Absorption Costing and Variable Costing

Filipino Accounting Tutorial

4 Dec 202013:41

Summary

TLDRThis script provides an in-depth explanation of absorption and variable costing methods. It outlines how each method treats manufacturing costs, including direct materials, direct labor, and both variable and fixed overheads. The script also compares income statements under both methods, analyzing how costs impact net income. Furthermore, it calculates cost per unit for a corporation producing 900 units, emphasizing the treatment of fixed overhead in both absorption and variable costing. The analysis includes the contribution margin and ending inventory valuation under both costing methods.

Takeaways

😀 Absorption costing is a product costing method that includes all manufacturing costs, such as direct materials, direct labor, and both variable and fixed overheads.
💼 Variable costing only includes variable manufacturing costs like direct materials, direct labor, and variable overhead, excluding fixed overhead costs.
🏗️ Manufacturing costs under absorption costing are higher than under variable costing, as absorption includes fixed factory overheads.
📊 Absorption costing impacts the income statement by including fixed overhead costs in inventory, which affects net income.
🛠️ Under variable costing, fixed overhead is treated as a period expense, impacting the income statement differently than absorption costing.
💰 Net income can differ under absorption costing and variable costing depending on the amount of inventory held during the period.
🔍 The product cost per unit under absorption costing includes direct materials, direct labor, variable factory overhead, and fixed factory overhead.
📈 The income statement under absorption costing typically shows higher inventory values and net income when inventory levels increase.
📉 Variable costing leads to a lower net income when inventory levels decrease, as fixed overheads are expensed in the period they occur.
🏢 Ending inventory is calculated differently under absorption costing and variable costing, with absorption typically resulting in higher inventory values.

Q & A

What is absorption costing?
-Absorption costing is a product costing method that includes all manufacturing costs, such as direct materials, direct labor, variable overhead, and fixed overhead, in the cost of the product.
What are the key components included in absorption costing?
-Absorption costing includes direct materials, direct labor, variable factory overhead, and fixed factory overhead in the total manufacturing cost.
How does variable costing differ from absorption costing?
-Variable costing only includes variable manufacturing costs, such as direct materials, direct labor, and variable overhead, while fixed overhead is treated as a period expense.
How is net income calculated under absorption costing?
-Under absorption costing, net income is calculated by subtracting total expenses (including fixed and variable costs) from total revenue, with all manufacturing costs allocated to inventory until the goods are sold.
How does the income statement under variable costing differ from absorption costing?
-In variable costing, the income statement is based on contribution margin, where only variable costs are deducted from revenue, and fixed costs are treated as period expenses, unlike absorption costing which allocates fixed overhead to product costs.
What are the advantages of absorption costing?
-Absorption costing provides a more comprehensive view of the total cost of manufacturing, as it includes fixed overhead. It is also required by accounting standards for external reporting.
What are the advantages of variable costing?
-Variable costing provides a clearer picture of how variable costs impact profitability and makes it easier to assess the impact of changes in production volume on net income.
How is ending inventory valued under absorption costing?
-Under absorption costing, ending inventory is valued by including all manufacturing costs (direct materials, direct labor, variable, and fixed overhead) in the cost of unsold units.
How is ending inventory valued under variable costing?
-Under variable costing, ending inventory only includes variable manufacturing costs (direct materials, direct labor, and variable overhead), excluding fixed overhead.
What impact does absorption costing have on net income when production exceeds sales?
-When production exceeds sales under absorption costing, some fixed overhead costs are included in ending inventory, which defers the expense to future periods, resulting in higher net income in the current period.

Outlines

00:00

🔍 Understanding Absorption Costing

This paragraph explains the concept of absorption costing, a method that includes all manufacturing costs in the cost of a product. The discussion highlights the components involved in this method, including direct materials, direct labor, variable overhead, and fixed factory overhead. The paragraph contrasts absorption costing with variable costing, where only variable manufacturing costs are included. It also touches on the impact of these costing methods on income statements and inventory valuation.

05:02

📊 Calculating Costs and Income Using Absorption and Variable Costing

This paragraph focuses on the calculation of product costs and income under both absorption and variable costing methods. It provides an example where the total cost is broken down into direct materials, direct labor, variable factory overhead, and fixed factory overhead. The paragraph explains how these costs contribute to the overall manufacturing cost and how they affect the income statement. It also compares the gross profit and net income results under the two costing methods.

10:03

💡 Analyzing Variable Costing and Contribution Margin

This paragraph delves into the analysis of variable costing and its impact on contribution margin and net income. It details how variable costs, such as direct materials, direct labor, and variable overhead, are calculated and how they influence the contribution margin. The discussion also includes an example that calculates the contribution margin and fixed costs to determine the net income under variable costing. The paragraph concludes with a brief mention of ending inventory calculations under absorption and variable costing.

Mindmap

Keywords

💡Absorption Costing

Absorption costing is a product costing method that includes all manufacturing costs—both variable and fixed—into the cost of a unit of production. In the script, it is mentioned multiple times as a key method for determining the cost of goods, emphasizing its importance in calculating the full cost per unit by accounting for direct materials, direct labor, and overheads.

💡Variable Costing

Variable costing, also known as direct costing, is a costing method that includes only variable manufacturing costs—direct materials, direct labor, and variable overhead—in the cost of a unit. The script contrasts this with absorption costing, highlighting that variable costing excludes fixed overhead from product costs, which can impact financial reporting and decision-making.

💡Direct Materials

Direct materials refer to the raw materials that can be directly attributed to the production of a specific product. In the script, direct materials are a key component of both absorption and variable costing, representing one of the primary costs associated with manufacturing.

💡Direct Labor

Direct labor is the cost of wages for the workers who are directly involved in the production process. The script mentions direct labor as a crucial element in calculating both absorption and variable costing, where it is directly added to the cost of production.

💡Fixed Overhead

Fixed overhead consists of the costs that do not vary with the level of production, such as rent, salaries of permanent staff, and depreciation. In the script, fixed overhead is included in the absorption costing method but is treated differently under variable costing, where it is not assigned to individual units of production.

💡Variable Overhead

Variable overhead includes manufacturing costs that vary directly with production volume, such as utilities for factory machines. The script discusses variable overhead in the context of both absorption and variable costing, noting its role in determining the overall cost per unit.

💡Income Statement

An income statement is a financial document that reports a company's revenues, expenses, and profits over a specific period. The script compares income statements prepared under absorption costing and variable costing, highlighting how the choice of costing method can affect reported net income.

💡Contribution Margin

The contribution margin is the amount remaining from sales revenue after all variable expenses have been deducted. It is used to cover fixed expenses and contribute to profit. The script references the contribution margin in the context of variable costing, where it serves as a key metric for assessing profitability.

💡Gross Profit

Gross profit is the difference between sales revenue and the cost of goods sold before deducting operating expenses, taxes, and interest. In the script, gross profit is mentioned when discussing the outcomes under absorption costing, illustrating how this figure is calculated differently based on the costing method used.

💡Cost Per Unit

Cost per unit refers to the total cost incurred to produce one unit of a product. The script repeatedly mentions the calculation of cost per unit under both absorption and variable costing, underscoring the significance of this metric in pricing, inventory valuation, and financial analysis.

Highlights

Absorption costing includes all manufacturing costs, such as direct materials, direct labor, and both variable and fixed overhead.

Absorption costing treats fixed factory overhead as part of the cost of production, making it part of the product cost.

Variable costing includes only variable manufacturing costs in product cost, excluding fixed factory overhead.

Fixed factory overhead is treated differently under variable costing and absorption costing, with variable costing excluding it from product cost.

The income statement under absorption costing includes fixed factory overhead as part of inventory costs.

Absorption costing leads to higher reported profits when inventory levels increase, as fixed overhead is included in inventory.

In variable costing, fixed factory overhead is treated as a period expense and does not affect the cost of inventory.

The contribution margin income statement is used under variable costing, emphasizing the separation between variable and fixed costs.

The difference in net income between absorption costing and variable costing is driven by changes in inventory levels.

Increased inventory under absorption costing defers some fixed factory overhead to future periods, raising net income.

Variable costing provides better insights into the effect of changes in production levels on profitability.

Absorption costing may incentivize managers to overproduce to increase reported profits by deferring fixed overhead costs.

Under variable costing, net income is affected more directly by changes in sales volume rather than production volume.

Ending inventory under absorption costing includes both variable and fixed manufacturing costs, making it higher than under variable costing.

Contribution margin under variable costing is calculated by subtracting variable costs from sales, providing clearer insight into profitability.