Abc Costing

Variable Costing
Activity Based Costing
ACCO 20113 Strategic Cost Management

Week 3
James Robert D. Aguila, CPA, CMA

House Rules
• Inform me if I am speaking too fast or unclear.

• Take an active part in class discussions by
asking questions.
• Professional demeanor is expected from
everyone.
• Avoid using mobile phones/gadgets during class
hours. Mobile phones/gadgets must be switched
off or turned to silent mode.

Variable Costing
• Absorption costing vs. variable costing
• Contribution margin income statement
• Reconciliation of absorption income vs. variable costing income

Overview of Absorption
and Variable Costing
Absorption Variable
Costing Costing
Direct Materials
Product
Product Direct Labor
Costs
Costs Variable Manufacturing Overhead
Fixed Manufacturing Overhead

Period
Period Variable Selling and Administrative Expenses
Costs
Costs Fixed Selling and Administrative Expenses

Quick Check ü
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 ü
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. . .

Unit Cost Computations
Harvey Company produces a single product

with the following information available:

Unit product cost is determined as follows:
Selling and administrative expenses are

always treated as period expenses and
deducted from revenue as incurred.
Income Comparison of
Absorption and Variable Costing
Let’s assume the following additional

information for Harvey Company.
w 20,000 units were sold during the year at a price of
$30 each.
w There were no units in beginning inventory.
Now, let’s compute net operating

income using both absorption
and variable costing.
Absorption Costing

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
Goods available for sale 250,000
manufacturing
Less ending inventory (5,000 × $10) 50,000
overhead is
Variable cost of goods sold 200,000 expensed.
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

Income Comparison of
Absorption and Variable Costing
Let’s compare the methods.

Reconciliation
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
Extended Comparison of Income Data
Harvey Company Year Two

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 vs. variable
costing income statements
Income statement under Income statement under
absorption costing variable costing


by function

by function

by function by behavior

Variable versus Absorption Costing
Fixed manufacturing
costs must be assigned Fixed manufacturing
to products to properly costs are capacity costs
match revenues and and will be incurred
costs. even if nothing is
produced.
Absorption Variable
Costing Costing
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
Less ending inventory - 480,000
Gross margin 420,000
Less selling & admin. exp.
Variable (30,000 × $3) $ 90,000
Fixed 100,000 190,000
These are the 25,000 units

produced in the current period.
Variable Costing
Variable
manufacturing
costs only.
All fixed
manufacturing
overhead is
expensed.

Reconciliation
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
Income Comparison

Summary

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.
Harvey Company Year One

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.
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 $ -
All fixed
Add COGM (30,000 × $10) 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

Harvey Company Year Two

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.
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
Less ending inventory - 425,000
Gross margin 325,000
Less selling & admin. exp.
Variable (25,000 × $3) $ 75,000
Fixed 100,000 175,000
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.

Income Comparison
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.
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.

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

Activity Based Costing and
Activity Based Management
• How costs are being treated under ABC
• Designing an ABC system
• ABC vs. Traditional costing systems
• Process Improvement

Activity Based Costing (ABC)
ABC is a
ABC is designed to good supplement
provide managers with to our traditional
cost information for cost system
I agree!
strategic and other
decisions that
potentially affect
capacity and therefore
affect fixed as well as
variable costs.

How Costs are Treated Under
Activity–Based Costing
“Best practice” ABC differs from traditional costing in five ways.
Manufacturing Nonmanufacturing
costs costs
Traditional ABC
product costing product costing
ABC assigns both types of costs to products.

Manufacturing Nonmanufacturing
costs costs
Some
All
Traditional ABC
product costing product costing
ABC does not assign all manufacturing costs to products.


Level of complexity
Activity–Based
Costing
Departmental
Overhead
Rates
Plantwide
Overhead
Rate
Number of cost pools

ABC uses more cost pools.
Volume
Allocation Bases
measures
plus other
Number of
Bases usually
rely solely on bases.
volume
measures.
Traditional Costing ABC

ABC uses more allocation bases.
The most commonly used allocation base

in traditional costing is direct labor hours.
Direct labor hours work

well when overhead
increases as direct
labor hours increase.

The most commonly used allocation base

in traditional costing is direct labor hours.
Problems:
In many processes, overhead is increasing
while direct labor is decreasing.
Variety and complexity of products is increasing.

ABC uses
volume as well as
other allocation bases not
All overhead related to the volume
costs are not related of production.
to volume measures like
direct labor
hours.

Traditional Costing ABC

The predetermined Products are charged
overhead rate is based for the costs of
on budgeted activity. capacity they use – not
This results in applying for the costs of
all overhead costs capacity they don’t
including unused, or use. Unused capacity
idle capacity costs to costs are treated as
products. period expenses.
ABC bases level of activity on capacity.

Characteristics of Successful
ABC Implementations
Strong top
management support
Link to evaluations
and rewards
Cross-functional
involvement

Designing an ABC System
Cost Objects
(e.g., products Activities
and customers)
Consumption
of Resources
Cost

Designing an ABC System
Steps for Implementing ABC

Identify and define activities and activity cost
pools.
Trace costs to activities and cost objects.
Assign costs to activity cost pools.
Calculate activity rates.
Assign costs to cost objects.
Prepare management reports.

Identify and Define Activities
and Activity Cost Pools
Unit-Level Batch-Level
Activity Activity
Manufacturing
companies typically combine
their activities into five
classifications.
Product-Level Customer-Level
Activity Organization- Activity
sustaining
Activity
Activities
should only be
combined within a level
if they are highly
correlated.
When combining
activities, they should be
grouped together only at
the appropriate
level.

An Activity Cost $$
Pool is a “bucket” in $
$ $
which costs are $
accumulated that
relate to a single
activity measure in
the ABC system.

Two types of activity measures:
Transaction Duration
driver driver
Simple count A measure

of the number of of the amount
times an activity of time needed
occurs. for an activity.

At Classic Brass, the ABC team, selected the following

activity cost pools and activity measures:

• Customer Orders - assigned all costs of resources

that are consumed by taking and processing
customer orders.
• Product Designs - assigned all costs of resources
consumed by designing products.
• Order Size - assigned all costs of resources
consumed as a consequence of the number of units
produced.
• Customer Relations – assigned all costs associated
with maintaining relations with customers.
• Other – assigned all overhead costs that are not
associated with the other cost pools.
When Possible, Directly Trace Overhead
Costs to Activities and Cost Objects

Assign Costs to Activity Cost Pools
At Classic Brass the following distribution of resource

consumption across activity cost pools is determined.
**Not included because they are directly traced to customer orders.

Indirect factory wages $500,000

Percent consumed by customer orders 25%
$125,000

Factory equipment depreciation $300,000

Percent consumed by customer orders 20%
$ 60,000


Calculate Activity Rates
The ABC team determines that Classic Brass will

have these total activities for each activity cost
pool . . .
w 1,000 customer orders,
w 200 new designs,
w 20,000 machine-hours,
w 100 customer relations activities.
Now the team can compute the individual

activity rates by dividing the total cost for
each activity by the total activity levels.
Calculate Activity Rates

Activity-Based Costing at Classic Brass
Direct Direct Shipping

Overhead Costs
Materials Labor Costs
Traced Traced Traced
Cost Objects:
Products, Customer Orders, Customers

Overhead Costs
First-Stage Allocation
Order Customer Product Customer

Other
Size Orders Design Relations
Cost Objects:

Overhead Costs
First-Stage Allocation
Order Customer Product Customer

Other
Size Orders Design Relations
Second-Stage Allocations
$/MH $/Order $/Design $/Customer
Cost Objects:
Unallocated
Assigning Costs to Cost Objects
Let’s take a look at how our system works

for just one customer – Windward Yachts.
Standard Stanchions (no design required)
1. 400 units ordered with 2 separate orders.
2. Each stanchion required 0.5 machine-hours.
3. Selling price is $34 each.
4. Direct materials total $2,110.
5. Direct labor totals $1,850.
6. Shipping costs total $180.
Custom Compass Housing (requires new design)
1. One order during the year.
2. Each housing required 4 machine-hours.
3. Selling price is $650 each.
4. Direct materials total $13.
5. Direct labor totals $50.
6. Shipping costs total $25.
Assigning Costs to Cost Objects
The customer-level
cost is assigned to
customers directly;
it is not assigned to
products.

Prepare Management Reports
Standard Stanchions
Sales $ 13,600
Cost:
Direct materials $ 2,110
Direct labor 1,850
Shipping costs 180
Customer orders 630
Product design -
Order size 3,800 8,570
Product margin $ 5,030
Custom Compass Housing

Sales $ 650
Cost:
Direct materials $ 13
Direct labor 50
Shipping costs 25
Customer orders 315
Product design 1,285
Order size 76 1,764
Product margin $ (1,114)
Prepare Management Reports
Customer Profitability Analysis

Product Margins
Traditional Cost Accounting System
400 units x 0.5 MH/unit x $50/MH = $10,000
Predetermined manufacturing $1,000,000

= = $50/MH
overhead rate 20,000 MH
Differences Between ABC and
Traditional Product Costs
Product margins are different for four reasons:
Traditional costing assigns design costs to both products
based on machine hours. ABC assigns product design
costs to a product only if product design work is required.
Traditional costing assigns customer order costs, a batch-
level cost, using a unit-level allocation base, machine hours.
ABC assigns these batch-level costs using a batch-level
activity measure.
Traditional costing assigns only manufacturing costs to
products. ABC also assigns nonmanufacturing costs to
products.
Traditional costing assigns all manufacturing costs to
products. The ABC system does not assign organization-
sustaining manufacturing costs to the products.
Differences Between ABC and
Traditional Product Costs
When batch-level and

product-level costs are present,
ABC will usually shift costs from high
volume products, produced in large batches,
to low volume products produced in small batches.
This cost shifting will usually have its

greatest impact on the per
unit cost of the low
volume products.

Targeting Process Improvement
Activity-based management is
used in conjunction with ABC to
identify areas that would benefit
from process improvements.
While the theory of constraints

approach is a powerful tool for
targeting improvement efforts, activity
rates can also provide valuable clues
on where to focus improvement
efforts.
Activity-Based Costing and External Reporting
Most companies do not use ABC

for external reporting because . . .
1. External reports are less detailed than internal
reports.
2. It may be difficult to make changes to the company’s
accounting system.
3. ABC does not conform to GAAP.
4. Auditors may be suspect of the subjective allocation
process based on interviews with employees.

ABC Limitations
Substantial resources Resistance to

required to implement unfamiliar numbers
and maintain. and reports.
Desire to fully Potential

allocate all costs misinterpretation of
to products. unfamiliar numbers.
Does not conform to

GAAP. Two costing
systems may be needed.
Exercise

Questions?

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Variable Costing

Activity Based Costing

ACCO 20113 Strategic Cost Management

ACCO 20113 Strategic Cost Management

• Inform me if I am speaking too fast or unclear.

ACCO 20113 Strategic Cost Management

ACCO 20113 Strategic Cost Management

Fixed Manufacturing Overhead

ACCO 20113 Strategic Cost Management

Which method will produce the highest values for

ACCO 20113 Strategic Cost Management

Which method will produce the highest values for

ACCO 20113 Strategic Cost Management

Harvey Company produces a single product

ACCO 20113 Strategic Cost Management

Unit product cost is determined as follows:

Selling and administrative expenses are

Let’s assume the following additional

Now, let’s compute net operating

ACCO 20113 Strategic Cost Management

ACCO 20113 Strategic Cost Management

Let’s compare the methods.

ACCO 20113 Strategic Cost Management

We can reconcile the difference between

Variable costing net operating income $ 90,000

Fixed mfg. Overhead $150,000

ACCO 20113 Strategic Cost Management

Since there was no change in the variable costs

ACCO 20113 Strategic Cost Management

ACCO 20113 Strategic Cost Management

ACCO 20113 Strategic Cost Management

ACCO 20113 Strategic Cost Management

ACCO 20113 Strategic Cost Management

These are the 25,000 units

ACCO 20113 Strategic Cost Management

We can reconcile the difference between

Variable costing net operating income $ 260,000

Fixed mfg. Overhead $150,000

ACCO 20113 Strategic Cost Management

ACCO 20113 Strategic Cost Management

Let’s revise the Harvey Company example.

In the previous example,

In this revised example,

ACCO 20113 Strategic Cost Management

Unit product cost is determined as follows:

Since the number of units produced increased

ACCO 20113 Strategic Cost Management

ACCO 20113 Strategic Cost Management

ACCO 20113 Strategic Cost Management

Unit product cost is determined as follows:

Since the number of units produced decreased in the

These are the 20,000 units produced in the current

ACCO 20113 Strategic Cost Management

Opponents of absorption costing argue that shifting

Those who favor variable costing argue that the income

ACCO 20113 Strategic Cost Management

Absorption costing does not support CVP

ABC assigns both types of costs to products.

ABC does not assign all manufacturing costs to products.

ABC uses more allocation bases.

ABC uses more allocation bases.

ABC uses more allocation bases.

ABC bases level of activity on capacity.