Traditional (Absorption) IS vs.

Contribution (Variable) IS

Traditional Approach Contribution Approach

(costs organized by function) (costs organized by behavior)

Sales $60,000 Sales $60,000

Less Variable Expenses:

Less CGS

Gross Profit

Less Operating Expenses: Contribution Margin

Less Fixed Expenses:
Selling

Administrative

Net Income Net Income

*Contains both variable and fixed elements since this is the income
statement for a manufacturing company. If this were a
merchandising company, then the cost of goods sold would be
entirely variable.
 Overview of Absorption
and Variable Costing

Ab so rp tio n V a ria b le
Co stin g Co stin g

2 3
 Variable vs. Absorption Costing

Variable Costing

Under variable costing, only those costs of production that

vary with out put are treated as product costs.

• These costs usually consist of DM, DL, and VMOH.

• FMOH is not treated as a product cost under variable

costing. Rather, it is treated as a period cost and
deducted in full each year from revenues.

• Variable costing may be used by companies internally for

planning and for controlling operations. However,
variable costing is not generally considered acceptable for
audited external reports and tax reporting.

Absorption Costing

Absorption costing treats all production costs as product costs.

• Unit product cost under the absorption costing method

consists of DM, DL, and both VMOH and FMOH.

• Under absorption costing a portion of the FMOH is

allocated to each unit of product.

3
 Summary
Relation between Effect Relation between
production on variable and
Year and sales iniventory absorption income
Inventory Absorption
1st Production > Sales increases by >
year 25,000 > 20,000 5,000 units. Variable
Inventory Absorption
2nd Production < Sales decreases <
year 25,000 < 30,000 to zero. Variable
Both Absorption
years Production = Sales No change =
combined 50,000 = 50,000 Variable

4 13
 Advantages of the
Contribution Approach
Consistent with
CVP analysis.
Management finds it
easy to understand. Net income is closer
to net cash flow.

Consistent with standard

Advantages costs and flexible budgeting.

Easier to estimate profitability

of products and segments.
Impact of fixed
costs on profits Profit is not affected by
emphasized. changes in inventories.

5 14
 Absorption versus Variable Costing
Absorption Variable
Costing Costing

All manufacturing costs Fixed costs are

must be assigned to
products to properly
match revenues and costs.
Depreciation, taxes,
insurance and salaries
are just as essential to
products as variable costs.
not really the costs
of any particular
product.
These are capacity
costs and will be
incurred if nothing
is produced.

6 15
 Variable vs. Absorption Costing

P9-20

The Zwatch Company manufactures trendy, high-quality moderately priced watches. As

Zwatch’s senior financial analyst, you are asked to recommend a method of inventory
costing. The CFO will use your recommendation to construct Zwatch’s 2004 income
statement. The following data are for the year ended December 31, 2004:

Beginning inventory, January 1, 2004 85,000 units

Ending inventory, December 31, 2004 34,500 units
2004 sales 345,400 units
Selling price (to distributor) $22.00 per unit
Variable mnfc cost per unit, incl. DM $5.10 per unit
Variable operating cost per unit sold $1.10 per unit sold
Fixed mnfc. Overhead $1,440,000
Denominator-level machine-hours 6,000
Standard production rate 50 units per machine-hour
Fixed operating costs $1,080,000

Assume standard costs per unit are the same for units in beginning inventory and units
produced during the year. Also, assume no price, spending, or efficiency variances.

1. Prepare income statements under variable and absorption costing for the year
ended December 31, 2004.
2. What is Zwatch’s operating income under each costing method (in percentage
terms)?
3. Explain the difference in operating income between the two methods.
4. Which costing method would you recommend to the CFO? Why?

7
 Absorption and Variable Costing

P9-21 (CMA)

Osawa, Inc., planned and actually manufactured 200,000 units of its single product in
2004, its first year of operation. Variable manufacturing costs was $20 per unit
produced. Variable operating cost was $10 per unit sold. Planned and actual fixed
manufacturing costs were $600,000. Planned and actual fixed operating costs totaled
$400,000 in 2004. Osawa sold 120,000 units of product in 2004 at $40 per unit.

1. Osawa’s 2004 operating income using absorption costing is:

a. $440,000
b. $200,000
c. $600,000
d. $840,000
e. None of these.

2. Osawa’s 2004 operating income using variable costing is:

a. $800,000
b. $440,000
c. $200,000
d. $600,000
e. None of these.

8
 Comparison of Actual-Costing Methods

P9-23

The Rehe Company sells its razors at $3 per unit. The company uses a FIFO actual-
costing system. A new FMOH overhead rate is computed each year by dividing the
actual FMOH cost by the actual production units. The following simplified data are
related to its first two years of operation:

2003 2004
Sales 1,000 units 1,200 units
Production 1,400 units 1,000 units
Costs:
Variable manufacturing $700 $500
Fixed manufacturing $700 $700
Variable operating $1,000 $1,200
Fixed operating $400 $400

1. Prepare income statements based on variable costing for each of the two years.
2. Prepare income statements based on absorption costing for each of the two years.
3. Prepare a numerical reconciliation and explanation of the difference between
operating income for each year under absorption costing and variable costing.
4. Critics have claimed that a widely used accounting system has led to undesirable
buildups of inventory levels.
a. Is variable costing or absorption costing more likely to lead to such
buildups? Why?
What can be done to counteract undesirable inventory buildups?

9
HORNGREN/DATAR/FOSTER, COST ACCOUNTING 11E

Problem 9-23

B C D E F G H
Data Input Section: Rehe Company
Year 2003 Year 2004
Unit data:
Sales 1,000 1,200
Production 1,400 1,000
Beginning inventory - 400
Ending inventory 400 200
Cost data:
Variable manufacturing $ 700 $ 500
Fixed manufacturing 700 700
Variable marketing and administration 1,000 1,200
Fixed marketing and administration 400 400

Selling price per razor $ 3.00

Output Section: Rehe Company
Part 1. Variable Costing
Year 2003 Year 2004
Sales $ 3,000 $ 3,600
Variable expenses:
Beginning inventory - 200
Variable manufacturing costs 700 500
Available for sale 700 700
Ending inventory 200 100
Variable manufacturing cost of goods sold 500 600
Variable marketing costs 1,000 1,200
Total variable costs 1,500 1,800
Contribution margin 1,500 1,800
Fixed expenses:
Manufacturing costs 700 700
Marketing costs 400 400
Total fixed expenses 1,100 1,100
Operating income $ 400 $ 700

continued
HORNGREN/DATAR/FOSTER, COST ACCOUNTING 11E

Problem 9-23

B C D E F G H
Part 2. Rehe Company
Absorption Costing
Year 2003 Year 2004
Sales $ 3,000 $ 3,600
Cost of goods sold:
Beginning inventory - 400
Variable manufacturing cost 700 500
Fixed manufacturing cost 700 700
Available for sale 1,400 1,600
Deduct ending inventory 400 240
Cost of goods sold: 1,000 1,360
Gross margin 2,000 2,240
Marketing costs:
Variable marketing and administration costs 1,000 1,200
Fixed marketing and administration costs 400 400
Total 1,400 1,600
Operating income $ 600 $ 640

Part 3. Year 2003 Year 2004

Variable costing:
Operating income $ 400 $ 700
Ending inventory 200 100
Absorption costing:
Operating income $ 600 $ 640
Ending inventory 400 240
Fixed manufacturing overhead
In beginning inventory 0 200
In ending inventory 200 140
 The All-Fixed Company in 2004

P9-32 (R. Marple, adapted)

It is the end of 2004. The All-Fixed Company began operations in January 2003. The
company is so named because it has no variable costs. All its costs are fixed; they do not
vary with output.

The All-Fixed Company is located on the bank of a river and its own hydroelectric plant
to supply power, light, and heat. The company manufactures a synthetic fertilizer from
air and river water and sells its product at a price that is not expected to change. It has a
small staff of employees, all hired on a fixed annual salary. The output of the plant can
be increased or decreased by adjusting a few dials on a control panel.

The following data are for the operations of the All-Fixed Company:

2003 2004a
Sales 10,000 tons 10,000 tons
Production 20,000 tons -------------
Selling price $30 per ton $30 per ton
Costs (all fixed):
Manufacturing $280,000 $280,000
Operating $ 40,000 $ 40,000
a
Management adopted the policy, effective January 1, 2004, of producing only as much
product as needed to fill sales orders. During 2004, sales were the same as for 2003 and
were filled entirely from inventory at the start of 2004.

1. Prepare income statements with one column for 2003, one column for 2004, and
one column for the two years together, using (a) variable costing and (b)
absorption costing?
2. What is the breakeven point under (a) variable costing and (b) absorption costing?
3. What inventory costs would be carried on the balance sheet on December 31,
2003 and 2004, under each method?
4. Assume that the performance of the top manager of the company is evaluated and
rewarded largely on the basis of reported operating income. Which costing
method would the manager prefer? Why?

10
9-32 (40 min.) The All-Fixed Company in 2004.
This problem always generates active classroom discussion.

1. The treatment of fixed manufacturing overhead in absorption costing is affected primarily by what
denominator level is selected as a base for allocating fixed manufacturing costs to units produced. In this case,
is 10,000 tons per year, 20,000 tons, or some other denominator level the most appropriate base?
We usually place the following possibilities on the board or overhead projector and then ask the students
to indicate by vote how many used one denominator level versus another. Incidentally, discussion tends to
move more clearly if variable-costing income statements are discussed first, because there is little disagreement
as to computations under variable costing.

a. Variable-Costing Income Statement:

2003 2004 Together

Revenues (and contribution margin) $300,000 $300,000 $600,000
Fixed costs:
Manufacturing costs $280,000
Operating costs 40,000 320,000 320,000 640,000
Operating income $ (20,000) $ (20,000) $ (40,000)

b. Absorption-Costing Income Statement:

The ambiguity about the 10,000- or 20,000-unit denominator level is intentional. IF YOU WISH, THE
AMBIGUITY MAY BE AVOIDED BY GIVING THE STUDENTS A SPECIFIC DENOMINATOR LEVEL
IN ADVANCE.

Alternative 1. Use 20,000 units as a denominator; fixed manufacturing overhead per unit is $280,000 ÷ 20,000
= $14.

1
9-32 (Cont’d.)

2003 2004 Together

Revenues $300,000 $ 300,000 $600,000
Manufacturing costs at $14 280,000 -- 280,000
Deduct ending inventory 140,000 -- --
Cost of goods sold 140,000 140,000* 280,000
Underallocated manuf. overhead--
output level variance -- 280,000 280,000
Operating costs 40,000 40,000 80,000
Total costs 180,000 460,000 640,000
Operating income $120,000 $(160,000) $( 40,000)

* Inventory carried forward from 2003 and sold in 2004.

Alternative 2. Use 10,000 units as a denominator; fixed manufacturing overhead per unit is $280,000 ÷10,000 =
$28.

2003 2004 Together

Revenues $300,000 $300,000 $600,000
Manufacturing costs at $28 560,000 -- 560,000
Deduct ending inventory 280,000 -- --
Cost of goods sold 280,000 280,000* 560,000
Underallocated manuf. overhead--
output level variance -- 280,000 --
Overallocated manuf. overhead --
output level variance (280,000) -- --
Operating costs 40,000 40,000 80,000
Total costs 40,000 600,000 640,000
Operating income $260,000 $(300,000) $ (40,000)

*Inventory carried forward from 2003 and sold in 2004.

Note that operating income under variable costing follows sales and is not affected by inventory changes.
Note also that students will understand the variable-costing presentation much more easily than the
alternatives presented under absorption costing.

Breakeven point
Fixed costs $320,000
2. under variable = =
costing Contribution margin per ton $30

= 10,667 tons per year or 21,333 for two years.

2
9-32 (Cont’d.)

If the company could sell 667 more tons per year at $30 each, it could get the extra $20,000 contribution
margin needed to break even.
Most students will say that the breakeven point is 10,667 tons per year under both absorption costing
and variable costing. The logical question to ask a student who answers 10,667 tons for variable costing is:
"What operating income do you show for 2003 under absorption costing?" If a student answers $120,000
(alternative 1 above), or $260,000 (alternative 2 above), ask: "But you say your breakeven point is 10,667
tons. How can you show an operating income on only 10,000 tons sold during 2003?"
The answer to the above dilemma lies in the fact that operating income is affected by both sales and
production under absorption costing.
Given that sales would be 10,000 tons in 2003, solve for the production level that will provide a
breakeven level of zero operating income. Using the formula in the chapter, sales of 10,000 units, and a fixed
manufacturing overhead rate of $14 (based on $280,000 ÷ 20,000 units denominator level = $14):

Let P = Production level

⎛ Target ⎞ ⎡⎛ Fixed manuf.⎞ ⎛ Breakeven ⎞⎤
⎛ Total fixed ⎞ ⎜ ⎟ ⎢⎜ ⎟ ⎜ Units ⎟⎥
⎜⎜ ⎟⎟ + ⎜ operating ⎟ + ⎢⎜ overhead ⎟ × ⎜ sales in − ⎟
Breakeven ⎝ costs ⎠ ⎜ income ⎟ ⎢⎜ ⎟ ⎜ produced ⎟⎥
sales ⎝ ⎠ ⎣⎝ rate ⎠ ⎝ units ⎠⎥⎦
=
in units Unit contribution margin
$320‚000 + $0 + $14(10‚000 − P)
10,000 tons =
$30
$300,000 = $320,000 + $140,000 – $14P
$14P = $160,000
P = 11,429 units (rounded)

Proof:
Gross margin, 10,000 × ($30 – $14) $160,000
Output level variance,
(20,000 – 11,429) × $14 $120,000
Marketing and administrative costs 40,000 160,000
Operating income $ 0

3
9-32 (Cont’d.)

Given that production would be 20,000 tons in 2003, solve for the breakeven unit sales level. Using the
formula in the chapter and a fixed manufacturing overhead rate of $14 (based on a denominator level of 20,000
units):

Let N = Breakeven sales in units

⎛ Target ⎞ ⎡⎛ Fixed manuf.⎞ ⎤
⎛ Total fixed ⎞ ⎜ ⎟ ⎢⎜ ⎟ ⎛ Units ⎞⎥
⎜⎜ ⎟⎟ + ⎜ operating ⎟ + ⎢⎜ overhead ⎟ × ⎜⎜ N − ⎟
⎝ costs ⎠ ⎜ income ⎟ ⎢⎜ ⎟ ⎝ produced ⎟⎠⎥
⎝ ⎠ ⎣⎝ rate ⎠ ⎥⎦
N =
Unit contribution margin
$320‚000 + $0 + $14( N-20‚000)
N =
$30
$30N = $320,000 + $14N – $280,000
$16N = $40,000
N = 2,500 units
Proof:
Gross margin, 2,500 × ($30 – $14) $40,000
Output level MOH variance $ 0
Marketing and administrative costs 40,000 40,000
Operating income $ 0

We find it helpful to put the following comparisons on the board:

Variable costing breakeven = f(sales)

= 10,667 tons

Absorption costing breakeven = f(sales and production)

= f(10,000 and 11,429)
= f(2,500 and 20,000)

3. Absorption costing inventory cost: Either $140,000 or $280,000 at the end of 2003 and zero at the end
of 2004.
Variable costing: Zero at all times. This is a major criticism of variable costing and focuses on the issue
of the definition of an asset.

Operating income is affected by both production and sales under absorption costing. Hence, most managers
would prefer absorption costing because their performance in any given reporting period, at least in the short
run, is influenced by how much production is scheduled near the end of a period.