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    College of San MateoAccounting 131Rosemary Nurre.Course InfoAnnouncementsAssignmentsStudent InfoHome PageChapter 7Variable Costing—A Tool for ManagementLearning Objectives

    1. Explain how variable costing differs from absorption costing and compute unit product costs under each method.

    2. Prepare income statements using both variable and absorption costing.

    3. Reconcile variable costing and absorption costing net operating incomes and explain why the two amounts differ.

    4. Understand the advantages and disadvantages of both variable and absorption costing.

    Chapter Overview

    A. Overview of Variable and Absorption Costing. At least two methods can be used in manufacturing companies to value units of product for accounting purposes—absorption costing and variable costing. These methods differ only in how they treat fixed manufacturing overhead costs.1. Variable Costing. Variable costing includes only variable production costs in product costs. Direct materials, direct labor and variable manufacturing overhead costs would ordinarily be included in product costs under variable costing. Fixed manufacturing overhead is not treated as a product cost under this method. Rather, fixed manufacturing overhead is treated as a period cost and is charged against income each period.2. Absorption Costing. Absorption costing treats all production costs as product costs, regardless of whether they are variable or fixed. Under absorption costing, a portion of fixed manufacturing overhead is allocated to each unit of product.B. Comparison of Absorption and Variable Costing. When comparing absorption costing and variable costing income statements, a number of points should be noted:1. Deferral of fixed manufacturing costs under absorption costing. Under absorption costing, if inventories increase then a portion of the fixed manufacturing overhead costs of the current period is deferred to future periods in the inventory account. When the units are later taken out of inventory and sold, the deferred fixed costs flow through to the income statement as part of cost of goods sold.2. Differences in inventories under the two methods. The ending inventory figures under the variable costing and absorption costing methods are different. Under variable costing, only the variable manufacturing costs are included in inventory. Under absorption costing, both variable and fixed manufacturing costs are included in inventory.3.Suitability for CVP analysis. An absorption costing income statement is not well suited for providing data for CVP computations since it makes no distinction between fixed and variable costs. In contrast, the variable costing method classifies costs by behavior and is very useful in setting-up CVP computations. C. Extended Comparison of Income Data. Exhibit 7-3 in the text presents a comparison of absorption costing and variable costing income statements over three years in which production is constant but sales vary. Exhibit 7-6 in the text also presents comparative income statements over three years but holds annual sales constant and varies annual production. From these Exhibits, several generalizations can be drawn. (All of these generalizations assume the LIFO inventory flow assumption is being used. The generalizations may not hold in some rare cases if a company uses an inventory flow assumption other than LIFO.)1. Production equals sales (no change in inventories). When production equals sales, inventories do not change. If inventories do not change, then there is no change in the fixed manufacturing overhead costs in inventories under absorption costing. Therefore, under both costing methods all of the current fixed manufacturing overhead will flow through to the income statement as an expense. In the case of absorption costing it will be part of cost of goods sold. In the case of variable costing, it will be a period expense.2. Production exceeds sales (inventories increase). When production exceeds sales, inventories grow. If inventories grow, then some of the current fixed manufacturing overhead costs will be deferred in inventories under absorption costing. Since all of the current fixed manufacturing overhead costs are expensed under variable costing, the net operating income reported under absorption costing will be greater than the net operating income reported under variable costing.3. Sales exceed production (inventories decrease). When sales exceed production, inventories shrink. If inventories decrease, then some of the fixed manufacturing overhead costs that had been deferred in inventories in previous periods will be released to the income statement as part of cost of goods sold as well as all of the current fixed manufacturing overhead costs. Since only the current fixed manufacturing overhead costs are expensed under variable costing, the net operating income reported under absorption costing will be less than the net operating income reported under variable costing.4. Long-term differences in income. Over an extended period of time, the cumulative net operating income figures reported under absorption costing and variable costing will be about the same; they will differ only by the amount of fixed manufacturing overhead cost in ending inventories under absorption costing. Cumulative net operating income figures will be identical whenever ending inventories are reduced to zero.

    Source : accounts.smccd.edu

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    T/F: Under variable costing, only variable production costs are treated as product costs.

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    True

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    T/F: Under variable costing, variable selling and administrative costs are included in product costs.

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    False

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    1/30 Created by katie_wright756

    Terms in this set (30)

    T/F: Under variable costing, only variable production costs are treated as product costs.

    True

    T/F: Under variable costing, variable selling and administrative costs are included in product costs.

    False

    T/F: Absorption costing treats all manufacturing costs as product costs.

    True

    T/F: In the preparation of financial statements using variable costing, fixed manufacturing overhead is treated as a period cost.

    True

    T/F: Absorption costing treats fixed manufacturing overhead as a period cost.

    False

    T/F: When the number of units in work in process and finished goods inventories increase, absorption costing net operating income will typically be greater than variable costing net operating income.

    True

    T/F: Net operating income computed using absorption costing will always be greater than net operating income computed using variable costing.

    False

    T/F: When production exceeds sales for the period, absorption costing net operating income will exceed variable costing net operating income.

    True

    T/F: Absorption costing net operating income is closer to the net cash flow of a period than is variable costing net operating income.

    False

    T/F: Variable costing is not permitted for income tax purposes, but it is widely accepted for external financial reports.

    False

    T/F: Variable costing is better suited to cost-volume-profit calculations than absorption costing.

    True

    T/F: When lean production is introduced, the difference in net operating income computed under the absorption and variable costing methods is reduced.

    True

    T/F: Allocating common fixed costs to segments on segmented income statements reduces the usefulness of such statements.

    True

    T/F: A segment is any part or activity of an organization about which a manager seeks cost, revenue, or profit data.

    True

    T/F: If a manufacturing company is using activity-based costing for internal purposes only, then organization-sustaining overhead costs should not be allocated to any of the products.

    True

    T/F: Batch-level activities are performed each time a batch of goods is handled or processed.

    True

    T/F: Organization-sustaining activities are carried out regardless of how many units are made, how many batches are run, or how many different products are made.

    True

    T/F: Direct labor-hours or direct labor cost should not be used as a measure of activity in an activity-based costing system.

    False

    T/F: In traditional costing systems, all manufacturing costs are assigned to products -- even manufacturing costs that are not caused by the products.

    True

    T/F: Activity-based costing involves a two-stage allocation in which overhead costs are first assigned to departments and then to jobs on the basis of direct labor hours.

    False

    T/F: In activity-based costing, some costs may be broken down and assigned to two activity cost pools. For example, part of a supervisor's salary may be classified as a product-level activity and part of it may be classified as a batch-level activity.

    True

    T/F: When a company shifts from a traditional cost system in which manufacturing overhead is applied based on direct labor-hours to an activity-based costing system in which there are batch-level and product-level costs, the unit product costs of high volume products typically decrease whereas the unit product costs of low volume products typically increase.

    True

    T/F: The usual starting point in budgeting is to make a forecast of net income.

    False

    T/F: A continuous or perpetual budget is one which covers a 12-month period but which is constantly adding a new month on the end as the current month is completed.

    True

    T/F: A self-imposed budget is one prepared by top management and passed downward through an organization.

    False

    T/F: When using the self-imposed budget approach, it is generally best for top management to accept all budget estimates without question in order to minimize adverse behavioral responses from employees.

    False

    T/F: The direct labor budget begins with sales in units from the sales budget.

    False

    T/F: In the manufacturing overhead budget, the non-cash charges (such as depreciation) are deducted from the total budgeted manufacturing overhead to determine the expected cash disbursements for manufacturing overhead.

    True

    T/F: The selling and administrative expense budget lists the budgeted expenses for areas other than manufacturing.

    True

    T/F: The disbursements section of a cash budget consists of all cash payments for the period except cash payments for dividends.

    False

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    6.1 Absorption Costing

    6.1 Absorption Costing

    Absorption costing, also called full costing, is what you are used to under Generally Accepted Accounting Principles.  Under absorption costing, companies treat all manufacturing costs, including both fixed and variable manufacturing costs, as product costs. Remember, total variable costs change proportionately with changes in total activity, while fixed costs do not change as activity levels change. These variable manufacturing costs are usually made up of direct materials, variable manufacturing overhead, and direct labor.   The product costs (or cost of goods sold) would include direct materials, direct labor and overhead.  The period costs would include selling, general and administrative costs.

    The following diagram explains the cost flow for product and period costs.

    The product cost, under absorption costing, would be calculated as:

    Direct Materials + Direct Labor + Variable Overhead + Fixed Overhead

    = Total Product Cost

    You can calculate a cost per unit by taking the total product costs / total units PRODUCED.  Yes, you will calculate a fixed overhead cost per unit as well even though we know fixed costs do not change in total but they do change per unit.  We will assign a cost per unit for accounting reasons.  When we prepare the income statement, we will use the multi-step income statement format.

    We will not get as complicated in our multi-step income statement as the video example but it should have provided a refresher from what you should have learning in financial accounting.  For our purpose, the absorption income statement will contain:

    Sales

    – Cost of Goods Sold

    = Gross Profit Operating Expenses: Selling Expenses

    + General and Admin. Expenses

    = Total Expenses

    = Net Operating Income

    Gross Profit is also referred to as gross margin.  Net operating income is Gross Profit – Total Operating Expenses and is also called Income before taxes.  Let’s look at an example:

    Bradley Company had the following information for May:

    Direct materials $13,000

    Direct labor $15,000

    Variable overhead $5,000

    Fixed overhead $6,000

    Fixed selling expenses $15,000

    Variable selling expenses $0.20 per unit

    Administrative expenses $12,000

    10,000 units produced

    9,000 units sold (1,000 remain in ending finished goods inventory)

    Sales price $8 per unit

    First, we need to calculate the absorption product cost per unit:

    Direct Materials $ 13,000

    + Direct Labor $ 15,000

    + Variable Overhead $  5,000

    + Fixed Overhead $  6,000

    = Total Product Cost $39,000

    ÷ Total Units Produced ÷ 10,000

    = Product cost per unit $ 3.90

    Next, we can use the product cost per unit to create the absorption income statement.  We will use the UNITS SOLD on the income statement (and not units produced) to determine sales, cost of goods sold and any other variable period costs.

    Bradley CompanyIncome Statement (absorption)For Month Ended May

    Sales (9,000 x $8 per unit) $ 72,000

    – Cost of Goods Sold (9,000 x $3.90 per unit)                        35,100

    = Gross Profit            36,900

    Operating Expenses:

    Selling Expenses (15,000 fixed + variable 0.20 x 9,000 units sold)                        16,800

    + General and Admin. Expenses                        12,000

    = Total Expenses            28,800

    = Net Operating Income $8,100

    Remember the following under absorption costing:

    Typically used for financial reporting (GAAP)

    ALL manufacturing costs are included in the cost (direct materials, direct labor, fixed and variable overhead)

    Can be misleading as some costs are not affected by products

    Fixed manufacturing overhead costs are applied to units PRODUCED and not just unit sold

    Income statement shows Sales – Cost of Goods sold = Gross Margin (or Gross Profit) – Operating Expenses = Net Income and is based on the number of units SOLD.

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