period 2nd Period Total

Absorption $ 120,000 $ 230,000 $ 350,000
Variable 90,000 260,000 350,000

For the two-year period, total absorption

income and total variable income are the same.

8-29
 Summary
Let’s see if we can get an overview
of what we have done.

8-30
 Summary Comparison of
Absorption (AC) and Variable
Costing (VC)

This was the case in the first period when production

of 25,000 units was greater than sales of 20,000 units.

Inventory increased from zero to 5,000 units and

$120,000 absorption income was greater than
$90,000 variable income. 8-31
 Summary Comparison of
Absorption (AC) and Variable
Costing (VC)

In the second period sales of 30,000 units

were greater than production of 25,000.

8-32
 Summary Comparison of
Absorption (AC) and Variable
Costing (VC)

Inventory decreased from 5,000 units to zero,

and $230,000 absorption income was less
than $260,000 variable income.

8-33
 Summary Comparison of
Absorption (AC) and Variable
Costing (VC)
Total
Production versus Inventory
Sales Effect Period Expense Effect Profit Effect

Fixed mfg. Fixed mfg.

Produced > Sold Increase costs expensed < costs expensed AC > VC
AC VC

For the two-year period, units produced

Fixed mfg. Fixed mfg.
Produced < Sold equals units
Decrease sold, so total absorption
costs expensed > costs income
expensed AC < VC
equals total variable income.
AC VC

Fixed mfg. Fixed mfg.

Produced = Sold No change costs expensed = costs expensed AC = VC
8-34
AC VC
 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.

8-35
Evaluation of Variable Costing

Management finds it Consistent with

easy to understand. CVP analysis.

Emphasizes contribution in
Advantages short-run pricing decisions.

Impact of fixed Profit for period not

costs on profits affected by changes
emphasized. in fixed mfg. overhead.
8-36
Evaluation of Absorption Costing
Fixed manufacturing overhead is
treated the same as the other product
costs, direct material and direct labor.

Consistent with long-run

Advantages pricing decisions that must
cover full cost.

External reporting
and income tax law
require absorption costing.
costing
8-37
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.
8-38
 Throughput Costing

Unit-level
Product
spending for
cost
direct costs.

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.

8-39
 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 Average unit cost does

overproduce not vary with changes
is reduced in production levels.

Advantages
8-40
 Throughput Income Statement
Sales Revenue $600,000
Throughput cost of goods sold (dir. mat.) 150,000
Gross Margin $450,000
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 375,000
Net Income $ 75,000
8-41