Absorption vs. Variable Costing

Absorption vs. Variable Costing

• Two product costing methods are absorption costing and variable costing.
• Absorption costing includes direct materials, direct labor, variable overhead, and fixed overhead.
• Absorption costing is required by GAAP for external reporting, but can lead to misleading cost information and poor decisions.
• Variable costing includes direct materials, direct labor, and ONLY variable overhead.
• Variable costing is only used for internal purposes.
• Absorption costing capitalizes fixed overhead to the inventory account.
• With absorption costing, capitalization of fixed costs on a per unit basis will increase as production levels increase, and will capitalize to the inventory account.
• With variable costing, fixed overhead is expensed immediately.
• Direct materials cost $4 per unit.
• Direct labor costs $8 per unit.
• Variable overhead is $3 per unit.
• Fixed overhead totals $600,000 per year.
• Based on 60,000 of units produced per year, cost per unit is $10.
• With absorption costing, product cost is $25 per unit.
• With variable costing, product cost is $15 per unit.
• Over the long run, income recognized under either costing approach is equal.
• When the units produced differ from the units sold, income will differ between the two methods.
• When Production = Sales, Absorption = Variable.
• When Production > Sales, Absorption > Variable.
• When Production < Sales, Absorption < Variable.
• The differences in income are due to the timing of expense recognition.
• Absorption costing expenses fixed overhead only when goods are sold.
• Variable costing expenses fixed overhead immediately.

Absorption Costing and Earnings Management

• Absorption costing is required by GAAP for reporting net income on financial statements.
• Managers and executives use absorption costing to their advantage by "managing" the bottom line to earn a bonus.
• By increasing production levels, product costs per unit decrease, leading to a lower cost of goods sold per unit and higher net income.
• With absorption costing, at 60,000 units produced, direct materials are $4 per unit, direct labor is $8 per unit, overhead is $3 per unit, and fixed overhead is $10 per unit for a total product cost of $25 per unit.
• With absorption costing, at 100,000 units produced, direct materials are $4 per unit, direct labor is $8 per unit, overhead is $3 per unit, and fixed overhead is $6 per unit for a total product cost of $21 per unit.
• Increasing production levels to 100,000 units decreased total product cost per unit by $4.
• When each unit is sold, the company recognizes $4 less of cost of goods sold per unit.
• Increasing net income by increasing production is a short-sighted decision by a manager.
• Long-run implications of unjustified production increases include increased inventory storage costs, spoilage, and obsolescence of the inventory.
• Income under variable costing remains the same as production levels increase.
• Fixed overhead costs are expensed immediately, so cost per unit is unaffected by production levels.

Setting a Target Price

• Managers can be creative in using absorption costing to their advantage.
• The inclusion of fixed costs in calculating a per unit product costs is important to ensure coverage of costs with acceptable returns.
• A three-step process to determine a selling price using absorption costing involves determining the product cost per unit under absorption costing, determining the target markup on product cost per unit, and adding the target markup to the product cost to find the target selling price.

Analyzing Special Orders

• A customer may place a special order from time-to-time at a discounted price.
• Two questions to ask when determining whether to accept the special order are, "Is there excess capacity?" and "Does the special-order price exceed variable cost?"
• Fixed costs don't change with production levels; if the special-order price > variable cost, a company can increase its contribution margin and contribute toward covering fixed costs and earning a profit.
• IceAge receives a special order for 1,000 pairs of skates at an offer price of $22, which won't impact regular sales, and there is excess capacity to fill the order.
• Absorption costing shows the product cost is $25 per unit.
• Variable cost of goods sold per unit is $15, and variable selling and administrative expenses are $2 per unit.
• IceAge's fixed costs will be incurred regardless of accepting the order, so assess whether the special order price exceeds the variable cost per unit.
• Sales (1,000 x $22) are $22,000.
• Variable costs (1,000 x $17) are $17,000.
• Contribution margin is $5,000.
• IceAge's contribution margin would increase by $5,000 if the order is accepted, so the order should be accepted.