Chapter 6-2

Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

6-2

Learning Objective 3
Reconcile variable costing and absorption costing net operating incomes and explain why the two amounts differ.

6-3

Comparing the Two Methods

6-4

Comparing the Two Methods

We can reconcile the difference between absorption and variable income as follows:
Variable costing net operating income $ 90,000 Add: Fixed mfg. overhead costs deferred in inventory (5,000 units $6 per unit) 30,000 Absorption costing net operating income $ 120,000

Fixed mfg. overhead $150,000 = = $6 per unit Units produced 25,000 units

6-5

Extended Comparisons of Income Data Harvey Company Year Two

6-6

Unit Cost Computations

Since the variable costs per unit, total fixed costs, and the number of units produced remained unchanged, the unit cost computations also remain unchanged.

6-7

Variable Costing Contribution Format Income Statement All fixed

Variable manufacturing costs only.
Sales (30,000 $30) Less variable expenses: Variable cost of goods sold (30,000 $10) Variable selling & administrative expenses (30,000 $3) Total variable expenses Contribution margin Less fixed expenses: Fixed manufacturing overhead Fixed selling & administrative expenses Net operating income

manufacturing overhead is expensed.

Variable Costing
$ 900,000 $ 300,000 90,000 390,000 510,000 $ 150,000 100,000

250,000 $ 260,000

6-8

Absorption Costing Income Statement

Unit product cost.

Fixed manufacturing overhead released from inventory is 5,000 units $6 = $30,000.

6-9

Comparing the Two Methods

We can reconcile the difference between absorption and variable income as follows:
Variable costing net operating income $ 260,000 Deduct: Fixed manufacturing overhead costs released from inventory (5,000 units $6 per unit) 30,000 Absorption costing net operating income $ 230,000

Fixed mfg. overhead $150,000 = = $6 per unit Units produced 25,000 units

6-10

Comparing the Two Methods

6-11

Summary of Key Insights

6-12

Effect of Changes in Production on Net Operating Income

Lets revise the Harvey Company example.

In the previous example, 25,000 units were produced each year, but sales increased from 20,000 units in year one to 30,000 units in year two.

In this revised example, production will differ each year while sales will remain constant.

6-13

Effect of Changes in Production Harvey Company Year One

6-14

Unit Cost Computations for Year One

Unit product cost is determined as follows:

Since the number of units produced increased in this example, while the fixed manufacturing overhead remained the same, the absorption unit cost is less.

6-15

Absorption Costing: Year One

6-16

Variable Costing: Year One

Variable Costing
Sales (25,000 $30) Less variable expenses: Beginning inventory $ Add COGM (30,000 $10) 300,000 Goods available for sale 300,000 Less ending inventory (5,000 $10) 50,000 Variable cost of goods sold 250,000 Variable selling & administrative expenses (25,000 $3) 75,000 Contribution margin Less fixed expenses: Manufacturing overhead $ 150,000 Selling & administrative expenses 100,000 Net operating income $ 750,000

325,000 425,000

250,000 $ 175,000

6-17

Effect of Changes in Production Harvey Company Year Two

6-18

Unit Cost Computations for Year Two

Unit product cost is determined as follows:

Since the number of units produced decreased in the second year, while the fixed manufacturing overhead remained the same, the absorption unit cost is now higher.

6-19

Absorption Costing: Year Two

Absorption Costing
Sales (25,000 $30) Less cost of goods sold: Beg. inventory (5,000 $15) Add COGM (20,000 $17.50) Goods available for sale Less ending inventory Gross margin Less selling & admin. exp. Variable (25,000 $3) Fixed Net operating income $ 750,000 $ 75,000 350,000 425,000 -

425,000 325,000

$ 75,000 100,000

175,000 $ 150,000

These are the 20,000 units produced in year 2 at the higher unit cost of $17.50 each.

6-20

Variable Variable Costing: Year Two manufacturing

costs only.

All fixed manufacturing overhead is expensed.

6-21

Comparing the Two Methods

Conclusions
Net operating income is not affected by changes in production using variable costing. Net operating income is affected by changes in production using absorption costing even though the number of units sold is the same each year.

6-22

Enabling CVP Analysis

Variable costing categorizes costs as fixed and variable so it is much easier to use this income statement format for CVP analysis. Because absorption costing assigns fixed manufacturing overhead costs to units produced ($6 per unit for Harvey Company), a portion of fixed manufacturing overhead resides in inventory when units remain unsold. The potential result is positive operating income when the number of units sold is less than the breakeven point.

6-23

Explaining Changes in Net Operating Income

Variable costing income is only affected by changes in unit sales. It is not affected by the number of units produced. As a general rule, when sales go up, net operating income goes up, and vice versa. Absorption costing income is influenced by changes in unit sales and units of production. Net operating income can be increased simply by producing more units even if those units are not sold.

6-24

Supporting Decision Making

Variable costing correctly identifies the additional variable costs incurred to make one more unit ($10 per unit for Harvey Company). It also emphasizes the impact of total fixed costs on profits. Because absorption costing assigns fixed manufacturing overhead costs to units produced ($6 per unit for Harvey Company), it gives the impression that fixed manufacturing overhead is variable with respect to the number of units produced, but it is not. The result can be inappropriate pricing decisions and product discontinuation decisions.

6-25

Companywide Income Statements

Both U.S. GAAP and IFRS require absorption costing for external reports.

Global View

Since absorption costing is required for external reporting, most companies also use it for internal reports rather than incurring the additional cost of maintaining a separate variable cost system for internal reporting.

6-26

Variable versus Absorption Costing

Fixed manufacturing costs must be assigned to products to properly match revenues and costs. Fixed manufacturing costs are capacity costs and will be incurred even if nothing is produced.

Absorption Costing

Variable Costing