In a manufacturing firm, costs are divided into two major categories: manufacturing costs and non-manufacturing costs. The latter are often referred to as selling and administrative expenses, and we will use the terms non-manufacturing costs and selling and administrative expenses interchangeably. Manufacturing costs can be further subdivided into the following categories: direct labor, direct material, variable overhead, and fixed overhead. Direct labor is the cost of labor used in making the finished product. It can typically be associated directly with specific steps in the manufacturing process, hence the term direct labor. Similarly, direct materials are the costs of the physical material that makes up the finished product. For example, we can figure out how much lumber and fabric it takes to make a piece of furniture, so we can directly associate the cost of that material with the finished item. Variable and fixed overhead are examples of indirect costs, and we will use the terms indirect costs and overhead interchangeably. Variable overhead includes things like some portion of heat, light and power, small tools, lubricants, and disposable things like rags and sandpaper. Fixed overhead includes factory rent, supervision, insurance premiums, property taxes and depreciation. Utilities might include a fixed component if there were some minimum charge, irrespective of the quantity used [i.e., there is a charge to be hooked up to the power grid whether you actually use any or not] . Recall that variable costs are those that vary in total in proportion to production or sales. Fixed costs are constant in total, irrespective of the volume of production or sales [within some range of volume, which we call the relevant range]. A plot of variable and fixed costs would look like this:
Generally Accepted Accounting Principles require that manufacturing firms use what is known as absorption costing. This is what you learned about in your financial accounting course, although they probably didn't use a special name for it; you just did it "the way the book said to." Under absorption costing, fixed manufacturing overhead is charged to inventory and written off pro-rata as part of cost of goods sold. In somewhat simplistic terms, this means that if we sell, say 75% of the production during the year, we'll expense 75% of the fixed manufacturing overhead. If we sell only 40% of what we make, we'll expense 40% of the overhead. The remaining amount [25% in the first instance, 60% in the second] will remain in finished goods inventory.
Note that absorption costing results in what is essentially a functional classification of costs in the income statement. The costs of manufacturing are grouped together and the costs of sales and administration are grouped together:
There is an alternative income statement format which is used extensively in managerial accounting. Because it categorizes costs by behavior [all the variable costs together in one group and all the fixed costs together in another] this method is especially useful in decision making. Variable costing [a.k.a. the contribution margin approach] is also the basis for the breakeven and cost-volume profit-analysis material in chapter 2 in the text. Breakeven analysis assumes that all fixed costs are expensed as incurred. Variable costing gives us an income statement that looks like this:
To illustrate the differences in these two ways of financial reporting, we'll used a very simple illustration called Crista's Critters. Crista makes teddy bears and other stuffed animals. She buys the fabric and stuffing, cuts the pieces and assembles them. She gives a sales commission to her sister Suzie for every animal Suzie sells. Here is the basic data:
Based on the information above, we can calculate the net incomes under the two different methods. Note that as long as production and sales are equal, net income under the two systems will be the same. Work through the numbers in the illustrations below to be sure you understand how they are derived.
Now let's assume that production is 10,000 units as originally stated, but Suzie decides she has better ways to spend her time than sell stuffed animals for her sister. She sells only 8,000, leaving 2,000 in inventory. Here is what the income statements look like now:
We produced 10,000 units but sold only 8,000, so there is a balance sheet impact here:
Notice the following relationships:
Under absorption costing, we have held back $1,000 worth of fixed overhead [2,000 units @ $0.50 each] in inventory. This $1,000 will be written off as part of cost of goods sold in the next fiscal period [or whenever Suzie decides she needs to earn a little money]. Under variable costing, the entire annual cost of fixed overhead has been expensed as a lump sum [what we call a period cost--the cost of operating for a fiscal period. The "extra" $1,000 has been written off on the income statement [but, note that it is NOT part of cost of goods sold here], so net income is $1,000 lower and the value of inventory is $1,000 lower. Net income is zero under variable costing in this scenario because 8,000 units happens to be the breakeven point. Suggestion: Do the calculation to prove to yourself that the breakeven point is, in fact, 8,000 units.
Now suppose that the situation is reversed. Crista is the one who slacks off, and makes only 8,000 units. Suppose further that Suzie is gung ho to earn more money and sells all 8,000 units that Crista makes and she also sells the 2,000 units that were in inventory from the year before [when Crista had her act together and produced 10,000 units as planned]. Assuming that the costs and prices in the prior year were the same as in the current year, determine the net income under each approach. Click here for the answer. Determine the value of ending inventory under each approach. [Hint: the latter is REALLY easy. Why?] Click here for the answer.
Copyright © 2010 Gerald M. Myers