Transcript T5M1
Slide 1
In this section we will look at the difference between absorption costing which is the costing system we have employed up to this point and variable costing. Absorption costing essentially treats all product costs the same and does not distinguish between fixed and variable costs. Variable costing on the other hand, only treats variable costs as product costs. All fixed costs are treated as period costs. That includes fixed manufacturing overhead.
Slide 2
Here is a great slide that pictorially shows the difference between the two costing methods and how product and period costs are tried. On the left is absorption costing or the method we have used through out the earlier discussions and on the right is variable costing. The main difference between the two is how they allocate fixed manufacturing overhead. Absorption costing absorbs or soaks up all the manufacturing overhead costs. Where as variable costing only allocates variable costs to the product costs and reports fixed manufacturing overhead as a period cost
Slide 3
Here we have THE COMPANY’s unit costs for the period. We will employ these costs in both absorption and variable costing methods.
Slide 4
First, using absorption costing, we will calculate the per unit cost. Under absorption costing per unit cost is $12 per unit
Slide 5
Under variable costing the per unit cost is $10 per unit a difference of $2 per unit.
Slide 6
Now let us take the per unit information and prepare an absorption costing income statement. Absorption costing uses the traditional income statement format Sales less Cost of Goods sold shows gross margin or profit. Then selling and administrative expenses are subtracted from gross margin to calculate net operating income. The areas where individuals get mixed up are how to calculate the inventory section. So I have provided the arithmetic to help you understand. Primarily the variable selling and administrative expenses section must be calculated by multiplying the number of units sold by the variable selling and administrative expense cost per unit. In this example it turns out to be $16,000 or 8,000 units times $2/unit.
Slide 7
Variable costing uses the contribution margin format for an income statement. This is where variable costs are subtracted from sales to determine the contribution margin. Then fixed costs are subtracted from the contribution margin to calculate net operating income. With this method all fixed costs are reported during the period.
Notice that variable costing net operating income is less than that reported under the absorption costing method. This is because absorption costing parks or defers some of the fixed manufacturing overhead in the inventory account which we find on the balance sheet. Thus the costs are deferred to another accounting period.
Slide 8
As previously mentioned the main difference between absorption and variable costing is the handling of fixed manufacturing overhead. In absorption some of it can be deferred to the next period where as with variable costing all of fixed manufacturing overhead is reported that accounting period. Consequently, net operating income using the absorption costing method can be impacted by inventory changes. This is not the case for variable costing.
Slide 9
So what is the best method to employ in your operations? That is a hard question. But here are some things to think about. First, absorption is widely used by organizations for both internal and external reporting. A serious negative is that absorption costing does not relate well to cost volume profit analysis. Third variable costing is not GAAP or generally accepted accounting principles so for external reporting an organization must use absorption costing. And lastly in US taxes can only be calculated using absorption costing. So, why use variable costing with all these barriers. Well, it can provide better insight into how costs are behaving within the organization. Thus in the best of all worlds, variable costing can be used internally and absorption can be used externally.