15 - 1 ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Chapter 15 Overhead Application: Variable

15 - 1©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

Chapter 15

Overhead Application:

Variable and Absorption Costing

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©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.

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Variable Versus Absorption Costing

This chapter compares twomethods of product costing.

Variable-Costing Absorption-Costing

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The differences between variable-costing and absorption-costing methods are based on the treatment of fixed manufacturing overhead.

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Variable costing excludes fixed manufacturingoverhead from inventoriable costs.

Absorption costing treats fixed manufacturingoverhead as inventoriable costs.

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Beginning inventory at $3 – $ 90plus cost of goodsmanufactured at standard,170,000 and 140,000 rings 510 420

Available for sale minus 510 510ending inventory, at $3 90* 30^

Variable manufacturingcost of goods sold $420 $480

*30,000 rings × $3 ^10,000 rings × $3

(in thousands of dollars) 2002 2003

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Comparative Income Statement for Variable-Costing Method

Sales, 140,000 and 160,000 rings $700 $800Variable expenses:

Variable manufacturing cost of goods sold 420 480Variable selling expenses, at 5% of dollar sales 35 40

Contribution margin $245 $280Fixed expenses:

Fixed factory overhead 150 150Fixed selling and admin. expenses 65 65

Operating income, variable costing $ 30 $ 65


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Objective 2

Construct an income statement

using the absorption-costing

approach.

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Fixed-Overhead Rate

The fixed-overhead rate is the amount offixed manufacturing overhead applied toeach unit of production.

It is determined by dividing the budgetedfixed overhead by the expected volumeof production for the budget period.

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Cost of Goods Sold forAbsorption-Costing Method

Beginning inventory $ – $120Add: Cost of goods manufactured

at standard, of $4* 680 560Available for sale $680 $680Deduct: Ending inventory 120 40Cost of goods sold, at standard $560 $640*Variable cost $3 Fixed cost ($150,000 ÷ $150,000) 1 Standard absorption cost $4


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Cost of Goods Sold forAbsorption-Costing Method

Sales $700 $800Cost of goods sold, at standard 560 640Gross profit at standard $140 $160Production-volume variance* 20 F 10 UGross margin or gross profit “actual” $160 $150Selling and administrative expenses 100 105Operating income, variable costing $ 60 $ 45*Based on expected volume of production of 150,000 rings: 2002: (170,000 – 150,000) × $1 = $20,000 F


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Comparison of Variable andAbsorption Costing

Absorption unit cost is higher.

Output-level (production-volume) varianceexists only under absorption costing.

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Reconciliation of Variable Costing and Absorption Costing

The difference in income equals thedifference in the total amount offixed manufacturing overheadcharged as expense duringa given year.

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Reconciliation of Variable Costing and Absorption Costing

Under absorption costing, fixed overhead appears in the cost of goods sold and also in the production volume variance.

Under variable costing, fixed overhead is a period cost.

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Compute the production-

volume variance and show

how it should appear in the

income statement.

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Production-Volume Variance

A production-volume variance is a variancethat appears whenever actual productiondeviates from the expected volume ofproduction used in computing thefixed overhead rate.

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Production-Volume Variance

Actual volume

– Expected volume

× Fixed overhead rate

= Production-volume variance

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Volume Variance

Applied fixed overhead – Budgeted fixed overhead= Production-volume variance

In practice, theproduction-volumevariance is usuallycalled simply thevolume variance.

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Other Variances

The fixed-overhead flexible budget variance(also called the fixed-overhead spendingvariance or simply the budget variance)is the difference between actual fixedoverhead and budgeted fixed overhead.

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Differentiate among the three

alternative cost bases of an

absorption-costing system:

actual, normal, and standard.

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Practical Capacity

Maximum, or full capacity, used as the expected activity level in calculating the fixed-overhead rate, is often called practical capacity.

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Normal Costing

Normal costing is a costing system thatapplies actual direct materials and actualdirect-labor costs to products or services butuses budgeted rates for applying overhead.

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Actual, Normal, and Standard Costing

ActualCostingNormalCostingStandardCosting

Variable FixedDirect Direct factory factorymaterials labor overhead overheadActual Actual Actual Actualcosts costs costs costsActual Actual Budgeted ratescosts costs × actual inputsStandard prices or rates × standard inputsallowed for actual output achieved

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Actual, Normal, and Standard Costing

Favorable Variance Unfavorable Variance

Both normal absorption costing and

standard absorption costing generate

production-volume variances.

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Explain why a company might

prefer to use a variable-costing

approach.

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Why Use Variable Costing?

One reason is that absorption-costingincome is affected by productionvolume while variable-costingincome is not.

Another reason is based on whichsystem the company believesgives a better signal aboutperformance.

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Flexible-Budget Variances

All variances other than the production-volumevariance are essentially flexible-budget variances.

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Flexible-budget variances measurecomponents of the differencesbetween actual amounts andthe flexible-budget amountsfor the output achieved.

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Flexible budgets are primarilydesigned to assist planning andcontrol rather than product costing.

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Identify the two methods for

disposing of the standard

cost variances at the end

of a year and give the

rationale for each.

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Disposition of Standard-Cost Variances

There are two methods for disposing of thestandard cost variances at the end of a year:

An adjustment to income of the current year.

An assignment to both inventory and costof goods sold by proration.

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One view is that in standard costing the “standards” are viewed as currently attainable.

Therefore, variances are not inventoriable and should be treated as adjustments to the income of the period instead of being added to inventories.

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Another view favors assigning the variances to the inventories and cost of goods sold related to the production during the period the variances arose.

This is often called prorating the variances.

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Understand how product-

costing systems affect

operating income.

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Product-Costing Systems Affect Operating Income

Managers’ performance measures and rewards are most often based on operating income.

As a result, managers are motivated to take actions that improve current operating income.

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Product-Costing Systems Affect Operating Income

Absorption- and variable-costing systemsaffect operating income because of theirtreatment of fixed factory overhead.

Absorption-costing systems, both normaland standard, generate production-volumevariances that also affect income.

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Effects of Sales and Production on Reported Income

Production > Sales

Variable costing income is lowerthan absorption income.

Production < Sales

Variable costing income is higherthan absorption income.

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Summary Comments

The difference between income reportedunder these two methods is entirely due tothe treatment of fixed manufacturing costs.

Under absorption costing, these costs aretreated as assets (inventory) until theassociated goods are sold.

15 - 39©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

End of Chapter Fifteen

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15 - 1 ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Chapter 15 Overhead Application: Variable