Principles of Managerial Accounting Chapter 7

Absorption Costing Treats ALL costs of production as product costs, regardless of whether they are variable or fixed. A portion of fixed manufacturing overhead is allocated to each unit of product which may carry over to the next year in the form of inventory. NOTE: Absorpotion costing is required for GAAP (external reporting).

Variable Costing Treats only variable production cost as product costs. All other costs are treated as period costs(charged off against revenue when incurred). All fixed costs are treated as period costs.

Impact on inventories Absorption Costing If the ending inventory increases then a portion of the fixed manufacturing overhead costs are deferred to future periods through the inventory account. If the ending inventory decreases, the deferred fixed costs flow through to the income statement

Differences on inventories Variable – no fixed costs are added to inventory Absorption – Fixed manufacturing costs are added to inventory

Impact on inventories (cont) Production in units equal sales in units: There is no change in the fixed overhead costs in the inventory—therefore under both costing methods all of the current fixed overhead costs will flow through to the income statement and against income.

Impact on Inventories (cont) Production in units exceeds sales in units (inventory increases) Some current fixed manufacturing overhead costs will be deferred in inventories under the absorption costing method. Net income under the absorption method will be greater than under the variable method.

Impact on inventories (cont) Sales in units exceeds production in units (inventories decrease) Some of the fixed overhead costs that have been deferred will be released to the income statement. The net income reported under absorption costing will be less than under the variable costing method.

Changes in production volume Net income is NOT affected by changes in production volume when using the variable costing method Under absorption costing, net income is affected by changes in production volume. For any given level of sales, net income under absorption costing will increase as the level of output increases and inventories increase.