In chapter 2 “How Is task Costing used to Track manufacturing Costs?”, we disputed how to report production costs and nonmanufacturing expenses following U.S. Generally Accepted accountancy Principles (U.S. GAAP). Under U.S. GAAP, every nonmanufacturing costs (selling and administrative costs) are treated as period costs because they room expensed ~ above the income statement in the duration in i m sorry they are incurred. All costs linked with production are treated as product costs, including straight materials, straight labor, and also fixed and variable manufacturing overhead. These prices are attached come inventory together an asset on the balance sheet till the items are sold, in ~ which allude the costs are moved to cost of products sold ~ above the revenue statement as an expense. This technique of accountancy is called absorption costing due to the fact that all manufacturing overhead expenses (fixed and variable) room absorbed right into inventory until the products are sold. (The term full costing is likewise used to define absorption costing.)

Question: Although absorption costing is supplied for external reporting, managers frequently prefer to usage an different costing method for interior reporting purposes referred to as variable costing. What is change costing, and also how walk it compare to absorb costing?

Answer: change costing calls for that every variable production expenses be contained in inventory, and also all fixed production prices (fixed production overhead) be report as period costs. For this reason all solved production costs are expensed as incurred.

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The only difference in between absorption costing and variable costing is in the treatment of fixed manufacturing overhead. Utilizing absorption costing, fixed manufacturing overhead is reported together a product cost. Using variable costing, fixed production overhead is reported as a period cost. Number 6.8 “Absorption Costing matches Variable Costing” summarizes the similarities and also differences between absorption costing and also variable costing.


Figure 6.8 absorb Costing versus Variable Costing


Impact of absorb Costing and Variable Costing top top Profit

Question: If a company uses just-in-time inventory, and also therefore has no start or ending inventory, profit will certainly be specifically the exact same regardless that the costing method used. However, many companies have units of product in inventory in ~ the end of the report period. How does the usage of absorption costing affect the value of ending inventory?

Answer: due to the fact that absorption costing consists of fixed manufacturing overhead together a product cost, all commodities that stay in finishing inventory (i.e., space unsold in ~ the finish of the period) incorporate a section of fixed production overhead prices as an legacy on the balance sheet. Due to the fact that variable costing treats fixed production overhead prices as duration costs, all fixed production overhead expenses are expensed on the earnings statement once incurred. Therefore if the amount of units created exceeds the quantity of units sold, absorption costing will an outcome in greater profit.

We illustrate this principle with an example. The complying with information is because that Bullard Company, a producer of clock radios:



Assume Bullard has no finished goods inventory at the beginning of month 1. We will look at absorption costing matches variable costing because that three various scenarios:

Month 1 scenario: 10,000 units produced equals 10,000 units soldMonth 2 scenario: 10,000 units produced is greater than 9,000 systems soldMonth 3 scenario: 10,000 units created is less than 11,000 units sold

Month 1: variety of Units produced Equals number of Units Sold

Question: throughout month 1, Bullard company sells all 10,000 units developed during the month. How does operation profit compare utilizing absorption costing and variable costing once the variety of units created equals the number of units sold?

Answer: figure 6.9 “Number that Units developed Equals variety of Units Sold” presents the outcomes for each costing method. Notification that the absorb costing income statement is referred to as a classic income statement, and the change costing earnings statement is called a contribution margin earnings statement.

As friend review number 6.9 “Number of Units produced Equals number of Units Sold”, notification that when the variety of units produced equals the number sold, benefit totaling $90,000 is the same for both costing methods. With absorption costing, fixed manufacturing overhead prices are totally expensed due to the fact that all units created are marketed (there is no ending inventory). Through variable costing, fixed manufacturing overhead expenses are cure as period costs and therefore are always expensed in the duration incurred. Since all other costs are cure the exact same regardless that the costing method used, benefit is similar when the variety of units produced and sold is the same.


Figure 6.9 variety of Units created Equals variety of Units Sold

a $250,000 = $25 × 10,000 units sold.

b $110,000 = ($4 every unit solved production expense × 10,000 devices sold) + ($7 per unit change production price × 10,000 systems sold).

c $70,000 = $7 per unit change production expense × 10,000 units sold.

d $50,000 = $20,000 fixed selling and also admin. Expense + ($3 per unit change selling and also admin. Price × 10,000 systems sold).

e $30,000 = $3 every unit change selling and also admin. Price × 10,000 devices sold.

f change costing treats fixed manufacturing overhead together a period cost. Hence all fixed production overhead prices are expensed in the period incurred regardless of the level the sales.

g Given.


Month 2: number of Units developed Is better Than number of Units Sold

Question: throughout month 2, Bullard company produces 10,000 units but sells just 9,000 units. How does operating profit compare using absorption costing and also variable costing when the variety of units created is better than the variety of units sold?

Answer: figure 6.10 “Number the Units produced Is better Than number of Units Sold” presents the outcomes for every costing method. An alert that absorb costing outcomes in greater profit. When absorption costing is used, a section of fixed manufacturing overhead costs remains in ending inventory as an legacy on the balance sheet until the items are sold. However, variable costing requires that all fixed manufacturing overhead expenses be expensed as occurs regardless the the level that sales. Thus when an ext units are produced than room sold, variable costing results in greater costs and lower profit.

The distinction in profit in between the two methods of $4,000 (= $79,000 − $75,000) is attributed come the $4 every unit fixed manufacturing overhead cost assigned to the 1,000 units in finishing inventory making use of absorption costing ($4,000 = $4 × 1,000 units).


Figure 6.10 number of Units developed Is higher Than number of Units Sold

a $225,000 = $25 × 9,000 systems sold.

b $99,000 = ($4 every unit addressed production cost × 9,000 units sold) + ($7 every unit change production cost × 9,000 units sold).

c $63,000 = $7 per unit variable production price × 9,000 units sold.

d $47,000 = $20,000 solved selling and also admin. Price + ($3 per unit variable selling and admin. Price × 9,000 systems sold).

e $27,000 = $3 every unit variable selling and admin. Expense × 9,000 devices sold.

f variable costing always treats fixed manufacturing overhead together a period cost. Hence all fixed production overhead prices are expensed in the duration incurred nevertheless of the level of sales.

g Given.


Month 3: variety of Units developed Is less Than variety of Units Sold

Question: during month 3, Bullard company produces 10,000 units but sells 11,000 systems (1,000 units were left end from month 2 and also therefore were in inventory at the start of month 3). How does operation profit compare utilizing absorption costing and also variable costing when the number of units produced is less than the number of units sold?

Answer: number 6.11 “Number the Units developed Is less Than variety of Units Sold” gift the results for each costing method. Utilizing variable costing, the $40,000 in fixed manufacturing overhead costs proceeds to be expensed when incurred. However, making use of absorption costing, the entire $40,000 is expensed since all 10,000 units produced were sold; second $4,000 related to the 1,000 units developed last month and also pulled native inventory this month is additionally expensed. Therefore when fewer systems are created than room sold, absorption costing results in higher costs and also lower profit.

The distinction in profit between the two techniques of $4,000 (= $105,000 − $101,000) is attributed come the $4 every unit fixed manufacturing overhead price assigned come the 1,000 systems in perform on the balance paper at the finish of month 2 and also recorded as expense of goods sold during month 3 using absorption costing ($4,000 = $4 × 1,000 units).


Figure 6.11 variety of Units produced Is much less Than variety of Units Sold

a $275,000 = $25 × 11,000 devices sold.

b $121,000 = ($4 every unit fixed production price × 11,000 systems sold) + ($7 per unit variable production cost × 11,000 devices sold).

c $77,000 = $7 every unit variable production expense × 11,000 systems sold.

d $53,000 = $20,000 resolved selling and admin. Price + ($3 per unit change selling and admin. Expense × 11,000 devices sold).

e $33,000 = $3 per unit change selling and also admin. Cost × 11,000 devices sold.

f variable costing constantly treats fixed manufacturing overhead as a period cost. Hence all fixed manufacturing overhead costs are expensed in the duration incurred regardless of the level the sales.

g Given.


Advantages of utilizing Variable Costing

Question: Why do establishments use variable costing?

Answer: variable costing offers managers with the information necessary to prepare a donation margin revenue statement, which leader to much more effective cost-volume-profit (CVP) analysis. Through separating variable and fixed costs, supervisors are able to identify contribution margin ratios, break-even points, and target benefit points, and to do sensitivity analysis. Conversely, absorption costing meets the needs of U.S. GAAP, yet is not as valuable for internal decision-making purposes.

Another benefit of utilizing variable costing within is that it prevents managers from enhancing production exclusively for the objective of inflating profit. For example, i think the manager at Bullard firm will receive a bonus for getting to a specific profit target yet expects to it is in $15,000 quick of the target. The agency uses absorption costing, and also the manager realizes enhancing production (and thus increasing inventory levels) will rise profit. The manager decides to develop 20,000 devices in month 4, also though only 10,000 devices will be sold. Fifty percent of the $40,000 in resolved production cost ($20,000) will be included in inventory at the finish of the period, in order to lowering prices on the revenue statement and increasing profit by $20,000. At part point, this will catch up to the manager due to the fact that the company will have excess or useless inventory in future months. However, in the quick run, the manager will boost profit by boosting production. This strategy go not work with change costing since all fixed production overhead expenses are expensed together incurred, nevertheless of the level of sales.


Key Takeaway

As presented in figure 6.8 “Absorption Costing matches Variable Costing”, the only difference between absorption costing and also variable costing is in the treatment of fixed manufacturing overhead costs. Absorption costing treats fixed production overhead together a product expense (included in perform on the balance sheet until sold), while variable costing treats fixed manufacturing overhead together a duration cost (expensed top top the revenue statement together incurred).When comparing absorb costing v variable costing, the following three rules apply: (1) as soon as units created equals devices sold, profit is the same for both costing approaches. (2) as soon as units produced is greater than systems sold, absorption costing returns the greatest profit. (3) when units developed is much less than devices sold, change costing yields the highest possible profit.

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Review difficulty 6.8

Winter Sports, Inc., to produce snowboards. The firm has no finished products inventory at the start of year 1. The complying with information comes to Winter Sports, Inc.,:



All 100,000 units developed during year 1 are sold throughout year 1.Prepare a timeless income statement assuming the agency uses absorb costing.Prepare a contribution margin income statement suspect the agency uses change costing.Although 100,000 systems are produced during year 2, only 80,000 are sold throughout the year. The remaining 20,000 units are in finished goods inventory in ~ the end of year 2.Prepare a traditional income statement suspect the firm uses absorption costing.Prepare a donation margin revenue statement suspect the company uses variable costing.

Solution come Review trouble 6.8