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INVENTORY COSTING AND CAPACITY ANALYSIS – CHAPTER 9
PROFESSOR MCDERMOTT
NOVEMBER 5, 2013
INTRODUCTION
In this chapter we will learn the difference between absorption costing (which we
learned in Accounting 2020), and variable costing.
Absorption costing is required by the FASB and the
Internal Revenue Service and is primarily designed for external
users. Variable costing conversely is designed for internal users. It
is advantageous in that it allows one to calculate such things as
contribution margin, breakeven, and so on.
Review of Principles Learned about Absorption Costing
Let’s first review what we learned earlier about absorption
costing by defining some terms.
One component of the total costs shown on the income
statement in absorption costing is product cost. In absorption
costing, product costs are the sum of direct labor, direct materials,
variable overhead, and fixed overhead. In variable costing,
however, product costs are only the sum of direct labor, direct
materials and variable overhead. Fixed overhead is excluded.
In absorption costing, overhead is allocated to the product
using an overhead rate. For example, if at the beginning of the
year we budget $100,000 of overhead (in this case the sum of
fixed and variable overhead),and if our base is units
manufactured, and if we anticipate manufacturing 10,000 units a
year, then the overhead rate would be calculated as follows:
$100,000
= $10.00 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡.
10,000 𝑢𝑛𝑖𝑡𝑠
In absorption costing we sometimes break overhead in to
two parts—a fixed rate and a variable rate. T
The fixed rate is calculated using the formula shown
above. The variable rate is usually given (like $12.50 per-unit).
We should also remember the definitions of product costs
and period costs. Product costs are costs that do not appear on the
income statement until the product is sold.
Absorption Costing: An
accounting system for external
users where fixed overhead costs
are included in the product costs.
Base: The denominator in the
formula used to calculate the
overhead rate. Common bases
include direct labor dollars, direct
labor hours, and units
manufactured.
Overhead Applied: The amount of
overhead added to a product using
an overhead rate.
Overhead Rate: A rate used to
distribute overhead to product
costs (and therefore work-inprocess). Some companies use
one overhead rate. Others have
two overhead rates, one for
variable overhead costs and the
other for fixed overhead costs.
Period Costs: In absorption
costing, administrative and selling
expense. Period costs are always
recognized in the period in which
they were incurred.
Product Costs: In absorption
costing, the sum of direct labor,
direct materials, variable overhead,
and fixed overhead. In variable
costing, the sum of direct labor,
direct materials, and variable
overhead. Period costs are
recognized in the period in which
the product is sold.
Period costs are costs that appear on the income statement in the period in which they are
incurred.
© 2013, Richard E. McDermott
Absorption Costing
Accounting 3300
We should also define the term overhead applied. This is the amount of overhead cost
added to product cost using a rate. The formula is:
Actual base (in this case units) x overhead rate = overhead applied
Calculating Product Costs in Absorption Costing
Now let’s review how we would calculate product costs, and then use this information to
prepare an income statement using absorption costing. In this first example, the units
manufactured during the period will equal units sold.
EXAMPLE ONE: UNITS MANUFACTURED EQUAL UNITS SOLD
Absorption Costing
Information given:
Units produced
Units Sold
Fixed overhead
Price
Fixed administrative and selling expense
Variable administrative and selling expense
Beginning inventory in units
Ending inventory in units
Direct labor
Direct materials
Variable Overhead
Fixed overhead per unit
100,000.00
100,000.00
$ 1,100,000.00
$120.00
$500,000.00
$9.00
25,000.00
25,000.00
10.00
15.00
6.00
11.00
Note that the number of beginning inventory units and the number of ending inventory
units are the same. We produced the same number of units as we sold. We assume on all
problems that units budgeted equals units manufactured so that there is no fixed overhead
volume variance to close against cost of goods sold.
Let’s take this data and calculate our per-unit cost at a production of 100,000 units.
Per Unit Product Cost Absorption Costing
Direct labor
Direct materials
Variable overhead
Fixed overhead
Total product costs
$
$
10.00
15.00
6.00
11.00
42.00
As discussed above, the fixed overhead per-unit is calculated by dividing total budgeted
overhead dollars by the number of budgeted units. In this example, we will assume that the
© 2013, Richard E. McDermott
Absorption Costing
Accounting 3300
number of units budgeted is exactly equal to the number of units manufactured. We will also
assume that the budgeted fixed costs exactly equal actual fixed costs.
So that you will easily be able to compare the two income statements (absorption costing
and variable costing), I will breakout the components of product costs (the $42.00) into the cost
of direct labor, direct materials, variable overhead and fixed overhead. These will be shown
separately on the income statement under the cost of goods sold section.
Preparing an Absorption Costing Income Statement
Now that we have our per unit product cost, it is time to create an absorption costing
income statement. Using the data given, this is shown below.
Absorption Costing Income Statement
Revenue
Cost of goods sold
Directl labor
Direct materials
Variable overhead
Fixed overhead
Cost of goods sold
Gross margin
Administrative and Selling Expense
Variable administrative and selling expense
Fixed administrative and selling expense
Total administrative and selling expense
Income
Units
Price/Cost Per Unit
100,000.00
$120.00
100,000.00
100,000.00
100,000.00
100,000.00
10.00
15.00
6.00
11.00
Income Statement
$ 12,000,000.00
1,000,000.00
1,500,000.00
600,000.00
1,100,000.00
4,200,000.00
7,800,000.00
100,000.00
100,000.00
$9.00
5.00
$900,000.00
$500,000.00
$1,400,000.00
$ 6,400,000.00
Calculating Product Costs in Variable Costing
Now let’s examine variable costing. We will start by calculating the per-unit product cost.
Per Unit Product Cost Variable Costing
Direct labor
Direct materials
Variable overhead
Total product costs
$
$
10.00
15.00
6.00
31.00
Note that the per-unit fixed overhead disappears when we use variable costing. Where do
fixed overhead costs go in variable costing? Further down the income statement under the
category of fixed costs. Fixed costs are product costs under absorption costing. Under variable
costing, they are period costs.
Preparing a Variable Costing Income Statement
Okay, having calculated our product costs, let’s produce a variable costing income
statement from the data given.
© 2013, Richard E. McDermott
Absorption Costing
Accounting 3300
Variable Costing Income Statement
Units
Revenue
Less variable costs
Direct labor
Direct materials
Variable overhead
Variable cost of goods sold
Total variable administrative and selling expense
Total variable costs
Contribution margin
Less fixed costs
Fixed overhead
Fixed administrative and selling expense
Total fixed costs
Income
100,000.00
$120.00
100,000.00
100,000.00
100,000.00
10.00
15.00
6.00
100,000.00
$9.00
Price/Cost Per Unit

1,000,000.00
1,500,000.00
600,000.00
3,100,000.00
900,000.00
4,000,000.00
$ 8,000,000.00
1,100,000.00
$500,000.00
1,600,000.00
6,400,000.00
There are several important differences in the
formats of absorption costing and variable costing income
statements.

$ 12,000,000.00
In absorption costing, we subtract cost of goods sold
from revenues to get a gross margin. In variable
costing, we subtract total variable costs from
revenues to get a contribution margin.
Contribution Margin: Revenue minus
variable costs.
Cost of Goods Sold. The dollar amount
of goods sold during the period. Cost of
goods sold is calculated by multiplying
per-unit product costs by the number of
units sold.
Gross Margin: Revenue minus cost of
goods sold.
In absorption costing, fixed overhead is a product
cost and is found in the cost of goods sold section of
the income statement. In variable costing, fixed
overhead is a period cost and appears under the fixed costs section of the income
statement.
Take a moment and compare the two statements just complied to verify the principles just
taught.
Does Income Under Absorption Costing Always Equal Income under Variable Costing?
No. The only time absorption income equals variable costing income is when the units
manufactured equals units soIn the real world, this rarely happens. Let’s give a more real-world
example.
EXAMPLE TWO: UNITS MANUFACTURED DO NOT EQUAL UNITS SOLD
Now let’s assume that the units manufactured do not equal the units sold. In this case the
income will be different. The difference in income between absorption costing and variable
costing can be calculated with the following formula:
Fixed overhead per-unit x change in units of inventory
© 2013, Richard E. McDermott
Absorption Costing
Accounting 3300
In the following example, we will assume we manufactured 100,000 units, but that we
only sold 90,000.
We calculated the fixed overhead per-unit in the above example ($11.00 per-unit). Thus,
we would expect the difference between the income shown in the absorption income statement
and the variable costing statement to be $11.00 x 10,000 units = $110,000.
How do we know which statement will produce the greater income? Here is the rule.

When the units manufactured are greater than the units sold, the absorption costing
income will be larger than the variable costing income.

When the units manufactured are less than the units sold, the absorption income will
be smaller than the variable costing income.
Shown below is the absorption costing income statement, followed by a variable costing
income statement under this new assumption.
Absorption Costing Income Statement
Revenue
Cost of goods sold
Direct labor
Direct materials
Variable overhead
Fixed overhead
Cost of goods sold
Gross margin
Variable administrative and selling expense
Fixed administrative and selling expense
Total administrative and selling expense
Income
Units
Price/Cost Per Unit
90,000.00 $
120.00
Variable Costing Income Statement
Revenue
Less variable costs
Direct labor
Direct materials
Variable overhead
Variable cost of goods sold
Total variable administrative and selling expense
Total variable costs
Contribution margin
Less fixed costs
Fixed overhead
Fixed administrative and selling expense
Total fixed costs
Income
Units
Price/Cost Per Unit
90,000.00 $
120.00
© 2013, Richard E. McDermott
90,000.00
90,000.00
90,000.00
90,000.00
10.00
15.00
6.00
11.00
Income Statement
$ 10,800,000.00
900,000.00
1,350,000.00
540,000.00
990,000.00
3,780,000.00
7,020,000.00
90,000.00
$9.00
810,000.00
$500,000.00
1,310,000.00
5,710,000.00
90,000.00 $
90,000.00 $
90,000.00 $
10.00
15.00
6.00
90,000.00
$9.00
Income Statement
$ 10,800,000.00
900,000.00
1,350,000.00
540,000.00
2,790,000.00
810,000.00
3,600,000.00
7,200,000.00
1,100,000.00
$500,000.00
1,600,000.00
5,600,000.00
Absorption Costing
Accounting 3300
Why the Difference Between Absorption Income and Variable Costing Income?
Note that the absorption costing income is $110,000 larger than the variable costing
income.
Why is this so? Actual fixed overhead costs for the period are $1,100,000. In variable
costing this is the amount shown on the income statement as a period cost.
In absorption costing, however, only overhead applied is shown, as a product cost in the
cost of goods sold section. Once again, in absorption the cost of goods sold for fixed costs are
calculated as follows:
$11 fixed overhead x 90,000 units sold = $990,000 fixed costs applied.
In absorption costing, what happens to the other fixed overhead (the difference between
$1,100,000 and $990,000)? It is “stored” on the balance sheet as work-in-process until the
remaining 10,000 in finished units are sold and their costs become cost of goods sold.
In variable costing, there is no difference between the stated fixed overhead costs shown
on the income statement ($1,100,000 in this example) and the actual fixed overhead costs
incurred in the period. Again, this is because fixed overhead is a period cost in variable costing.
In Summary
Since the difference between $990,000 fixed costs on the absorption income statement is
$110,000 different than the $1,100,000 of fixed costs on the absorption income statement, the
absorption costing income will be $110,000 higher as demonstrated below
.
Income from absorption costing
Income from variable costing
Difference in income
$ 5,710,000.00
5,600,000.00
$ 110,000.00
Some Parting Comments
Before we close, I should mention one disadvantage of absorption accounting. In times of
decreasing sales, absorption costing can be used to distort income.
Assume that sales are declining and therefore profits are declining. Assume that a
manager is paid a bonus based upon quarterly sales. Assume that he or she plans on leaving the
company after this quarter and wants to maximize his or her bonus.
What he or she can do is to manufacture many more units than are sold. In this situation a
large amount of fixed overhead costs are taken off the income statement and put on the balance
sheet. This decreases costs and therefore increases profits.
I should note one other thing. In the author’s answers to the homework problems he uses
a somewhat complex formula for calculating cost of goods sold. Specifically: he takes the
beginning dollar inventory, adds the cost of units manufactured, and subtracts the cost of ending
inventory.
An easier way calculate the same figure is to multiply the per-unit product cost by the
number of units sold. Given the choice between teaching a complex or simple way to calculate a
figure, I prefer the latter. You can use either on the test.
© 2013, Richard E. McDermott
Absorption Costing
Accounting 3300
This is all a student in my class needs to know about absorption and variable costing.
You can read the chapter if you wish, but it is not required. You will of course need to work the
homework problems in the book.
© 2013, Richard E. McDermott
Absorption Costing
Accounting 3300
© 2013, Richard E. McDermott
Absorption Costing
Accounting 3300
© 2013, Richard E. McDermott
Absorption Costing
Accounting 3300