Chapter Five

Absorption Costing and

Variable Costing

OLD-CHAPTER SEVEN
Learning Objective 1

Explain how variable

costing differs from
absorption costing and
compute unit product
costs under each method.
 Overview of Absorption
and Variable Costing
the full cost method

Absorption Variable
Costing Costing
Direct Materials 1 1
Product
Product Direct Labor 2 2
Costs
Costs Variable Manufacturing Overhead 3 3

Fixed Manufacturing Overhead 4 4

Period
Period Variable Selling and Administrative Expenses 5
Costs
Costs Fixed Selling and Administrative Expenses 6
 Absorption C osting Variable C osting
Income State me nt Income State me nt
Sale s Sale s
Dire ct mate rials

Dire ct labor Cost of Goods Sold

( V a ria b l e P ro d uc t C o s t s )

C ost of Goods Sold Variable manufacturing ove rhe ad

(Fixe d and variable
product costs)
Variable
Se lliing &
Administrative
e xpe nse s
Gross Profit
Fixe d manufacturing ove rhe ad Contribution Margin
(Gross Margin)
Fixe d
Manufacturing
ove rhe ad
Fixe d
Se lling &
Se lling &
Adminstrative Se lling & Administrative e xpe nse s
Administrative
e xpe nse s
e xpe nse s
Ne t O pe rating Income Ne t O pe rating Income

KEY: = Pe riod e xpe nse s

 Prestudy-1
 1.The principal difference between variable
costing and absorption costing centers on:
 A) whether variable manufacturing costs
should be included as product costs.
 B) whether fixed manufacturing costs
should be included as product costs.
 C) whether fixed manufacturing costs and
fixed selling and administrative costs should be
included as product costs.
 D) none of these.
 Quick Check 
Which method will produce the highest
values for work in process and finished
goods inventories?
a. Absorption costing.
b. Variable costing.
c. They produce the same values for
these inventories.
d. It depends. . .
 Prestudy-2
 2. Which of the following costs at a
manufacturing company would be
treated as a product cost under the
variable costing method?
 A) direct material cost
 B) property taxes on the factory
building
 C) sales manager's salary
 D) all of the above
 Unit Cost Computations
Harvey Company produces a single product
with the following information available:
 Unit Cost Computations
Unit product cost is determined as follows:

Under absorption costing, selling and

administrative expenses are
always treated as period expenses and
deducted from revenue as incurred.
Prestudy-3
Prestudy-4
Learning Objective 2

Prepare income
statements using both
variable and absorption
costing.
 Income Comparison of
Absorption and Variable Costing
Let’s assume the following additional
information for Harvey Company.
 20,000 units were sold during the year at a
price of $30 each.
 There were no units in beginning inventory.

Now, let’s compute net operating

income using both absorption
and variable costing.
 Unit Cost Computations
Harvey Company produces a single product
with the following information available:
 Unit Cost Computations
Unit product cost is determined as follows:

Under absorption costing, selling and

administrative expenses are
always treated as period expenses and
deducted from revenue as incurred.
 Absorption Costing

Fixed manufacturing overhead deferred in

inventory is 5,000 units × $6 = $30,000.
 Variable Costing
Variable
manufacturing
Variable Costing
costs only.
Sales (20,000 × $30) $ 600,000
Less variable expenses:
Beginning inventory $ -
All fixed
Add COGM (25,000 × $10) 250,000
manufacturing
Goods available for sale 250,000
overhead is
Less ending inventory (5,000 × $10) 50,000
expensed.
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
Prestudy-5
Prestudy-6
Learning Objective 3

Reconcile variable costing

and absorption costing net
operating incomes and
explain why the two
amounts differ.
Comparing the Two Methods
Comparing the Two Methods
We can reconcile the difference between
absorption and variable income as follows:
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 operating income $ 120,000

Fixed mfg. Overhead $150,000

= = $6.00 per unit
Units produced 25,000 units
 Prestudy-7
 7. Swifton Company produces a single
product. Last year, the company had net
operating income of $40,000 using
variable costing. Beginning and ending
inventories were 22,000 and 27,000 units,
respectively. If the fixed manufacturing
overhead cost was $3.00 per unit, what
was the income using absorption costing?
 A) $15,000
 B) $25,000
 C) $40,000
 D) $55,000
Extended Comparisons of Income
Data Harvey Company Year Two
 Unit Cost Computations

Since there was no change in the variable costs

per unit, total fixed costs, or the number of
units produced, the unit costs remain unchanged.
 Absorption Costing
Absorption Costing
Sales (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
These are the 25,000 units
produced in the current period.
Variable Costing
Variable
manufacturing
costs only.

All fixed
manufacturing
overhead is
expensed.
Comparing the Two Methods
We can reconcile the difference between
absorption and variable income as follows:
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

Fixed mfg. Overhead $150,000

= = $6.00 per unit
Units produced 25,000 units
Comparing the Two Methods
Summary of Key Insights
 Prestudy-8
 8. Net operating income under variable
and absorption costing will generally:
 A) always be equal.
 B) never be equal.
 C) be equal only when production
and sales are equal.
 D) be equal only when production
exceeds sales.


Effect of Changes in Production
on Net Operating Income

Let’s revise the Harvey Company example.

In the previous example,

25,000 units were produced each year,
but sales increased from 20,000 units in year
one to 30,000 units in year two.

In this revised example,

production will differ each year while
sales will remain constant.
Effect of Changes in Production
Harvey Company Year One
Unit Cost Computations for Year One

Unit product cost is determined as follows:

Since the number of units produced increased

in this example, while the fixed manufacturing overhead
remained the same, the absorption unit cost is less.
Absorption Costing: Year One
Variable Costing: Year One
Variable
manufacturing
Variable Costing
costs only.
Sales (25,000 × $30) $ 750,000
Less variable expenses:
Beginning inventory $ -
Add COGM (30,000 × $10) 300,000
All fixed
Goods available for sale 300,000
manufacturing
Less ending inventory (5,000 × $10) 50,000 overhead is
Variable cost of goods sold 250,000 expensed.
Variable selling & administrative
expenses (25,000 × $3) 75,000 325,000
Contribution margin 425,000
Less fixed expenses:
Manufacturing overhead $ 150,000
Selling & administrative expenses 100,000 250,000
Net operating income $ 175,000
Effect of Changes in Production
Harvey Company Year Two
Unit Cost Computations for Year Two

Unit product cost is determined as follows:

Since the number of units produced decreased in the

second year, while the fixed manufacturing overhead
remained the same, the absorption unit cost is now higher.
 Absorption Costing: Year Two
Absorption Costing
Sales (25,000 × $30) $ 750,000
Less cost of goods sold:
Beg. inventory (5,000 × $15) $ 75,000
Add COGM (20,000 × $17.50) 350,000
Goods available for sale 425,000
Less ending inventory - 425,000
Gross margin 325,000
Less selling & admin. exp.
Variable (25,000 × $3) $ 75,000
Fixed 100,000 175,000
Net operating income $ 150,000

These are the 20,000 units produced in the current

period at the higher unit cost of $17.50 each.
Variable Costing: Year Two
Variable
manufacturing
costs only.

All fixed
manufacturing
overhead is
expensed.
 Comparing the Two Methods

Conclusions
 Net operating income is not affected by changes in
production using variable costing.
 Net operating income is affected by changes in production
using absorption costing even though the number of units
sold is the same each year.
 Prestudy-9
 9.In its first year of operations, Bronfren
Corporation produced 800,000 sets and sold
780,000 sets of artificial tan lines. What would
have happened to net operating income in this
first year under the following costing methods if
Bronfren had produced 20,000 fewer sets?
(Assume that Bronfren has both variable and
fixed production costs.)
Variable costing Absorption costing
A) Increase Increase
B) Decrease Increase
C) Decrease Decrease
D) No effect Decrease
Learning Objective 4

Understand the
advantages and
disadvantages of both
variable and absorption
costing.
 Impact on the Manager
Opponents of absorption costing argue that
shifting fixed manufacturing overhead costs
between periods can lead to faulty decisions.

These opponents argue that variable costing income

statements are easier to understand because net operating
income is only affected by changes in unit sales. This
produces net operating income figures that are
more consistent with managers’ expectations.
 Prestudy-10
 10. A reason why absorption costing income
statements are sometimes difficult for the
manager to interpret is that:
 A) they omit variable expenses entirely in
computing net operating income.
 B) they shift portions of fixed
manufacturing overhead from period to period
according to changing levels of inventories.
 C) they include all fixed manufacturing
overhead on the income statement each year as
a period cost.
 D) they ignore inventory levels in
computing income charges.
 Problem5-12 Year 1 Year 2
Sales (at $25 per unit) $1,000,000 $1,250,000
Less cost of goods sold:
Beginning inventory 0 90,000
Add cost of goods manufactured (at $18 per unit) 810,000 810,000
Goods available for sale 810,000 900,000
Less ending inventory (at $18 per unit) 90,000 0
Cost of goods sold 720,000 900,000
Gross margin 280,000 350,000
Less selling and admin expenses* 210,000 230,000
Net operating income $70,000 $120,000
*Variable cost per unit $2
Fixed each year $130,000
Unit product cost:
Direct materials $4
Direct labor 7
Variable manufacturing overhead 1
Fixed manufacturing overhead 6
Unit product cost $18
Year 1 Year 2
Units produced 45,000 45,000
Units sold 40,000 50,000