EBSC7290 Managerial
Finance and Accounting
Week 3
McGraw-Hill Education | Seal & Rohde Management Accounting 6th edition © 2018 1
Overview of Absorption and Variable Costing
The only costs of driving my car
on a 200-mile trip today are
£12 for petrol.
Variable
Costing
McGraw-Hill Education | Seal & Rohde Management Accounting 6th edition © 2018 2
Overview of Absorption and Variable Costing
No! You must consider these costs too!
Cost Per month Per day
Car payment £ 300 £ 10
Insurance 60.00 2.00
Absorption
Costing
McGraw-Hill Education | Seal & Rohde Management Accounting 6th edition © 2018 3
Overview of Absorption and Variable Costing
You’re wrong. I have the car
payment and the
insurance payment even if
I do not make the trip.
Variable
Costing
McGraw-Hill Education | Seal & Rohde Management Accounting 6th edition © 2018 4
Overview of Absorption and Variable Costing
Who’s right?
How should we treat the car
payment and the insurance?
McGraw-Hill Education | Seal & Rohde Management Accounting 6th edition © 2018 5
Overview of Absorption and Variable Costing
Absorption Variable
Costing Costing
Direct materials
Direct labour Product costs
Product costs Variable mfg. overhead
Fixed mfg. overhead
Period costs
Period costs Selling & admin. exp.
McGraw-Hill Education | Seal & Rohde Management Accounting 6th edition © 2018 6
Overview of Absorption and Variable Costing
Let’s put some numbers to the
issue and see if it will
sharpen our understanding.
McGraw-Hill Education | Seal & Rohde Management Accounting 6th edition © 2018 7
Unit Cost Computations
Harvey Co. produces a single product with the
following information available:
McGraw-Hill Education | Seal & Rohde Management Accounting 6th edition © 2018 8
Unit Cost Computations
Unit product cost is determined as
follows:
Selling and administrative expenses are
always treated as period expenses and
deducted from revenue.
McGraw-Hill Education | Seal & Rohde Management Accounting 6th edition © 2018 9
Profit Comparison of Absorption and
Variable Costing
Harvey Co. had no beginning inventory, produced
25,000 units and sold 20,000 units this year.
Absorption Costing
Sales (20,000 × £30) £600,000
Less cost of goods sold:
Beginning inventory £ -
Add COGM (25,000 × £16) 400,000
Goods available for sale 400,000
Ending inventory (5,000 × £16) 80,000 320,000
Gross margin 280,000
Less selling & admin. exp.
Variable
Fixed
Operating profit
McGraw-Hill Education | Seal & Rohde Management Accounting 6th edition © 2018 10
Profit Comparison of Absorption and
Variable Costing
Harvey Co. had no beginning inventory, produced
25,000 units and sold 20,000 units this year.
Absorption Costing
Sales (20,000 × £30) £600,000
Less cost of goods sold:
Beginning inventory £ -
Add COGM (25,000 × £16) 400,000
Goods available for sale 400,000
Ending inventory (5,000 × £16) 80,000 320,000
Gross margin 280,000
Less selling & admin. exp.
Variable (20,000 × £3) £ 60,000
Fixed 100,000 160,000
Operating profit £120,000
McGraw-Hill Education | Seal & Rohde Management Accounting 6th edition © 2018 11
Profit Comparison of Absorption and
Variable Costing
Now let’s look at variable costing by Harvey Co.
Variable
costs Variable Costing
Sales (20,000 × £30) £ 600.000
only.
Less variable expenses:
Beginning inventory £ - All fixed
Add COGM (25,000 × £10) 250.000 manufacturing
Goods available for sale 250.000
Ending inventory (5,000 × £10) 50.000
overhead is
Variable cost of goods sold 200.000 expensed.
Variable selling & administrative
expenses (20,000 × £3) 60.000 260.000
Contribution margin 340.000
Less fixed expenses:
Manufacturing overhead £ 150.000
Selling & administrative expenses 100.000 250.000
Operating profit £ 90.000
McGraw-Hill Education | Seal & Rohde Management Accounting 6th edition © 2018 12
Profit Comparison of Absorption and
Variable Costing
Let’s compare the methods.
McGraw-Hill Education | Seal & Rohde Management Accounting 6th edition © 2018 13
Profit Comparison of Absorption and
Variable Costing
Let’s compare the methods.
McGraw-Hill Education | Seal & Rohde Management Accounting 6th edition © 2018 14
Reconciliation
We can reconcile the difference between
absorption and variable profit as follows:
Variable costing operating profit £ 90,000
Add: Fixed mfg. overhead costs
deferred in inventory
(5,000 units × £6 per unit) 30,000
Absorption costing operating profit £ 120,000
Fixed mfg. overhead £150,000
= = £6.00 per unit
Units produced 25,000
McGraw-Hill Education | Seal & Rohde Management Accounting 6th edition © 2018 15
Extending the Example
Let’s look at the
second year
of operations
for Harvey
Company.
McGraw-Hill Education | Seal & Rohde Management Accounting 6th edition © 2018 16
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.
McGraw-Hill Education | Seal & Rohde Management Accounting 6th edition © 2018 17
Harvey Co. Year 2
Unit product cost is determined as follows:
No change in Harvey’s
cost structure.
McGraw-Hill Education | Seal & Rohde Management Accounting 6th edition © 2018 18
Harvey Co. Year 2
Now let’s look at Harvey’s statement of profit or
loss assuming absorption costing is used.
McGraw-Hill Education | Seal & Rohde Management Accounting 6th edition © 2018 19
Harvey Co. Year 2
Absorption Costing
Sales (30,000 × £30) £900,000
Less cost of goods sold:
Beginning inventory (5,000 × £16)£ 80,000
Add COGM (25,000 × £16) 400,000
Goods available for sale 480,000
Ending inventory - 480,000
Gross margin 420,000
Less selling & admin. exp.
Variable (30,000 × £3) £ 90,000
Fixed 100,000 190,000
These are the 25,000 units
produced in the current period.
McGraw-Hill Education | Seal & Rohde Management Accounting 6th edition © 2018 20
Harvey Co. Year 2
Next, we’ll look at Harvey’s statement of profit or
loss assuming is used.
McGraw-Hill Education | Seal & Rohde Management Accounting 6th edition © 2018 21
Harvey Co. Year 2
Variable
costs
only.
All fixed
manufacturing
overhead is
expensed.
McGraw-Hill Education | Seal & Rohde Management Accounting 6th edition © 2018 22
Summary
McGraw-Hill Education | Seal & Rohde Management Accounting 6th edition © 2018 23
Summary
McGraw-Hill Education | Seal & Rohde Management Accounting 6th edition © 2018 24
Advantages of Variable Costing and the
Contribution Approach
Consistent with
CVP analysis.
Management finds it
easy to understand. Operating profit is
closer
to net cash flow.
Consistent with standard
Advantages costs and flexible budgeting.
Easier to estimate profitability
of products and segments.
Impact of fixed
costs on profits Profit is not affected by
emphasized. changes in inventory.
McGraw-Hill Education | Seal & Rohde Management Accounting 6th edition © 2018 25
Variable versus Absorption Costing
Absorption Variable
Costing Costing
All manufacturing costs Fixed costs are
must be assigned to not really the costs
products to properly of any particular
match revenues and costs. product.
McGraw-Hill Education | 26
Variable versus Absorption Costing
Absorption Variable
Costing Costing
Depreciation, taxes, These are capacity
insurance and salaries costs and will be
are just as essential to incurred if nothing
products as variable costs. is produced.
McGraw-Hill Education | 27
Choosing a Costing Method
A basic problem with absorption costing is that fixed
manufacturing overhead costs appear to be variable
with respect to the number of units sold.
A company that attempts to use variable costing on its
external financial reports runs the risk that its auditors
may not accept the financial statements as conforming
to internationally accepted accounting principles.
The issue of performance evaluation.
McGraw-Hill Education | Seal & Rohde Management Accounting 6th edition © 2018 28
Variable versus Absorption Costing
I guess we won’t be
solving this controversy
today!
McGraw-Hill Education | Seal & Rohde Management Accounting 6th edition © 2018 29
Impact of JIT Inventory Methods
In a JIT inventory system . . .
Production
tends to equal
sales . . .
So, the difference between variable and
absorption profit tends to disappear.
McGraw-Hill Education | Seal & Rohde Management Accounting 6th edition © 2018 30
