 Hello and welcome to this session in which we would look at absorption costing and variable costing. Absorption costing and variable costing are two methods to estimate cost for product. Absorption costing is using GAP. GAP is used for external reporting purposes. Variable costing is used for internal decision making. Sometimes it's called the contribution method or the direct method. The reason we need to learn about absorption costing and variable costing is because this topic is covered in your managerial accounting cost accounting CPA exam BEC section as well as the CMA exam. So if you are a CPA candidate studying for the CPA exam, I strongly suggest you check out my website farhatlectures.com. I don't replace your CPA review course. I can be a useful addition to your CPA review course. I can add 10 to 15 points to your CPA review course by explaining the material differently. Your risk is one month of subscription. Your potential gain is passing the exam and if not for anything, take a look at my website to find out how well or not well your university is doing on the CPA exam. I do have resources to many other courses. Please connect with me on LinkedIn if you haven't done so and take a look at LinkedIn reviews. Students that use my resources to pass the CPA exam like this recording connect with me on Instagram, Facebook. I'm also on LinkedIn and Reddit. So let's go ahead and start our discussion. Absorption costing versus variable costing. Absorption costing, sometimes it's called full costing, just another term for it. Just so you know, in case your textbook is using a different method. Now, absorption costing, it absorbs all product costs. So when you are costing the product, it's going to absorb direct material, direct labor, variable manufacturing overhead, and fixed manufacturing overhead. And hopefully you know that these are the product costs. And basically absorption costing is what you've been learning all about throughout your managerial accounting or cost accounting course, because the new method really is variable costing. So it includes all the product costs. The period costs will include variable selling and administrative, fixed selling and administrative. Now, variable costing, hopefully from the word, you would know that variable costing is considered only variable manufacturing costs in costing the product itself, in costing the product itself. And that is direct material, direct labor, so far so good, variable manufacturing overhead. This is to cost the product. Then we have period cost. Period cost, we will have variable selling and administrative and fixed selling and administrative. So the difference is, so hold on a second, what happened to this fixed manufacturing overhead? I don't see it. Well, here's what's going to happen. This fixed manufacturing overhead, that's going to be the difference between variable and absorption costing. This fixed manufacturing overhead under the variable costing, it's going to be x pence. Why? Because it's considered a period cost. And hopefully we all know that a period cost get expensed. A period cost get expensed. So what's going to happen? What's going to make the difference between absorption costing and variable costing is how we treat fixed manufacturing overhead. Let me highlight this number in yellow. So this is the number that makes the difference between the two. Okay? Fixed manufacturing overhead. Under absorption costing, this is first considered an asset. Well, let's be specific. It's inventory. Then once it's sold, it's turned into cost of goods sold. So if it's not sold, it sits in inventory as an asset. Under the variable costing, fixed manufacturing overhead is expensed immediately. So basically it turned into an expense and to a cost immediately, immediately during the period. Now, let's take a look at the income statement format because we have to clarify how the income statement format is set up for each method. The traditional format and when we say the traditional, we mean absorption costing because this is what we've been learning. We'll take sales minus cost of goods sold. We get to gross profit. Under the contribution margin, CM method under the contribution margin, we'll take revenues minus variable cost and we'll get contribution margin, not gross margin. So some of the questions on the CPA exam will deal around compute the contribution margin, compute the gross profit margin. So notice here's what I need to clarify here. When we say, when we say variable cost, we mean direct material. I mean, you use a different color because I want to grab your attention, direct material, direct labor, variable overhead and variable selling and administrative. So all of those are variable cost. Now the product cost is only material, labor and manufacturing overhead. But all of them are variable costs to come up to contribution margin. Then from the contribution margin, we will deduct fixed costs under the contribution margin format. Under the traditional format, we deduct selling and administrative and the selling and administrative could be variable, could be fixed, variable and fixed. Then we come up with operating expenses. So again, the only difference between the two method is how we treat fixed manufacturing overhead. This number here. Under variable costing, we expense it right away. Under absorption costing, we don't expense it until we sell the inventory. So it gets inventoried first. It's an inventory. It's an asset and it doesn't turn into an expense until we sell it. Now if we produce everything, if we sell everything that we produce, well, guess what? Those will equal to each other. If we sell and produce, if we produce and sell, it's going to be expensed. It's going to be expensed. Therefore, they equal to each other. So let's take a look at some numbers for this to make a little bit more sense. Let's assume we are producing 2,000 units for a particular company and we're selling, we're actually producing tablet and we are selling each tablet for $500. We have manufacturing cost of direct labor, $150 per tablet, direct material, $150, direct labor, $75, variable manufacturing overhead, $20 and fixed manufacturing overhead overall, $111,000. Now this $111,000, it's going to be divided by how many we are going to produce to find the fixed manufacturing overhead per one tablet. Okay, now we have selling an administrative cost. The variable selling an administrative cost is $62 per tablet, then we have a fixed selling an administrative cost in a total of $116,000. First, let's find the product cost. For direct material, it's going to be under absorption and it's going to be under variable. Direct labor, same thing, variable manufacturing overhead, the same thing. Now fixed manufacturing overhead, the cost is $55.50. Under variable cost, we don't account for fixed manufacturing overhead. So what happened to this very fixed manufacturing overhead? Does it evaporate? Does it go away? No, under the variable method, it's going to be the whole thing will be expense. The $111,000 will be expense. So we don't factor it into the product cost. Therefore, the total unit product cost is $300.50 for absorption and $245 for variable. Now if you want to copy these numbers down, because I'm going to be using them on the next slide. So pause and copy the numbers down. Now variable costing and absorption costing would result in different operating income when either unit produced are more than unit sold or unit produced are less. Simply put, there's a difference between what you produce and what you sold. If they're equal to each other, the numbers, the operating income will be the same. If unit produced equal unit sold. And I want you to understand this before we start to go into numbers. Unit produced equal unit sold, it means this whole thing, this $111,000 went to inventory, then went to cost. And obviously, under absorption costing, this is what I mean, under absorption costing and under variable costing, we expense it. Therefore, the $111,000 was expensed under both method because we produced and whatever we produced was sold. So whatever we included in fixed manufacturing overhead, we expensed. Whatever we produced to inventory, we expensed. And under variable costing, we expensed, we expensed we expensed both. Voila. They all be equal to each other. When unit produced is not equal to unit sold, then we'll have to, we'll have a different story. So the best way to illustrate this is to work actual example. Assume there is no beginning finished goods inventory. The number of unit produced is 2000. The number of units sold is 2000. There we go. What does that mean? It means the operating income will not differ whether you are using absorption or variable and we'll prove that. There is no ending inventory of finished goods because all units are sold and we have no beginning inventory. Operating income is the same for both method. Let me show you how it works. Sales revenue is a million because we produced 2000. We sold each unit at 500. 2000 unit times $300.50 is your cost of goods sold, your gross profit, the term that we use for absorption costing is 399 minus selling and administrative cost variable, which is 2000 unit times $62.50 minus the fixed selling and administrative total operating income is 158 and we have no inventory left inventory is zero. Let's take a look at variable costing for the same company. Sales is the same. Variable cost is we have 2000 unit times 245. The product cost minus the variable selling and administrative cost 2000 unit times $62.50. The contribution margin, the terminology we use for variable costing is 385. Notice those are different. Then we deduct fixed cost, the whole thing, the $111,000 and we deduct the fixed selling and administrative cost. Notice we have variable costs in one place and fixed costs in the other and operating income. Notice operating income is the same whether we are using both methods. The reason it's the same it's because every unit we sold, every unit we produced, which is 2000, we sold. Therefore, ending inventory obviously is zero if we sold everything. Now the best way to illustrate the concept is to work another example for different assumptions. Assume the following. There is no beginning, finished goods inventory. The company produced 2500 tablets. The company sold 2000. What does that mean? It means you have an ending inventory 500 unit. What does that mean? If I know I have more units in ending inventory, it means my absorption costing will have less expenses, less to be more specific, not expenses, less cost of goods sold because some of those units 500 they're not sold. We're not going to expense them. Under variable costing we're going to have more expenses under the period cost because we're going to expense all fixed manufacturing overhead and we're going to show this in numbers that I just told you. Hopefully you can follow this. So we have 500 in ending inventory. Therefore, we started with zero unit. We produced 2500 sold 2000. We have 500 unit remaining. Here's the unit cost 150, 75, 20. Now notice the fixed manufacturing overhead 111 divided by 2500. So what I want you to notice is our fixed manufacturing overhead per unit went down. Now it is 40, $44.40. In the prior example, it was, let me take a look. It should be here fixed manufacturing overhead. It was around $50. Let me just show you. I want you to see this. It's $55.50. So how did our fixed manufacturing overhead went down? We produced more units. So notice as you produce more unit, your fixed unit per your fixed cost per unit for manufacturing fixed manufacturing overhead goes down. Okay, kind of it looks good for the managers. Oh, great. Why? Why it goes down because what's happening is you are using the same electricity, you are using the same electricity, but producing more units. Therefore, let's look at absorption costing. We sold 2000 unit at $500, 2000 unit times 298 the number here. This is our gross profit. Our variable cost 2000 unit times $62.50 minus the fixed selling and administrative. So operating income 180 200 under variable costing 2000 unit times 500 2000 unit times 245 2000 unit times $62.50 sales minus variable cost gives us contribution margin. The language is very important here. We're going to expense all of fixed manufacturing costs, which is 111. And we're going to expense fixed selling and administrative. We're going to take contribution margin minus the fixed cost. The operating income is 158. So notice the operating income is lower. So our income is lower than absorption costing is because we expense this whole, this whole amount 111,000 variable costing that not expense the whole amount. Why? Because we still have 500 unit 500 unit and those 500 unit. Let me show you what happened really. Well, let's compute the difference between the two first. Let me show you how you can compute the difference between the two. So what is the difference? What's the difference in profit between variable costing and absorption costing absorption costing 180,200 minus 158.4 variable. So the difference is 22,200. Let me show you where that difference came from. We still have 500 units unsold and those 500 unit absorbed in them $44 and 40 cent of fixed manufacturing overhead. Therefore, if we take 500 times $44 and 40 cent and voila, 22,000, this is what explained the difference. And this is why absorption costing will have a lower cost, which is a higher profit is because 500 unit are inventory in those 500 units. What's hitting, what's hitting in them, what's absorbed in them is that $44 and 40 cent. That's kind of staying on the balance sheet, which is right here. Look, finished goods inventory, we still have 500 unit. Part of those is fixed manufacturing overhead. Okay. And this is what created the difference. And obviously the 144 and the 144,700 and 122,500, the difference is 22,200. Now let's go ahead and change the scenario again. Let's go ahead and change the scenario. Assume the following. There are 500 units in beginning inventory and beginning finished goods inventory that costs 144,700, which is where this came from. Don't be surprised it came from here. So it came from the prior year because this is what we started with. And the company produced 1,500 unit. We're starting with 500. We produced 1,500 and we sold 2,000. What happened here is this. We produced, notice what happened, we produced 1,500 sold 2,000. Hold on a second. How can you sell more than you produce? Well, the reason I sold more than I produce is because I have 500 from the prior period. That's why. But if I'm going to sell more than what I produced, you're going to see what's going to happen under variable costing. I'm going to have more profit under variable costing. I'm going to have more profit because some of the cost was expensed in the prior year for the variable costing. For the absorption costing now, all the cost that was hitting on the inventory, an inventory on the balance sheet, it's going to be released to the income statement. Let's see how it works. Let's work this example. Again, direct material, direct labor and variable cost is the same for both. Now the fixed overhead per unit is 111 times 1,500. Notice fixed overhead went up now. Overhead per unit. Fixed manufacturing overhead because we only produced 1,500 unit. So the unit cost under variable is 319, under absorption is 319, under variable 245. It's only the same thing, labor material and manufacturing overhead. Let's compute the income statement. Sales is a million. Cost of goods sold is number of units from the prior period times 28940. This is from prior period and 1,500 unit times 319 for this period. So total cost is 623200. Sales minus cost of goods sold equal to gross profit. Variable cost is 2,000 unit times 6250. Fixed selling and administrative 116. Contribute gross profit minus selling, minus fixed selling at administrative will give us 135,800. We sold everything. We have no inventory. Let's take a look at variable costing. Revenue of a million. Variable cost 2,000 times 245. 2,000 unit times 6250, which is the same as here, 125, but now it's under variable cost. Contribution margin is 385 million minus 615. Fixed cost is fixed manufacturing cost 111. Fixed selling and administrative cost 116. So notice here what's happening is fixed manufacturing cost is 111. Now we are expensing this 111, but notice what happened over all operating income. Operating income is 158. So it's 158, 158. It says more than 135,800. Why it's more? It's because from the prior year, remember the prior year for this company under variable costing, they had some inventory that was not released. That was not released to the income statement. Now it was released right here. Let me highlight to you. It was released right here. So those 500 units are released. Those 500 units had additional. They had additional fixed manufacturing overhead. And as a result, we have more expenses here. We have less expenses here now because remember we sold 2,000, but we produce only 1,500. Therefore operating income is 185, and the inventory is gone. Now the best way also to look at this is to look at the whole picture. What I mean by a whole picture? Look at the results over three years. Kind of to see the effect. So let's take a look at the results of three years. This is year one and we already did all of this. Operating income was 158. Operating income was 158. Why? Because in unit one, unit produce equal to unit sold. Therefore, absorption operating income will equal to variable operating income. Fair enough. Year two. Year two is this one right here. Remember in year two, we produced more units than we sold. If we produce more units than we sold, some of the costs for absorption costing will be hitting, will be hitting an inventory on the balance sheet. Therefore, we're going to have more operating income, 182,000, than operating income under variable costing. And remember I told you, I showed you the difference and I showed you how to compute the difference. In year three, the opposite happened. Unit produce were less than the unit sold. Therefore, absorption costing income will be less than variable costing. Absorption costing income 135,800 is less than 158. Then we zeroed out. Inventory is gone. So let's see what happened over a three-year period. The first thing I want to tell you in the long run, and not in the long run, when everything is expense, notice operating income is the same over a period of three years, 474,474,000 in total. Why? Because in the long run, you are going to expense everything. Once you sell it, therefore, everything will consolidate, will not consolidate, everything will clear. All your costs will clear into the income statement. Okay? Therefore, the two will equal to each other. Sales is obviously the same. Again, cost of goods sold will defer and selling an administrator, which they're not, you know, they're not comparable, you know, cost of goods sold versus contribution margin. Of course, they will defer because of the fixed manufacturing overhead, how we treat this. And selling an administrative cost versus fixed cost, those will defer because the way we treat fixed manufacturing overhead. But overall, over a three-year period, over a three-year period, once again, once the inventory is cleared, the two numbers are equal to each other. Overall, they are equal to each other. So this is an overview about variable costing versus absorption costing. It's very important to understand this topic, whether you're a candidate for the CPA exam or an accounting student. Now, in the next session, I will, I will work an example just to show you how this method is being, is used for what purpose. Obviously, managers use variable costing because they don't care about absorption costing because managers are concerned with what cost is going to vary with the, with their operation. They believe, they believe manufacturing overhead is irrelevant because it's a sunk cost. There's nothing that they can do about that. Therefore, they will produce using variable costing. Okay. But anyway, the best way to illustrate this concept is through an example. Once again, I'm going to invite you to visit my website for hatlectures.com. And if you're a CPA candidate, invest in your career, try it for a month. If it works, it will be great. If not, then you would learn something. Good luck, study hard, and of course, stay safe.