Absorption costing is required for GAAP

Absorption costing charges fixed overhead to production Fixed overhead is expensed as cost of goods sold is written off against revenues

Absorption costing: how it works

Suppose production is greater than sales.
Were adding to finished goods inventory A pro-rata share of variable and fixed production costs are held back in finished goods until the product is sold Less than 100% of the total fixed overhead will be written off in the current period

Under FIFO, the old production costs will be expensed in the next fiscal period, along with the costs of the new production that is actually sold

Absorption costing: how it works, continued

But, suppose we have the reverse situation; sales exceeds production and we draw down inventory
Now were selling all of the current production, plus some of whatever we had sitting around on the shelf As a result, well write off all of the current years fixed overhead, plus some fixed overhead from the previous year

But what happens under variable costing

Under variable costing, 100% of fixed costs are expensed in the period incurred. Zero (zip, nada) fixed costs are charged to inventory.

Lets use the Widget Works data to illustrate the difference between absorption and variable costing. Heres the original information again.
STANDARDS PRICE OR RATE $2.50 $4.50 QUANTITY PER UNIT 3.0 Direct material purchased 1.50 Direct material used ACTUAL OUTCOMES COSTS $330,000 VOLUME Direct material cost/foot Direct labor cost/DLH 110,000 feet 105,000 feet

Variable ohd rate/DLH

$2.80

Direct labor used

$255,000

52,000 DLH

Budgeted fixed overhead Planned output (denominator ) Fixed overhead rate/DLH Budgeted unit sales Budgeted sales price Variable selling & admin expenses Fixed selling & admin expenses

$157,500 35,000 units 3.00 35,000 $29.95 $2.00 $140,000

Variable overhead Fixed overhead Actual production Units sold Variable selling & admin exp Fixed Selling & admin exp Selling price/unit

$147,900 $160,000 36,000 units 34,000 units $2.05 $143,690 $29.50

STANDARD COST/UNIT Direct material Direct labor Variable overhead Total variable cost Fixed overhead Absorption cost/unit $7.50 6.75 4.20 $18.45 4.50 $22.95

CALCULATION OF TOTAL ACTUAL COST Direct material purchased $330,000 Less: direct material not used (at standard cost) 5,000 $ 2.50 (12,500) Direct labor used $255,000 Variable overhead $147,900 Fixed overhead $160,000 Total actual costs $ 880,400 Total std cost of production 36,000 22.95 $ 826,200 Total variance $ 54,200

What would a variable costing income statement look like here?

Sta a a ia le c sti i c e e e ess a ia le c st f ss l ate ial a a ia le e ea tal a ia le a fact i c sts ess a ia le S ex e ses t i ti a i at sta a j st f a ia le c st a ia ces j ste c t i ti a i ess fixe c sts e ea S x e ses et i c e e state e t $1,003,000 255,000 229,500 142,800 627,300 69,700 306,000 56,200 249,800 160,000 143,690 (53,890)

$ $

But absorption costing net income was...

Sales revenue Cost of goods sold Gross profit @ standard Variable selling & admin exp Fixed selling & admin exp Net in ome $ $ $ $ $ $ 1,003,000 834,500 168,500 69,700 143,690 (44,890)

Hmmmthats a difference of $9,000! Were better off (smaller loss), but where did the $9,000 come from?

Absorption and variable costing net income reconciliation

Recall that we produced 36,000 units and sold 34,000 units.
2,000 units wound up in inventory The fixed costs of those 2,000 units is:
$3.00/DLH * 1.5 DLH/unit * 2,000 units, or $9,000!

Therefore under absorption costing, $9,000 of fixed overhead is held back in inventory. Under variable costing, that amount is expensed in the period incurred.

This leads directly to the following conclusions. Ceteris paribus,

when production > sales, absorption costing net income will be greater than variable costing net income due to the current period fixed costs held in inventory. when production < sales, absorption costing net income will be less than variable costing net income due to the old fixed costs released from inventory. when production = sales, absorption costing net income and variable costing net income will be equal.

Now suppose you find yourself in the following situation:

Your bonus is a function of profit 4th quarter sales are off; prospects for that bonus are looking less and less favorable The factory has excess production capacity How can you take advantage of this set of circumstances to improve the likelihood of getting the bonus?

Answer?
Crank up production!
What doesnt get sold will just go to inventory. The variable costs of the unsold output wont affect profits anyway The fixed costs per unit will drop as production increases. Well write off less fixed overhead resulting in higher profits, even if total sales are unchanged.

Ethical?
Not really, but it happens. During a period when its sales were taking a hit in the 1960s, Chrysler Corporation kept building cars for inventory in order to drive up apparent profits. They rented cow pastures, vacant lots, any space they could find to store the unsold vehicles It got to the point that the rent and security costs (vandalism got to be a serious problem) were a substantial expense.