{"id":89,"date":"2021-01-26T22:03:11","date_gmt":"2021-01-26T22:03:11","guid":{"rendered":"https:\/\/courses.lumenlearning.com\/wm-managerialaccounting\/?post_type=chapter&p=89"},"modified":"2021-07-21T20:13:34","modified_gmt":"2021-07-21T20:13:34","slug":"introduction-to-costing-methods","status":"publish","type":"chapter","link":"https:\/\/courses.lumenlearning.com\/wm-managerialaccounting\/chapter\/introduction-to-costing-methods\/","title":{"raw":"Introduction to Costing Methods","rendered":"Introduction to Costing Methods"},"content":{"raw":"What you will learn to do: distinguish between variable costing and full absorption costing<\/h2>\r\n![\"Computers](\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5469\/2021\/01\/12225644\/scott-graham-5fNmWej4tAA-unsplash-300x200.jpg\")
Operating income on the income statement is one of the most important results that a manufacturing company reports on its financial statements. External parties such as investors, creditors, and governmental agencies look to this amount to evaluate a company\u2019s performance and how it affects them. Managers and others within a company use operating income as a measure for evaluating and improving operational performance.\r\n\r\nThere are two basic ways accountants present sales and expense data:\r\n
Variable costing<\/strong> \u2014 which is the method you\u2019ve been studying in this module, and<\/p>\r\nFull absorption costing<\/strong> \u2014 which is the method financial accountants use<\/p>\r\nFull absorption costing (often simply called absorption costing) is required by generally accepted accounting principles (GAAP) for external reporting. All manufacturing costs, whether fixed or variable, must be treated as product costs and included in an inventory amount on the balance sheet (absorbed by inventory) until the product is sold. When the product is sold, its cost is then expensed as cost of goods sold on the income statement.\r\n\r\nHere is a CVP analysis based on 2,900 units produced and sold:\r\n\r\n
BlankBooks, Inc.\r\nCVP Analysis - target profit\r\nFor the month ending July 31, 20XX<\/caption>\r\n\r\n\r\n| <\/th>\r\n | Units<\/th>\r\n | $\/Unit<\/th>\r\n | Total<\/th>\r\n<\/tr>\r\n<\/tbody>\r\n |
\r\n\r\n| Sales<\/td>\r\n | 2,900<\/td>\r\n | $\u00a0\u00a0\u00a0\u00a0\u00a010.00<\/td>\r\n | $\u00a0\u00a0\u00a0\u00a0\u00a029,000.00<\/td>\r\n<\/tr>\r\n |
\r\n| Variable costs<\/td>\r\n | 2,900<\/td>\r\n | $\u00a0\u00a0\u00a0\u00a0\u00a0\u00a08.30<\/td>\r\n | 24,070.00<\/td>\r\n<\/tr>\r\n |
\r\n| Contribution Margin<\/td>\r\n | <\/td>\r\n | $\u00a0\u00a0\u00a0\u00a0\u00a0\u00a01.70<\/td>\r\n | Single Line<\/span>4,930.00<\/td>\r\n<\/tr>\r\n\r\n| Fixed costs<\/td>\r\n | <\/td>\r\n | <\/td>\r\n | \u00a0\u00a0\u00a0\u00a0\u00a0\u00a03,400.00<\/td>\r\n<\/tr>\r\n | \r\n| Operating income<\/td>\r\n | <\/td>\r\n | <\/td>\r\n | Single Line<\/span>$\u00a0\u00a0\u00a0\u00a0\u00a0\u00a01,530.00Double line<\/span><\/td>\r\n<\/tr>\r\n\r\n| <\/td>\r\n | <\/td>\r\n | <\/td>\r\n | <\/td>\r\n<\/tr>\r\n | \r\n| CM ratio<\/td>\r\n | <\/td>\r\n | 17.00%<\/td>\r\n | <\/td>\r\n<\/tr>\r\n<\/tbody>\r\n<\/table>\r\n<\/div>\r\n \r\n\r\nHere is the same information using absorption costing:\r\n\r\n BlankBooks, Inc.\r\nIncome Statement\r\nFor the month ending July 31, 20XX<\/caption>\r\n\r\n\r\n| Description<\/th>\r\n | Total<\/th>\r\n<\/tr>\r\n<\/thead>\r\n | \r\n\r\n| Sales<\/td>\r\n | $ \u00a0 \u00a0 29,000.00<\/td>\r\n<\/tr>\r\n | \r\n| Cost of Goods Sold<\/td>\r\n | 24,400.00<\/td>\r\n<\/tr>\r\n | \r\n| Gross Profit<\/td>\r\n | Single Line<\/span>$4,600.00<\/td>\r\n<\/tr>\r\n\r\n| Selling, general, and administrative costs<\/td>\r\n | 3,070.00<\/td>\r\n<\/tr>\r\n | \r\n| Operating income<\/td>\r\n | Single Line<\/span>1,530.00<\/td>\r\n<\/tr>\r\n\r\n| Provision for income taxes<\/td>\r\n | 321.30<\/td>\r\n<\/tr>\r\n | \r\n| <\/td>\r\n | Single Line<\/span>$ \u00a0 \u00a0 \u00a01,208.70Double line<\/span><\/td>\r\n<\/tr>\r\n\r\n| <\/td>\r\n | <\/td>\r\n<\/tr>\r\n<\/tbody>\r\n<\/table>\r\n<\/div>\r\n \r\n\r\nExpenses are separated into two accounts: Cost of Goods Sold, which are product costs of the manufactured goods themselves, and Selling, General, and Administrative Expenses, which are general operating costs.\r\n\r\nEach of these two expense accounts includes both variable and fixed costs. Cost of Goods Sold is made up of the three costs of manufacturing: direct materials and direct labor, which are variable; and factory overhead, which may be both variable and fixed. Likewise, Selling and Administrative (SGA) Expenses may include both variable and fixed costs.\r\n\r\nUnder both methods, direct costs (materials and labor) and variable factory overhead costs are applied to the cost of the product. The difference between the two costing methods is how the fixed factory overhead costs are treated. Under variable costing, fixed factory overhead costs are expensed in the period in which they are incurred, regardless of whether the product is sold yet. Under absorption costing, fixed factory overhead costs are expensed only when the product is sold.\r\n\r\nIn both of the above examples, we are assuming that the company produced and sold 2,900 books using a Just-in-Time inventory management system, and therefore, operating income for both statements is $1,530.00.\r\n\r\nHowever, as you will see in the following sections, because we allocate costs to units produced but not yet sold, under a full absorption costing system, operating income will not be equal to the CVP operating income unless we modify that model significantly. Remember, in managerial accounting, we don\u2019t have to follow Generally Accepted Accounting Principles; instead, we create reports that help management plan, control, and direct both short and long-term operations, so if we wanted to come up with a more complicated CVP model, we could.\r\n\r\nTo recap, the variable costing income statement is different from the absorption costing income statement in several ways:\r\n\r\n \r\n\r\n\r\n| Variable Costing<\/td>\r\n | Full Absorption Costing<\/td>\r\n<\/tr>\r\n | \r\n| Sales<\/td>\r\n | Sales<\/td>\r\n<\/tr>\r\n | \r\n| Less: Variable product costs\u00a0and variable SGA<\/td>\r\n | Less: Cost of Goods Sold\u00a0that include fixed MOH<\/td>\r\n<\/tr>\r\n | \r\n| = Contribution Margin<\/td>\r\n | = Gross Profit<\/td>\r\n<\/tr>\r\n | \r\n| Less: Fixed MOH and Fixed SGA<\/td>\r\n | Less: SGA<\/td>\r\n<\/tr>\r\n | \r\n| = Operating Income<\/td>\r\n | = Operating Income<\/td>\r\n<\/tr>\r\n<\/tbody>\r\n<\/table>\r\n<\/div>\r\n \r\n\r\nWhen you are done with this section, you will be able to:\r\n\r\n \t- Distinguish between variable costing and full absorption costing<\/li>\r\n \t
- Compare and contrast operating income using variable costing and full absorption costing<\/li>\r\n<\/ul>\r\n
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