 Hello and welcome to the session. This is Professor Fahad and the session we'd look at a question that deals with absorption costing. This topic is covered on the CPABEC section as well as the CMA on a college level. You would see this topic in cost or managerial accounting. As always, I would like to remind you to connect with me on LinkedIn. If you haven't done so, YouTube is where you would need to subscribe. I have 1,700 plus accounting, auditing, tax, finance, as well as tutorial, Excel tutorial. If you like my lectures, please like them, share them. Subscribe to the channel. If they help you, it means they might help other people. Now, how do my lectures help? For example, absorption costing. If you're taking a CPA or a review course or a CMA review course, what's going to happen? They will review the material with you. However, in my course, such as cost accounting or managerial accounting, I explain the concept in details. So that's the difference between my service and a CPA review course. Please connect with me on Instagram. On my website, farhadlectures.com. This is where you find the additional resources, such as multiple choice through false and for cost and managerial. I have plenty of resources, managerial accounting, as well as cost accounting courses. And I do have all four CPA exam covered, as well as the CMA. If you are looking to improve your score, check out my website. If you want to add those 10 to 15 points on your CPA exam. So let's take a look at this question that's going to illustrate the concept that we are trying to illustrate, which is absorption costing. This company sells a manufacturer radio control toy dogs. Summary budget financial data for this company for the current year is as follows. Sales, 5,000 unit variable manufacturing cost, fixed manufacturing cost, variable selling and administrative, fixed selling and administrative. The company uses absorption costing system. And here we have to stop. If you don't know what absorption costing, then you are you are going to have some issues. We have absorption costing and we have variable costing. You need to understand the difference between the two. If you don't, then you won't be able to you won't be able to answer this question. So what's the difference with what's absorption costing? Absorption costing, first of all, is a gap method, is a gap method. Simply put, when it comes to cost of goods sold, we are going to look at variable cost as well as fixed cost. So we're going to look at variable costing as well as fixed costing. So variable costs would include labor, direct labor, direct material and variable overhead and fixed cost would include fixed manufacturing overhead. So this is under absorption costing. This is what cost of goods sold with. This is what cost of goods sold with would involve now under variable costing, since we are looking at this under variable costing, we will treat fixed manufacturing overhead as a period cost. That's the difference. But if you want to know a little bit more, go to my website and I will have additional explanation, but that's what you have to know for now. And the fixed, the overhead applied based on the number of unit produced with the denominator level of activity of 5,000 unit. So for right now, they are allocating the fixed manufacturing overhead, which is this cost based on 5,000 unit produced. And they're telling us underapplied or overapplied overhead is written off to cost of goods sold in the year incurred. So in case we overapply, we overestimate or underestimate manufacturing overhead, we close it to cost of goods sold. The 20,000 budgeted operating income from producing and selling 5,000 toy dogs planned for this year is is concerned to Trudy George. The president, she believed she could increase operating income by 50,000 if she can produce more unit that she can sell, thus building up finished goods and inventory. This is important. Also, this is assuming you understand how absorption costs affect inventory. Simply put, when you are using absorption costing, if you sell, if you produce, but you don't sell those, what's going to happen is the fixed manufacturing overhead, it's going to sit in inventory. And as a result, your fixed cost per unit will go down. So simply put, if you can produce more, let's your fixed manufacturing overhead, let's take a look at this, your fixed manufacturing overhead right now is 100,000 based on 5,000 activity. So if we take a hundred thousand dollar of fixed manufacturing cost divided by 5,000 unit, you're going to produce your fixed cost per unit is $20. Now, let me tell you this, if you can produce rather than 5,000, if you could produce 10,000 unit and fixed costs will stay the same, your cost per unit goes down to 10. So if you could, if you can produce more, your fixed cost per unit goes down in absorption costing. Why? Because whatever you don't sell, whatever you produce and you don't sell, it's going to sit in inventory. It doesn't get expensed until later when you actually sell it. This is where the matching occurs under absorption costing. Under variable costing, you know, it doesn't matter because fixed manufacturing overhead cost will get expensed regardless. But under this method, the president is thinking, let me increase my production so I could reach a $20,000 profit. So this is the idea. So let's see where does the president stands now? The president stands now at sales of 750,000. Let's take a look at this income statement. Sales, this is sales minus variable manufacturing cost minus fixed manufacturing cost. This is going to give us gross profit. So 750 minus 500, we have a gross profit of 250,000 minus 80 minus one minus 150. That's going to give us a current profit of 20,000. So this is where the president stands now. And the president wants this number to be 50,000 rather than 20,000 because this is where the president gets the bonus. What does that mean? What does that mean? If you want to have a net income of 50,000, it means somehow you have to produce more. So when you allocate your fixed manufacturing overhead, you should not allocate 100,000. In this example, they are producing and selling 5,000 units. On this example, they are producing 5,000 units and selling 5,000 units. So this budget is based on producing 5,000 and selling 5,000. Well, what does that mean? It means if you can produce more unit and not sell it, your fixed cost per unit goes down and this fixed manufacturing overhead will go down, which in return gives us a profit of 50. What does that mean? It means we have to build another income statement, but it's going to look something like this, 750 sales minus 400 variable minus 70 fixed cost. Okay. Well, how can we get to fixed cost of 170? Because how can we get to the fixed cost of 170? Well, we have to produce enough unit to bring our fixed cost to 70. So how do we do so? Well, right now our fixed cost per unit is $20. Fixed cost per unit is $20. How do I know it's $20? Once again, let me take, let me show you. It's $100,000 divided by 5,000 unit equal to $20 per unit. Now I need to bring down my fixed cost to, I need to bring down my fixed cost enough to $30,000. So I need to save $30,000. Well, if I need to save $30,000, my fixed manufacturing, my fixed cost per unit right now is $20. So if I need to reduce it by, if I need to reduce it by, by $30,000, how many new units I will need to produce? Let me get my calculator here. So if I take $30,000 unit, let me keep my calculator up here, $30,000 unit, I'm sorry, $30,000 divided by $20. I need to produce an additional $1,500 unit. So if I produce an additional $1,500 unit and not sell it, remember, we're only able to sell $5,000. So simply put, I am producing an additional $1,500 unit. So in other words, I'm producing $6,500. I'm only expensing $5,000 to fixed manufacturing overhead. The remaining, what's the remaining? The remaining is $1,500 unit. What do I do with this $5,100 unit that I did not sell? What happened to the cost that, that's embedded? The cost that's embedded in those unit goes to the, goes to the balance sheet in form of inventory. So simply put, if I take $30,000 divided by $1,500 additional unit that I produced, again, if you notice, it's the same thing. I, I am putting away $1,500 times $20, $1,520. I did not sell, I'm putting that in inventory. I'm putting that in inventory. And this is how I find out it's what I need to produce an additional $1,500 unit because I need to reduce my fixed cost by $30,000. To reduce my fixed cost by $30,000, my fixed cost per unit is $20. I produce $1,500 unit. If I produce those units, I will have an overapplied, overapplied fixed manufacturing overhead, then I will close it to cost of goods sold, reducing cost of goods sold by $30,000. So this is the idea. So, so, so to generate $50,000 of budgeted operating income based on absorption costing, what the, what the president has to do is produce $6,500 unit. The president can only sell $1,500, not a big deal. As a result, those $1,500 unit applied at $20, applied at $20 with, with put $30,000 in inventory. So simply put the 100, this $100,000, what happened to this under this new scenario, this $100,000, $70,000 of it was expense, so $70,000 was now cost of goods sold and $30,000 is inventory. Why? Because we did not sell it. We produce it. We produce an additional $1,500 unit at $20 a piece, which is $30,000. It's not expense. Why it's not expense? Remember, in absorption costing, you only expense what you sell. Since we did not sell it, we don't match it. It's going to be sold in future period in the following period. Or who knows, maybe never sold. But the point is it's, for now, the president was able to change operating income to $50,000, which in turn, get the bonus. This topic, again, it's covered in my managerial accounting and cost accounting. And I think this is more like a CMA rather than a CPA question. But you could see it in a CPA question. This is the person that sent me this is from a CPA review course. I don't know which one, but they will have a problem understanding this topic. As always, check out my website, subscribe. You invest for your CPA or CMA or your education once in your lifetime. Don't shortchange yourself, study hard. And as always, stay safe, especially during those coronavirus days. Good luck.