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CHAPTER 8
8-2
8-2
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
8-3
Variable Costing
A system of cost accounting that only assigns the variable
production cost to product cost.
Fixed
Costs
Product
Variable
Costs
8-4
Absorption and Variable Costing
Absorption Variable
Costing Costing
Direct materials
Direct labor Product costs
Product costs Variable mfg. overhead
8-5
Absorption and Variable Costing
Absorption Variable
Costing Costing
Direct materials
Direct labor Product costs
Product costs Variable mfg. overhead
Variable Absorption
costing costing
9
Learning Objective 2
8-10
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.
8-11
Absorption and Variable Costing
Mellon Co. produces a single product with the following
information available:
8-12
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
Absorption Costing
Sales (20,000 $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
8-14
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) $ 600,000
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) 80,000 320,000
Gross margin $ 280,000
Less selling & admin. exp.
Variable
Fixed
Net income
8-15
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) $ 600,000
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) 80,000 320,000
Gross margin $ 280,000
Less selling & admin. exp.
Variable (20,000 $3) $ 60,000
Fixed 100,000 160,000
Net income $ 120,000
8-16
Learning Objective 3
8-17
Variable Costing
Income Statements
Now lets look at variable costing by Mellon Co.
Variable Costing
Sales (20,000 $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
8-18
Variable Costing
Income Statements
Now lets look at variable costing by Mellon Co.
We exclude
Variable the
Costing
Sales (20,000 $30) fixed manufacturing
$ 600,000
Less variable expenses: overhead.
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
8-19
Variable Costing
Income Statements
Now lets look at variable costing by Mellon Co.
Variable Costing
Sales (20,000 $30) $ 600,000
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 (20,000 $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
8-20
Comparing Absorption and
Variable Costing
Lets 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
8-21
Comparing Absorption and
Variable Costing
Lets 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
8-22
Comparing Absorption and
Variable Costing
Lets 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
8-23
Learning Objective 4
8-24
Reconciling Income Under Absorption and
Variable Costing
We can reconcile the difference between absorption and
variable net income as follows:
8-26
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.
8-27
Learning Objective 6
8-28
Extending the Example
Lets look at
the second
year of
operations
for Mellon
Company.
8-29
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.
8-30
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
8-32
Mellon Co. Year 2
Units in ending inventory from the previous period.
Absorption Costing
Sales (30,000 $30) $ 900,000
Less cost of goods sold:
Beg. inventory (5,000 x $16) $ 80,000
Add COGM (25,000 $16) 400,000
Goods available for sale $ 480,000
Ending inventory - 480,000
Gross margin $ 420,000
Less selling & admin. exp.
Variable (30,000 $3) $ 90,000
Fixed 100,000 190,000
Net income $ 230,000
8-33
Mellon Co. Year 2
Absorption Costing
Sales (30,000 $30) $ 900,000
Less cost of goods sold:
Beg. inventory (5,000 x $16) $ 80,000
Add COGM (25,000 $16) 400,000
Goods available for sale $ 480,000
Ending inventory - 480,000
Gross margin $ 420,000
Less selling & admin. exp.
Variable (30,000 $3) $ 90,000
Fixed 100,000 190,000
Net income $ 230,000
8-35
Mellon Co. Year 2
Variable Costing
Sales (30,000 $30) $ 900,000
Less variable expenses:
Beg. inventory (5,000 $10) $ 50,000
Add COGM (25,000 $10) 250,000
Goods available for sale $ 300,000
Ending inventory -
Variable cost of goods sold $ 300,000
Variable selling & administrative
expenses (30,000 $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
8-38
Variable Costing and Absorption Costing
39
Summary
Lets see if we can get an overview of what we have
done.
8-40
Summary Comparison of Absorption (AC)
and Variable Costing (VC)
Total
Production versus Inventory
Sales Effect Period Expense Effect Profit Effect
Total
Production versus Inventory
Sales Effect Period Expense Effect Profit Effect
46
CVP Analysis, Decision Making
and Absorption costing
Absorption costing does not support CVP analysis
because it essentially treats fixed manufacturing
overhead as a variable cost by assigning a per unit
amount of the fixed overhead to each unit of
production.
Treating fixed manufacturing overhead as a
variable cost can:
Lead to faulty pricing decisions and keep-or-drop
decisions.
Produce positive net operating income even
when the number of units sold is less than the
breakeven point. 47
Evaluation of Variable Costing
Management finds it Consistent with
easy to understand CVP analysis
and more useful
External reporting
and income tax law
require absorption costing.
8-49
Variable versus Absorption Costing
Fixed manufacturing
costs must be assigned Fixed manufacturing
to products to properly costs are capacity costs
match revenues and and will be incurred
costs. even if nothing is
produced.
Absorption Variable
Costing Costing 50
Impact of JIT Inventory Methods
In a JIT inventory system . . .
Production tends
to equal sales . . .
8-52
Costs of Assuring Quality
Grade Quality
8-53
There are four types of quality costs.
8-55
8-55
What is the Optimal Level
of Product Quality?
8-56
ISO 9000 Standards
ISO 9000 standards require that a
company have a well-defined quality
control system in place and that the target
level of product quality is consistently
maintained.
8-57
Learning Objective 9
8-58
Costs of Environmental
Sustainability
Sustainable development includes business activity that
produces the goods and services needed in the present without
limiting the ability of future generations to meet their meets.
Environmental costs are the costs of dealing with
environmental issues, such as BPs costs in cleaning up the
companys spill in the Gulf of Mexico.
Environmental cost management is the strategic
implantation of systems for identifying, measuring, controlling,
and reducing the private environmental costs borne by a
company or other organization.
8-59
Environmental costs may be
categorized in several ways:
Private environmental costs are those borne by a company or
individual. Social environmental costs are those borne by the
public at large.
Visible environmental costs are those that are known and
clearly identified as tied to environmental issues. Hidden
social environmental costs cannot be clearly tied to
environmental issues.
8-60
Visible and hidden environmental costs may be further
classified into one of three types.
Monitoring costs include the costs of monitoring the regulatory
environmental as well as monitoring the production process to determine
if pollution is being generated.
Abatement costs include costs to reduce or eliminate pollution.
Remediation costs include on-site and off-site remediation costs. On-site
remediation includes costs of reducing or preventing the discharge into
the environment of pollutants that have been generated in the production
process. Off-site remediation includes the costs of reducing or
eliminating pollutants from the environment after they have been
discharged.
8-61
End of Chapter 8
The End
8-62