1、Absorption Costing and Variable CostingChapter 5Learning Objective 1Explain how variable costing differs from absorption costing and compute unit product costs under each method.Overview of Absorption and Variable CostingQuick Check Which method will produce the highest values for work in process an

2、d finished goods inventories? a. Absorption costing.b. Variable costing.c. They produce the same values for these inventories.d. It depends. . . Which method will produce the highest values for work in process and finished goods inventories? a. Absorption costing.b. Variable costing.c. They produce

3、the same values for these inventories.d. It depends. . .Quick Check Harvey Company produces a single productwith the following information available:Unit Cost ComputationsUnit product cost is determined as follows:Under absorption costing, all production costs, variable and fixed, are included when

4、determining unit product cost. Under variable costing, only the variable production costs are included in product costs. Unit Cost ComputationsLearning Objective 2Prepare income statements using both variable and absorption costing.Income Comparison ofAbsorption and Variable CostingLets assume the f

5、ollowing additional information for Harvey Company.20,000 units were sold during the year at a priceof $30 each.There is no beginning inventory.Now, lets compute net operatingincome using both absorptionand variable costing.Absorption CostingFixed manufacturing overhead deferred in inventory is 5,00

6、0 units $6 = $30,000.Variablemanufacturing costs only.All fixedmanufacturingoverhead isexpensed.Variable CostingLearning Objective 3Reconcile variable costing and absorption costing net operating incomes and explain why the two amounts differ.Comparing the Two MethodsFixed mfg. overhead $150,000 Uni

7、ts produced 25,000 units= = $6 per unitWe can reconcile the difference betweenabsorption and variable income as follows:Comparing the Two MethodsExtended Comparisons of Income Data Harvey Company Year TwoUnit Cost ComputationsSince the variable costs per unit, total fixed costs, and the number of un

8、its produced remained unchanged, the unit cost computations also remain unchanged.Absorption CostingFixed manufacturing overhead released from inventory is 5,000 units $6 = $30,000.Unit product cost.Variable CostingAll fixedmanufacturingoverhead isexpensed.Variablemanufacturing costs only.We can rec

9、oncile the difference betweenabsorption and variable income as follows:Fixed mfg. overhead $150,000 Units produced 25,000 units= = $6 per unitComparing the Two MethodsComparing the Two MethodsSummary of Key InsightsLearning Objective 4Understand the advantages and disadvantages of both variable and

10、absorption costing.Impact on the ManagerOpponents of absorption costing argue thatshifting fixed manufacturing overhead costsbetween periods can lead to faulty decisions.These opponents argue that variable costing incomestatements are easier to understand because net operatingincome is only affected

11、 by changes in unit sales. Thisproduces net operating income figures that areconsistent with managers expectations.CVP Analysis, Decision Makingand Absorption costing Absorption costing does not dovetail with CVP analysis, nor does it support decision making. It treats fixed manufacturing overhead a

12、s a variable cost. It assigns per unit fixed manufacturing overhead costs to production. Treating fixed manufacturing overhead as a variable cost can: Lead to faulty pricing decisions and faulty keep-or-drop decisions.Assigning per unit fixed manufacturing overhead costs to production can: Potential

13、ly produce positive net operating income even when the number of units sold is less than the breakeven point.External Reporting and Income TaxesTo conform toIFRS and US GAAP requirements, absorption costing must be used forexternal financial reports.In many countries, including US,absorption costing

14、 must beused when filling out income tax returns.Since top executivesare typically evaluated based on earnings reported to shareholdersin external reports, they may feel that decisions should be based on absorption costing data.Advantages of Variable Costingand the Contribution ApproachAdvantagesMan

15、agement findsit more useful.Consistent withCVP analysis.Net operating income is closer tonet cash flow.Profit is not affected bychanges in inventories.Consistent with standardcosts and flexible budgeting.Impact of fixedcosts on profitsemphasized.Easier to estimate profitabilityof products and segmen

16、ts.VariableCostingVariable versus Absorption CostingAbsorptionCostingFixed manufacturingcosts must be assignedto products to properlymatch revenues andcosts.Fixed manufacturing costs are capacity costsand will be incurredeven if nothing isproduced.Variable Costing and the Theory of Constraints (TOC)

17、 Companies involved in TOC use a form of variable costing. However, one difference of the TOC approach is that it treats direct labor as a fixed cost for three reasons: Many companies have a commitment to guarantee workers a minimum number of paid hours. Direct labor is usually not the constraint. T

18、OC emphasizes the role direct laborers play in driving continuous improvement. Since layoffs often devastate morale, managers involved in TOC are extremely reluctant to lay off employees. Impact of Lean ProductionWhen companies use Lean Production . . .Productiontends to equalsales . . .So, the diff

19、erence between variable andabsorption income tends to disappear.Learning Objective 5Compute predetermined overhead rates and explain why estimated overhead costs (rather than actual overhead costs) are being used in the costing process.Why Use an Allocation Base?Manufacturing overhead is applied to

20、products/jobs that are in process. An allocation base, such as direct labor hours, direct labor dollars, or machine hours, is used to assign manufacturing overhead to individual products/jobs.We use an allocation base because:It is impossible or difficult to trace overhead costs to particular produc

21、ts/jobs.Manufacturing overhead consists of many different items ranging from the grease used in machines to production managers salary.Many types of manufacturing overhead costs are fixed even though output fluctuates during the period. The predetermined overhead rate (POHR) used to apply overhead t

22、o products/jobs is determined before the period begins.Manufacturing Overhead ApplicationEstimated total manufacturingoverhead cost for the coming periodEstimated total units in theallocation base for the coming periodPOHR =Ideally, the allocation base is a cost driver that causes overhead.Using a p

23、redetermined rate makes itpossible to estimate total product/job costs sooner.Actual overhead for the period is notknown until the end of the period.The Need for a POHRDetermining Predetermined Overhead RatesPredetermined overhead rates are calculated using a three-step process.Estimate the level of

24、 production for the period.Estimate total amount of the allocation base for the period.Estimate total manufacturing overhead costs.POHR = Actual amount of allocation is based upon the actual level of activity (normal costing system).Based on estimates, and determined before the period begins.Applica

25、tion of Manufacturing OverheadOverhead applied = POHR Actual activity For each direct labor hour worked on a particular product, $3.00 of factory overhead will be applied to it. For product valuation, it must be valued by unit. In this case, assume each unit requires 2 direct labor hours. Hence, eac

26、h unit of the product absorbs $6 predetermined overhead. In order to match back with Harveys example, we further assume that variable manufacturing overhead = 0. So the predetermined overhead represents only fixed manufacturing overhead cost as shown in slides 14 & 19.Overhead Application Rate for t

27、he Harvey ExamplePOHR = $3.00 per DLH$150,00050,000 direct labor hours (DLH)POHR =Estimated total manufacturingoverhead cost for the coming periodEstimated total units in theallocation base for the coming periodPOHR =Learning Objective 6Understand the implications of basing the predetermined overhea

28、d rate on activity at capacity rather than on estimated activity for the period.Predetermined Overhead Rate and CapacityCalculating predetermined overhead rates using an estimated, or budgeted amount of the allocation base has been criticized because:Basing the predetermined overhead rate upon budge

29、ted activity results in product costs that fluctuate depending upon the activity level.Calculating predetermined rates based upon budgeted activity charges products for costs that they do not use.Capacity-Based Overhead RatesCriticisms can be overcome by using estimated total units in the allocation

30、 base at capacity in the denominator of the predetermined overhead rate calculation.Lets look at the difference!An ExampleEquipment is leased for $100,000 per year. Running at full capacity, 50,000 units may be produced. The company estimates that 40,000 units will be produced and sold next year. Wh

31、at is the predetermined overhead rate?An ExampleEquipment is leased for $100,000 per year. Running at full capacity, 50,000 units may be produced. The company estimates that 40,000 units will be produced and sold next year. TraditionalMethod= $2.50 per unit$100,00040,000=Capacity Method= $2.00 per u

32、nit$100,00050,000=Quick Check Barossa Winery in Barossa Valley, South Australia, leases an automatic corking machine for $100,000 per year. At full capacity, it can cork 50,000 cases of wine per year. The company estimates 40,000 cases of wine will be produced and sold next year. What is the predete

33、rmined overhead rate based on the estimated number of cases of wine?a. $2.00 per case.b. $2.50 per case.c. $4.00 per case. Barossa Winery in Barossa Valley, South Australia, leases an automatic corking machine for $100,000 per year. At full capacity, it can cork 50,000 cases of wine per year. The co

34、mpany estimates 40,000 cases of wine will be produced and sold next year. What is the predetermined overhead rate based on the estimated number of cases of wine?a. $2.00 per case.b. $2.50 per case.c. $4.00 per case.Quick Check Quick Check Barossa Winery in Barossa Valley, South Australia, leases an

35、automatic corking machine for $100,000 per year. At full capacity, it can cork 50,000 cases of wine per year. The company estimates 40,000 cases of wine will be produced and sold next year. What is the predetermined overhead rate based on the number of cases of wine at capacity?a. $2.00 per case.b.

36、$2.50 per case.c. $4.00 per case. Barossa Winery in Barossa Valley, South Australia, leases an automatic corking machine for $100,000 per year. At full capacity, it can cork 50,000 cases of wine per year. The company estimates 40,000 cases of wine will be produced and sold next year. What is the pre

37、determined overhead rate based on the number of cases of wine at capacity?a. $2.00 per case.b. $2.50 per case.c. $4.00 per case.Quick Check Quick Check When capacity is used in the denominator of the predetermined rate, what happens to the predetermined overhead rate as estimated activity decreases?

38、a. The predetermined overhead rate goes up when activity goes down.b. The predetermined overhead rate stays the same because it is not affected by changes in activity.c. The predetermined overhead rate goes down when activity goes down. When capacity is used in the denominator of the predetermined r

39、ate, what happens to the predetermined overhead rate as estimated activity decreases?a. The predetermined overhead rate goes up when activity goes down.b. The predetermined overhead rate stays the same because it is not affected by changes in activity.c. The predetermined overhead rate goes down whe

40、n activity goes down.Quick Check Quick Check When estimated activity is used in the denominator of the predetermined rate, what happens to the predetermined overhead rate as estimated activity decreases?a. The predetermined overhead rate goes up when activity goes down.b. The predetermined overhead

41、rate stays the same because it is not affected by changes in activity.c. The predetermined overhead rate goes down when activity goes down. When estimated activity is used in the denominator of the predetermined rate, what happens to the predetermined overhead rate as estimated activity decreases?a.

42、 The predetermined overhead rate goes up when activity goes down.b. The predetermined overhead rate stays the same because it is not affected by changes in activity.c. The predetermined overhead rate goes down when activity goes down.Quick Check Income Statement Preparation Capacity Income Statement

43、 Preparation Traditional Learning Objective 7Compute underapplied or overapplied overhead cost and prepare the journal entry to close the balance in Manufacturing Overhead to the appropriate accounts.Problems of Overhead ApplicationThe difference between the overhead cost applied to Work in Process

44、and the actual overhead costs of a period is referred to as either underapplied or overapplied overhead.Underapplied overhead exists when the amount of overhead applied to products/ jobs during the period using the predetermined overhead rate is less than the total amount of overhead actually incurr

45、ed during the period.Overapplied overhead exists when the amount of overhead applied to products/jobs during the period using the predetermined overhead rate is greater than the total amount of overhead actually incurred during the period. Recall the Harvey example between slides 9 and 36. Lets rena

46、me the example as Harvey Fresh and assume actual overhead for the year was $120,000 (instead of $150,000 in the original Harvey example). The total direct labor hours incurred were 50,000. The rest remains the same.How much total overhead was applied to Harvey Freshs products during the year? Use Ha

47、rveys predetermined overhead rate of $3.00 per direct labor hour. Overhead Application ExampleOverhead Applied During the PeriodApplied Overhead = POHR Actual Direct Labor HoursApplied Overhead = $3.00 per DLH 50,000 DLH = $150,000 Harvey Freshs actual overhead for the year was $120,000 with a total

48、 of 50,000 direct labor hours worked on products.How much total overhead was applied to Harvey Freshs products during the year? Use Harveys predetermined overhead rate of $4.00 per direct labor hour. Overhead Applied During the PeriodApplied Overhead = POHR Actual Direct Labor HoursApplied Overhead

49、= $3.00 per DLH 50,000 DLH = $150,000Overhead Application ExampleHarvey Fresh has overappliedoverhead for the yearby $30,000. What willHarvey Fresh do? Tiger, Ltd. had actual manufacturing overhead costs of $1,210,000 and a predetermined overhead rate of $4.00 per machine hour. Tiger, Ltd. worked 29

50、0,000 machine hours during the period. Tigers manufacturing overhead is a. $50,000 overapplied.b. $50,000 underapplied.c. $60,000 overapplied.d. $60,000 underapplied.Quick Check Tiger, Ltd. had actual manufacturing overhead costs of $1,210,000 and a predetermined overhead rate of $4.00 per machine h

51、our. Tiger, Ltd. worked 290,000 machine hours during the period. Tigers manufacturing overhead isa. $50,000 overapplied.b. $50,000 underapplied.c. $60,000 overapplied.d. $60,000 underapplied.Quick Check Overhead Applied $4.00 per hour 290,000 hours = $1,160,000Underapplied Overhead $1,210,000 - $1,1

52、60,000 = $50,000Disposition of Under- or Overapplied Overhead$30,000 may beclosed directly to cost of goods sold.Cost of Goods SoldHarvey Freshs MethodWork inProcessFinishedGoods Cost of Goods Sold$30,000may be allocatedto these accounts.ORDisposition of Under/Overapplied Overhead Harvey Fresh sMfg.

53、 OverheadActualoverhead costs$120,000$30,000 overapplied Harvey Freshs Costof Goods SoldUnadjusted BalanceAdjustedBalance$30,000$30,000Overhead appliedto products$150,000Under/Overapplied Adjustment Through COGSIf Harvey Freshs overapplied adjustment is directly through COGS, then its profit will be

54、 as follows:Allocating Under- or Overapplied Overhead Between AccountsIn Year 1, Harvey Fresh s overhead applied in ending Work in Process Inventory, ending Finished Goods Inventory, and Cost of Goods Sold is shown below:Allocating Under- or Overapplied Overhead Between AccountsWe would complete the

55、 following allocation of $30,000 overapplied overhead:20% $30,000Allocating Under- or Overapplied Overhead Between AccountsUnder/Overapplied Adjustment Through the Proportional Allocation MethodNet result of $24,000 adjusted against COGSNet Operating Income is different from the one with adjustment

56、directly through COGS ($150,000) Revisit the earlier Tiger, Ltd. exercise on slide 56. Before any manufacturing fixed overhead over/underapplied adjustment, the relevant figures are as follows: Work in process20,000Finished goods30,000Cost of goods sold50,000How much should Tigers over/underapplied

57、manufacturing fixed overhead be adjusted to Finished Goods (FG) if the proportional allocation method is used?a. $15,000 more (i.e. debit) to FG.b. $15,000 less (i.e. credit) to FG.c. $30,000 more (i.e. debit) to FG.d. $30,000 less (i.e. credit) to FG.Quick Check Revisit the earlier Tiger, Ltd. exer

58、cise on slide 56. Before any manufacturing fixed overhead over/underapplied adjustment, the relevant figures are as follows: Work in process20,000Finished goods30,000Cost of goods sold50,000How much shouldTigers over/underapplied manufacturing fixed overhead be adjusted to Finished Goods (FG) if the

59、 proportional allocation method is used? a. $15,000 more (i.e. debit) to FG.b. $15,000 less (i.e. credit) to FG.c. $30,000 more (i.e. debit) to FG.d. $30,000 less (i.e. credit) to FG.Quick Check Revisit the earlier Tiger, Ltd. exercise on slide 56. Before any manufacturing fixed overhead over/undera

60、pplied adjustment, the relevant figures are as follows: Work in process$20,000Finished goods$30,000Cost of goods sold$50,000How much shouldTigers over/underapplied manufacturing fixed overhead be adjusted to Cost of Goods Sold (COGS) if the proportional allocation method is used?a. $50,000 more (i.e