1. The paper is expected to be at least 8 pages long (not including the title page, table of contents, references, and any appendices).

2- Table of contents (10% of total grade)

3- Introduction (10% of total grade)

4- The body (50% of total grade)

5- Summary (10% of total grade)

6- Conclusion (10% of total grade)

7- References (10% of total grade)

The topic that is being discussed is absorption costing and variable costing. The outline is as follows:

Define the term absorption costing and define the term variable costing.

Discuss the main difference between the absorption and variable costing approaches.

Explain how absorption costing as well as how variable costing is used to calculate the cost of goods manufactured. Give examples for both.

Explain how the income would be higher or lower under the variable costing method compared to the absorption costing method.

Explain the arguments in favor of treating the fixed manufacturing overhead costs as period costs.

If the units produced and the unit sales are equal, discuss which method you would expect to show the higher net operating income, variable costing or absorption costing. Explain how is that so.

If the units produced would exceed the unit sales, discuss which method you would expect to show the higher net operating income, variable costing or absorption costing. Explain how is that so.

If a company has an instance in which the fixed manufacturing overhead costs are released from the inventory under absorption costing, explain what this tells the company about the level of production in relation to the level of sales.

Under absorption costing, discuss how it is possible to increase the net operating income without increasing sales.

In a situation of lean production, explain how does that reduce or eliminate the difference in reported net operating income between absorption and variable costing.

Please use the outline provided. If you need more material to cover the assignment page requirement, you can select another topic or two that has to do with absorption and variable costing.

1. The paper is expected to be 8 to 10 pages long (not including the title page, table of contents, references, and any appendices). 2- Table of contents (10% of total grade) 3- Introduction (10% of total grade) 4- The body (50% of total grade) 5- Summary (10% of total grade) 6- Conclusion (10% of total grade) 7- References (10% of total grade) The topic that is being discussed is absorption costing and variable costing. The outline is as follows: Define the term absorption costing and define the term variable costing. Discuss the main difference between the absorption and variable costing approaches. Explain how absorption costing as well as how variable costing is used to calculate the cost of goods manufactured. Give examples for both. Explain how the income would be higher or lower under the variable costing method compared to the absorption costing method. Explain the arguments in favor of treating the fixed manufacturing overhead costs as period costs. If the units produced and the unit sales are equal, discuss which method you would expect to show the higher net operating income, variable costing or absorption costing. Explain how is that so. If the units produced would exceed the unit sales, discuss which method you would expect to show the higher net operating income, variable costing or absorption costing. Explain how is that so. If a company has an instance in which the fixed manufacturing overhead costs are released from the inventory under absorption costing, explain what this tells the company about the level of production in relation to the level of sales. Under absorption costing, discuss how it is possible to increase the net operating income without increasing sales. In a situation of lean production, explain how does that reduce or eliminate the difference in reported net operating income between absorption and variable costing. Please use the outline provided. If you need more material to cover the assignment page requirement, you can select another topic or two that has to do with absorption and variable costing. 1 ABSORPTION AND VARIABLE COSTING Absorption and variable costing Name of Student: Course title: Instructor's Name: Date of submission: 2 ABSORPTION AND VARIABLE COSTING Introduction Variable (direct) costing and absorption (full) costing in the accounting discipline are two different techniques that are used to apply costs of production to products or services. The key distinctive feature between the two techniques is in the application of fixed manufacturing overhead costs. Fixed manufacturing overhead costs are expensed during the period in which they are incurred under the direct costing method. Under the full costing method, fixed manufacturing overhead costs are charged at the moment when the product is sold. Definitions Variable (direct) costing The direct costing method applies all direct costs as well as variable manufacturing overhead costs to the end product. These costs move with the product through the inventory accounts until the product is sold, at which point they are expensed on the income statement as costs of goods sold. Fixed manufacturing overhead costs are expensed during the period in which they are incurred. Variable costing can also be referred to as direct or marginal costing. Absorption (full) costing The full costing method applies all direct costs and both fixed and variable manufacturing overhead costs to the end product. These entire costs move with the product through the inventory accounts until the product is sold, at which point they are expensed on the income statement as costs of goods sold. Absorption costing is also called full costing. Discuss the main difference between the absorption and variable costing approaches. 3 ABSORPTION AND VARIABLE COSTING The heart of the difference between variable costing and absorption costing for financial accounting is the accounting for fixed manufacturing costs. All variable manufacturing costs are inventoriable product costs under the both methods. But fixed manufacturing costs are treated differently. Under variable costing, fixed manufacturing costs are treated as expenses of the period. Under absorption costing, fixed manufacturing costs are inventoriable costs. They are then deducted as the costs of goods sold when sales occur. Since fixed manufacturing costs are excluded in inventoriable product costs under variable costing, it shows a lesser inventory value. In other words, the value of inventory is understated under variable costing. Unlike that, under absorption costing, product costs are inflated by fixed manufacturing costs. Therefore, inventories are over-stated in absorption costing. There is a direct relation between the difference in the value of inventory or asset and the net income of the period. Inventory is a current asset. As the size of an asset increases profit also increases and vice-verse. Explain how absorption costing as well as how variable costing is used to calculate the cost of goods manufactured. Give examples for both. Under absorption costing system, the product cost consists of all variable as well as all fixed manufacturing costs i.e., direct materials, direct labor and factory overhead (FOH). But when variable costing system is used, the fixed cost (both manufacturing and non- 4 ABSORPTION AND VARIABLE COSTING manufacturing) is treated as a period or capacity cost and is, therefore, not included in the product cost. For example; A company manufactures and sells 5000 units of product X per year. Suppose one unit of product X requires the following costs: Direct materials: $5 per unit Direct labor: $4 per unit Variable manufacturing overhead: $1 per unit Fixed manufacturing overhead: $20,000 per year The unit product cost of the company is computed as follows: Absorption Costing: $5 + $4 + $1 + $4 = $14 Variable Costing: $5 + $4 + $1 = $10 $20,000 / 5,000 Notice that the fixed manufacturing overhead cost has not been included in the unit cost under variable costing system but it has been included in the unit cost under absorption costing system. This is the primary difference between variable and absorption costing. 5 ABSORPTION AND VARIABLE COSTING Explain how the income would be higher or lower under the variable costing method compared to the absorption costing method. Variable costing and absorption costing usually produce different net operating income figures. The reason is that the fixed manufacturing overhead cost is not treated the same way under two costing methods. To understand how the difference in treatment of fixed manufacturing overhead cost changes the net operating income figures of two costing systems, we need to prepare two income statements, one under variable costing and one under absorption costing. For this purpose, consider the following example: Income statements (a). Absorption Costing: 6 ABSORPTION AND VARIABLE COSTING Variable Costing: 7 ABSORPTION AND VARIABLE COSTING 8 ABSORPTION AND VARIABLE COSTING Reconciliation of net operating income: 9 ABSORPTION AND VARIABLE COSTING Notice that the net operating income under absorption costing is $7,500 ($92,000 - $84,500) higher than the net operating income under variable costing. This difference is because of fixed manufacturing overhead that becomes the part of ending inventory under absorption costing system. The ending inventory absorbs a portion of fixed manufacturing overhead and reduces the burden of the current period. In this way a portion of fixed cost that relates to the current period is transferred to the next period. Under variable costing, the fixed manufacturing overhead cost is not included in the product cost but charged to the income statement of the relevant period in its entirety. Therefore no portion of fixed cost is absorbed by the ending inventory. Explain the arguments in favor of treating the fixed manufacturing overhead costs as period costs. An argument for treating fixed manufacturing overhead as period costs could be that variable costing can act as capacity costs. Thus fixed manufacturing cost will be incurred even if no units were produced. If the units produced and the unit sales are equal, discuss which method you would expect to show the higher net operating income, variable costing or absorption costing. Explain how that is so. If production and sales are equal, net operating income should be the same under absorption and variable costing. When production equals sales, inventories do not increase or decrease and therefore under absorption costing fixed manufacturing overhead cost cannot be deferred in inventory or released from inventory. 10 ABSORPTION AND VARIABLE COSTING If the units produced would exceed the unit sales, discuss which method you would expect to show the higher net operating income, variable costing or absorption costing. Explain how that is so Net operating income would be higher under absorption costing because some of the fixed manufacturing overhead during the period is held over in inventories (under absorption costing). If a company has an instance in which the fixed manufacturing overhead costs are released from the inventory under absorption costing, explain what this tells the company about the level of production in relation to the level of sales. If fixed manufacturing overhead cost is released from inventory, then inventory levels must have decreased and therefore production must have been less than sales. Under absorption costing, discuss how it is possible to increase the net operating income without increasing sales. With absorption costing income can be increased by increasing the level of production without any increase in sales. In a situation of lean production, explain how does that reduce or eliminate the difference in reported net operating income between absorption and variable costing. Difference in reported operating income between absorption and variable costing arises because of changing levels of inventory. In lean production, goods and services are produced strictly to customer's offers. With production geared to sales, inventories are largely or entirely eliminated. If inventories are completely eliminated, they are zero from one period to another hence absorption and variable costing methods will yield same results of net operating income. 11 ABSORPTION AND VARIABLE COSTING Conclusion Absorption costing and variable costing as two costing methods in accounting field have a range of differences as well as a number of similarities. In incidences where there is a difference in their reporting, a reconciliation is done so that there is a vivid understanding of their source of differences. 12 ABSORPTION AND VARIABLE COSTING References Ray H. Garrison, Eric W. Noreen, Peter C. Brewer (2012). Managerial Accounting. 14th edition. 1 ABSORPTION AND VARIABLE COSTING Absorption and variable costing Name of Student: Course title: Instructor's Name: Date of submission: 2 ABSORPTION AND VARIABLE COSTING Introduction Variable (direct) costing and absorption (full) costing in the accounting discipline are two different techniques that are used to apply costs of production to products or services. The key distinctive feature between the two techniques is in the application of fixed manufacturing overhead costs. Fixed manufacturing overhead costs are expensed during the period in which they are incurred under the direct costing method. Under the full costing method, fixed manufacturing overhead costs are charged at the moment when the product is sold. Definitions Variable (direct) costing The direct costing method applies all direct costs as well as variable manufacturing overhead costs to the end product. These costs move with the product through the inventory accounts until the product is sold, at which point they are expensed on the income statement as costs of goods sold. Fixed manufacturing overhead costs are expensed during the period in which they are incurred. Variable costing can also be referred to as direct or marginal costing. Absorption (full) costing The full costing method applies all direct costs and both fixed and variable manufacturing overhead costs to the end product. These entire costs move with the product through the inventory accounts until the product is sold, at which point they are expensed on the income statement as costs of goods sold. Absorption costing is also called full costing. Discuss the main difference between the absorption and variable costing approaches. 3 ABSORPTION AND VARIABLE COSTING The heart of the difference between variable costing and absorption costing for financial accounting is the accounting for fixed manufacturing costs. All variable manufacturing costs are inventoriable product costs under the both methods. But fixed manufacturing costs are treated differently. Under variable costing, fixed manufacturing costs are treated as expenses of the period. Under absorption costing, fixed manufacturing costs are inventoriable costs. They are then deducted as the costs of goods sold when sales occur. Since fixed manufacturing costs are excluded in inventoriable product costs under variable costing, it shows a lesser inventory value. In other words, the value of inventory is understated under variable costing. Unlike that, under absorption costing, product costs are inflated by fixed manufacturing costs. Therefore, inventories are over-stated in absorption costing. There is a direct relation between the difference in the value of inventory or asset and the net income of the period. Inventory is a current asset. As the size of an asset increases profit also increases and vice-verse. Explain how absorption costing as well as how variable costing is used to calculate the cost of goods manufactured. Give examples for both. Under absorption costing system, the product cost consists of all variable as well as all fixed manufacturing costs i.e., direct materials, direct labor and factory overhead (FOH). But when variable costing system is used, the fixed cost (both manufacturing and non- 4 ABSORPTION AND VARIABLE COSTING manufacturing) is treated as a period or capacity cost and is, therefore, not included in the product cost. For example; A company manufactures and sells 5000 units of product X per year. Suppose one unit of product X requires the following costs: Direct materials: $5 per unit Direct labor: $4 per unit Variable manufacturing overhead: $1 per unit Fixed manufacturing overhead: $20,000 per year The unit product cost of the company is computed as follows: Absorption Costing: $5 + $4 + $1 + $4 = $14 Variable Costing: $5 + $4 + $1 = $10 $20,000 / 5,000 Notice that the fixed manufacturing overhead cost has not been included in the unit cost under variable costing system but it has been included in the unit cost under absorption costing system. This is the primary difference between variable and absorption costing. 5 ABSORPTION AND VARIABLE COSTING Explain how the income would be higher or lower under the variable costing method compared to the absorption costing method. Variable costing and absorption costing usually produce different net operating income figures. The reason is that the fixed manufacturing overhead cost is not treated the same way under two costing methods. To understand how the difference in treatment of fixed manufacturing overhead cost changes the net operating income figures of two costing systems, we need to prepare two income statements, one under variable costing and one under absorption costing. For this purpose, consider the following example: Income statements (a). Absorption Costing: 6 ABSORPTION AND VARIABLE COSTING Variable Costing: 7 ABSORPTION AND VARIABLE COSTING 8 ABSORPTION AND VARIABLE COSTING Reconciliation of net operating income: 9 ABSORPTION AND VARIABLE COSTING Notice that the net operating income under absorption costing is $7,500 ($92,000 - $84,500) higher than the net operating income under variable costing. This difference is because of fixed manufacturing overhead that becomes the part of ending inventory under absorption costing system. The ending inventory absorbs a portion of fixed manufacturing overhead and reduces the burden of the current period. In this way a portion of fixed cost that relates to the current period is transferred to the next period. Under variable costing, the fixed manufacturing overhead cost is not included in the product cost but charged to the income statement of the relevant period in its entirety. Therefore no portion of fixed cost is absorbed by the ending inventory. Explain the arguments in favor of treating the fixed manufacturing overhead costs as period costs. An argument for treating fixed manufacturing overhead as period costs could be that variable costing can act as capacity costs. Thus fixed manufacturing cost will be incurred even if no units were produced. If the units produced and the unit sales are equal, discuss which method you would expect to show the higher net operating income, variable costing or absorption costing. Explain how that is so. If production and sales are equal, net operating income should be the same under absorption and variable costing. When production equals sales, inventories do not increase or decrease and therefore under absorption costing fixed manufacturing overhead cost cannot be deferred in inventory or released from inventory. 10 ABSORPTION AND VARIABLE COSTING If the units produced would exceed the unit sales, discuss which method you would expect to show the higher net operating income, variable costing or absorption costing. Explain how that is so Net operating income would be higher under absorption costing because some of the fixed manufacturing overhead during the period is held over in inventories (under absorption costing). If a company has an instance in which the fixed manufacturing overhead costs are released from the inventory under absorption costing, explain what this tells the company about the level of production in relation to the level of sales. If fixed manufacturing overhead cost is released from inventory, then inventory levels must have decreased and therefore production must have been less than sales. Under absorption costing, discuss how it is possible to increase the net operating income without increasing sales. With absorption costing income can be increased by increasing the level of production without any increase in sales. In a situation of lean production, explain how does that reduce or eliminate the difference in reported net operating income between absorption and variable costing. Difference in reported operating income between absorption and variable costing arises because of changing levels of inventory. In lean production, goods and services are produced strictly to customer's offers. With production geared to sales, inventories are largely or entirely eliminated. If inventories are completely eliminated, they are zero from one period to another hence absorption and variable costing methods will yield same results of net operating income. 11 ABSORPTION AND VARIABLE COSTING Conclusion Absorption costing and variable costing as two costing methods in accounting field have a range of differences as well as a number of similarities. In incidences where there is a difference in their reporting, a reconciliation is done so that there is a vivid understanding of their source of differences. 12 ABSORPTION AND VARIABLE COSTING References Ray H. Garrison, Eric W. Noreen, Peter C. Brewer (2012). Managerial Accounting. 14th edition