AFM102 Lecture Notes - Lecture 8: Total Absorption Costing
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The Dorset Corporation produces and sells a single product. The following data refer to the year just completed:
| Beginning inventory | 0 | |
| Units produced | 34,000 | |
| Units sold | 25,900 | |
| Selling price per unit | $ | 482 |
| Selling and administrative expenses: | ||
| Variable per unit | $ | 16 |
| Fixed per year | $ | 362,600 |
| Manufacturing costs: | ||
| Direct materials cost per unit | $ | 240 |
| Direct labor cost per unit | $ | 56 |
| Variable manufacturing overhead cost per unit | $ | 34 |
| Fixed manufacturing overhead per year | $ | 578,000 |
Assume that direct labor is a variable cost.
Required:
a. Compute the unit product cost under both the absorption costing and variable costing approaches.
b. Prepare an income statement for the year using absorption costing.
c. Prepare an income statement for the year using variable costing.
d. Reconcile the absorption costing and variable costing net operating income figures in (b) and (c) above.
Variable Costing
An approach to measuring profitability that avoids the problemsinherent in making fixed overhead look like a variable cost isvariable costing. Variable costing (sometimes called directcosting) assigns only unit-level variable manufacturing costs tothe product; these costs include direct materials, direct labor,and variable overhead. Fixed overhead is treated as a period costand is not inventoried with the other product costs. Instead, it isexpensed in the period incurred.
The result of treating fixed manufacturing overhead as a periodexpense is to reduce the factory costs that are inventoriable.Under variable costing, only direct materials, direct labor, andvariable overhead are inventoried. (Remember that marketing andadministrative expenses are never inventoried-whether variable orfixed.)
Example: Fender Company showed the followingunit costs for its product:
| Direct materials | $1.15 |
| Direct labor | 0.60 |
| Variable overhead | 0.22 |
| Fixed overhead* | 2.44 |
| *Based on capacity of 29,800units. |
Last year, Fender made 29,800 units and sold 27,700 units at aprice of $9.01. Selling and administrative expense equaled $49,170(all fixed). Beginning Finished Goods Inventory contained 410 unitswith cost of $1,808.10.
| Cost of one unit under variablecosting | = Direct materials + Direct labor +Variable overhead |
| = $1.15 + $0.60 + $0.22 =$1.97 | |
| Units in ending Finished GoodsInventory | = 410 + 29,800 - 27,700 = 2,510units |
| Ending Finished GoodsInventory | = 2,510 Ã $1.97 = $4,944.70 |
The income statement for Fender Company is as follows:
| Sales | $249,577 | |
| Variable cost of Goods Sold ($1.97Ã 27,700) | 54,569 | |
| Contribution margin | $195,008 | |
| Less: | ||
| Fixed overhead | 72,712 | |
| Selling andadministrative expense | 49,170 | 121,882 |
| Variable-costing operatingincome | $73,126 |
Notice that all of the fixed factory overhead of $72,712 ($2.44Ã 29,800) and the variable cost of manufacturing for the units sold($1.97 Ã 27,700 units sold) appear on the variable-costing incomestatement. None of the fixed factory overhead is attached to unsoldunits added to Finished Goods inventory because the fixed overheadis treated as a period expense. Only the variable cost ofmanufacturing ($1.97 Ã 2,100) is added to Finished Goods inventory- attached to the 2,100 units that were produced but not sold.
| 1. | Under variable costing, ifbeginning Finished Goods Inventory equaled zero, the value ofending Finished Goods Inventory would be $?? . |
| 2. | Ignoring question 1 above,if Fender Company sold 30,020 units, there wouldbe units in ending Finished Goods Inventory with a valueof $?? (round to the nearest cent). |
Reconciling the Difference Between Absorption andVariable Costing
When inventories change from the beginning to the end of theperiod, the two costing approaches will give different operatingincomes. The reason for this is that absorption costing assignsfixed manufacturing overhead to units produced. If those units aresold, the fixed overhead appears on the income statement under costof goods sold. If the units are not sold, the fixed overhead goesinto inventory. Under variable costing, however, all fixed overheadfor the period is expensed. As a result, absorption costing allowsmanagers to manipulate operating income by producing for inventory.Let's compare the income statements under the two methods forFender Company.
Example: Fender Company showed the followingunit costs for its product:
| Direct materials | $1.15 |
| Direct labor | 0.60 |
| Variable overhead | 0.22 |
| Fixed overhead* | 2.44 |
| *Based on capacity of 29,800units. |
Last year, Fender made 29,800 units and sold 27,700 units at aprice of $9.01. Selling and administrative expense equaled $49,170(all fixed). Beginning Finished Goods Inventory contained 410 unitswith cost of $1,808.1.
| Absorption-CostingIncome | Variable CostingIncome | |||
|---|---|---|---|---|
| Sales | $249,577.00 | Sales | $249,577.00 | |
| COGS ($4.41 Ã 27,700) | 122,157.00 | Variable COGS ($1.97 Ã 27,700) | 54,569.00 | |
| Gross margin | $127,420.00 | Contribution margin | $195,008.00 | |
| Less: | Fixed overhead | 72,712 | ||
| Selling & admin.exp | 49,170 | Selling & admin. exp. | 49,170 | |
| Operating income | $78,250.00 | Operating income | $73,126.00 | |
There is a difference of $5,124 between the absorption-costingoperating income and the variable-costing operating income. This$5,124 is caused by the different treatment of fixed factoryoverhead. Under absorption costing, the 2,100 units added to endinginventory took not only the $1.97 of variable manufacturing cost,but also $2.44 per unit in fixed overhead. Under variable costing,however, all the fixed factory overhead of $72,712 was expensed.None of it was added to units going into ending inventory.
| Absorption-costing income -Variable-costing income | = Change in inventory à fixedoverhead rate |
| = 2,100 units à $2.44 = $5,124 |
What if more units are sold than are produced? That is, what ifending inventory is less than beginning inventory? Let's look atthe comparative income statement assuming Fender sells 29,890units.
| Absorption-CostingIncome | Variable CostingIncome | |||
|---|---|---|---|---|
| Sales | $269,308.9 | Sales | $269,308.9 | |
| COGS ($4.41 Ã 29,890) | 131,814.9 | Variable COGS ($1.97 Ã 29,890) | 58,883.3 | |
| Gross margin | $137,494 | Contribution margin | $210,425.6 | |
| Less: | Fixed overhead | 72,712 | ||
| Selling & admin.exp | 49,170 | Selling & admin. exp. | 49,170 | |
| Operating income | $88,324 | Operating income | $88,543.6 | |
Now we see that variable-costing income is higher thanabsorption costing income. This is because each of the 90 unitsthat came out of inventory had $2.44 of fixed overhead attached.However, this did not occur under variable costing.
| Absorption-costing income -Variable-costing income | = Change in inventory à fixedoverhead rate |
| = 90 units à $2.44 = $219.60 |
The following table summarizes the impact of changes ininventory on the difference between absorption-costing income andvariable-costing income.
| Changes in Inventoryunder Absorption and Variable Costing | |
|---|---|
| If | Then |
| Production > Sales | Absorption-costing income >Variable-costing income |
| Production < Sales | Variable-costing income >Absorption-costing income |
| Production = Sales | Absorption-costing income =Variable-costing income |
The variable-costing income statement has an advantage inaddition to providing better signals regarding performance. It alsoprovides more useful information for management decision making.For example, how much more will Fender Company earn if it sells onemore unit? Under absorption costing, the per-unit gross profit is$4.60 ($9.01 - $4.41). However, that figure includes some fixedoverhead, and fixed overhead will not change if another unit isproduced and sold. The variable-costing gives more usefulinformation. Additional contribution margin of the extra unit is$7.04 ($9.01 - $1.97). The key insight of variable costing is thatfixed expenses do not change as units produced and sold change.Therefore, while the variable-costing income statement cannot beused for external reporting, it is a valuable tool for somemanagement decisions.
