HR Accounting Unit 2
Chapter 8
Absorption costing is the most widely used method of determining product costs- can lead to artificial
increases in short0term profits when firms increase the quantity of goods produced.
Actually required for external financial reporting
Treats all manufacturing costs as product costs – All costs that are involved in the purchase or
manufacture of goods. In the case of manufactured goods, these costs consist of direct
materials, direct labour, and manufacturing overhead. They are also called inventoriable costs.
The cost of a unit of product under the absorption costing method therefore consists of direct
materials, direct labour, and both variable and fixed manufacturing overhead.
Because absorption costing includes all manufacturing costs as product costs, it is frequently
referred to as full costing.
Variable Costing- A costing method that includes only variable manufacturing costs—direct materials,
direct labour, and variable manufacturing overhead—in the cost of a unit of product.
is therefore preferred by some managers for internal decision making.
This generally includes direct materials, direct labour, and the variable portion of manufacturing
overhead.
Fixed manufacturing overhead is not treated as a product cost under this method.
Period costs- All costs that are expensed on the income statement in the period in which they
are incurred or accrued. Selling (marketing) and administrative expenses are period costs.
The cost of a unit of product in inventory or in cost of good sold under the variable costing
method does not contain any fixed overhead cost.
Sometimes referred to as: direct costing or marginal costing.
Under either absorption or variable costing, selling and administrative expenses are always treated as
period costs (expenses) and deducted from revenues as incurred.
Fixed manufacturing overhead cost deferred in inventory- The portion of the fixed manufacturing
overhead cost of a period that goes into inventory under the absorption costing method as a result of
production exceeding sales.
Essentially the difference between the absorption costing method and the variable costing method
centres on timing. Advocates of variable costing say that fixed manufacturing costs should be expensed
immediately in total, whereas advocates of absorption costing day that fixed manufacturing costs should
be charged against revenues bit by bit as units of product are sold. Any unit of product not sold under
the absorption costing result in fixed costs being inventoried and carried forward as assets to the nest
period.
When production are sales are equal, operating income will generally be the same regardless of whether
absorption or variable costing is used. This is because the only difference that can exist between
absorption and variable costing operating incomes is the amount of fixed manufacturing overhead
recognized as expense on the income statement. So, under either method, when production equals
sales (and hence there is no changed in inventories), all of the fixed manufacturing overhead incurred
during the year flows through to the income statement as expense.
Fixed manufacturing overhead cost released from inventory- The portion of the fixed manufacturing
overhead cost of a prior period that becomes an expense of the current period under the absorption
costing method as a result of sales exceeding production.
Operating Income is NOT affected by changes in production under variable costing. A change in
production has no effect on operating income when variable costing is used.
Operating income IS affected by changes in production under absorption costing. The reason for this
effect can be traced to the shifting of fixed manufacturing overhead costs between periods under the
absorption costing method as a result of changes in inventory.
Under Variable costing revenue drives operating income, while under absorption costing, revenue and
production drive operating income.
To obtain the break-even point, we divide total fixed costs by the contribution margin per unit.
A basic problem with absorption costing is that fixed manufacturing overhead costs appear to be
variable with respect to the number of units sold, but they are not.
Even if a company uses absorption costing for its external reports (as required in the US is predominant
in Canada) a manager can use variable costing statements for internal reports. No particular accounting
problems are created by using both costing methods – the variable costing method for internal reports
and the absorption costing method for external reports.
The advantages of variable costing can be summarized as follows:
1. Data required for CVP analysis can be taken directly from a contribution format income
statement. These data are not available on a conventional absorption costing statement.
2. Under variable coating, the profit for a period is not affected by changes in inventories. Other
things remaining equal (e.g., selling prices, costs, sales mix), profits move in the same direction
as sales when variable costing is used.
3. Managers often assume that unit product costs are variable costs. This is a problem under
absorption costing because unit product costs are a combination of both fixed and variable
costs. Under variable costing, unit product costs do not contain fixed costs.
4. The impact of fixed costs on profits is emphasized under the variable costing and contribution
approach. The total amount of fixed costs appears explicitly on the income statement,
highlighting that the whole amount of fixed costs must be covered for the company to be truly
profitable. Under absorption costing, the fixed costs are mingled with the variable costs and are
buried in cost of goods sold and in ending inventories.
5. Variable costing data make it easier to estimate the profitability of products, customers and
other segments of the business. With absorption costing, profitability is obscured by arbitrary
allocations of fixed costs.
6. Variable costing ties in with cost control methods such as standard costs and flexible budgets.
7. Variable costing operating income is closer to net cash flow then absorption costing operating
income. This is particularly important for companies with potential cash flow problems.
Lean thinking only allows production in response to customer orders, so the number of units produced
tends to equal the number of units sold, thereby resulting in minimal inventory. Under lean production,
goods are produced to customers orders and the goal is to eliminate finished goods inventories entirely
and reduce work in process inventory to almost nothing. In addition to minimizing inventory holding
costs, lean production reduces the ability of an unethical manager to manage reported earnings by
building inventory.
Difference between lean and traditional:
Under leans production methods, little if any inventory is held on hand; thus, there is no ability
to move fixed overhead costs on to the balance sheet at the end of each period. On the other
hand, under traditional production methods, inventory tends to build during periods of low
demand and is drawn down in periods of high demand. Inventory values on the balance sheet
must include a portion of fixed manufacturing overhead and thus, these costs are moved to the
balance sheet rather than expensed on the income statement when inventory builds.
Just-in-time (JIT) production- A system in the lean production model where production is not initiated
until a customer has ordered a product.
Managerial Accounting
Twelfth Canadian Edition
Chapter 8: Variable Costing: A Tool for Management
What You Really Need To Know
A. Two different methods can be used for determining unit product costs—absorption
costing and variable costing.
1. Under absorption costing, all manufacturing costs, both variable and fixed, are
included in unit product costs.
Direct materials .......................................... $XXX
Direct labour ............................................... XXX
Variable manufacturing overhead .......... XXX
Fixed manufacturing overhead ................ XXX
Unit product cost ........................................ $XXX
2. Under variable costing, only variable manufacturing costs which usually consist of
direct materials, direct labour, and variable manufacturing overhead—are included in
unit product costs.
Direct materials .......................................... $XXX
Direct labour ............................................... XXX
Variable manufacturing overhead ........... XXX
Unit product cost ........................................ $XXX
a. Variable costing focuses on cost behaviour. One of the strengths of this costing
method is that it harmonizes fully with both the contribution approach and the cost-
volume-profit concepts discussed in a previous chapter.
b. Under the variable costing method, fixed manufacturing costs are treated as period
costs and are charged against revenues in the period in which they are incurred, just
like selling and administrative expenses.
B. Under absorption costing, fixed manufacturing costs may be shifted from one
period to another due to changes in inventories.
1. A portion of the period’s fixed manufacturing overhead costs is assigned to each
unit that is produced. If the unit is not sold during the period, the fixed manufacturing
overhead assigned to the unit is part of the inventories on the balance sheet rather than
cost of goods sold on the income statement. This is referred to as deferral of fixed
manufacturing overhead in inventory.
2. Exhibit 8-2 is a key exhibit that illustrates the differences between variable and
absorption costing. Study this exhibit carefully before going on.
C. Exhibit 8-3 is also a key exhibit that summarizes the relationship between variable
and absorption costing. Any difference in operating income between the two methods
can be reconciled to changes in the level of inventories.
1. When production and sales (in units) are equal, inventories don’t change. When this
occurs, variable and absorption costing yield the same operating income.
2. When production exceeds sales (in units) and hence inventories increase, greater
operating income will be reported under absorption costing than under variable
costing.
a. When inventories increase, some of the current period’s fixed manufacturing
overhead costs are deferred in inventory.
b. The amount of fixed manufacturing overhead cost deferred is equal to the increase
in units in inventory multiplied by the fixed manufacturing overhead cost per unit.
3. When production is less than sales (in units) and hence inventories decrease, less
operating income will be reported under absorption costing than under variable
costing.
a. Fixed manufacturing overhead costs are released from inventory when the units are
sold.
b. The amount of fixed manufacturing overhead cost released is equal to the decrease
in units in inventory multiplied by the fixed manufacturing overhead cost per unit.
4. Over an extended period of time, the operating income reported by the two costing
methods will tend to be the same. Over the long run sales can’t exceed production, nor
can production much exceed sales. The shorter the period, the more the operating
income figures will tend to differ.
D. The following form, which is illustrated in Exhibits 8-4 and 8-6, can be used to
reconcile variable costing and absorption costing operating incomes.
Variable costing operating income...... $XXX
Add fixed manufacturing overhead
costs deferred in inventory under
absorption costing .................................. XXX
Deduct fixed manufacturing overhead
costs released from inventory under
absorption costing .................................. (XXX)
Absorption costing operating income ..... $XXX
E. Exhibit 8-6 shows the effects of changes in production on operating income—
holding sales constant—under both variable and absorption costing.
1. Holding sales constant, operating income under variable costing is not affected by
changes in production.
2. Holding sales constant, operating income under absorption costing is affected by
changes in production.
a. Under absorption costing, operating income increases as production increases, and
decreases as production decreases. This occurs because of changes in ending
inventories. As inventories grow, fixed manufacturing overhead is deferred in
inventories. As inventories shrink, fixed manufacturing overhead is released to the
income statement.
b. The effects of changes in production on operating income are a major drawback of
absorption costing. This results in confusing financial statements and can be used by
managers to manipulate reported profits.
F. A number of factors should be considered when choosing between variable and
absorption costing.
1. Advantages of variable costing and the contribution approach are as follows:
a. The contribution approach works well with cost-volume-profit analysis. The data
for the analysis can be taken directly from the contribution format income statement
because it categorizes costs by how they behave.
b. Unlike absorption costing, variable costing profits are unaffected by changes in
production (and inventories).
c. Under variable costing, unit product costs are variable costs. Under absorption
costing, unit product costs are a mixture of variable and fixed costs. This can be
confusing to managers who tend to think of unit product costs as variable costs.
d. Under variable costing, fixed costs are highlighted rather than buried in cost of
goods sold and in inventories.
e. As discussed in later chapters, variable costing data make it easier to estimate the
profitability of products.
f. Also as discussed in later chapters, variable costing works well with cost control
methods such as standard cost variance analysis and flexible budgets.
g. Variable costing operating income is closer to net cash flows than absorption
costing operating income. This can be important for organizations that need to closely
monitor their cash resources.
2. Nevertheless, absorption costing is the generally accepted method for preparing
external financial reports and for preparing income tax returns. Variable costing is
usually limited to internal use within a company. And because of the cost and possible
confusion of maintaining two separate costing systems, most companies use
absorption costing for internal as well as for external reports.
G. When companies adopt lean production, differences in operating income between
variable costing and absorption costing are reduced or eliminated.
1. The sometimes erratic movement of operating income under absorption costing,
and the differences in operating income between absorption and variable costing, arise
because of changing levels of inventory.
2. Under lean production, inventories are largely eliminated. Consequently, there is
little opportunity for fixed manufacturing overhead costs to be shifted between
periods under absorption costing. Thus, under lean production, operating income is
essentially the same whether variable and absorption costing is used, and the
sometimes erratic movement of operating income under absorption costing is largely
eliminated.
What To Watch Out For (Hints, Tips and Traps)
· Study Exhibit 8-1 carefully as it shows how various costs are handled under variable
and absorption costing. Students who grasp the big picture shown in Exhibit 8-1 find
it easier to work with the details of variable and absorption costing. The only
difference between variable and absorption costing is in how the two methods treat
fixed manufacturing overhead costs. Also, under both methods, selling and
administrative costs are period costs and are not product costs.
· For simplicity, nearly all examples, exhibits, problems, and exercises in this chapter
treat direct labour as a variable cost. However, labour is essentially a fixed cost in
some companies. This is a growing phenomenon as pointed out in earlier chapters.
Under variable costing, direct labour would not be included in product costs when it is
a fixed cost. This point is reinforced in the discussion on theory of constraints in a
later chapter.
· Before beginning the income comparisons in LO2 and specifically in Exhibit 8-2,
remember the relationship between ending inventory and operating income. Higher
ending inventory results in higher operating income since costs of goods available for
sale less ending inventory equals cost of goods sold. Therefore, a higher ending
inventory results in a lower expense (cost of goods sold) deducted to arrive at
operating income.
· Under absorption costing, the recognition of fixed costs as an expense is really a
timing issue. When the items are sold, the fixed costs will be reflected on the income
statement as part of cost of goods sold.
· Careful review of Exhibits 8-4 and 8-6 may help clear up misconceptions about why
variable and absorption costing operating incomes differ. The differences are
explained by the changes in fixed manufacturing overhead costs in inventories under
absorption costing. When inventories increase, current fixed manufacturing overhead
is deferred in inventories. When inventories decrease, fixed
manufacturing overhead from prior periods is released to become part of cost of goods
sold.
· Remember that the calculation of fixed manufacturing overhead (FMOH) per unit
(essentially the conversion of a fixed cost to a variable cost) requires that the
denominator be the number of units produced (or rather, expected production) during
the period rather than the number of units sold during the period. The formula to
represent this is:
FMOH per unit = total FMOH for the period / units produced (or expected
production)
Chapter 11 Pages 468-478
Decentralized organization- An organization in which decision making is spread throughout
the organization rather than being confined to a few top executives.
The Major advantages of decentralization include:
1. By delegating day-to-day problem solving to lower-level managers, top management can
concentrate on bigger issues, such as overall strategy.
2. Empowering lower-level managers to make decisions puts the decision-making authority
in the hands of those who tend to have the most detail and up-to-date information about
day-to-day operations.
3. By eliminating layers of decision making and approvals, organizations can respond more
quickly to customers and to changes in the operating environment.
4. Granting decision-making authority helps train lower-level managers for higher-level
positions
5. Empowering lower-level managers to make decisions can increase their motivation and
job satisfaction.
The Major disadvantages of decentralization include:
1. Lower-level managers may make decisions without fully understanding the company’s
overall strategy.
2. If lower-level managers make their own decisions independently of each other,
coordination may be lacking.
3. Spreading innovative ideas may be difficult in a decentralized organization. Someone in
one part of the organization may have a terrific idea that would benefit other parts of the
organization, but without strong central direction the idea may not be shared with and
adopted by other parts of the organization.
4. Lower-level managers may have objectives that clash with the objectives of the entire
organization. For example, a manager may be more interested in increasing the size of his
or her department, leading to more power and prestige, than increasing the departments
effectiveness.
Effective decentralization requires “segment reporting” to permit analysis and evaluation of the
decisions made by the segment managers. A segment is defined as a part of activity of an
organization bout which managers would like cost, revenue, or profit data. A company’s
operations can be segmented in many ways (i.e., geographic region, individual store, the nature
of the merchandise etc.)
An operating segment for financial accounting purposes is a component of an enterprise
That engages in business activites from which it may earn revenues and incur expenses
Whose operating results are regularly reviewed by the enterprises chief operating officer
to make decisions about resources to be allocated to the segment and asses its
performance
For which discrete financial information is available.
The order of the breakdown should not affect the numbers, but it can alter what appears on a
given report and the ease of review.
Two guidelines are followed in assigning costs to the various segments of a company under the
contribution approach:
1. First, According to cost behaviour patterns (i.e., variable and fixed).
2. Second, according to whether the costs are directly traceable to the segments involved.
CM= contribution margin
Is the sales volume goes up or down the effect on operating income can easily be
computer by simply multiplying the unit CM by the change in units sold or by
multiplying the change in sales dollars by the CM ratio.
A short-run planning tool
Decisions relative to the short run usually involve only variable costs and revenues which
are the elements involved in CM.
What the contribution approach des imply is that different costs are needed for different purpose.
Variable costs and revenues may be adequate for a mangers need for one purpose but for another
purpose the manager’s needs any encompass the fixed costs as well.
Traceable fixed costs- Fixed costs that can be identified with a particular segment and that arise
because of the existence of the segment. – If the segment had never existed, the fixed cost would
not have been incurred and/or if the segment were eliminated, the fixed cost would disappear.
Common fixed cost- A fixed cost that supports the operations of more than one segment but is
not traceable in whole or in part to any one segment. Even if the segment were entirely
eliminated, there would be no change in a true common fixed cost.
Common Fixed costs are not allocated to segments- the total amount is deducted to arrive at the
income for the company as a whole.
The general guideline is to treat traceable costs as only those costs that would disappear over
time if the segment itself disappeared.
Some Managers like to separate the traceable fixed costs into two classes
1. Discretionary- under the immediate control of the manager
2. Committed- not under the immediate control of the manager
Segment performance margin- the amount remaining after deducting the discretionary fixed
costs. The discretionary fixed costs should be separated from the committed fixed costs and
deducted as a separate group from the segments CM.
Segment margin- A margin obtained by deducting a segment’s traceable fixed costs from the
segment’s contribution margin. The segment margin is the best gauge of the long-run
profitability of a segment, because it includes only those costs that are caused by the segment.
From a decision-making point of view, the segment margin is most useful in major decisions that
affect capacity, such as dropping a segment.
The IFRS (International Financial Reporting Standard) 8- Operating Segments requires that
segmented reports prepared for external users use the same methods and definitions used for
internal segmented reports that are prepared to aid in making operating decisions. This is a very
unusual requirement.
Hindrances to Proper Cost Assignment:
Omission of Costs
o Upstream costs- research and development and product design
o Downstream Costs- marketing, distribution, and customer service
Inappropriate methods for Assignment Traceable Costs among Segments
o May not trace fixed expenses to segments even when it is feasible to do so.
o They may use inappropriate allocation bases to allocate traceable fixed expenses
to segments.
Failure to Trace Costs Directly
Inappropriate allocation Base
Arbitrarily Dividing Common Costs among Segments
o Adding a share of common costs to the real costs of a segment may make an
otherwise profitable segment appear to be unprofitable.
Online Notes
Compute the segment margin and explain how it differs from the contribution margin
Segment margin is the excess of a segment’s revenues over the variable expenses and traceable
fixed expenses. Whereas, a segment’s contribution margin is the excess of a segment’s revenues
over the variable expenses only. The segment margin is the best gage of the long-run profitability
of a segment because it includes all those costs that are caused by the segment.
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.
Variable costing income is only affected by changes in unit sales. It is not affected by the number
of units produced. As a general rule, when sales go up, net operating income goes up, and vice
versa.
•Absorption costing income is influenced by changes in unit sales and units of production. Net
operating income can be increased simply by producing more units even if those units are not
sold.
Absorption Costing Fixed manufacturing costs must be assigned to products to properly
match revenues and costs.
•Variable Costing Fixed manufacturing costs are capacity costs and will be incurred even
if nothing is produced.
In a lean production (JIT) inventory system, productions tends to be equal to sales.
•So, the difference between variable and absorption income tends to disappear.
