Absorption Costing

Absorption Costing
A system of accounting for costs in which both fixed
and variable production costs are considered
product costs.

Fixed
Costs
Product
Variable
Costs

8-2
Variable Costing
A system of cost accounting that only assigns the
variable cost of production to products.

Fixed
Costs
Product
Variable
Costs

8-3
 Absorption and Variable
Costing
Absorption Variable
Costing Costing

Direct materials
Direct labor Product costs
Product costs Variable mfg. overhead

Fixed mfg. overhead

Period costs
Period costs Selling & Admin. exp.

8-4
 Absorption and Variable
Costing
Absorption Variable
Costing Costing

Direct materials
Direct labor Product costs
Product costs Variable mfg. overhead

Fixed mfg. overhead

Period costs
Period costs Selling & Admin. exp.

The difference between absorption and variable

costing is the treatment of fixed manufacturing overhead.
8-5
Absorption and Variable
Costing
Let’s put some numbers to an example and
see what we can learn about the difference
between absorption and variable costing.

8-6
Absorption and Variable
Costing
Mellon Co. produces a single product with the
following information available:

Number of units produced annually 25,000

Variable costs per unit:
Direct materials, direct labor,
and variable mfg. overhead $ 10
Selling & administrative
expenses $ 3
Fixed costs per year:
Mfg. overhead $ 150,000
Selling & administrative
expenses $ 100,000

8-7
Absorption and Variable
Costing
Unit product cost is determined as follows:

Absorption Variable
Costing Costing
Direct materials, direct labor, and
variable mfg. overhead $ 10 $ 10
Fixed mfg. overhead
($150,000 ÷ 25,000 units) 6 -
Unit product cost $ 16 $ 10

Selling and administrative expenses are

always treated as period expenses and
deducted from revenue.
8-8
Absorption Costing
Income Statements
Mellon Co. had no beginning inventory, produced 25,000 units, and
sold 20,000 units this year at $30 each.

Absorption Costing
Sales (20,000 × $30) $ 600,000
Less cost of goods sold:
Beginning inventory
Add COGM
Goods available for sale
Ending inventory
Gross margin
Less selling & admin. exp.
Variable
Fixed
Net income

8-9
Absorption Costing
Income Statements
Mellon Co. had no beginning inventory, produced 25,000 units, and
sold 20,000 units this year at $30 each.
Absorption Costing
Sales (20,000 × $30) $ 600,000
Less cost of goods sold:
Beginning inventory $ -
Add COGM (25,000 × $16) 400,000
Goods available for sale $ 400,000
Ending inventory (5,000 × $16) 80,000 320,000
Gross margin $ 280,000
Less selling & admin. exp.
Variable
Fixed
Net income

8-10
Absorption Costing
Income Statements
Mellon Co. had no beginning inventory, produced 25,000 units, and
sold 20,000 units this year at $30 each.

Absorption Costing
Sales (20,000 × $30) $ 600,000
Less cost of goods sold:
Beginning inventory $ -
Add COGM (25,000 × $16) 400,000
Goods available for sale $ 400,000
Ending inventory (5,000 × $16) 80,000 320,000
Gross margin $ 280,000
Less selling & admin. exp.
Variable (20,000 × $3) $ 60,000
Fixed 100,000 160,000
Net income $ 120,000

8-11
Variable Costing
Income Statements
Now let’s look at variable costing by Mellon Co.
Variable Costing
Sales (20,000 × $30) $ 600,000
Less variable expenses:
Beginning inventory $ -
Add COGM
Goods available for sale
Ending inventory
Variable cost of goods sold
Variable selling & administrative
expenses
Contribution margin
Less fixed expenses:
Manufacturing overhead
Selling & administrative expenses
Net income

8-12
Variable Costing
Income Statements
Now let’s look at variable costing by Mellon Co.
We exclude the
fixed manufacturing
Variable Costing
Sales (20,000 × $30) $ 600,000
Less variable expenses: overhead.
Beginning inventory $ -
Add COGM (25,000 × $10) 250,000
Goods available for sale $ 250,000
Ending inventory (5,000 × $10) 50,000
Variable cost of goods sold $ 200,000
Variable selling & administrative
expenses
Contribution margin
Less fixed expenses:
Manufacturing overhead
Selling & administrative expenses
Net income

8-13
Variable Costing
Income Statements
Now let’s look at variable costing by Mellon Co.
Variable Costing
Sales (20,000 × $30) $ 600,000
Less variable expenses:
Beginning inventory $ -
Add COGM (25,000 × $10) 250,000
Goods available for sale $ 250,000
Ending inventory (5,000 × $10) 50,000
Variable cost of goods sold $ 200,000
Variable selling & administrative
expenses (20,000 × $3) 60,000 260,000
Contribution margin $ 340,000
Less fixed expenses:
Manufacturing overhead $ 150,000
Selling & administrative expenses 100,000 250,000
Net income $ 90,000

8-14
Comparing Absorption and
Variable Costing
Let’s compare the methods.
Cost of
Goods Ending Period
Sold Inventory Expense Total
Absorption costing
Variable mfg. costs $ 200,000
Fixed mfg. costs 120,000
$ 320,000

Variable costing
Variable mfg. costs $ 200,000
Fixed mfg. costs -
$ 200,000

8-15
Comparing Absorption and
Variable Costing
Let’s compare the methods.
Cost of
Goods Ending Period
Sold Inventory Expense Total
Absorption costing
Variable mfg. costs $ 200,000 $ 50,000 $ -
Fixed mfg. costs 120,000 30,000 -
$ 320,000 $ 80,000 $ -

Variable costing
Variable mfg. costs $ 200,000 $ 50,000 $ -
Fixed mfg. costs - - 150,000
$ 200,000 $ 50,000 $ 150,000

8-16
Comparing Absorption and
Variable Costing
Let’s compare the methods.
Cost of
Goods Ending Period
Sold Inventory Expense Total
Absorption costing
Variable mfg. costs $ 200,000 $ 50,000 $ - $ 250,000
Fixed mfg. costs 120,000 30,000 - 150,000
$ 320,000 $ 80,000 $ - $ 400,000

Variable costing
Variable mfg. costs $ 200,000 $ 50,000 $ - $ 250,000
Fixed mfg. costs - - 150,000 150,000
$ 200,000 $ 50,000 $ 150,000 $ 400,000

8-17
Cost-Volume-Profit Analysis
• CVP includes all fixed costs to compute breakeven.
• Variable costing and CVP are consistent as both treat fixed
costs as a lump sum.
• Absorption costing defers fixed costs into inventory.
• Absorption costing is inconsistent with CVP because
absorption costing treats fixed costs on a per unit basis.

8-18
Extending the Example

Let’s look at
the second
year of
operations
for Mellon
Company.

8-19
Mellon Co. Year 2
In its second year of operations, Mellon Co. started with an
inventory of 5,000 units, produced 25,000 units, and sold
30,000 units at $30 each.
Number of units produced annually 25,000
Variable costs per unit:
Direct materials, direct labor,
and variable mfg. overhead $ 10
Selling & administrative
expenses $ 3
Fixed costs per year:
Mfg. overhead $ 150,000
Selling & administrative
expenses $ 100,000

8-20
Mellon Co. Year 2
Unit product cost is determined as follows:

Absorption Variable
Costing Costing
Direct materials, direct labor,
and variable mfg. overhead $ 10 $ 10
Fixed mfg. overhead
($150,000 ÷ 25,000 units) 6 -
Unit product cost $ 16 $ 10

There has been no

change in Mellon’s
cost structure.
8-21
Mellon Co. Year 2
Now let’s look at Mellon’s income statement
assuming absorption costing is used.

8-22
Mellon Co. Year 2
Units in ending inventory from the previous period.
Absorption Costing
Sales (30,000 × $30) $ 900,000
Less cost of goods sold:
Beg. inventory (5,000 x $16) $ 80,000
Add COGM (25,000 × $16) 400,000
Goods available for sale $ 480,000
Ending inventory - 480,000
Gross margin $ 420,000
Less selling & admin. exp.
Variable (30,000 × $3) $ 90,000
Fixed 100,000 190,000
Net income $ 230,000

8-23
Mellon Co. Year 2

Absorption Costing
Sales (30,000 × $30) $ 900,000
Less cost of goods sold:
Beg. inventory (5,000 x $16) $ 80,000
Add COGM (25,000 × $16) 400,000
Goods available for sale $ 480,000
Ending inventory - 480,000
Gross margin $ 420,000
Less selling & admin. exp.
Variable (30,000 × $3) $ 90,000
Fixed 100,000 190,000
Net income $ 230,000

25,000 units produced in the current period.

8-24
Mellon Co. Year 2
Next, we’ll look at Mellon’s income statement
assuming variable costing is used.

8-25
Mellon Co. Year 2
Variable Costing
Sales (30,000 × $30) $ 900,000
Less variable expenses:
Beg. inventory (5,000 × $10) $ 50,000
Add COGM (25,000 × $10) 250,000
Goods available for sale $ 300,000
Ending inventory -
Variable cost of goods sold $ 300,000
Variable selling & administrative
expenses (30,000 × $3) 90,000 390,000
Contribution margin $ 510,000
Less fixed expenses:
Manufacturing overhead $ 150,000
Selling & administrative expenses 100,000 250,000
Net income $ 260,000

Excludes fixed manufacturing overhead.

8-26
Summary
Income Comparison

Costing Method 1st Period 2nd Period Total

Absorption $ 120,000 $ 230,000 $ 350,000
Variable 90,000 260,000 350,000

In the first period, production (25,000 units)

was greater than sales (20,000 units).

In the second period, production (25,000 units)

was less than sales (30,000 units).
8-27
Summary
Income Comparison

Costing Method 1st Period 2nd Period Total

Absorption $ 120,000 $ 230,000 $ 350,000
Variable 90,000 260,000 350,000

For the two-year period, total absorption

income and total variable income are the same.

8-28
Summary
Let’s see if we can get an overview of what we
have done.

8-29
 Summary Comparison of Absorption
(AC) and Variable Costing (VC)
Tota l
Production ve rsus Inve ntory
Sa le s Effe ct Pe riod Ex pe nse Effe ct Profit Effe ct

Fix e d mfg. Fix e d mfg.

Produce d > Sold Incre a se costs e x pe nse d < costs e x pe nse d AC > VC
AC VC

Fix e d mfg. Fix e d mfg.

Produce d < Sold De cre a se costs e x pe nse d > costs e x pe nse d AC < VC
AC VC

Fix e d mfg. Fix e d mfg.

Produce d = Sold No cha nge costs e x pe nse d = costs e x pe nse d AC = VC
AC VC

This was the case in the first period when production

of 25,000 units was greater than sales of 20,000 units.

Inventory increased from zero to 5,000 units and

$120,000 absorption income was greater than
$90,000 variable income. 8-30
 Summary Comparison of Absorption
(AC) and Variable Costing (VC)

Total
Production versus Inventory
Sales Effect Period Expense Effect Profit Effect

Fixed mfg. Fixed mfg.

Produced > Sold Increase costs expensed < costs expensed AC > VC
AC VC

Fixed mfg. Fixed mfg.

Produced < Sold Decrease costs expensed > costs expensed AC < VC
AC VC

Fixed mfg. Fixed mfg.

Produced = Sold No change costs expensed = costs expensed AC = VC
AC VC

In the second period, sales of 30,000 units

were greater than production of 25,000.
8-31
 Summary Comparison of Absorption
(AC) and Variable Costing (VC)
Total
Production versus Inventory
Sales Effect Period Expense Effect Profit Effect

Fixed mfg. Fixed mfg.

Produced > Sold Increase costs expensed < costs expensed AC > VC
AC VC

Fixed mfg. Fixed mfg.

Produced < Sold Decrease costs expensed > costs expensed AC < VC
AC VC

Fixed mfg. Fixed mfg.

Produced = Sold No change costs expensed = costs expensed AC = VC
AC VC

Inventory decreased from 5,000 units to zero,

and $230,000 absorption income was less
than $260,000 variable income. 8-32
 Summary Comparison of Absorption
(AC) and Variable Costing (VC)
Total
Production versus Inventory
Sales Effect Period Expense Effect Profit Effect

Fixed mfg. Fixed mfg.

Produced > Sold Increase costs expensed < costs expensed AC > VC
AC VC

For the two-year period,

Fixed mfg. unitsFixed
produced
mfg.
Produced < Sold Decrease costs expensed > costs expensed AC < VC
equals units sold, so total AC absorption VC income
equals total variable income.
Fixed mfg. Fixed mfg.
Produced = Sold No change costs expensed = costs expensed AC = VC
AC VC

8-33