©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Chapter 15 Overhead Application: Variable and Absorption Costing

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Learning Objective 1 Construct an income statement using the variable-costing approach.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Variable Versus Absorption Costing This chapter compares two methods of product costing. Variable-CostingAbsorption-Costing

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Variable Versus Absorption Costing l The differences between variable-costing and absorption-costing methods are based on the treatment of fixed manufacturing overhead.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Variable Versus Absorption Costing Variable costing excludes fixed manufacturing overhead from inventoriable costs. Absorption costing treats fixed manufacturing overhead as inventoriable costs.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Variable Versus Absorption Costing Beginning inventory at $3 –$ 90 plus cost of goods manufactured at standard, 170,000 and 140,000 rings Available for sale minus ending inventory, at $3 90* 30^ Variable manufacturing cost of goods sold$420$480 *30,000 rings × $3 ^10,000 rings × $3 (in thousands of dollars)

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Comparative Income Statement for Variable-Costing Method Sales, 140,000 and 160,000 rings$700$800 Variable expenses: Variable manufacturing cost of goods sold Variable selling expenses, at 5% of dollar sales Contribution margin$245$280 Fixed expenses: Fixed factory overhead Fixed selling and admin. expenses Operating income, variable costing$ 30$ 65 (in thousands of dollars)

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Objective 2 Construct an income statement using the absorption-costing approach.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Fixed-Overhead Rate The fixed-overhead rate is the amount of fixed manufacturing overhead applied to each unit of production. It is determined by dividing the budgeted fixed overhead by the expected volume of production for the budget period.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Cost of Goods Sold for Absorption-Costing Method Beginning inventory$ –$120 Add: Cost of goods manufactured at standard, of $4* Available for sale$680$680 Deduct: Ending inventory Cost of goods sold, at standard$560$640 *Variable cost$3 Fixed cost ($150,000 ÷ $150,000) 1 Standard absorption cost $4 (in thousands of dollars)

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Cost of Goods Sold for Absorption-Costing Method Sales$700$800 Cost of goods sold, at standard Gross profit at standard$140$160 Production-volume variance* 20 F 10 U Gross margin or gross profit “actual”$160$150 Selling and administrative expenses Operating income, variable costing$ 60$ 45 *Based on expected volume of production of 150,000 rings: 2002: (170,000 – 150,000) × $1 = $20,000 F (in thousands of dollars)

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Comparison of Variable and Absorption Costing Absorption unit cost is higher. Output-level (production-volume) variance exists only under absorption costing.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Reconciliation of Variable Costing and Absorption Costing The difference in income equals the difference in the total amount of fixed manufacturing overhead charged as expense during a given year.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Reconciliation of Variable Costing and Absorption Costing l Under absorption costing, fixed overhead appears in the cost of goods sold and also in the production volume variance. l Under variable costing, fixed overhead is a period cost.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Learning Objective 3 Compute the production- volume variance and show how it should appear in the income statement.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Production-Volume Variance A production-volume variance is a variance that appears whenever actual production deviates from the expected volume of production used in computing the fixed overhead rate.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Production-Volume Variance Actual volume – Expected volume × Fixed overhead rate = Production-volume variance

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Volume Variance Applied fixed overhead – Budgeted fixed overhead = Production-volume variance In practice, the production-volume variance is usually called simply the volume variance.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Other Variances The fixed-overhead flexible budget variance (also called the fixed-overhead spending variance or simply the budget variance) is the difference between actual fixed overhead and budgeted fixed overhead.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Learning Objective 4 Differentiate among the three alternative cost bases of an absorption-costing system: actual, normal, and standard.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Practical Capacity l Maximum, or full capacity, used as the expected activity level in calculating the fixed- overhead rate, is often called practical capacity.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Normal Costing Normal costing is a costing system that applies actual direct materials and actual direct-labor costs to products or services but uses budgeted rates for applying overhead.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Actual, Normal, and Standard Costing Actual Costing Normal Costing Standard Costing VariableFixed DirectDirectfactoryfactory materialslaboroverheadoverhead ActualActual Actual Actual costscosts costs costs ActualActual Budgeted rates costscosts × actual inputs Standard prices or rates × standard inputs allowed for actual output achieved

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Actual, Normal, and Standard Costing Favorable VarianceUnfavorable Variance Both normal absorption costing and standard absorption costing generate production-volume variances.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Learning Objective 5 Explain why a company might prefer to use a variable-costing approach.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Why Use Variable Costing? One reason is that absorption-costing income is affected by production volume while variable-costing income is not. Another reason is based on which system the company believes gives a better signal about performance.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Flexible-Budget Variances All variances other than the production-volume variance are essentially flexible-budget variances.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Flexible-Budget Variances Flexible-budget variances measure components of the differences between actual amounts and the flexible-budget amounts for the output achieved.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Flexible-Budget Variances Flexible budgets are primarily designed to assist planning and control rather than product costing.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Learning Objective 6 Identify the two methods for disposing of the standard cost variances at the end of a year and give the rationale for each.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Disposition of Standard-Cost Variances There are two methods for disposing of the standard cost variances at the end of a year: An adjustment to income of the current year. An assignment to both inventory and cost of goods sold by proration.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Disposition of Standard-Cost Variances l One view is that in standard costing the “standards” are viewed as currently attainable. l Therefore, variances are not inventoriable and should be treated as adjustments to the income of the period instead of being added to inventories.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Disposition of Standard-Cost Variances l Another view favors assigning the variances to the inventories and cost of goods sold related to the production during the period the variances arose. l This is often called prorating the variances.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Learning Objective 7 Understand how product- costing systems affect operating income.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Product-Costing Systems Affect Operating Income l Managers’ performance measures and rewards are most often based on operating income. l As a result, managers are motivated to take actions that improve current operating income.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Product-Costing Systems Affect Operating Income Absorption- and variable-costing systems affect operating income because of their treatment of fixed factory overhead. Absorption-costing systems, both normal and standard, generate production-volume variances that also affect income.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Effects of Sales andProduction on Reported Income Production > Sales Variable costing income is lower than absorption income. Production < Sales Variable costing income is higher than absorption income.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Summary Comments The difference between income reported under these two methods is entirely due to the treatment of fixed manufacturing costs. Under absorption costing, these costs are treated as assets (inventory) until the associated goods are sold.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton End of Chapter Fifteen