BEC 2

Variable Costing vs. Absorption Costing

A fundamental difference between absorption costing and variable costing is that the former treats fixed factory overhead as a product cost (included in inventory on the balance sheet), while the latter treats it as a period cost (included as an expense on the income statement). In a period where inventory production exceeds sales, fixed factory overhead under the absorption method will remain on the balance sheet as part of the unsold inventory; this keeps these costs off of the income statement until the inventory is actually sold (therefore raising net income). Under variable costing, fixed factory overhead would have been expensed to the income statement in the period incurred (therefore lowering net income).When more units are produced in a period than sold, a portion of the fixed manufacturing overhead is included in the ending inventory under absorption costing (GAAP). Under variable costing, all fixed manufacturing overhead is an immediate expense. As a result, the ending inventory is lower under variable costing and the cost of sales is higher. The opposite effect is present when the number of units sold exceeds the number of units produced.

Cost-Volume-Profit Analysis

All costs can be divided into fixed and variable elements; Selling prices are to be unchanged; Volume is the only relevant factor affecting cost; Only total VARIABLE costs are directly proportional to volume over the relevant range.

Operating Income

CM <Fixed Costs>

Conversion Costing

Conversion costing does NOT include direct material in inventoriable cost.

Break-even Point in UNITS

Fixed Costs / CM Per Unit ... CM x Break-even Units = FC

Break-even Point in SALES $

Fixed Costs / CM Ratio ... [CM / Sales]

Absorption Costing

GAAP. External Reporting. Accounts for fixed manufacturing overhead costs in inventory and produces inventory values greater than variable costing. Charges direct material, direct labor, variable overhead and fixed overhead as inventoriable costs. Absorption costs are NOT relevant in situations when management must decide on accepting or rejecting one-time-only special orders, and where there is sufficient idle capacity Absorption costing, which is required under U.S. GAAP, requires all product costs to be included in inventory. No segregation is made between fixed and variable costs, and the costs are expensed when the product is sold. All of the costs listed, except for the bookkeeper salary and the office rent, are product costs.

Variable (Direct) Costing

LOWEST Inventory Value since only Variable Expenses Capitalized. Other methodologies of inventory accounting will account for fixed costs in inventory and result in greater values than variable costing. Does NOT consider Fixed Manufacturing OH as an inventoriable cost.

Contribution Margin

Net Sales Revenue <Variable Expenses> ... Operating Income + Fixed Costs = CM To maximize profit at full capacity, contribution margin per hour should be maximized The contribution margin approach calculates the contribution margin as revenue less variable costs. Net income is derived by subtracting fixed costs from the contribution margin.

Opportunity Cost

Opportunity cost is the potential benefit lost by selecting a particular course of action. If idle space has no alternative use, there is no benefit foregone; opportunity cost is zero.

Budgets

The annual business plan process typically begins with operating budgets that are driven by sales budgets that, in turn, provide the required variables for production, selling and personnel budgets. Financial budgets including pro forma financial statements and cash budgets come at the end of the process and are prepared last. Cash budgets are typically derived from the operating budgets that assume accrual basis assumptions (e.g., credit sales and credit purchases). Operating Budgets and then Financial Budgets (marketing budget is an operating budget).

Variable Costing vs. Absorption Costing

The difference between variable costing and full absorption costing lies in the treatment of fixed manufacturing costs. Full absorption costing treats fixed manufacturing costs as product costs, while Variable Costing expenses these as period costs. Under full absorption costing, all manufacturing costs are product costs. Selling costs, regardless if fixed or variable, are all considered period costs. Under variable costing, all fixed costs, including fixed manufacturing costs, are period costs.

Decision Analysis Situation

The relevant costs are: Opportunity Cost, Incremental Cost, Avoidable Cost, Variable (Direct) Costs NOT Absorption Costs, Historical Costs

Period Costs

Under the absorption method, only variable and fixed SG&A expenses are period costs. Direct labor, direct materials, variable, and fixed overhead are product costs. Under the variable cost method, variable SG&A expenses, fixed SG&A expenses, and fixed overhead are all period costs, while direct labor, direct materials, and variable overhead are product costs.

Variable Costing vs. Absorption Costing

When production exceeds sales, inventory increases. As inventory increases, net income under absorption costing benefits from fixed manufacturing overhead that is recorded in inventory instead of recognition in cost of goods sold. Variable costing, however, bears the full cost of all fixed costs. Variable costing is less than absorption costing when inventory increased. Conversely, when sales exceeds production, inventory fall. As inventory falls, net income under absorption costing is reduced by cost of goods sold that includes fixed manufacturing overhead from prior periods that had been recorded in inventory. Absorption costing net income is less than variable costing net income.

Margin of Safety

difference between CURRENT Sales & BREAK-EVEN Sales --> Actual or Budgeted Sales <Break-even Sales> ... [Sales - Margin of Safety = Break-even Sales]