Presentation is loading. Please wait.

Presentation is loading. Please wait.

© 2006 McGraw-Hill Ryerson Ltd.. Variable vs. Absorption Costing: A Tool for Management Chapter Seven.

Similar presentations


Presentation on theme: "© 2006 McGraw-Hill Ryerson Ltd.. Variable vs. Absorption Costing: A Tool for Management Chapter Seven."— Presentation transcript:

1 © 2006 McGraw-Hill Ryerson Ltd.. Variable vs. Absorption Costing: A Tool for Management Chapter Seven

2 © 2006 McGraw-Hill Ryerson Ltd.. Learning 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 operating incomes, and explain why the two amounts differ. After studying this chapter, you should be able to:

3 © 2006 McGraw-Hill Ryerson Ltd.. Learning Objectives 4. Explain the advantages and disadvantages of both variable and absorption costing. 5.Explain how the use of JIT reduces the difference in reported operating income under the variable and absorption costing methods. After studying this chapter, you should be able to:

4 © 2006 McGraw-Hill Ryerson Ltd.. Overview of Absorption and Variable Costing Direct Materials Direct Labour Variable Manufacturing Overhead Fixed Manufacturing Overhead Variable Selling and Administrative Expenses Fixed Selling and Administrative Expenses Variable Costing Absorption Costing Product Costs Period Costs Product Costs Period Costs

5 © 2006 McGraw-Hill Ryerson Ltd.. 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... 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...

6 © 2006 McGraw-Hill Ryerson Ltd.. 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... 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... Quick Check

7 © 2006 McGraw-Hill Ryerson Ltd.. Harvey Company produces a single product with the following information available: Unit Cost Computations

8 © 2006 McGraw-Hill Ryerson Ltd.. Unit product cost is determined as follows: Selling and administrative expenses are always treated as period expenses and deducted from revenue as incurred. Unit Cost Computations

9 © 2006 McGraw-Hill Ryerson Ltd.. 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.

10 © 2006 McGraw-Hill Ryerson Ltd.. Absorption Costing

11 © 2006 McGraw-Hill Ryerson Ltd.. Variable manufacturing costs only. All fixed manufacturing overhead is expensed. Variable Costing

12 © 2006 McGraw-Hill Ryerson Ltd.. Income Comparison of Absorption and Variable Costing Let’s compare the methods.

13 © 2006 McGraw-Hill Ryerson Ltd.. Reconciliation Fixed mfg. Overhead $150,000 Units produced 25,000 units = = $6.00 per unit We can reconcile the difference between absorption and variable income as follows:

14 © 2006 McGraw-Hill Ryerson Ltd.. Extended Comparison of Income Data Harvey Company Year Two

15 © 2006 McGraw-Hill Ryerson Ltd.. 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.

16 © 2006 McGraw-Hill Ryerson Ltd.. Absorption Costing These are the 25,000 units produced in the current period.

17 © 2006 McGraw-Hill Ryerson Ltd.. Variable Costing All fixed manufacturing overhead is expensed. Variable manufacturing costs only.

18 © 2006 McGraw-Hill Ryerson Ltd.. Reconciliation We can reconcile the difference between absorption and variable income as follows: Fixed mfg. Overhead $150,000 Units produced 25,000 units = = $6.00 per unit

19 © 2006 McGraw-Hill Ryerson Ltd.. Income Comparison

20 © 2006 McGraw-Hill Ryerson Ltd.. Summary

21 © 2006 McGraw-Hill Ryerson Ltd.. 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.

22 © 2006 McGraw-Hill Ryerson Ltd.. Effect of Changes in Production Harvey Company Year One

23 © 2006 McGraw-Hill Ryerson Ltd.. Unit product cost is determined as follows: Unit Cost Computations for Year One Since the number of units produced increased in this example, while the fixed manufacturing overhead remained the same, the absorption unit cost is less.

24 © 2006 McGraw-Hill Ryerson Ltd.. Absorption Costing: Year One

25 © 2006 McGraw-Hill Ryerson Ltd.. Variable Costing: Year One Variable manufacturing costs only. All fixed manufacturing overhead is expensed.

26 © 2006 McGraw-Hill Ryerson Ltd.. Effect of Changes in Production Harvey Company Year Two

27 © 2006 McGraw-Hill Ryerson Ltd.. Unit product cost is determined as follows: Unit Cost Computations for Year Two 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.

28 © 2006 McGraw-Hill Ryerson Ltd.. Absorption Costing: Year Two These are the 20,000 units produced in the current period at the higher unit cost of $17.50 each.

29 © 2006 McGraw-Hill Ryerson Ltd.. Variable Costing: Year Two All fixed manufacturing overhead is expensed. Variable manufacturing costs only.

30 © 2006 McGraw-Hill Ryerson Ltd.. Income Comparison  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. Conclusions

31 © 2006 McGraw-Hill Ryerson Ltd.. Impact on the Manager Opponents of absorption costing argue that shifting fixed manufacturing overhead costs between periods can lead to misinterpretations and faulty decisions. Those who favor variable costing argue that the income statements are easier to understand because net operating income is only affected by changes in unit sales. The resulting income amounts are more consistent with managers’ expectations.

32 © 2006 McGraw-Hill Ryerson Ltd.. CVP Analysis, Decision Making and Absorption costing Absorption costing does not support CVP analysis because it essentially treats fixed manufacturing overhead as a variable cost by assigning a per unit amount of the fixed overhead to each unit of production. Treating fixed manufacturing overhead as a variable cost can: Lead to faulty pricing decisions and keep/drop decisions. Produce positive net operating income even when the number of units sold is less than the breakeven point. Treating fixed manufacturing overhead as a variable cost can: Lead to faulty pricing decisions and keep/drop decisions. Produce positive net operating income even when the number of units sold is less than the breakeven point.

33 © 2006 McGraw-Hill Ryerson Ltd.. External Reporting and Income Taxes Though GAAP allow the use of either method, absorption costing Is the predominant method used in Canada. Though GAAP allow the use of either method, absorption costing Is the predominant method used in Canada. Either variable or absorption costing can be used when filing income tax returns. Since top executives are usually evaluated based on external reports to shareholders, they may feel that decisions should be based on absorption cost income.

34 © 2006 McGraw-Hill Ryerson Ltd.. Advantages of Variable Costing and the Contribution Approach Advantages Management finds it more useful. Consistent with CVP analysis. Net operating income is closer to net cash flow. Profit is not affected by changes in inventories. Consistent with standard costs and flexible budgeting. Impact of fixed costs on profits emphasized. Easier to estimate profitability of products and segments.

35 © 2006 McGraw-Hill Ryerson Ltd.. Variable Costing Variable versus Absorption Costing Absorption Costing Fixed manufacturing costs must be assigned to products to properly match revenues and costs. Fixed manufacturing costs are capacity costs and will be incurred even if nothing is produced.

36 © 2006 McGraw-Hill Ryerson Ltd.. Variable Costing and the Theory of Constraints (TOC) Companies involved in TOC use a form of variable costing, but treating direct labour as a fixed cost for three reasons:  Many companies have a commitment to guarantee workers a minimum number of paid hours.  TOC emphasizes the role of direct labour in continuous improvement. Fluctuating levels of direct labour can devastate morale and defeat the role of employees in continuous improvement efforts.  Direct labour is usually not the constraint. Companies involved in TOC use a form of variable costing, but treating direct labour as a fixed cost for three reasons:  Many companies have a commitment to guarantee workers a minimum number of paid hours.  TOC emphasizes the role of direct labour in continuous improvement. Fluctuating levels of direct labour can devastate morale and defeat the role of employees in continuous improvement efforts.  Direct labour is usually not the constraint.

37 © 2006 McGraw-Hill Ryerson Ltd.. Impact of JIT Inventory Methods In a JIT inventory system... Production tends to equal sales... So, the difference between variable and absorption income tends to disappear.

38 © 2006 McGraw-Hill Ryerson Ltd.. Review Problem Contrasting Variable and Absorption Costing

39 © 2006 McGraw-Hill Ryerson Ltd.. Review Problem Dexter Company produces and sells a single product, a wooden hand loom for weaving small items such as scarves. Selected cost and operating data relating to the product for two years are given below:

40 © 2006 McGraw-Hill Ryerson Ltd.. Review Problem 1.Assume that the company uses absorption costing. a.Compute the unit product cost in each year. b.Prepare an income statement for each year. 2.Assume that the company uses variable costing. a.Compute the unit product cost in each year. b.Prepare an income statement for each year. 3.Reconcile the variable costing and absorption costing operating incomes.

41 © 2006 McGraw-Hill Ryerson Ltd.. End of Chapter 7


Download ppt "© 2006 McGraw-Hill Ryerson Ltd.. Variable vs. Absorption Costing: A Tool for Management Chapter Seven."

Similar presentations


Ads by Google