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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