Flashcards

What is absorption costing?

All manufacturing costs (DM + DL + VOH + FOH) are product costs — inventoriable, attached to each unit. Required by GAAP for external reporting.

What is variable costing?

Only variable manufacturing costs (DM + DL + VOH) are product costs; FOH is a period cost expensed immediately. Used for internal decisions.

The one cost that changes classification

Fixed manufacturing overhead (FOH) — product cost under absorption, period cost under variable.

S&A costs under both methods

Always period costs — never inventoriable, never in product cost, under either method.

FOH rate formula

Total FOH / Units produced (or budgeted production). The denominator choice matters — state your assumption.

Absorption unit product cost

DM + DL + VOH + FOH rate. Example: $10 + $8 + $4 + $10 = $32.

Variable unit product cost

DM + DL + VOH. Example: $10 + $8 + $4 = $22.

Absorption income statement format

Revenue − COGS = Gross margin; Gross margin − S&A = Operating income.

Variable income statement format

Revenue − Variable costs = CM; CM − Fixed costs = Operating income.

Contribution margin (CM)

Revenue − Variable COGS − Variable S&A. The pool available to cover fixed costs and generate profit.

The reconciliation formula

Abs OI − Var OI = ending-inventory FOH − beginning-inventory FOH. If one FOH rate applies to both layers, this equals Δ inventory units × FOH rate = (produced − sold) × FOH rate.

Production > sales (inventory builds)

With one unchanged FOH rate, absorption reports higher income because FOH in unsold units is deferred to inventory; otherwise compare ending- and beginning-inventory FOH.

Sales > production (inventory draws down)

With one unchanged FOH rate, variable reports higher income because absorption releases previously deferred FOH into COGS; otherwise compare ending- and beginning-inventory FOH.

Production = sales (inventory unchanged)

Both methods report the same operating income when inventory FOH per unit is unchanged; otherwise compare FOH in ending and beginning inventory.

The overproduction trap

Under absorption, producing more than needed inflates profit by deferring FOH in inventory. Variable removes this incentive.

Which method is GAAP?

Absorption costing for GAAP/IFRS external statements. US tax inventory capitalization generally also requires absorption treatment, subject to statutory exceptions.

Which method for CVP and break-even?

Variable costing — the contribution margin format separates variable from fixed, enabling CVP analysis.

Which method discourages overproduction?

Variable costing — FOH hits income immediately regardless of production volume.

Break-even units formula

Fixed costs / CM per unit. Only works with the variable (contribution margin) format.

GAAP compliance answer

Use absorption costing for GAAP/IFRS external reporting. For tax, apply the jurisdiction’s capitalization rules; US rules generally require absorption treatment but include exceptions.

Internal decision answer

Use variable contribution-margin format for CVP and break-even. For pricing, make-or-buy, and special orders, use relevant-cost analysis, including avoidable fixed and opportunity costs.

Timing vs total profit

The two methods agree in total profit over the firm's life — they differ only in the timing of FOH recognition.

FOH in ending inventory (absorption)

FOH rate × units in ending inventory is deferred on the balance sheet — not expensed until those units sell.

FOH in ending inventory (variable)

Zero — all FOH is expensed in the period incurred regardless of inventory changes.

Scenario 1 result (prod 10k, sell 8k)

Abs OI $78,000; Var OI $58,000; difference $20,000 = 2,000 × $10.

Scenario 2 result (prod 10k, sell 10k)

Both methods: OI $110,000. Difference $0.

Scenario 3 result (prod 10k, sell 12k)

With 2,000 units of same-cost beginning inventory: Abs OI $142,000; Var OI $162,000; difference −$20,000 = ending FOH $0 − beginning FOH $20,000.

How to predict which income is higher

With one unchanged FOH rate, inventory builds → absorption higher, inventory shrinks → variable higher, and no change → equal. Otherwise compare FOH in ending and beginning inventory.

Sign convention in reconciliation

With an unchanged FOH rate, an inventory drawdown makes Abs OI − Var OI negative. With changing layers, compare ending-inventory FOH with beginning-inventory FOH.

Performance evaluation and absorption

Absorption lets managers inflate profit by overproducing (deferring FOH). Variable prevents this — better for evaluating profit centers.

Quiz

1. Under absorption costing, which cost is treated as a product cost but is treated as a period cost under variable costing?

   • Direct materials
   • Fixed manufacturing overhead (answer)
   • Variable manufacturing overhead
   • Direct labor

   FOH is the only cost that changes classification. DM, DL, and VOH are product costs under BOTH methods. S&A is a period cost under both.

2. A company's absorption unit product cost is $32 (DM $10, DL $8, VOH $4, FOH rate $10). Its variable unit product cost is:

   • $32
   • $30
   • $22 (answer)
   • $12

   Variable costing excludes FOH: $10 + $8 + $4 = $22. The $10 FOH rate is the only difference — it is a period cost under variable costing.

3. Selling and administrative (S&A) costs are classified as:

   • Period costs under both methods (answer)
   • Product costs under both methods
   • Product costs under absorption, period costs under variable
   • Period costs under absorption, product costs under variable

   S&A is always a period cost — never inventoriable, under either method. Only manufacturing costs can be product costs, and only FOH flips between the two.

4. The FOH rate is $10/unit. Production is 10,000 units and sales are 8,000 units. Absorption OI exceeds variable OI by:

   • $0
   • $10,000
   • $30,000
   • $20,000 (answer)

   Reconciliation: (10,000 − 8,000) × $10 = 2,000 × $10 = $20,000. Absorption defers FOH in the 2,000 unsold units and reports higher income.

5. Production is 10,000 units and sales are 12,000 units. FOH rate is $10/unit. Which statement is correct?

   • Variable OI exceeds absorption OI by $20,000 (answer)
   • Both methods report the same OI
   • Variable OI exceeds absorption OI by $120,000
   • Absorption OI exceeds variable OI by $20,000

   Sales exceed production by 2,000, so 2,000 units leave inventory. Because those units carry the same $10 FOH rate, ending-inventory FOH $0 minus beginning-inventory FOH $20,000 = −$20,000; the same-rate shortcut gives (10,000 − 12,000) × $10. Absorption releases that previously deferred FOH into COGS and reports lower income.

6. Production equals sales (10,000 each). FOH rate is $10/unit. The income difference is:

   • $100,000
   • $0 (answer)
   • $20,000
   • $10,000

   Here there is no beginning or ending inventory, so ending-inventory FOH minus beginning-inventory FOH is $0. Variable costing never defers FOH, and the incomes match. Equal unit counts alone are insufficient if beginning and ending layers carry different FOH rates.

7. Which method is required by GAAP for external financial reporting?

   • Variable costing
   • Both equally
   • Absorption costing (answer)
   • Neither — GAAP allows any method

   GAAP and IFRS require absorption costing for external financial statements. Variable costing is for internal use. US tax inventory-capitalization rules generally require absorption treatment but contain statutory exceptions; that requirement comes from tax law, not IFRS.

8. A manager wants to maximize reported profit this quarter by increasing production beyond sales demand. This incentive exists under:

   • Variable costing only
   • Both methods equally
   • Neither method
   • Absorption costing only (answer)

   Absorption defers FOH in extra inventory units, inflating current profit. Variable expenses all FOH immediately — no overproduction incentive.

9. Which method is best suited for break-even (CVP) analysis?

   • Neither — CVP uses a separate model
   • Absorption costing
   • Both equally
   • Variable costing (answer)

   CVP requires the contribution margin format — revenue minus variable costs — which is exactly the variable costing income statement. Absorption's gross margin mixes variable and fixed costs.

10. FOH is $100,000. Production is 10,000 units. The FOH rate is:

    • $10/unit (answer)
    • $8/unit
    • $12/unit
    • $20/unit

    $100,000 / 10,000 = $10/unit. The rate depends on the production volume — always state your denominator.

11. Under variable costing, FOH in ending inventory is:

    • Expensed in full in the period incurred (answer)
    • Deferred on the balance sheet
    • Allocated to units produced
    • Recorded as a period cost only when units sell

    Variable costing expenses all FOH immediately as a period cost. Nothing is inventoried — that is the whole difference from absorption.

12. A company produces 10,000 and sells 8,000 units. FOH rate is $10. How much FOH is deferred in ending inventory under absorption?

    • $80,000
    • $100,000
    • $0
    • $20,000 (answer)

    2,000 unsold units × $10/unit = $20,000 deferred on the balance sheet. Under variable, this $20,000 would already be expensed.

13. The contribution margin is:

    • Revenue minus all variable costs (answer)
    • Revenue minus fixed costs
    • Gross margin minus S&A
    • Revenue minus COGS

    CM = Revenue − Variable COGS − Variable S&A. It is the pool available to cover fixed costs and generate profit. Gross margin (revenue − COGS) is the absorption costing subtotal.

14. Under absorption costing, COGS includes:

    • Only variable manufacturing costs
    • All manufacturing costs including FOH allocated per unit (answer)
    • All manufacturing costs plus S&A
    • Only FOH

    Absorption allocates ALL manufacturing costs (DM + DL + VOH + FOH rate) to each unit. S&A is excluded — it is a period cost.

15. Which statement about total profit over the firm's entire life is true?

    • Absorption costing always reports higher total profit
    • Both methods report the same total profit — they differ only in timing (answer)
    • Variable costing always reports higher total profit
    • The method with higher profit depends on the tax rate

    Every dollar of FOH is eventually expensed under both methods. They defer and release it differently, but over the firm's life the totals converge.

16. A cost card shows: DM $15, DL $12, VOH $3, FOH rate $8. Absorption unit cost is:

    • $30
    • $38 (answer)
    • $35
    • $43

    $15 + $12 + $3 + $8 = $38. Variable unit cost is $30 — the $8 FOH rate is the only difference.

17. Revenue $500,000; variable COGS $220,000; variable S&A $20,000; FOH $100,000; fixed S&A $50,000. Variable costing OI is:

    • $110,000 (answer)
    • $130,000
    • $160,000
    • $260,000

    CM = $500,000 − $220,000 − $20,000 = $260,000. OI = $260,000 − $100,000 − $50,000 = $110,000.

18. Revenue $500,000; COGS $320,000; variable S&A $20,000; fixed S&A $50,000. Absorption costing OI is:

    • $210,000
    • $130,000
    • $160,000
    • $110,000 (answer)

    GM = $500,000 − $320,000 = $180,000. OI = $180,000 − $20,000 − $50,000 = $110,000 (same as variable when production = sales).

19. Production 10,000, sales 8,000, FOH rate $10. The reconciliation is:

    • Abs OI − Var OI = 8,000 × $10 = $80,000
    • Abs OI − Var OI = (8,000 − 10,000) × $10 = −$20,000
    • Abs OI − Var OI = (10,000 − 8,000) × $10 = $20,000 (answer)
    • Abs OI − Var OI = 10,000 × $10 = $100,000

    General reconciliation: ending-inventory FOH $20,000 − beginning-inventory FOH $0 = +$20,000. Because one rate applies, the shortcut is (10,000 − 8,000) × $10. Absorption is higher — FOH deferred in inventory.

20. Assuming one unchanged FOH rate, which scenario makes variable costing income HIGHER than absorption?

    • Sales > Production (inventory draws down) (answer)
    • Production = Sales
    • Production = 0
    • Production > Sales (inventory builds)

    With one unchanged FOH rate, sales above production draw down inventory and absorption releases previously deferred FOH into COGS, lowering its income below variable.

21. A manager produces 15,000 units but sells only 10,000. FOH rate is $10. Under absorption costing, how much FOH is deferred in the extra 5,000 units?

    • $15,000
    • $10,000
    • $50,000 (answer)
    • $100,000

    5,000 unsold units × $10 = $50,000 deferred. This inflates absorption profit — the overproduction trap that variable costing eliminates.

22. The break-even formula in units is:

    • Variable costs / CM per unit
    • Fixed costs / Selling price per unit
    • Total costs / Units sold
    • Fixed costs / CM per unit (answer)

    Break-even units = Fixed costs / CM per unit. CM per unit = Price − Variable cost per unit. This formula requires the variable costing format.

23. Which cost is a period cost under BOTH absorption and variable costing?

    • Fixed manufacturing overhead
    • Direct materials
    • Selling and administrative expense (answer)
    • Variable manufacturing overhead

    S&A is always a period cost. FOH is the one that flips (product vs period). DM and VOH are product costs under both methods.

24. Which approach is appropriate for pricing a special order?

    • Absorption costing — it includes all costs
    • Either method gives the same answer
    • Relevant-cost analysis — include incremental variable costs, avoidable fixed costs, opportunity costs, and capacity (answer)
    • Neither — special orders use full cost plus markup

    Special-order pricing requires relevant-cost analysis. Contribution margin is useful, but avoidable fixed costs, opportunity costs, available capacity, and qualitative effects can also change the decision; allocated unavoidable fixed overhead is not relevant.

25. Which cost is a product cost under BOTH absorption and variable costing?

    • Fixed manufacturing overhead
    • Direct materials (answer)
    • Selling and administrative expense
    • Interest expense

    Direct materials are always a product cost under both methods. FOH flips (product vs period); S&A and interest are always period costs.

Formula Sheet

• FOH rate = Total FOH / Units produced
• Absorption unit cost = DM + DL + VOH + FOH rate
• Variable unit cost = DM + DL + VOH
• Gross margin = Revenue − COGS (absorption format)
• Contribution margin = Revenue − Variable COGS − Variable S&A
• Absorption OI = Gross margin − Variable S&A − Fixed S&A
• Variable OI = CM − FOH − Fixed S&A
• General income difference = FOH in ending inventory − FOH in beginning inventory
• Same-rate shortcut = (Units produced − Units sold) × FOH rate
• Same rate + inventory builds (produced > sold) → Abs OI > Var OI (FOH deferred)
• Same rate + inventory draws down (sold > produced) → Var OI > Abs OI (FOH released)
• Inventory units unchanged + same FOH rate → Abs OI = Var OI
• Break-even units = Fixed costs / CM per unit
• S&A is always a period cost (both methods)
• Absorption = GAAP/IFRS external reporting; variable format = CVP; relevant costs = specific decisions
• Overproduction inflates absorption profit; variable removes the incentive

MindMap

• Variable vs Absorption Costing
  • Product cost definition
    • Absorption: DM+DL+VOH+FOH
    • Variable: DM+DL+VOH only
    • FOH is the only flip
    • S&A always period cost
  • Income statements
    • Absorption: Rev−COGS=GM−S&A=OI
    • Variable: Rev−Var=CM−Fixed=OI
    • GM vs CM distinction
  • Reconciliation
    • General diff = ending inventory FOH − beginning inventory FOH
    • Same rate: inventory builds → Abs higher
    • Same rate: inventory shrinks → Var higher
    • Same rate and no unit change → equal
    • Total profit same over life
  • When to use which
    • GAAP: absorption
    • CVP: variable format; pricing: relevant costs
    • Performance: variable
    • Overproduction trap

Comparison

Absorption costing versus variable costing