Absorption costingAbsorption costing

Group no-4Apparel Production-6National Institute Of Fashion TechnologyMumbai

Absorption costing

• Costing method which involves or “absorbs” all the costs necessary to produce the product into its saleable form.

The layman’s language

The only cost of driving my caron a 200 mile trip today is

$12 for gasoline.

VariableCosting

No! You must consider these costs too!

AbsorptionCosting

Cost Per month Per day

Car payment 300.00$ 10.00$

Insurance 60.00 2.00

Two Costing MethodsTwo Costing Methods

Used for external financial reporting

Includes direct materials, direct labor, variable factory overhead, and fixed factory overhead as part of total product cost

Absorption CostingAbsorption Costing

Two Costing MethodsTwo Costing Methods

Variable CostingVariable Costing

Used for internal planning and decision making

Does not include fixed factory overhead as a product cost

Absorption Costing Compared to Absorption Costing Compared to Variable CostingVariable Costing

Variable Costing

Absorption Costing

Cost of Goods ManufacturedCost of Goods Manufactured

Cost of Goods ManufacturedCost of Goods Manufactured

DirectDirectMaterialsMaterials

DirectDirectLaborLabor

VariableVariableFactory OHFactory OH

FixedFixedFactory OHFactory OH

Period ExpensePeriod Expense

Overview of Absorption and Variable Costing

Direct Materials

Direct Labor

Variable Manufacturing Overhead

Fixed Manufacturing Overhead

Variable Selling and Administrative Expenses

Fixed Selling and Administrative Expenses

VariableCosting

AbsorptionCosting

ProductCosts

PeriodCosts

ProductCosts

PeriodCosts

• An example of income comparisons using variable and absorption costings

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

Unit Cost Computations

Unit product cost is determined as follows:

Selling and administrative expenses arealways treated as period expenses and

deducted from revenue.

Unit Cost Computations

Absorption CostingSales (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 FixedNet operating income

ABC Co. had no beginning inventory, produced 25,000 units and sold 20,000 units this year.

Income Comparison of Absorption and Variable Costing

ABC Co. had no beginning inventory, produced 25,000 units and sold 20,000 units this year.

Absorption CostingSales (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 Net operating income 120,000$

Income Comparison of Absorption and Variable Costing

Variable CostingSales (20,000 × $30) 600,000$ Less variable expenses: Beginning inventory -$ Add COGM (25,000 × $10) 250,000 Goods available for sale 250,000 Less ending inventory (5,000 × $10) 50,000 Variable cost of goods sold 200,000 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 Net operating income 90,000$

Now let’s look at variable costing by ABC Co.Variable

costsonly.

All fixedmanufacturing

overhead isexpensed.

Income Comparison of Absorption and Variable Costing

Let’s compare the methods.

Income Comparison of Absorption and Variable Costing

Reconciliation

Variable costing net operating income 90,000$ Add: Fixed mfg. overhead costs deferred in inventory (5,000 units × $6 per unit) 30,000 Absorption costing net opearting income 120,000$

Fixed mfg. overhead $150,000 Units produced 25,000 units

= = $6.00 per unit

We can reconcile the difference betweenabsorption and variable income as follows:

Extending the Example

Let’s look at thesecond yearof operations

for ABCCompany.

ABC Co. Year 2 In its second year of operations, ABC Co. started with

an inventory of 5,000 units, produced 25,000 units and sold 30,000 units.

ABC Co. Year 2

Unit product cost is determined as follows:

No change in ABC’scost structure.

ABC Co. Year 2

Now let’s look at ABC’s income statementassuming absorption costing is used.

Absorption CostingSales (30,000 × $30) 900,000$ Less cost of goods sold: Beg. inventory (5,000 × $16) 80,000$ Add COGM (25,000 × $16) 400,000 Goods available for sale 480,000 Less ending inventory - 480,000 Gross margin 420,000 Less selling & admin. exp. Variable (30,000 × $3) 90,000$ Fixed 100,000 190,000 Net operating income 230,000$

ABC Co. Year 2

These are the 25,000 unitsproduced in the current period.

ABC Co. Year 2

Next, we’ll look at ABC’s income statementassuming is used.

ABC Co. Year 2Variable

costsonly.

All fixedmanufacturing

overhead isexpensed.

Reconciliation

Variable costing net operating income 260,000$ Deduct: Fixed manufacturing overhead costs released from inventory (5,000 units × $6 per unit) 30,000 Absorption costing net operating income 230,000$

We can reconcile the difference betweenabsorption and variable income as follows:

Fixed mfg. overhead $150,000 Units produced 25,000 units

= = $6.00 per unit

Summary

IFIF Units Sold < Units produced

THENTHEN Variable Costing < Absorption CostingIncome Income

IFIF Units Sold > Units produced

THENTHEN Variable Costing > Absorption CostingIncome Income

• when production > sales, absorption costing net income will be greater than variable costing net income due to the current period fixed costs held in inventory.

• when production < sales, absorption costing net income will be less than variable costing net income due to the “old” fixed costs released from inventory.

• when production = sales, absorption costing net income and variable costing net income will be equal.

VariableCosting

Absorptioncosting product costs

are misleading fordecision making.

They are the numbers that appear on our

external reports.

AbsorptionCosting

Variable versusAbsorption Costing

Variable cost $10Fixed manufacturing overhead $100,000Units sold 10,000

Units Produced

Total Variable Cost

Fixed Manufacturing

Overhead

Total Manufacturing

Cost

Average Manufacturing

CostCost of

Goods Sold10,000 $100,000 $100,000 $200,000 20.00$ 200,000$ 12,000 $120,000 $100,000 $220,000 18.33$ 183,333$ 14,000 $140,000 $100,000 $240,000 17.14$ 171,429$ 16,000 $160,000 $100,000 $260,000 16.25$ 162,500$ 18,000 $180,000 $100,000 $280,000 15.56$ 155,556$ 20,000 $200,000 $100,000 $300,000 15.00$ 150,000$

Absorption CostingCost of goods sold decreases because production

exceeds sales, leaving a portion of fixedmanufacturing costs in inventory.

COGS for 10,000 units

$100,000

$150,000

$200,000

Number of units produced

CO

GS

Absorption CostingCost of goods sold decreases because production

exceeds sales, leaving a portion of fixedmanufacturing costs in inventory.

Impact of JIT Inventory Methods

In a JIT inventory system . . .

Productiontends to equalsales . . .

So, the difference between variable andabsorption income tends to disappear.

Management’s Use of Costing MethodsManagement’s Use of Costing MethodsManagement’s Use of Costing MethodsManagement’s Use of Costing Methods

1. Controlling costs

2. Pricing products

3. Planning production

4. Analyzing market segments

5. Analyzing contribution margins

Variable costing reports and absorption costing reports are useful in the following situations:

Accounting Reports and Accounting Reports and Management DecisionsManagement DecisionsAccounting Reports and Accounting Reports and Management DecisionsManagement Decisions

ACCOUNTING REPORTS

Absorption Costing and Variable Costing

MANAGEMENT

MANAGEMENT

DECISIONS

Controlling Controlling CostsCosts

PricingPricingPlanning Planning

ProductionProduction

Analyzing Analyzing Market Market

SegmentsSegments

Analyzing Analyzing Contribution Contribution

MarginsMargins

ACTUAL PLANNED

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