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Chap 007
Chap 007
McGraw-Hill/Irwin Slide 2
Overview of Absorption and Variable Costing
Absorption Variable
Costing Costing
Direct Materials
Product
Product Direct Labor
Costs
Costs Variable Manufacturing Overhead
McGraw-Hill/Irwin Slide 3
Quick Check
McGraw-Hill/Irwin Slide 4
Quick Check
McGraw-Hill/Irwin Slide 5
Unit Cost Computations
McGraw-Hill/Irwin Slide 6
Unit Cost Computations
Unit product cost is determined as follows:
McGraw-Hill/Irwin Slide 7
Learning Objective 2
McGraw-Hill/Irwin Slide 8
Income Comparison of
Absorption and Variable Costing
McGraw-Hill/Irwin Slide 9
Absorption Costing
McGraw-Hill/Irwin Slide 11
Learning Objective 3
McGraw-Hill/Irwin Slide 12
Comparing the Two Methods
McGraw-Hill/Irwin Slide 13
Comparing the Two Methods
McGraw-Hill/Irwin Slide 15
Unit Cost Computations
McGraw-Hill/Irwin Slide 16
Absorption Costing Unit product
cost.
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
Goods available for sale 480,000
Less ending inventory - 480,000
Gross margin 420,000
Less selling & admin. exp.
Variable (30,000 × $3) $ 90,000
Fixed 100,000 190,000
Net operating income $ 230,000
All fixed
manufacturing
overhead is
expensed.
McGraw-Hill/Irwin Slide 18
Comparing the Two Methods
McGraw-Hill/Irwin Slide 20
Summary of Key Insights
McGraw-Hill/Irwin Slide 21
Learning Objective 4
Understand the
advantages and
disadvantages of both
variable and absorption
costing.
McGraw-Hill/Irwin Slide 22
Impact on the Manager
Opponents of absorption costing argue that
shifting fixed manufacturing overhead costs
between periods can lead to faulty decisions.
McGraw-Hill/Irwin Slide 23
CVP Analysis, Decision Making
and Absorption costing
Absorption costing does not dovetail with CVP analysis,
nor does it support decision making. It treats fixed
manufacturing overhead as a variable cost. It assigns per
unit fixed manufacturing overhead costs to production.
Treating fixed manufacturing overhead as a
variable cost can:
• Lead to faulty pricing decisions and faulty
keep-or-drop decisions.
McGraw-Hill/Irwin Slide 24
External Reporting and Income Taxes
To conform to
GAAP requirements,
absorption costing must be used for
external financial reports in the Under the Tax
United States. Reform Act of 1986,
absorption costing must be
used when filling out
Since top executives income tax returns.
are typically evaluated based on
earnings reported to shareholders
in external reports, they may feel that
decisions should be based on
absorption costing data.
McGraw-Hill/Irwin Slide 25
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.
McGraw-Hill/Irwin Slide 26
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
McGraw-Hill/Irwin Slide 27
Variable Costing and the Theory of
Constraints (TOC)
Companies involved in TOC use a form of variable
costing. However, one difference of the TOC approach
is that it treats direct labor as a fixed cost for three
reasons:
Many companies have a commitment to guarantee
workers a minimum number of paid hours.
Direct labor is usually not the constraint.
TOC emphasizes the role direct laborers play in driving
continuous improvement. Since layoffs often devastate
morale, managers involved in TOC are extremely
reluctant to lay off employees.
McGraw-Hill/Irwin Slide 28
Impact of Lean Production
Production
tends to equal
sales . . .
McGraw-Hill/Irwin Slide 29
End of Chapter 7
McGraw-Hill/Irwin Slide 30