Tutorial

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1 Learning Objectives 7 Income Statement: Variable versus Absorption Costing 2 Overview 8 Direct versus Common Costs 3 Absorption Costing 9 Segment Margin 4 Variable Costing 10 Review Question 1 5 Cost of Goods Sold: Variable versus Absorption Costing 11 Summary 6 Ending Inventory: Variable versus Absorption Costing 12 Key Terms

Learning Objectives

After completing this tutorial you should be able to:

1. understand the calculation of: (1) unit cost, (2) cost of goods sold, (3) ending inventory, and (4) net income using absorption and variable costing.
2. be able to reconcile the difference between absorption costing and variable costing net income.
3. prepare and use segmented income statements using a variable costing approach.

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Overview

Previous tutorials discussed the difference between product cost and period cost. Product costs or inventoriable costs are costs assigned to goods manufactured. These costs are expensed when the goods are sold. Period costs are expensed in the period in which they are incurred.

This tutorial discusses two approaches to calculating product costs: (1) absorption costing and (2) variable costing. Costs which are treated as product costs are different under the two approaches. The strengths and weaknesses of the two approaches are discussed.

This tutorial also introduces the concept of segment margin and explains why segment margin is a better measure of the performance of a product line, division, etc. than net income.

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Absorption Costing

Under absorption costing, all manufacturing costs are considered inventoriable or product costs. Direct materials, direct labor, variable overhead, and fixed overhead are included in product cost. These costs are expensed as the products are sold.

The following example will be used throughout this tutorial to explain the difference between absorption costing and variable costing.

The following data are available for 2001 from the accounting records of Doyle Company:

Units in beginning inventory	0
Units produced	10,000
Units in ending inventory	2,000
Selling price per unit	$20
Manufacturing costs
Direct materials (per unit)	$2
Direct labor (per unit)	$4
Variable overhead (per unit)	$1
Fixed overhead (total)	$20,000
Selling and administrative expenses
Variable (per unit)	$1
Fixed (total)	$10,000

Unit cost can be calculated using absorption costing as follows:

Total fixed overhead costs = $20,000
Units produced = 10,000
Fixed overhead cost per unit = 20,000/10,000 = $2

Unit cost

Direct materials (per unit)	$2
Direct labor (per unit)	4
Variable overhead (per unit)	1
Fixed overhead (per unit)	2
Total unit cost	$9

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Variable Costing

Under variable costing only variable manufacturing costs are considered inventoriable or product costs. Thus, direct materials, direct labor, and variable overhead are included in product cost. Fixed costs are treated as period costs

Thus, the unit cost of the product for Doyle Company is:

Direct materials (per unit)	$2
Direct labor (per unit)	4
Variable overhead (per unit)	1
Total unit cost	$7

Since fixed costs are not included in product costs, the unit cost under variable costing is lower than the unit cost using absorption costing.

The use of absorption costing or variable costing affects the information presented in financial statements as follows:

(1) Since the unit cost is different under the two approaches, the amount reported on the income statement for cost of goods sold is different.
(2) Fixed overhead costs incurred during a period are on the income statement as an expense under variable costing. Under absorption costing, only the fixed cost assigned to the goods that have been sold will be expensed in the current period. The remaining fixed costs for the period are included in ending inventory.
(3) Since the unit cost is different under the two approaches, the amount reported on the balance sheet for ending inventory is different.

The following sections illustrate these differences using the information for Doyle Company.

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Cost of Goods Sold: Absorption Costing versus Variable Costing


To calculate the cost of goods sold, we must first calculate the sales in units. The sales in units is multiplied by the unit cost to calculate cost of goods sold.

Units sold = Beginning inventory + Units produced - Ending inventory
= 0 + 10,000 - 2,000
= 8,000

Cost of goods sold using absorption costing = $9 x 8,000 = $72,000
Cost of goods sold using absorption costing = $7 x 8,000 = $56,000


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Ending Inventory: Absorption Costing versus Variable Costing

There are 2,000 units in ending inventory. The number of units is multiplied by unit cost to calculate the dollar value of the ending inventory.

Ending inventory using absorption costing = $9 x 2,000 = $18,000
Ending inventory using variable costing = $7 x 2,000 = $14,000

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Income Statement: Absorption Costing versus Variable Costing


This section shows how to prepare the income statement under both approaches and explains the differences between these income statements.

The sales revenue and selling and administrative expenses are calculated as follows:

Sales revenue = $20 x 8,000 = $160,000

Selling and administrative expenses
variable: $1 x 8,000 = $8,000
Total selling and administrative expenses: $8,000 + $10,000 = $18,000

Doyle Company
Absorption-Costing Income Statement

Sales revenue	$160,000
Less: Cost of goods sold	72,000
Gross margin	$88,000
Less: Selling and administrative expenses	18,000
Net income	$70,000

Doyle Company
Variable-Costing Income Statement

Sales revenue	$160,000
Less variable expenses
Cost of goods sold	56,000
Variable selling and administrative expenses	8,000
Contribution margin	$96,000
Less fixed expenses
Fixed overhead	20,000
Fixed selling and administrative expenses	10,000
Net income	$66,000

Thus, the net income under variable costing is less than the net income under absorption costing by $4,000. Why does this difference arise?

The total fixed overhead is $20,000.
Under absorption costing, the fixed overhead is included in product cost. The amount assigned to each unit is $20,000/10,000 = $2. Of the 10,000 units produced, 8,000 units are sold. The fixed overhead assigned to the units sold is $2 x 8,000 = $16,000. The remaining fixed overhead of $4,000 is included in ending inventory.

Under variable costing, the total amount of fixed overhead ($20,000) is shown as a period cost. That is, the entire $20,000 is included as an expense in the current period. Thus, the expenses are higher by $4,000 under variable costing than under absorption costing. This in turn means that the income is lower by $4,000 under variable costing than under absorption costing.

Note also that because the entire amount of fixed overhead is expensed under variable costing while $4,000 of fixed overhead is included as part of finished goods under absorption costing, the inventory value is lower by $4,000 under variable costing than under absorption costing.


Generally, the relationship between variable costing and absorption costing incomes is as follows:

If production is greater than sales, absorption-costing income is higher than variable-costing income. This is because only that portion of fixed overhead that is attached to goods sold during the period are expensed in the period. On the other hand, the entire amount of fixed overhead for the period is expensed in variable costing.

However, sometimes production can be lower than sales (How? Because you may have beginning inventory that also is available for sale this period). If production is lower than sales, absorption-costing income is lower than variable costing income. Since more units are sold than those produced, the fixed overhead costs expensed during this period includes the total fixed overhead for the current period plus some fixed overhead assigned to products in previous periods. Thus, the amount expensed is higher and net income is lower under absorption costing when production is lower than sales.

If production equals sales, the net income under absorption costing equals net income under variable costing.

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Direct versus Common Costs

Responsibility accounting was discussed in module 8. Responsibility accounting is based on the idea that managerial performance must be evaluated based on only those items that are under the control of the manager. Thus, managers must be held responsible only for those costs over which they have control.

Costs can be classified into direct and common costs based on controllability.

A direct cost is one that can be physically traced to the particular cost object under consideration without undue cost or inconvenience. Direct costs are generally eliminated if the activity is eliminated.

Common fixed costs or indirect fixed costs are costs that cannot be accurately traced to the particular cost object under consideration without undue cost or inconvenience. Common costs are incurred for the benefit of several segments or activities and usually are not eliminated if the activity is eliminated.

The above cost classification is the basis for preparing segmented income statements as discussed below.


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Segment Margin

Managers need to evaluate the performance of different segments of their business. The segments could include product lines, divisions, regions, etc.

To evaluate the profitability of segments, managers prepare segmented income statements. Segmented income statements prepared using a variable-costing approach are more useful than absorption-costing income statements for making decisions such as discontinuing a segment which is not profitable. Why?

Segmented income statements provide information about variable and fixed costs. Revenues minus variable costs equal contribution margin. A positive contribution margin from a segment means that the segment covers its variable costs and some profit is available to cover fixed costs.

However, some of the fixed costs are direct costs that arise due to the operation of the segment itself. Thus, it is important to know whether the revenues from a segment cover the variable costs as well as direct fixed costs. If the revenue is greater than the sum of the variable costs and direct fixed costs, the segment makes a contribution towards covering the common fixed costs and making a profit.

The difference between the contribution margin and the direct fixed costs for the segment is called the segment margin.

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Review Question 1

absorption costing

common fixed cost

direct fixed cost

greater

less

variable costing

If production is greater than sales, absorption costing income is   than variable costing net income.

Direct fixed costs are included in product costs under   

A(n)   is one that can be physically traced to the particular cost object under consideration without undue cost or inconvenience.

A(n)   is one that cannot be accurately traced to the particular cost object under consideration without undue cost or inconvenience.

If the production is less than sales, absorption-costing income is    than variable-costing net income.

Direct fixed costs are treated as period costs under  .

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Summary

Under absorption costing, all manufacturing costs are treated as product costs. These costs are included in inventory and expensed when the goods are sold.

Under variable costing, only variable costs of production (direct materials, direct labor and variable overhead) are treated as product costs. Fixed overhead costs are expensed in the period in which they are incurred.

Segmented income statements are prepared using the variable-costing approach to evaluate the performance of segments. The difference between the contribution margin and the direct fixed costs for the segment is called the segment margin.

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Key Terms

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