 Hello and welcome to this session in which we would look at absorption costing and variable costing example. This topic is covered in managerial accounting, cost accounting, CPA exam, as well as the CMA exam. If you are studying for the CPA exam, I strongly suggest you check out my website farhat-lectures.com. I don't replace your CPA review course. What I do is I can be a supplemental tool, a useful addition, an alternative explanation to your CPA material. And by doing so, I can increase your grade by 10 to 15 points where you can pass your CPA exam and move on with your life and focus on your career. 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 your university doing on the CPA exam or not doing. Also, I do have resources for other courses. So if you're taking other accounting courses, you can take a look at my website. Please connect with me on LinkedIn if you haven't done so. And on LinkedIn, you can view reviews from other students that use the system to pass the CPA exam. Please like this recording, share it, connect with me on Instagram, Facebook, LinkedIn and Reddit. Let's go ahead and take a look at this exercise. We have the annual data of Eli Electric Eyewear. They manufacture swimming goggles and there are no beginning inventory, finished goods in January. So here's what we have here. We have number of goggles produced 245, number of goggles sold 215. What does that mean? It means they still have 30,000 units unsold, in other words, in ending inventory. They sell each unit for $22. The variable manufacturing cost is 8. Sales commission per unit is 5, which is a variable cost as well. Fixed manufacturing overhead 1,470. Fixed selling, this is manufacturing, and fixed selling and administrative 250. And we're going to answer several questions about this exercise. First, we're going to prepare a variable and an absorption costing income statement and which statement shows a higher operating income and why? So before we answer this question, can you answer which statement shows a higher operating income? Would it be the absorption costing and would it be the variable costing? So I'll give you a second to try to answer that question based on your understanding from my explanation from the prior session. Okay, and hopefully you know that absorption costing will have a higher operating income. Why? Why did I know this? The reason I know this is because I produced 245 unit and I sold 215. So it's going to happen under absorption costing, some of the fixed manufacturing overhead, some of this 1,470. Some of it, some of it will stay on the balance sheet. It will not be expensed. Why? Because if you did not sell it, you don't expense it. However, this under variable costing, this 1,470,000, the whole thing will be expense on the income statement. So there's going to be a difference because the whole amount will be expensed here, not here, not under absorption costing. As a result, absorption costing will have a higher income and variable costing will have a lower operating income. Now let's prove that, but that's the basic idea of variable versus absorption costing. But let's show this. Let's first look at our revenues. Our revenues is 215,000 unit times $22,4,730. Our cost of goods sold first, we are preparing, this is the absorption costing income statement. Variable, $8 per unit times 215,000, which is 1,720, the fixed manufacturing overhead. Now what we did is we took 1,470,000 divided by the unit produced. And it's a good idea to see what is our manufacturing cost per unit, because that's important to see that. If we take fixed manufacturing overhead costs divided by the unit produced, we notice that our fixed manufacturing overhead, I did 254, let me one second, 1,470,000 divided by 245,000 unit. Our fixed manufacturing overhead cost is $6 per unit times 215,290,000. Together, they'll give us 3,010,000, which is our cost of goods sold. Therefore, our gross profit sales minus cost of goods sold 1,720,000. We have now, selling an administrative cost, the variable component, 215 times $5, which is the sales commission, and fixed cost of 250. Now we're going to take gross profit minus our selling at administrative, we get to our operating income 395,000, copy this number down. Let's take a look at the variable, at the variable or contribution margin income statement, starting with sales should be the same. Then we're going to have to compute our variable cost, which we have variable manufacturing cost, and we have variable selling and administrative expenses. In total, our contribution margin, notice the terminology, which is sales minus the variable cost is 1,935,000. Then we're going to deduct fixed cost, which is manufacturing fixed cost. Remember this number 1,720,000, the whole thing is expensed here. Here we only expensed 1,290,000. So there's a difference between the two. So 1 million, I'm going to put the number here, 1,290,000. This is the absorption cost, and here we have only, let's see, here we have 1,470,000. That's the difference, as I told you, that's the difference. Then we're going to expense selling and administrative. Then we're going to take contribution margin minus the fixed cost will give us 215,000. So notice, as I told you, 215,000 is lower than what? Lower than the operating income for the absorption. Under the absorption costing, our operating income was 395,000. Under the variable costing, the profit, the operating income is 215,000. Now what we have to do, let's find the difference between the two and try to explain that difference. And basically we did explain it, but I want to show it to you again, just to kind of prove that explanation, minus 215,000. So the difference between the two is 180,000. Well, let's find the difference between this number and this number. 1,290,000 minus 1,470,000 will give us 180,000. Again, the difference is 180,000. And what is that difference really composed of? Well, what is composed of? It's the 30,000 unit. That's an ending inventory that we did not sell under the absorption costing. And remember, the fixed manufacturing cost per unit I computed for you, which is $30. And that's your 180,000. And this is your 180,000. And this is your 180,000. So that's the difference between the two methods. That's the difference between the two methods. So which statement shows a higher operating income and why? We just explained it. We just explained what's going on here. Which is the conventional method. It shows a higher operating income, which is 30,000 unit. What's remaining times 30,000 unit times $6. So let's take a look at the third question. Electric eyewear marketing VP believes that a new sales promotion cost 60,000 with increased sales to 220. Should the company go ahead with this promotion? Well, we're currently selling 215. And we're going to go up to 220. So we are going to sell an additional 5,000 unit. Is it worth it? Well, how do we know whether it's worth it or not? We have to find out how much contribution margin those additional 5,000 unit will provide us. So we're selling each unit for $22. We have $8 in variable, variable selling cost. And I believe 8 and what else? 8 and 5. Let me go back here. 8 and 5. $8 and 5. 8 minus 5. So we have a contribution margin of $9 per unit. Contribution margin equal to $9 per unit. Now, what we do is if we're going to take $9,000 times 5,000 additional units, what we're going to get is 45,000 in additional contribution margin. This is the additional contribution margin. We have to compare this to 60,000. So we have negative 60 plus 45 from an accounting perspective. It's not worth it. Okay. From an accounting perspective, we say it's not worth it from numbers perspective. Now, it could be other reasons why we should go with this promotion. It may increase our brand or whatever, but we're not concerned about this here. We're strictly concerned with numbers. If we are concerned with numbers, then we will not undertake this promotion. We will not undertake this promotion. Again, at the end of this recording, I would like to remind you to visit my website, farhatlectures.com, especially if you are studying for your CPA exam. I can help you understand the material differently. I can help you understand your CPA review course better, in turn, which will help you increase your score by 10 to 15 points, help you pass the exam, focus on your career. Good luck, study hard, and of course, stay safe.