Overhead Application: Variable and Absorption Costing

Chapter 15
Overhead Application:
Variable and Absorption Costing
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 15 - 1
Learning Objective 1
Construct an income statement

using the variable-costing
approach.
15 -
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Variable Versus Absorption
Costing
This chapter compares two

methods of product costing.
Variable-Costing Absorption-Costing
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Costing
 The differences between variable-costing
and absorption-costing methods are based
on the treatment of fixed manufacturing
overhead.
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Costing
Variable costing excludes fixed manufacturing

overhead from inventoriable costs.
Absorption costing treats fixed manufacturing

overhead as inventoriable costs.
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Costing
(in thousands of dollars) 2002 2003
Beginning inventory at $3 – $ 90
plus cost of goods
manufactured at standard,
170,000 and 140,000 rings 510 420
Available for sale minus 510 510
ending inventory, at $3 90* 30^
Variable manufacturing
cost of goods sold $420 $480
*30,000 rings × $3 ^10,000 rings × $3
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Comparative Income Statement
for Variable-Costing Method
Sales, 140,000 and 160,000 rings $700 $800
Variable expenses:
Variable manufacturing
cost of goods sold 420 480
Variable selling expenses,
at 5% of dollar sales 35 40
Contribution margin $245 $280
Fixed expenses:
Fixed factory overhead 150 150
Fixed selling and admin. expenses 65 65
Operating income, variable costing $ 30 $ 65
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Objective 2
Construct an income statement

using the absorption-costing
approach.
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Fixed-Overhead Rate
The fixed-overhead rate is the amount of

fixed manufacturing overhead applied to
each unit of production.
It is determined by dividing the budgeted

fixed overhead by the expected volume
of production for the budget period.
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Cost of Goods Sold for
Absorption-Costing Method
Beginning inventory $ – $120
Add: Cost of goods manufactured
at standard, of $4* 680 560
Available for sale $680 $680
Deduct: Ending inventory 120 40
Cost of goods sold, at standard $560 $640
*Variable cost $3
Fixed cost ($150,000 ÷ $150,000) 1
Standard absorption cost $4
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Cost of Goods Sold for
Absorption-Costing Method
Sales $700 $800
Cost of goods sold, at standard 560 640
Gross profit at standard $140 $160
Production-volume variance* 20 F 10 U
Gross margin or gross profit “actual” $160 $150
Selling and administrative expenses 100 105
Operating income, variable costing $ 60 $ 45
*Based on expected volume of production of 150,000 rings:
2002: (170,000 – 150,000) × $1 = $20,000 F
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Comparison of Variable and
Absorption Costing
Absorption unit cost is higher.
Output-level (production-volume) variance

exists only under absorption costing.
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Reconciliation of Variable
Costing and Absorption Costing
The difference in income equals the

difference in the total amount of
fixed manufacturing overhead
charged as expense during
a given year.
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Reconciliation of Variable
Costing and Absorption Costing
 Under absorption costing, fixed overhead
appears in the cost of goods sold and also in
the production volume variance.
 Under variable costing, fixed
overhead is a period cost.
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Compute the production-

volume variance and show
how it should appear in the
income statement.
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Production-Volume Variance
A production-volume variance is a variance

that appears whenever actual production
deviates from the expected volume of
production used in computing the
fixed overhead rate.
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Production-Volume Variance
Actual volume
– Expected volume
× Fixed overhead rate
= Production-volume variance
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Volume Variance
Applied fixed overhead – Budgeted fixed overhead

= Production-volume variance
In practice, the
production-volume
variance is usually
called simply the
volume variance.
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Other Variances
The fixed-overhead flexible budget variance

(also called the fixed-overhead spending
variance or simply the budget variance)
is the difference between actual fixed
overhead and budgeted fixed overhead.
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Differentiate among the three

alternative cost bases of an
absorption-costing system:
actual, normal, and standard.
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Practical Capacity
 Maximum, or full
capacity, used as the
expected activity level
in calculating the fixed-
overhead rate, is often
called practical
capacity.
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Normal Costing
Normal costing is a costing system that

applies actual direct materials and actual
direct-labor costs to products or services but
uses budgeted rates for applying overhead.
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Actual, Normal, and
Standard Costing
Variable Fixed
Direct Direct factory factory
materials labor overhead overhead
Actual Actual Actual Actual Actual
Costing costs costs costs costs
Normal Actual Actual Budgeted rates
Costing costs costs × actual inputs
Standard Standard prices or rates × standard inputs
Costing allowed for actual output achieved
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Actual, Normal, and
Standard Costing
Both normal absorption costing and

standard absorption costing generate
production-volume variances.
Favorable Variance Unfavorable Variance
15 -
Explain why a company might

prefer to use a variable-costing
approach.
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Why Use Variable Costing?
One reason is that absorption-costing
income is affected by production
volume while variable-costing
income is not.
Another reason is based on which

system the company believes
gives a better signal about
performance.
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Flexible-Budget Variances
All variances other than the production-volume

variance are essentially flexible-budget variances.
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Flexible-budget variances measure

components of the differences
between actual amounts and
the flexible-budget amounts
for the output achieved.
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Flexible budgets are primarily

designed to assist planning and
control rather than product costing.
15 -
Identify the two methods for

disposing of the standard
cost variances at the end
of a year and give the
rationale for each.
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Disposition of
Standard-Cost Variances
There are two methods for disposing of the

standard cost variances at the end of a year:
An adjustment to income of the current year.
An assignment to both inventory and cost

of goods sold by proration.
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Disposition of
 One view is that in standard costing the
“standards” are viewed as currently
attainable.
 Therefore, variances are not inventoriable
and should be treated as adjustments to the
income of the period instead of being added
to inventories.
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Disposition of
 Another view favors assigning the variances
to the inventories and cost of goods sold
related to the production during the period
the variances arose.
 This is often called prorating the variances.
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Understand how product-

costing systems affect
operating income.
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Product-Costing Systems
Affect Operating Income
 Managers’ performance measures and
rewards are most often based on operating
income.
 As a result, managers are motivated to take
actions that improve current operating
income.
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Product-Costing Systems
Affect Operating Income
Absorption- and variable-costing systems

affect operating income because of their
treatment of fixed factory overhead.
Absorption-costing systems, both normal

and standard, generate production-volume
variances that also affect income.
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Effects of Sales and Production
on Reported Income
Production > Sales

Variable costing income is lower
than absorption income.
Production < Sales

Variable costing income is higher
than absorption income.
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Summary Comments
The difference between income reported

under these two methods is entirely due to
the treatment of fixed manufacturing costs.
Under absorption costing, these costs are

treated as assets (inventory) until the
associated goods are sold.
15 -
End of Chapter Fifteen
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 15 - 39

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Chapter 15

Construct an income statement

This chapter compares two

Variable costing excludes fixed manufacturing

Absorption costing treats fixed manufacturing

Construct an income statement

The fixed-overhead rate is the amount of

It is determined by dividing the budgeted

Absorption unit cost is higher.

Output-level (production-volume) variance

The difference in income equals the

Compute the production-

A production-volume variance is a variance

× Fixed overhead rate

Applied fixed overhead – Budgeted fixed overhead

The fixed-overhead flexible budget variance

Differentiate among the three

Normal costing is a costing system that

Both normal absorption costing and

Favorable Variance Unfavorable Variance

Explain why a company might

Another reason is based on which

All variances other than the production-volume

Flexible-budget variances measure

Flexible budgets are primarily

Identify the two methods for

There are two methods for disposing of the

An adjustment to income of the current year.

An assignment to both inventory and cost

Understand how product-

Absorption- and variable-costing systems

Absorption-costing systems, both normal

Production > Sales

Production < Sales

The difference between income reported

Under absorption costing, these costs are

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