Chapter 5 Variable Costing Contains Fixed Manufacturing Overhead

Presentation Outline I. Absorption Costing v. Variable Costing II. A Comparison of Income Data for Absorption Costing and Variable Costing III. An Illustration

I. Absorption Costing v. Variable Costing A. B. C. D. Cost Classifications Fixed Manufacturing Overhead Format of Income Statement Report Usage

A. Cost Classifications Absorption Costing Variable Costing Product costs include: > Direct materials > Direct labor > Variable mfg. overhead > Fixed mfg. overhead Period costs include: > Selling & admin. expenses > Fixed mfg. overhead

B. Fixed Manufacturing Overhead Absorption Costing Variable Costing Fixed manufacturing overhead is treated as a product cost. Fixed manufacturing overhead is treated as a period cost and deducted in full each year from revenues. fg. m Fixed ad overhe Ba t e e h S e c n la Fixed mfg. overhead is never an asset.

C. Format of Income Statement Full (Absorption) Costing Sales Variable Costing Sales - Cost of goods sold - Variable expenses = Gross margin = Contribution margin - Selling & admin. expenses - Fixed expenses = Net income See Illustration 5 -2 on page 166.

D. Report Usage Absorption costing is required for external reporting. Variable costing is permitted for internal use only.

II. A Comparison of Income Data for Absorption Costing and Variable Costing A. Production = Sales (no change in inventories) B. Production > Sales (inventories increase) C. Production < Sales (inventories decrease)

A. Production = Sales (No change in inventories) Absorption Costing Net Income Variable Costing Net Income If there is no change in inventories, then there is generally no change in the fixed manufacturing overhead costs in inventories under absorption costing.

B. Production > Sales (Inventories increase) Absorption Costing Net Income Variable Costing Net Income If inventories increase, then some of the current fixed manufacturing overhead costs will be deferred in inventories under absorption costing.

C. Production < Sales (Inventories decrease) Absorption Costing Net Income Variable Costing Net Income If inventories decrease, then some of the prior fixed manufacturing overhead costs that had been deferred in inventories under absorption costing, will be released as a current charge against income.

III. An Illustration Selling price per unit $2, 000 Variable costs per unit: Direct materials $ 600 Direct labor $ 225 Variable manufacturing overhead $ 75 Variable selling and administrative expenses $ 40 Fixed costs per year: Fixed manufacturing overhead $1, 200, 000 Fixed selling expenses $ 100, 000 Fixed administrative expenses $ 500, 000 Annual production in units 5, 000

Year 1 Assumption: Production = Sales 5, 000 units = 5, 000 units

Year 2 Assumption: Production > Sales 5, 000 units = 4, 800 units

Year 3 Assumption: Production < Sales 5, 000 units = 5, 200 units

A Comparison of Incomes Year 1 Absorption Net Variable Net Income 3, 500, 000 (Production = Sales) Year 2 3, 336, 000 3, 288, 000 3, 664, 000 3, 712, 000 10, 500, 000 (Production > Sales) Year 3 (Production < Sales) 3 Year Totals When total production over the 3 year period = total sales over that period, total net income under the approaches is equal.