Direct labor
Variable manufacturing overhead
Fixed manufacturing overhead ($111,000 / 2,000 units) Total unit product cost
Absorption Costing
75.00 20.00 55.50
$ 300.50
$ 150.00 $ 150.00 75.00 20.00
$ 245.00
Try It!
1. Pierce Company had the following costs:
Units produced 500 units
Manufacturing costs:
Direct materials $ 25 per unit
Direct labor 45 per unit
Variable manufacturing overhead 15 per unit Fixed manufacturing overhead 5,000 per year Selling and administrative costs:
Variable selling and administrative costs 30 per unit Fixed selling and administrative costs 3,200 per year Calculate the unit product cost using absorption costing and variable costing.
Check your answer online in MyAccountingLab or at http://www.pearsonhighered.com/Horngren.
For more practice, see Short Exercises S21-1 through S21-3. MyAccountingLab
HOW DOES OPERATING INCOME DIFFER BETWEEN VARIABLE COSTING AND ABSORPTION COSTING?
Now that you know how to calculate unit product costs using variable costing and absorption Learning Objective 2
Units Produced Equal Units Sold
Let’s assume that for Year 1 Smart Touch Learning has the following history:
• No beginning balance in Finished Goods Inventory
• Produced 2,000 tablet computers during the year
• Sold 2,000 tablet computers during the year
Based on these assumptions, we can also conclude that Smart Touch Learning has no end- ing balance in Finished Goods Inventory because the beginning balance was zero and all units produced were sold.
Exhibit 21-4 shows the income statements for Smart Touch Learning using absorp- tion costing and variable costing. The unit costs and total fixed costs were given or calcu- lated in Exhibits 21-2 and 21-3.
As shown in Exhibit 21-4, the absorption costing income statement includes all manu- facturing costs (direct materials, direct labor, variable manufacturing overhead, and fixed manufacturing overhead) in the cost of goods sold. Net sales revenue less cost of goods sold determines gross profit, and then selling and administrative costs (both variable and fixed) are subtracted to determine operating income.
In the variable costing income statement, variable costs are reported separately from fixed costs. Variable costs (direct materials, direct labor, variable manufacturing overhead, and variable selling and administrative costs) are subtracted from net sales revenue to deter- mine the contribution margin. Fixed costs (both manufacturing and selling and administra- tive) are then subtracted from contribution margin to determine operating income.
Exhibit21-4 | Absorption and Variable Costing: Year 1—Units Produced Equal Units Sold
Absorption Costing
(2,000 units × $500.00 per unit) (2,000 units × $300.50 per unit)
Net Sales Revenue $ 1,000,000
601,000 Cost of Goods Sold
Gross Profit 399,000
241,000 Selling and Administrative Costs:
(2,000 units × $62.50 per unit)
(2,000 units × $500.00 per unit) (2,000 units × $245.00 per unit) (2,000 units × $62.50 per unit) Variable S&A Costs
Fixed S&A Costs Operating Income
Finished Goods Inventory, Ending Balance
$ 158,000
$ 0 Variable Costing
Net Sales Revenue Variable Costs:
$ 1,000,000
Variable Manufacturing Costs
Variable S&A Costs 615,000
385,000 Contribution Margin
Fixed Costs:
Fixed Manufacturing Costs Fixed S&A Costs
Operating Income
Finished Goods Inventory, Ending Balance
116,000 227,000
$ 158,000
$ 0 111,000
$ 125,000 116,000
$ 490,000 125,000
When all of the units produced are sold, there is no difference in operating income between the two costing methods. The reason is that all fixed costs are expensed under both methods. In other words, because the ending Finished Goods Inventory balance is zero and there are no production costs assigned to the inventory accounts, all costs incurred have been recorded as expenses and deducted from net sales revenue on the income statement.
Units Produced Are More Than Units Sold
Let’s assume that for Year 2 Smart Touch Learning shows the following:
• No beginning balance in Finished Goods Inventory (Year 1 ended with a zero balance;
therefore, Year 2 will start with a zero balance)
• Produced 2,500 tablet computers during the year
• Sold 2,000 tablet computers during the year
• Ending balance in Finished Goods Inventory of 500 units
Ending balance in Finished Goods Inventory= Beginning balance + Units Produced − Units sold
= 0 units + 2,500 units - 2,000 units
= 500 units
With the change in number of tablets produced, the unit product costs must be recalculated because fixed costs are spread over a greater number of units produced. The calculations are summarized in Exhibit 21-5. The increase in production decreased the total unit product cost from $300.50 (Exhibit 21-3) to $289.40 under absorption costing.
Exhibit21-5 | Comparison of Unit Product Cost Computations—2,500 Units Produced
Variable Costing Direct materials
Direct labor
Variable manufacturing overhead
Fixed manufacturing overhead ($111,000 / 2,500 units) Total unit product cost
Absorption Costing
75.00 20.00 44.40
$ 289.40
$ 150.00 $ 150.00 75.00 20.00
$ 245.00
Suppose you invite a friend for dinner and you make an apple pie.
There are only two of you, so you can each have half of the pie.
Now suppose you invite two more friends. There are four people having dinner and still only one pie. Each person can have only a fourth of the pie.
Exhibit 21-6 shows the income statements for Smart Touch Learning for Year 2 using absorption costing and variable costing. The unit costs and total fixed costs were given or calculated in Exhibits 21-2 and 21-5.
Exhibit21-6 | Absorption and Variable Costing: Year 2—Units Produced Are More Than Units Sold
Absorption Costing
(2,000 units × $500.00 per unit) (2,000 units × $289.40 per unit)
Net Sales Revenue $ 1,000,000
578,800 Cost of Goods Sold
Gross Profit 421,200
241,000 Selling and Administrative Costs:
(2,000 units × $62.50 per unit)
(2,000 units × $500.00 per unit) (2,000 units × $245.00 per unit) (2,000 units × $62.50 per unit) Variable S&A Costs
Fixed S&A Costs Operating Income
Finished Goods Inventory, Ending Balance
$ 180,200
Variable Costing Net Sales Revenue Variable Costs:
$ 1,000,000 Variable Manufacturing Costs
Variable S&A Costs 615,000
385,000 Contribution Margin
Fixed Costs:
Fixed Manufacturing Costs Fixed S&A Costs
Operating Income
Finished Goods Inventory, Ending Balance
116,000 227,000
$ 158,000 111,000
$ 125,000 116,000
$ 490,000 125,000
(500 units × $289.40 per unit) $ 144,700
(500 units × $245.00 per unit) $ 122,500
As shown in Exhibit 21-6, when more units are produced than sold, operating income is greater under absorption costing than variable costing. The reason is that with absorp- tion costing some fixed manufacturing costs remain in ending Finished Goods Inventory on the balance sheet and have not been expensed. The difference between the operating incomes for the two methods is $22,200 ($180,200 - $158,000). This is the same differ- ence in ending Finished Goods Inventory ($144,700 - $122,500). This difference is due to the fixed manufacturing overhead costs. Under variable costing, all of the fixed manu- facturing overhead is expensed. Under absorption costing, though, $22,200 (500 units of ending inventory * $44.40 per unit fixed manufacturing overhead cost) remain in ending inventory and are therefore not expensed in the time period. This $22,200 difference results in the operating income being greater under absorption costing.
Units Produced Are Less Than Units Sold
Let’s assume that for Year 3 Smart Touch Learning shows the following:
• A beginning balance in Finished Goods Inventory of 500 units that cost $144,700 under absorption costing and $122,500 under variable costing (Year 2’s ending balances)
• Produced 1,500 tablet computers during the year
• Sold 2,000 tablet computers during the year
Based on the above assumptions, we can also conclude that Smart Touch has no ending bal- ance in Finished Goods Inventory because the beginning balance was 500 units, which was increased by the 1,500 units produced and decreased by the 2,000 units sold:
Ending balance in Finished Goods Inventory = Beginning balance + Units produced − Units sold
= 500 units + 1,500 units - 2,000 units
= 0 units
With the change in number of tablets produced, the unit product costs must be recal- culated. The calculations are summarized in Exhibit 21-7. The decrease in production increased the total unit product cost from $289.40 (Exhibit 21-5) to $319.00 under absorp- tion costing because the total fixed manufacturing overhead costs were distributed among fewer units produced.
Exhibit21-7 | Comparison of Unit Product Cost Computations—1,500 Units Produced
Variable Costing Direct materials
Direct labor
Variable manufacturing overhead
Fixed manufacturing overhead ($111,000 / 1,500 units) Total unit product cost
Absorption Costing
75.00 20.00 74.00
$ 319.00
$ 150.00 $ 150.00 75.00 20.00
$ 245.00
Exhibit 21-8 (on the next page) shows the income statements for Smart Touch Learn- ing for Year 3 using absorption costing and variable costing. The unit costs and total fixed costs were given or calculated in Exhibits 21-2 and 21-7.
As shown in Exhibit 21-8, when more units are sold than produced, operating income is less under absorption costing than variable costing. The only way to sell more units than were produced is to sell some units that were in inventory at the beginning of the period.
Notice the cost of goods sold calculation using absorption costing includes the 500 units in beginning Finished Goods Inventory at $289.40 per unit, $144,700. This is the amount shown as the ending Finished Goods Inventory for Year 2 in Exhibit 21-6. Remember that Year 2’s ending inventory becomes Year 3’s beginning inventory.
In variable costing, the fixed manufacturing costs for the prior year were expensed in the prior year. Because only variable costs are assigned to the units, the unit product cost is the same for all three accounting periods, $245.00 per unit. Under absorption costing, the units in beginning inventory have fixed manufacturing costs assigned to them. Therefore, the units sold under absorption costing have a higher cost per unit, which increases cost of goods sold and decreases operating income. The difference between the operating incomes for the two methods is $22,200 ($135,800 - $158,000). This difference is due to when the fixed manufacturing overhead costs are expensed. Under variable costing, all of the fixed manufacturing overhead costs from the prior period were expensed in the prior period and therefore are not shown on the current year income statement. Under absorpotion costing, the prior period fixed manufacturing costs attached to beginning inventory are expensed in the current year.
Summary
In the three years illustrated for Smart Touch Learning, the only difference was the number of tablet computers produced. In each year, the number of tablets sold (2,000 units), the sales price per unit, the variable costs per unit, and the total fixed costs were the same. Let’s
Exhibit21-8 | Absorption and Variable Costing: Year 3—Units Produced Are Less Than Units Sold
Absorption Costing
(2,000 units × $500.00 per unit) (500 units × $289.40 per unit) (1,500 units × $319.00 per unit)
Net Sales Revenue $ 1,000,000
Cost of Goods Sold Gross Profit
241,000 Selling and Administrative Costs:
(2,000 units × $62.50 per unit)
(2,000 units × $500.00 per unit) (2,000 units × $245.00 per unit) (2,000 units × $62.50 per unit) Variable S&A Costs
Fixed S&A Costs Operating Income
Finished Goods Inventory, Ending Balance
$ 135,800
$ 0 Variable Costing
Net Sales Revenue Variable Costs:
$ 1,000,000 Variable Manufacturing Costs
Variable S&A Costs 615,000
385,000 Contribution Margin
Fixed Costs:
Fixed Manufacturing Costs Fixed S&A Costs
Operating Income
Finished Goods Inventory, Ending Balance
116,000 227,000
$ 158,000 111,000
125,000
$ 144,700 478,500
116,000
$ 490,000 125,000
623,200 376,800
$ 0
compare the three years to determine why many managers prefer to use variable costing for planning, directing, and controlling. Exhibit 21-9 summarizes the income statements for the three years. Notice that the total operating income for the three years ($474,000) is the same under both methods but that the operating income for each year differs under absorption costing.
Exhibit21-9 | Absorption and Variable Costing: 3-Year Summary—2,000 Units Sold Each Year
Absorption Costing Year 1 Year 2 Year 3 Total*
Net Sales Revenue $ 1,000,000 $ 1,000,000 $ 1,000,000 $ 3,000,000
Cost of Goods Sold 578,800 623,200 1,803,000
Gross Profit
601,000
399,000 421,200 376,800 1,197,000
Selling and Administrative Costs 241,000 241,000 723,000
Operating Income
241,000
$ 158,000 $ 180,200 $ 135,800 $ 474,000 Gross Profit per Unit
Variable Costing Year 1 Year 2 Year 3 Total
Net Sales Revenue $ 1,000,000 $ 1,000,000 $ 1,000,000 $ 3,000,000
Variable Costs 615,000 615,000 1,845,000
Contribution Margin
615,000
385,000 385,000 385,000 1,155,000
Fixed Costs 227,000 227,000 681,000
Operating Income
227,000
$ 158,000 $ 158,000 $ 158,000 $ 474,000 Contribution Margin per Unit $ 192.50 $ 192.50 $ 192.50
*Year 1: Units Produced = Units Sold Absorption Operating Income = Variable Operating Income Year 2: Units Produced > Units Sold Absorption Operating Income > Variable Operating Income Year 3: Units Produced < Units Sold Absorption Operating Income < Variable Operating Income
$ 199.50 $ 210.60 $ 188.40
Suppose the production supervisor receives a bonus based on the amount of operat- ing income under absorption costing. Will the supervisor increase or decrease production?
Based on the summary of income statements presented in Exhibit 21-9, operating income under absorption costing was greater than operating income under variable costing in Year 2, when production exceeded sales. The production supervisor knows that absorption costing assigns fixed manufacturing overhead costs to each tablet produced. In absorption costing:
• For every tablet that is produced but not sold, absorption costing “hides” some of the fixed manufacturing overhead costs in ending Finished Goods Inventory (an asset).
• The more tablets added to ending Finished Goods Inventory, the more fixed manufacturing overhead costs are “hidden” in ending Finished Goods Inventory at the end of the month.
• The more fixed manufacturing overhead costs in ending Finished Goods Inventory, the smaller the Cost of Goods Sold and the higher the operating income.
How can using absorption costing