ABSORPTION VS VARIABLE COSTING LECTURE

BREAKEVEN ANALYSIS

Absorption Costing vs Variable Costing

Remember: An asset is a resource of the company that gives a future economic benefit. Inventories are assets because they give future benefits to the company in the terms of sales revenue.

Absorption costing: includes all manufacturing costs --- including direct materials, direct labor, and BOTH variable and fixed manufacturing overhead.

Absorption Costing = Full Costing

Under absorption costing, fixed overhead is a product cost until sold.

Absorption costing makes no distinction between fixed and variable costs thus is not suited for CVP analysis.

Sales less Absorption Cost of Goods Sold will equal Gross Profit

Functional Analysis of the Income Statement

Variable costing: includes only variable manufacturing costs --- direct materials, direct labor, and variable manufacturing overhead.

The entire amount of fixed costs are expenses in the year incurred.

When calculating Contribution Margin, Variable Cost of Goods Sold and Variable Selling and Administrative Expenses and subtracted from Sales.

Behavioral Analysis of the Income Statement

Variable costing can be used for Cost Volume Profit (Break-even Analysis)

Rules about Absorption Costing versus Variable Costing.

Rules about unit sales and production under the two costing methods.

If sales are variable and production constant.

a. When production is equal to sales, then absorption costing and variable costing will give the same amount of net income.

b. When production is greater than sales, then Net Income under absorption costing will be greater than net income under variable costing because a portion of the fixed costs was deferred to other years under the absorption method.

c. When production is less than sales, then Net Income under absorption costing will be less than net income under variable costing because a portion of the fixed costs that were deferred from previous years will be absorbed into this years cost of goods sold.

d. The value of inventory will be greater under the absorption method because of the deferred costs, however the total unit count will be the same for each accounting method.

e. Over the long-term, net income will be equal under both methods.

If sales are constant and production is variable then:

a. Net income under variable costing is not influenced by the fluctuations in sales (given a constant production) because none of the fixed manufacturing costs are deferred.

b. Net income under absorption costing is influenced by the fluctuations in sales (given a constant production) because a portion of the fixed manufacturing costs are deferred and may be used each year to increase costs.

Should Fixed Manufacturing Costs be Included in Inventories?

Advocates of full costing say yes, because all of the production costs are needed to create the products. Thus, they have "future economic benefits."

Advocates of variable costing argue that in order for a fixed manufacturing cost to be an asset, it has to meet a "future cost avoidance" criteria much the same way as prepaid insurance. In the case of fixed manufacturing costs, they do not meet this criteria because they are incurred each time the production line opens. Thus, they need to be expenses in that period and only variance expenses inventoried.

Problems with absorption costing also include potential manipulations by plant managers such as increasing production regardless of sales levels to defer costs to the next year and show a higher current profit for the sake of bonuses and promotions

Example of Absorption versus Variable Costing Data

Unit Cost Under Absorption Costing:

Data

Unit Cost Under Variable Costing:

Income statement under Absorption if only 180,000 units were sold:

Income statement under Variable Costing if 180,000 units were sold:

Reconciliation:

Example of Absorption versus Variable Costing -- Answer

Data

Unit Cost Under Absorption Costing:

Data

Unit Cost Under Variable Costing:

Target Profit ---- $150,000 Tax Rate --- 40%

Income statement under Absorption if only 180,000 units were sold:

Income statement under Variable Costing if 180,000 units were sold:

Reconciliation: $620,000 - $600,000 = $20,000/20,000 units = The $1.00 per unit difference in inventory costs. Essentially $20,000 [20,000 units x $1.00] in costs were deferred to the next accounting period under Absorption costing.