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Chapter 15

Chapter 15 . Overhead Application: Variable and Absorption Costing. Construct an income statement using the variable-costing approach. Learning Objective 1. Variable Versus Absorption Costing. This chapter compares two methods of product costing. Variable-Costing. Absorption-Costing.

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Chapter 15

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  1. Chapter 15 Overhead Application: Variable and Absorption Costing

  2. Construct an income statement using the variable-costing approach. Learning Objective 1

  3. Variable Versus Absorption Costing This chapter compares two methods of product costing. Variable-Costing Absorption-Costing

  4. Variable Versus Absorption Costing • The differences between variable-costing and absorption-costing methods are based on the treatment of fixed manufacturing overhead.

  5. Variable Versus Absorption Costing Variable costing excludes fixed manufacturing overhead from inventoriable costs. Absorption costing treats fixed manufacturing overhead as inventoriable costs.

  6. Variable Versus Absorption 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

  7. Comparative Income Statement for Variable-Costing Method (in thousands of dollars) 2002 2003 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 6565 Operating income, variable costing $ 30 $ 65

  8. Construct an income statement using the absorption-costing approach. Objective 2

  9. Fixed-Overhead Rate The fixed-overheadrateis 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.

  10. Cost of Goods Sold forAbsorption-Costing Method (in thousands of dollars) 2002 2003 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

  11. Cost of Goods Sold forAbsorption-Costing Method (in thousands of dollars) 2002 2003 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

  12. Comparison of Variable andAbsorption Costing Absorption unit cost is higher. Output-level (production-volume) variance exists only under absorption costing.

  13. 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.

  14. 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.

  15. Compute the production- volume variance and show how it should appear in the income statement. Learning Objective 3

  16. 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.

  17. Production-Volume Variance Actual volume Expected volume – Fixed overhead rate × Production-volume variance =

  18. Volume Variance Applied fixed overhead – Budgeted fixed overhead = Production-volume variance In practice, the production-volume variance is usually called simply the volume variance.

  19. 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.

  20. Differentiate among the three alternative cost bases of an absorption-costing system: actual, normal, and standard. Learning Objective 4

  21. Practical Capacity • Maximum, or full capacity, used as the expected activity level in calculating the fixed-overhead rate, is often called practicalcapacity.

  22. 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.

  23. Actual, Normal, and Standard Costing Variable Fixed Direct Direct factory factory materials labor overhead overhead Actual Costing Normal Costing Standard Costing Actual Actual Actual Actual costs costs costs costs Actual Actual Budgeted rates costs costs × actual inputs Standard prices or rates × standard inputs allowed for actual output achieved

  24. Actual, Normal, and Standard Costing Both normal absorption costing and standard absorption costing generate production-volume variances. Favorable Variance Unfavorable Variance

  25. Explain why a company might prefer to use a variable-costing approach. Learning Objective 5

  26. 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.

  27. Flexible-Budget Variances All variances other than the production-volume variance are essentially flexible-budget variances.

  28. Flexible-Budget Variances Flexible-budget variances measure components of the differences between actual amounts and the flexible-budget amounts for the output achieved.

  29. Flexible-Budget Variances Flexible budgets are primarily designed to assist planning and control rather than product costing.

  30. Identify the two methods for disposing of the standard cost variances at the end of a year and give the rationale for each. Learning Objective 6

  31. 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.

  32. Disposition of Standard-Cost Variances • 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.

  33. Disposition of Standard-Cost Variances • 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.

  34. Understand how product- costing systems affect operating income. Learning Objective 7

  35. 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.

  36. 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.

  37. 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.

  38. 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.

  39. End of Chapter Fifteen

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