Absorption Costing and Variable Costing I PDF

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Taught by Professor Emmanuel Adegbite...

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Lecture 10B – Absorption Costing and Variable Costing I Variable and Absorption Costing Compared Variable Costing  All overhead costs are the expenses which were incurred in the period  Only concerned with costs that change as I do something  Only considers the costs of driving a car a 200-mile trip today are £50 for petrol  Variable costing would only consider what the costs of actually going on the trip are o If you didn’t go on this trip, you wouldn’t incur these costs  i.e. the variable costs Absorption Costing  Takes into account the indirect expenses (overheads) as well as the direct costs  Where the variable costs are not the only costs, you must take into account other costs  e.g. for a car journey, you would have to include how much you paid for the car and how much you paid for insurance as well as petrol

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Product costs – costs incurred to create a product Period costs – any cost that can’t be capitalized into prepaid expenses, inventory or fixed assets. It is associated with the passage of time Variable costing take account into the things that change when we make an extra unit – direct materials, direct labour and variable manufacturing overhead

Example – Harvey Co. Year 1

Harvey Co. produces a single product with the following information available:

Unit product cost is determined as follows: Both methods treat selling and administrative expenses the same way, they are period expenses and are deducted from revenue. Under absorption costing, fixed manufacturing overhead is split equally between the number of units produced – it is included in the cost of goods sold not the fixed expenses. Income Comparison of Absorption and Variable Costing If there is gross margin on the statement, it is absorption costing. If there is contribution margin on the statement, it is under variable costing. Absorption Costing Harvey Co. had no beginning inventory, produced 25,000 units and sold 20,000 units this year.

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£320,000 is how much it actually cost to make the goods that were sold The gross margin is sales – cost of goods sold

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Selling and administration expenses are only calculated for the goods that are actually sold  only multiply £3 by 20,000 rather than 25,000

Variable Costing

Only multiply by the number of units sold

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Only take account of the variable costs  £10 each to manufacture Total variable costs of goods sold = variable costs of goods sold from opening and closing inventory add the variable selling and administrative expenses Contribution margin = sales – total cost of goods sold (expenditure) o Contribution margin is the contribution towards covering fixed costs. Once fixed costs are covered, it is the contribution to profit After working out the contribution margin, we take away the fixed expenses which is the manufacturing overhead and the selling and administrative expenses Net income is £90,000 – different to what we calculated for absorption costing

Why are they different?  Under absorption costing, we attach a fixed element to each unit produced  We made 25,000 but only sold 20,000 so the 5,000 units not sold have a fixed element of cost attached to them  For absorption costing, we are valuing our inventory with the variable costs of the units left and including the fixed costs per unit into it  Under variable costing, I charge all the fixed overheads at the bottom of the statement when the units are produced (not per unit sold like absorption costing)  more costs at once  Under absorption costing, for each of the 5,000 units not sold, we have £6 worth of cost in them in the form of fixed costs  £30,000 worth of overhead for those 5,000 units o We only charge 20,000 units worth of fixed costs because that is the amount we have sold

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 £30,000 is the difference in profit

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Under absorption costing o Variable manufacturing costs:  All included in the cost of goods sold  Included in the ending inventory  £10 x 5,000 units o Fixed manufacturing costs  In terms of the fixed cost, each unit had a fixed cost of £6 in it  Fixed manufacturing costs is included in the cost of goods sold because there is a fixed cost within the cost of each unit  Cost of goods sold = £6 x 20,000  Ending inventory = £6 x 5,000 o No period expense because the fixed costs are split equally between the number of units produced and not The ending inventories are worth different amounts under absorption and variable costing o Under absorption costing, it is worth £80,000 because the fixed manufacturing costs are included but under variable costing it is with £50,000 because the fixed costs are not included in the ending inventory but as a period expense o Difference is the amount of the fixed costs that are included in inventory o Effectively, I charge £30,000 less of fixed costs in absorption costing than in variable costing o In total, it is exactly the same cost but that cost won’t be incurred in my profit and loss statement until I sell those goods

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Reconciliation We can reconcile the difference between absorption and variable income as follows.  

First work out the fixed cost included in each unit for absorption costing ¿ manufacturing overhead £ 150,000 =£ 6.00 per unit = 25,000 units produced

Harvey Co. Year 2 In its second year of operations, Harvey Co. started with an inventory of 5,000 units, produced 25,000 units and sold 30,000 units (sell all our inventory).

Unit Product Cost No change to Harvey’s cost structure.

Income Comparison of Absorption and Variable Costing

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This time, the income from absorption costing is less than the income from variable costing This is because the ending inventory left after year 1 is carried through to the next year so when this is sold, the fixed cost for each of those units is charged whereas with variable costing, the fixed costs of all the units produced (25,000) in year 1 are charged to the profit or loss statement from the first year  in the second year under absorption costing, the fixed costs from the units sold is £180,000 (£150,000 + (5,000 x £6)) rather than £150,000 under variable costing This is £30,000 more than charged under variable which is why there is a difference of £30,000 in the net income

Summary 

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adds up exactly the same after the two years Therefore, the only difference between their profits is to do with movements of inventory and overheads within that inventory

We start and end with no inventory so although we have a difference between absorption and variable costing between the periods, the profit...