Module 17:

Product Costing: Job and Process Operations

 Objectives:
- Discuss flow of costs through the inventories.
- Learn about allocating indirect costs: why it is done and how it is done.
- Understand job order costing vs. process costing.
- Explain why profits under absorption and variable costing may not
always be the same.

Module 17 – page 1

1. Inventory Costs in Various Organizations

As inventories are sold or used, they are matched against expenses.

Module 17 – page 2
2. Cost Classifications

Manufacturing Out-of-pocket costs that relate Direct materials (DM)

costs to a firm’s production Direct labor (DL)
operations; all costs incurred in Overhead (OH)
the factory to manufacture the
product. Indirect materials
Indirect labor
Other
Non- All out-of-pocket costs of the Selling or marketing costs
manufacturing company that are not Administrative costs
costs manufacturing costs. R&D Costs

Which costs are manufacturing and which are non-manufacturing costs are
regulated by GAAP.

Module 17 – page 3

Manufacturing cost (=Product cost = Inventoriable cost)

Costs of a product A measurement, in monetary terms, of the amount of resources used to
manufacture a product.
Direct Materials Materials:
(DM) - that become physically embodied in the products being manufactured;
- whose cost is sufficiently large to justify the record-keeping

expenses necessary to trace the costs to each different product line.

Indirect Materials Materials used in the manufacturing process that are not direct materials.
(IM)
Direct Labor (DL) Employee time that
- is physically traceable to the products being manufactured;

- whose cost is sufficiently large to justify the record-keeping

expenses necessary to trace the costs to each different product line.

Indirect Labor (IL) Employee time used in the manufacturing process that is not direct labor.

Overhead (OH) All of the manufacturing costs other than direct labor and direct
materials; thus it includes indirect materials, indirect labor, and other
overhead.

Which costs are direct and which are indirect is the firm’s choice. No rigid rules that a
firm must follow.
Module 17 – page 4
Direct Costs (Prime costs) Direct Labor + Direct Materials
Conversion Costs (CC) Direct Labor + Manufacturing Overhead
Non-manufacturing costs
Marketing Costs Costs incurred in getting orders from customers and providing
(or Selling Costs) customers with the finished product

Administration Costs Executive, organizational, and clerical that cannot logically be

considered manufacturing or marketing costs
R&D Costs Costs of developing new products and services

Product Costs vs. Period Costs

Product costs Costs assigned to products, which Inventory on Balance Sheet;
(=Inventoriable were either purchased for resale or Cost of Goods Sold to be recognized
costs) manufactured for sale. only when the goods are sold
Period costs Costs associated with the period in The expense is recognized
which they occur (not a particular immediately or in the same period as
product manufactured or acquired the cost.
for resale during that period)

Module 17 – page 5

3. Flow of Costs through the Inventories

Purchase raw materials and store them in Raw or Direct Materials Inventory.

Requisition the raw materials from the inventory and move to production area.
Combine raw materials with other inputs (e.g. labor, machinery) in the production area
to manufacture the product.
The costs of all inputs used in the production are recorded in the Work In Process
(WIP) Inventory.

Take the finished products and move it to the Finished Goods (FG) Inventory.

Module 17 – page 6
 Direct Materials Inventory
Beginning balance

Ending balance

Work In Process (WIP) Inventory

Beginning balance

Ending balance

Finished Goods (FG) Inventory

Beginning balance

Ending balance

Module 17 – page 7

Basic inventory equation:

Beginning Inventory + Additions = Ending Inventory + Items Removed

Total Manufacturing Costs Costs of Goods Cost of Goods Sold

(of the Period) Manufactured
BB of materials BB of WIP BB of FG
+ Materials purchased + Total manufacturing costs + COGM
Materials available for use Total Costs in WIP Costs of goods available
- EB of materials - EB of WIP sale
Materials used in production COGM - EB of FG
+ DL COGS
+ OH
Total manufacturing costs

Module 17 – page 8
3. Product Costing Systems

 Full cost: All the resources used for a cost object

= direct costs + fair share of indirect costs.
The accounting method or system that assigns a firm’s production/
manufacturing costs to the different products (services) produced.
In cost allocation process, we make several decisions:

1. How many costs pools should be used for indirect costs?

Single overhead rate
Overhead rate for each department
Many overhead rates or Activity-based Costing
2. How should costs be measured?
Actual costs,
Estimated costs (Normal vs. Standard costs)
3. What costs should be assigned to a product?
All manufacturing costs vs. all manufacturing costs plus some selling costs

4. Is production continuous or in batches?

Job order costing vs. Process costing
Module 17 – page 9

Job (Job-order) vs. Process Costing

Job costing system Process costing system
A product costing system in which A product costing system in which
costs are assigned to batches, lots, job production costs are averaged over a
orders, or single units of production. large number of identical product units.

Costs must be averaged over all

Used for custom, heterogeneous
products produced in small numbers.
production for the period where some
units are finished and others only
partially completed.
Used for homogeneous products in
large numbers.

Module 17 – page 10
 Example: Job Costing vs. Process Costing
Some companies use process costing and some use job costing. A number of companies
in different industries are listed below:
1. Contract water drilling company
2. Commercial photographer
3. Tortilla manufacturer
4. Electric utility
5. Mushroom farm that produces the standard button mushroom in caves

Required:
For each company, indicate whether the company is most likely to use job costing or
process costing.

Module 17 – page 11

3.1 Job Costing

Two Stage Allocation Process
Step 1: Divide the total indirect (OH) costs into different categories or cost
pools.
Step 2: Use an allocation base for each pool to assign the costs:
a. Compute an allocation rate for each pool.
b. Assign costs in a pool to each product according to the product’s
usage of the allocation base for that pool.

Cost driver Some item which can be used to assign the overhead to
(= allocation base) different products. Products are assigned overhead in
proportion to the amount of the allocation base they use. A
good allocation base is easily measured and highly correlated
with the generation of overhead.

Overhead rate Costs to be allocated

Total amount of allocation base

Module 17 – page 12
Example: The Caterpillar
During the month of May, Caterpillar, Inc. manufactured earthmovers, medium sized
tractors, and bobcats. The direct materials and labor spent on each product is known.
Caterpillar also knows that it spent $30,000,000 in indirect costs during the month.
Caterpillar, Inc.
Costs per unit
Earthmovers Tractors Bobcats
(5 units) (10 units) (100 units)
Direct materials $10,000,000 $1,000,000 $ 100,000
Direct labor $ 5,000,000 $ 300,000 $ 20,000
Overhead ? ? ?

How should the $30,000,000 in overhead be divided among the different products?

Module 17 – page 13

How much of the $30,000,000 in overhead costs is assigned to each product (earth mover,
tractor, or bobcat) made by Caterpillar?

The easiest way would be dividing the costs evenly among all products.
Each product is assigned $30,000,000/(5+10+100) = $260,870/unit.

Any problems whit this method of dividing the overhead costs?

Are there better ways of dividing up the overhead costs?

Module 17 – page 14
Caterpillar’s management knows earth movers and bobcats use different amounts of
overhead. It requires significantly more time (both labor and machine time) to
manufacture earthmovers than bobcats.

Caterpillar, Inc.
Earthmovers Tractors Bobcats
(5 units) (10 units) (100 units)
Machine hours per unit 1,620 MH/unit 90 MH/unit 10 MH/unit

a. Compute an allocation rate. What is the overhead cost per machine hour?

b. Assign costs to each product according to the product’s usage of the allocation
base.

Module 17 – page 15

Using multiple allocation bases:

Step 1: Divide total indirect costs into pools, (i) materials ordering and handling
costs, (ii) engineering support, and (iii) all other overhead costs.

Caterpillar Overhead Costs

Salaries for staff purchasing supplies $ 240,000
Engineers’ salaries 483,000
Electricity 325,000
Depreciation on factory and support building 7,000,000
Other 21,952,000
Total $ 30,000,000

After much analysis, Caterpillar has divided the overhead into the following pools:
Material handling and ordering costs 480,000
Engineering costs 960,000
All other overhead costs 28,560,000
Total $ 30,000,000

Module 17 – page 16
Step 2: Use an allocation base for each pool to assign the costs in the pools to
each product type.
The following allocation bases can be used for each cost pool:
Cost pool Cost driver/Allocation base
Materials handling and ordering Number of requisitions
Engineering Number of engineering hours
All other overhead Machine hours

The information about the amount of each allocation base used by each product:
Earthmovers Tractors Bobcats
Amount of base (5 units) (10 units) (100 units) Total
Number of requisitions
for the product line 5,430 530 40
Number of engineering
hours for the product line 19,650 250 100
Machine hours (per unit) 1,620 MH 90 MH 10 MH

Module 17 – page 17

a. Compute an allocation rate for each pool.

Name of cost pool Costs in pool Total amount of Allocation rate

allocation base
used
Materials handling $480,000 6,000 requisitions
and ordering

Engineering $960,000 20,000

engineering hours

All other overhead $28,560,000 10,000 MH

Module 17 – page 18
b. Assign costs in a pool to each product according to the product’s usage of the allocation
base for that pool. Find the overhead per unit.

Caterpillar, Inc.
Overhead costs per unit
Materials Engineering All other Total
handling and overhead
ordering
Earthmovers

Tractors

Bobcats ($80*40)/10 ($48*100)/10 $2,856*10 $28,640

=$32 =$48 =$28,560

Module 17 – page 19

Caterpillar Inc.
Total per unit cost (=DM+DL+OH)
Method Earthmovers Tractors Bobcats
1. Same costs for each product – DM $ 10,000,000 $ 1,000,000 $100,000
equal share
DL 5,000,000 300,000 200,000
OH 260,870 260,870 260,870
Total $15,260,870 $1,560,870 $380,870

2. Single allocation rate – DM $ 10,000,000 $ 1,000,000 $100,000

per machine hour
DL 5,000,000 300,000 200,000
OH 4,860,000 270,000 30,000
Total 19,860,000 $1,570,000 $150,000

3. Several allocation rates – DM $ 10,000,000 $ 1,000,000 $100,000

Per number of requisitions,
number of engineering hours, DL 5,000,000 300,000 200,000
and machine hours. OH 4,902,240 262,480 28,640
Total $19,902,240 $1,562,480 $148,640

Module 17 – page 20
Question 1: Do any of the methods tell us the “actual or “true” costs for each product?

Question 2: What are the problems with actual costing?

Question 3: Is there a solution to the problems with actual costing?

Question 4: What is normal costing?

Module 17 – page 21

Two stage allocation process for JOB COSTING

Step 1. Divide the total estimated indirect costs into different categories or cost
pools.
Step 2. Use an allocation base for each pool to assign the costs:
a. Compute a predetermined overhead rate for each pool.
b. Assign costs in a pool to each product according to the product’s actual
usage of the allocation base for that pool.

Predicted total amount of overhead in cost pool

Predetermined Overhead rate =
Predicted total amount of allocation base

Overhead applied or added to each product in WIP

= Actual amount of base used by each product x Predetermined overhead rate

Module 17 – page 22
Time line:

Beginning End of
of period Throughout the period period

Module 17 – page 23

Example:
In the 3rd quarter, the Meadowcraft Furniture Company made 20,100 tables of different
sizes and shapes, 68,400 various chairs, and 5,430 other metal furniture products, for a
total of 93,930 units. We are not going to find the cost of all different products; we want
to find the cost of two special orders:
Order #23 consists of 10 chairs with cushions.
Order #57 consists of 7 tables.

Since direct materials and direct labor are traced to the product or job, we know the
direct materials and labor costs for each special order:

Order #23 Order #57

Direct materials per unit $ 25.00 $ 30.00
Direct labor per unit 20.00 85.00
Total direct costs per unit $45.00 $115.00
Total overhead ? ?
Total cost per unit ? ?

Module 17 – page 24
Meadowcraft uses normal costing. At the beginning of the year, Meadowcraft formed
the following estimates:

MEADOWCRAFT
Estimates of overhead for the quarter
Fabrication Department:
Depreciation of robotic welder, salaries for levelers and quality
control personnel, depreciation on facilities for Fabrication
Department, etc.
$ 501,000
Painting Department:
Depreciation of primer tank, paint cleaners, depreciation on
facilities for Painting Department, etc.
1,200,000
Sewing Department:
Sewing supplies, depreciation on sewing machines, etc. 243,000

Total Estimated Overhead Costs $1,944,000

Module 17 – page 25

Entire plant – Estimated usage of resources

Fabrication Painting Sewing Total
Direct labor 10,000 DLH 1,000 DLH 3,000 DLH 14,000 DLH
Machine time 13,000 MH 40,000 MH 1,000 MH 54,000 MH

At the end of the quarter, Meadowcraft noted the following actual results:

MEADOWCRAFT
Actual overhead costs for the Quarter
Fabrication department $ 490,000
Painting department 1,300,000
Sewing department 260,000
Total actual overhead costs $2,050,000

Module 17 – page 26
 Entire plant – Actual total usage of resources
Fabrication Painting Sewing Total
Direct labor 9,000 DLH 2,500 DLH 2,100 DLH 13,600 DLH
Machine time 13,000 MH 38,000 MH 1,200 MH 52,200 MH

Order 23 (10 chairs with cushions) – Actual usage of resources per unit
Fabrication Painting Sewing Total
Direct labor 0.2 DLH 0.7 DLH 0.5 DLH 1.2 DLH
Machine time 0.5 MH 0.4 MH 0.1 MH 1.0 MH

Order 57 (7 tables) – Actual usage of resources per unit

Fabrication Painting Sewing Total
Direct labor 3.0 DLH 1.0 DLH 0 DLH 4.0 DLH
Machine time 0.2 MH 0.4 MH 0 MH 0.6 MH

Module 17 – page 27

Suppose management has decided it needs more accurate product information to make
its pricing and production choices.

The Fabrication Department is labor intensive, and overhead costs are largely related to
labor time used in the manufacture of the product.
The Painting Department is highly automated, and overhead costs are driven by
machine time.
The Sewing Department is very labor intensive, and overhead costs are related to labor
time.

If Meadowcraft were to use department rates, what is the cost of each order?
Step 1: form pools.
Step 2: calculated predetermined OH rate and assign OH costs to each job.

OH rate for Fabrication Department

OH rate for Painting Department

OH rate for Sewing Department

Module 17 – page 28
 Order 23 (chairs) Order 57 (tables)
Direct costs
Fab. OH
Paint OH
Sewing OH
Total

* units in Job

Was overhead for the quarter over- or under-applied?

Actual overhead $2,050,000
Applied Fabrication OH
Applied Paint OH
Applied Sewing OH
Applied overhead

Under-applied by $ 289,000

Module 17 – page 29

Can we understand why we got different costs for the products with different methods?

Disposition of Under- or Overapplied Overhead

(1) Allocate a portion of the over- or underapplied overhead to work in process inventory,
finished goods inventory, and cost of goods sold. The allocation would be based on
the relative dollar value in each of the three accounts involved.
(2) Adjust to adjust cost of goods sold for the entire amount of the over- or under-
applied overhead. An easier way to deal with the problem

If COGS before adjustment = $500,000?

COGS after adjustment = $500,000 + $289,000 = $789,000

Module 17 – page 30
3.2 Process costing
- Collects costs by process (i.e., department).
- Determine unit costs by dividing total costs by total number of units worked on.
- Inventory cost = Conversion cost per unit + DM
- Why is a different accounting method needed for process costing?

Module 17 – page 31

Equivalents units of output for a given input (DM, DL, or OH):

With process costing, one must divide the costs of production between the finished and
unfinished units manufactured. It is clear that it costs more to make a totally finished
items than a partially finished item. One needs a way of comparing finished and
unfinished units.

Equivalent units of output for a = # of partially completed units * % completion

given input (DM, DL, or OH)

Example 1:
Suppose your cousin Sue was hired to assemble 10 bicycles. At the end of the month Sue is
paid $1,600 for her labor. One would like to know the labor cost of each bike.

Four of the bikes are complete; it took Sue 25 hours to assemble each. The other six bikes
are as yet unfinished and still in process; Sue has spent only 10 hours on each of the
unfinished bikes.

Equivalent units for the labor in the bikes:

Module 17 – page 32
4 complete bikes equivalent to 4 complete bikes
6 bikes partially complete equivalent to

TOTAL EQUIVALENT BIKES

Labor cost for each finished bike (=labor cost per equivalent unit):

Labor cost for each unfinished bike:

Equivalent units of output are always with respect to some input(s).

Module 17 – page 33

Example 2:
John Boos & Company (www.johnboos.com) has been in business making stainless steel
and wood products since 1887. Suppose John Boos manufactures several types of serving
trays. The deluxe model has a stainless bottom with wooden handles. At the end of the
period, John Boos finds that it has 100 trays partially done in its ending WIP Inventory.
Labor and overhead are added continuously throughout the manufacturing process. All of
the steel is added at the beginning of the production process; the wooden handles are
attached when the manufacturing process is 60% finished. John Boos estimated that these
100 trays are 35% finished.
What are the equivalents units for the trays in terms of the steel? in terms of the wood? in
terms of conversion costs? Time line indicating the manufacturing process or the percent
of the required CC that has been applied to the product:

Input Percentage complete Equivalent units

Steel
Wood
Conversion costs (CC)
Module 17 – page 34
 Weighted-average process costing method:

General approach to process costing

For 1. Find the total cost for an input.
each 2. Compute the total number of equivalent units made with that input.
input:
3. Compute the cost per unit for that input: (1) / (2)

Costs in BB + Costs added during this period

=
Units finished + EU for unfinished units in ending WIP

WIP Inventory
Costs in beginning inventory Units completed and transferred
Costs added during period to Finished Goods Inventory or to
the next department

Unfinished units in ending inventory

Note these units are unfinished. So one must use equivalent units here.
Module 17 – page 35

Example:
The beginning work in process inventory showed a balance of $48,240. Of this amount,
$16,440 is the cost of direct materials, and $31,800 are conversion costs. There were 8,000
units in the beginning inventory that were 30% complete with respect to both direct
materials and conversion costs.

During the period, 14,000 units were started; 5,000 remained in the ending inventory at the
end of the period. The units in ending inventory were 80% complete with respect to direct
materials and 40% complete with respect to conversion costs.

Costs incurred during the period amounted to $126,852 for direct materials and $219,120
for conversion.

WIP inventory (in units)

BI: 8,000 (given) Transferred out: 17,000

Started: 14,000 (given)

EI: 5,000 (given)

Module 17 – page 36
 Direct materials (DM) Conversion costs (CC)

Total cost per finished unit =

Costs of units completed and transferred out and units in ending WIP
Units completed and transferred out
(17,000 units):
Unfinished units in ending WIP
(5,000 units)
DM cost: 80%*5,000 = 4,000EU
CC cost: 40%*5,000 = 2,000EU
Total costs:

Module 17 – page 37

WIP Inventory
Beginning Inventory:
DM $16,440
CC 31,800
Total 48,240

Manufacturing Cost of the Period:

DM $126,852
CC 219,120
Total $345,972

Total Costs in WIP

BI $ 48,240
Added 345,972
Total $394,212

Module 17 – page 38
4. Absorption and Variable Costing
When designing a product costing system we have identified 4 choices a manager must
make:

(1) How many overhead rates or drivers or cost pools should be used?
∙ Single overhead rate
∙ Overhead rate for each department
∙ Many overhead rates or Activity based Costing (ABC)

(2) Can the accounting be dome for batches or is production continuous and
equivalent units must be considered?
∙ Job order costing
∙ Process costing

(3) Should costs be the actual cost numbers or estimates?

∙ Actual costs – use actual dollar expenditures for direct material, direct labor
and overhead.
∙ Normal costs – use actual dollar expenditure for direct material and direct
labor; use predetermined or estimated manufacturing overhead rates.
∙ Standard costs – use predetermined norms or estimates for direct labor, direct
materials and overhead.

Module 17 – page 39

(4) What costs should be treated as product costs?

∙ Full absorption costing, absorption costing, full costing – assign all
manufacturing costs (fixed manufacturing overhead as well as direct
materials, direct labor, and variable manufacturing overhead) to the units
produced.

∙ Assign all manufacturing costs and some variable selling and administration
costs to the units produced.

New choice:
∙ Variable costing, direct costing – assign only variable manufacturing costs
(direct materials, direct labor, variable manufacturing overhead) to the
product; treat fixed manufacturing costs as an expense of the period.

Which manufacturing costs are product costs and which are period costs?
Absorption costing Variable costing
Product costs

Period costs

Module 17 – page 40
 Overview of Variable and Absorption Costing

Variable Absorption
Costing Costing

Direct Materials
Product
Direct Labor Product
Costs
Variable Manufacturing Overhead Costs

Fixed Manufacturing Overhead

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

Module 17 – page 41

4.1 Report Formats of Absorption vs. Variable Costing

Absorption Costing (or Functional) Variable Costing (or Contribution

Format Margin) Format

Sales Revenue Sales Revenue

Less: Cost of Goods Sold:
Variable manufacturing costs
of units sold
Fixed manufacturing costs of
units sold
GROSS MARGIN
Less: Variable expenses:
Variable manufacturing costs
of units sold
Variable S&A expenses
CONTRIBUTION MARGIN

Less: S&A expenses Less: Fixed expenses:

Variable S&A expenses Fixed manufacturing costs of
the period
Fixed S&A expenses Fixed S&A expense
NET OPERATING INCOME NET OPERATING INCOME

Module 17 – page 42
4.2 Absorption Net Income vs. Variable Net Income
Absorption net income and variable net income may be quite different. In this
section, we want to understand what causes the difference.

Example 1: The difference between absorption income and variable income

Suppose the Big Crate Company uses actual costing and in each period manufactures
5 crates. Actual costs are as follows:

Variable manufacturing costs (DM+DL+VOH) per crate $5/unit

Total fixed manufacturing costs (FOH) $100
No selling or administration costs

When FOH is assigned to products, each crate is allocated the same amount of FOH.
What is the FOH rate?
$100/5 = $20/crate

Absorption cost per crate Variable cost per crate

Module 17 – page 43

First period: Produced 5 crates, but sold 3 crates at $50/crate.

FG Inventory – Absorption Costing FG Inventory – Variable Costing

$25 $25 $25 $25 $25
($20 ($20 ($20 ($20 ($20 $5 $5 $5 $5 $5
in FOH) in FOH) in FOH) in FOH) in FOH)

Income Statement – Absorption Costing Income Statement – Variable Costing

Sales Revenue Sales Revenue
COGS VCOGS
VS&A
Gross Margin Contribution Margin
VS&A Fixed Manuf. Costs
FS&A FS&A
Absorption Income Variable Income
Why do variable and absorption incomes differ in the first year?

Module 17 – page 44
Second period: Produced 5 crates, but sold 6 crates at $50/crate.
FG Inventory – Absorption Costing FG Inventory – Variable Costing
This period’s production: This period’s production:
$25 $25 $25 $25 $25
($20 ($20 ($20 ($20 ($20 $5 $5 $5 $5 $5
in FOH) in FOH) in FOH) in FOH) in FOH)
Last period’s production: Last period’s production:
$25 $25
($20 ($20 $5 $5
in FOH) in FOH)

Income Statement – Absorption Costing Income Statement – Variable Costing

Sales Revenue Sales Revenue
COGS VCOGS
VS&A
Gross Margin Contribution Margin
VS&A Fixed Manuf. Costs
FS&A FS&A
Absorption Income Variable Income
Why do variable and absorption incomes differ in the second year?

Module 17 – page 45

In general when and why do variable and absorption income differ?

Production > Sales
Production < Sales
Production = Sales

If production costs and quantities are constant:

Module 17 – page 46
Example 2: The difference between absorption income and variable income
Conair (www.conair.com) is a well-known manufacturer of hairdryers. Suppose
Conair use normal costing and has estimated overhead for the period as follows:
Estimated production 16,000 units
VOH/unit $2.00/unit
Total FOH* $40,000
*The same FOH is allocated to each unit.
Actual results for the period, are as follows:
Actual production 16,000 units
Direct materials/unit $10.00/unit
Direct labor/unit $8.00/unit
VOH/unit $2.00/unit
Total FOH* $40,000
Variable S&A/unit $6.00/unit
Total Fixed S&A $60,000
Selling price $40.00/unit
*The same FOH is allocated to each unit.
There is no beginning or ending WIP balances; all units started were completed.
Absorption cost per unit: Variable cost per unit:

Module 17 – page 47

A. Suppose sales are 12,000 units.

Income Statement – Absorption Costing Income Statement – Variable Costing

Sales Revenue Sales Revenue

COGS: VCOGS:
VMC VMC
FMC applied VS&A

Gross Margin Contribution Margin

S&A costs: Fixed costs:
VS&A FMC
FS&A FS&A
Net Income Net Income
Changes in FG inventory
4,000 units added to FG @ Changes in FG inventory
$22.50 + $90,000 4,000 units @ $20.00 + $80,000

With absorption costing $10,000 in FOH costs went into inventory.

Module 17 – page 48
B. Suppose sales are 18,000 units.
Income Statement – Absorption Costing Income Statement – Variable Costing

Sales Revenue Sales Revenue

COGS:* VCOGS:
VMC VMC
FMC applied VS&A

Gross Margin Contribution Margin

S&A costs: Fixed costs:
VS&A FMC
FS&A FS&A
Net Income Net Income
Changes in FG inventory
2,000 units @ $22.50 came Changes in FG inventory
out of inventory - $45,000 2,000 units @ $20.00 - $40,000

Module 17 – page 49

C. Suppose sales are 16,000 units – an easy one.

Income Statement – Absorption Costing Income Statement – Variable Costing

Sales Revenue Sales Revenue

COGS: VCOGS:
VMC VMC
FMC applied VS&A

Gross Margin Contribution Margin

S&A costs: Fixed costs:
VS&A FMC
FS&A FS&A
Net Income Net Income
Change in FG inventory 0 Change in FG inventory 0

No FOH costs being deferred to inventory or extra FOH costs coming out of the inventory.

Module 17 – page 50
Case: Managerial Incentives with Absorption Costing
Company Q produced and sold 10,000,000 units at 43.00 per unit in Year 0.
Variable manufacturing cost per unit was $1.00. Total fixed manufacturing costs
were $24,000,000, and total fixed selling and administration costs were
$5,000,000. The company uses absorption costing, incompliance with GAAP.
The same amount of overhead is assigned to each unit.
Company Q – Income Statement (Absorption Costing),
For Year Ending December 31, Year 0
Absorption cost per unit:

Sales Revenue 10,000,000 * $3.00 = $30,000,000

Less: COGS 10,000,000 * $3.40 = (34,000,000)
Gross Margin (4,000,000)
Less: Fixed S&A Costs (5,000,000)
Operating Profit $(9,000,000)

Module 17 – page 51

A new president was hired the following year. He was paid no salary but was
promised 10% of operating profit (before considering the bonus). The new
president stepped up production to an annual rate of 30,000,000 units. Sales
remained constant at 10,000,000. Total fixed costs, selling and administration
costs, and variable cost per unit were unchanged.
Company Q – Income Statement (Absorption Costing),
For Year Ending December 31, Year 1
Absorption cost per unit:

Sales Revenue 10,000,000 * $3.00 = $30,000,000

Less: COGS 10,000,000 * $1.80= (18,000,000)
Gross Margin 12,000,000
Less: Fixed S&A Costs (5,000,000)
Operating Profit $7,000,000

Module 17 – page 52
What is going on?

What is going to happen next year?

Redo both years using variable costing format:

Company Q – Income Statement (Variable Costing),
For Year Ending December 31, Year 0
Variable cost per unit: $1/unit
Sales Revenue 10,000,000 * $3.00 = $30,000,000
Less: Variable COGS 10,000,000 * $1.00 = (10,000,000)
Contribution Margin 20,000,000
Less: Fixed Manufacturing Costs (24,000,000)
Fixed S&A Costs (5,000,000)
Operating Profit $(9,000,000)

Module 17 – page 53

Company Q – Income Statement (Variable Costing),

For Year Ending December 31, Year 1
Variable cost per unit: $1/unit
Sales Revenue 10,000,000 * $3.00 = $30,000,000
Less: Variable COGS 10,000,000 * $1.00 = (10,000,000)
Contribution Margin 20,000,000
Less: Fixed Manufacturing Costs (24,000,000)
Fixed S&A Costs (5,000,000)
Operating Profit $(9,000,000)

Module 17 – page 54
Example 3: The difference between absorption income and variable income
when production changes annually.
In the first two examples, production and costs were the same each year; hence
the production cost of each unit was the same each year. In this example, the
cost of making a unit of production is different in the two years.

Bell sports (www.bellsports.com) makes bicycle helmets as well as other

sporting goods. Suppose Bell Sports began production in Year 1, producing
10,000 helmets and selling 9,000. Its costs were as follows:
Variable costs/unit $20/unit
Total fixed costs $75,000
Selling and administration (all fixed) $100,000

Bell ports uses actual costing, assigning the same fixed costs to each unit. In
Year 2, Bell sports had the same costs as above made 15,000 while selling
15,500 pairs. The price per helmet was $60. Bell Sports uses LIFO inventory
method.

Module 17 – page 55

a. What is the variable cost per unit in each year? Absorption cost per unit in each
year?
Year 1 Year 2
Variable cost / unit
Absorption cost / unit

b. What was the value of Bell Sports’ finished good inventory at the end of Year 1
using variable costing? Using absorption costing?
Variable costing Absorption costing
FG inventory end of
Year 1

c. Which income costing method results in the larger income in Year 1?

By how much? Explain your answer.

Module 17 – page 56
d. Using absorption costing, what was income in Year 2?
Using variable costing, what was income in Year 2?
How is the difference explained?
Absorption Costing Variable Costing

Sales Revenue Sales Revenue

COGS: VCOGS:

Gross Margin Contribution Margin

S&A costs: Fixed costs:
FMC
FS&A
Operating Income Operating Income

Module 17 – page 57

Example 4: The difference between absorption income and variable income

when production costs change and FIFO is used
This problem is a continuation of problem 3 – Bell Sports. Again, Bell Sports
began production in Year 1, producing 10,00 helmets and selling 9,000. Its costs
were as follows:
Variable costs/unit $20/unit
Total fixed costs $75,000
Selling and administration (all fixed) $100,000
Bell Sports uses actual costing, assigning the same fixed costs to each unit. In
year 2, Bell Sports had the same costs as above but made 15,000 while selling
15,500 units. The price per helmet was $60. In this problem, we will assume the
company uses FIFO inventory method. In problem 3 above, we computed the
following per unit costs:
Year 1 Year 2
Variable cost / unit $20 $20
Absorption cost / unit $27.50 $25.00
Variable costing Absorption costing
FG inventory, end of Year 1 $20,000 $27,500
Module 17 – page 58
Using absorption costing, what was income in Year 2? Using variable costing,
what was income Year 2? How is the difference explained? (Recall using the
FIFO method.)
Absorption Costing Variable Costing

Sales Revenue Sales Revenue

COGS: VCOGS:

Gross Margin Contribution Margin

S&A costs: Fixed costs:
FMC
FS&A
Operating Income Operating Income

Module 17 – page 59