Overhead Rates and Absorption versus Variable Costing

Applying overhead to work in process In the air max 95 femme second instalment of Student Notes (‘Cost Concepts, Categories and Flows’) I mentioned that manufacturing overhead costs are applied (or allocated) to products by using overhead rates. However, if products are to be costed as soon as they have been produced, it is necessary to establish at the beginning of each period (which usually comprises 12 months) a predetermined overhead rate (or POR). This rate is then used during the period to apply overhead to products (as explained below). A costing system which calculates product unit cost as the total of (i) actual direct materials cost, (ii) actual direct labour cost and (iii) an applied amount of overhead cost, is known as normal costing. If actual overhead costs were allocated to products it would be necessary to wait until the end of each financial year when the actual overhead costs for the period could be determined. This system (called actual costing) is of little use to management as decisions have to be made during the year.

In order to establish a predetermined overhead rate, management must:

  • Estimate the total amount of manufacturing cost for the next 12 months.
  • Select a single volume-related cost driver such as direct labour hours, direct labour cost or machine hours. The choice will depend on which factor best reflects the major cause of overhead in that organisation.
  • Establish the level of manufacturing activity measured in terms of the volume-related cost driver that has been selected.

The predetermined overhead rate is then calculated by dividing the estimated overhead amount by the estimated level of activity to arrive at a rate per unit of the chosen cost driver. If the cost driver is direct labour hours, then

POR = estimated total manufacturing overhead

           estimated total direct labour hours

During the period, overhead will be applied to products at the predetermined overhead rate by multiplying this rate by the actual amount of the cost driver used.

e.g. estimated overhead costs for the year: $200,000

cost driver: direct labour hours

estimated direct labour hours for the year: 10,000

predetermined overhead rate $200,000/10,000 = $20 per DLH

actual DLHs worked on batch number 230 was 25 DLH

overhead applied to batch number 230 = 25 DLH x $20 = $500

 

In the ledger, a single Manufacturing Overhead account is maintained. All the actual manufacturing overhead costs incurred are debited to this account, and credited to Cash at Bank or to a payable account. All the overhead applied (i.e. POR x DLH used) is credited to the Manufacturing Overhead account and debited to Work in Process. Any balance in the Manufacturing Overhead account (a temporary or holding account) at the end of the year represents either over or under-applied overhead.

If the actual overhead incurred was greater than the applied overhead there will be a debit balance representing under-applied overhead, while if the actual overhead incurred was less than the applied overhead there will be a credit balance representing over-applied overhead. At the end of each year it is necessary to close the air max 95 femme Manufacturing Overhead account and to dispose of any balance so that the final cost records are as close as possible to the costs which would have been shown had actual overhead costs been used. The balance is usually disposed of by transferring the full amount to the Cost of Goods Sold account. Thus, a debit balance in the Manufacturing Overhead account that represents the under-applied overhead amount will increase the cost of goods sold when it is transferred, while a credit balance that represents over-applied overhead will reduce the cost of goods sold.

Absorption versus variable costing

So far, we have assumed that all manufacturing overhead costs are to be included in the calculation of product unit cost. This assumption is the basis of the costing system known as absorption costing. All of a product’s manufacturing costs, both variable and fixed, are said to be ‘absorbed’ by the product. An alternative approach is to include only the variable manufacturing costs in product unit cost and to treat fixed manufacturing overhead as a period cost i.e. as an expense on the income statement. This system is known as variable costing (or sometimes as direct costing). We will now examine these two costing systems and see how they can affect profit determination and also inventory values on the balance sheet. We will also consider their usefulness for managerial decision making.

Under absorption costing, a certain amount of fixed manufacturing overhead cost is attached (applied) to each unit of output. This air max 95 femme means that under absorption costing unit manufacturing cost includes direct material, direct labour, applied variable manufacturing overhead and applied fixed manufacturing overhead. Thus, when a unit is sold the fixed overhead cost per unit is included in the expense ‘Cost of goods sold’ shown on the income statement. If the unit is unsold, the fixed overhead cost per unit is included in the closing balance of the asset account called ‘Finished Goods Inventory’ which is shown on the balance sheet. When the unit is eventually sold, the total absorption unit cost (including the amount of fixed manufacturing overhead cost per unit) will come out of the Finished Goods Inventory account and become part of the Cost of Goods Sold account (which is closed off at the end of each period to the Profit and Loss account).

With variable costing, the total amount of fixed manufacturing overhead cost is expensed in the current accounting period, irrespective of how many units were produced and sold. Unit manufacturing cost, therefore, includes only variable costs i.e. direct material, direct labour and applied variable overhead. When variable costing is used, it is necessary to divide the total amount of manufacturing overhead into its variable and fixed components by using a cost analysis technique like the High-Low method. Remember that variable costs change in total in direct proportion to changes in the level of output (or the level of the cost driver such as direct labour hours or machine hours) but on a per unit basis they remain constant. Variable manufacturing overhead costs would include the costs of electricity, fuel oil used for furnaces, indirect labour and indirect materials such as solvents or the detergents used to clean equipment. By contrast, fixed costs remain constant in total even though the level of output may vary within a certain range. Fixed manufacturing overhead costs would include factory rent, council rates, insurance premiums on the factory buildings and equipment, and the salary paid to the factory manager.

The key issue with these two costing systems is really one of timing: the time at which fixed manufacturing overhead costs are charged against revenue i.e. either when units are sold (absorption costing) or when units are produced (variable costing). Any difference between the number of units produced and the number of units sold allows us to make the following two statements:

1. When production is greater than sales, absorption costing profit will be greater than variable costing profit, because some of the fixed manufacturing overhead cost incurred in the current accounting period is held in an inventory (asset) account under absorption costing, whereas under variable costing the total amount of the current period’s fixed manufacturing overhead is expensed.

2. When production is less than sales, absorption costing profit will be lower than variable costing profit, because some of the fixed manufacturing overhead costs incurred in the previous accounting period will be included in the current period’s cost of goods sold, in addition to all of the current period’s fixed manufacturing overhead costs. Under variable costing only the total amount of the current period’s fixed manufacturing overhead costs is charged against revenue—the previous period’s fixed manufacturing overhead costs were expensed in the previous period.

Of course when production equals sales (and also over a long period of time), both methods will show the same profit because the same amount of fixed manufacturing overhead will be expensed.

With variable costing profit is a function of sales volume only, provided that selling prices and cost structure remain unchanged. However, with absorption costing profit is a function of both sales volume and production volume i.e. it is influenced by changes in the level of finished goods inventory even when prices and costs remain constant. The air max 95 femme following example illustrates how profit reported under the two costing systems can differ when sales in units is higher or lower than production in units. The example covers two consecutive months for a company, XYZ Ltd, which makes and sells only one product, and which commenced operations at the start of January 2012. It, therefore, had no inventory on hand at the start of 2012. Costs and production information for January follow (table 1):

 

The following two income statements show the calculation of January profit under both costing systems (table 2,3):

Profit in January was $40,000 higher under absorption costing because only $160,000 of January’s fixed manufacturing overhead (8000 units sold x $20/unit for FMOH) was included in cost of goods sold. The $40,000 of fixed manufacturing overhead that was applied to the 2000 units not sold was not expensed but carried forward as part of the balance in the Finished Goods Inventory account. Under variable costing the full amount of air max 95 femme January’s fixed manufacturing overhead ($200,000) was expensed.

Now assume that in February 8000 units were sold, but planned and actual production was only 6000 units. This means that in February, 2000 units that were made in January were sold along with all the 6000 units made in February. Costs and production information for February follow (table 4).

The table shows that although the total amount of fixed manufacturing overhead was the same in February as in January ($200,000), the amount applied per unit increased because the planned and actual production levels were both 2000 units lower in February compared to January. The fixed manufacturing overhead per unit in February was $33.33 instead of $20.00 as in January. This caused February’s absorption unit cost to be higher at $78.33 compared to the January amount of $65.00. The 2000 units remaining from January’s production represented the opening Finished Goods Inventory for February and they were carried in the accounts at their unit cost for January ($65) i.e. at a total amount of $130,000 (2000 units x $65). As noted above, this carrying amount included $40,000 of January’s fixed manufacturing overhead (2000 x $20/unit). When the 2000 units were sold in February this $40,000 became part of cost of goods sold expense for February.

Hence, under absorption costing, the cost of goods sold amount for February included a total of $240,000 of fixed manufacturing overhead [(6000 x $33.3333*) + (2000 x $20)] compared to only $200,000 under variable costing. As a result, the absorption costing profit for February was $40,000 lower than the variable costing profit, as shown in the two income statements (table 5,6).

 

Notice that the absorption costing profits reported in January ($180,000) and February ($100,000) are different but the sales revenue was the same in both months ($800,000). In contrast, variable costing shows the same profit for each of the two months ($140,000). The reason for this is that variable costing always deducts the full amount of fixed manufacturing overhead each month as a period expense – none of it is carried forward to a future month as part of an asset account balance (i.e. in Finished Goods Inventory).

Under variable costing, if total sales revenue, total variable costs and total fixed costs remain constant so will operating profit. This is not so with absorption costing, because some of the total fixed cost amount for a period may not be expensed in the current period but in a future period.

Notice also that because there was no opening Finished Goods Inventory balance at the start of January and there was no closing Finished Goods Inventory balance at the end of February (i.e. for January and February taken together total sales in units was equal to total production in units), the profit reported for the two-month period was the same under both costing systems. See table 7.

If sales in units for a period is the same as production in units, both costing systems will report the same profit. However, in any period where sales in units is different to production in units the difference in profit between absorption costing and variable costing is directly related to the fixed manufacturing overhead cost per unit and the change in the number of units in ending inventory, as shown in the following formula.

Summary

A variable costing income statement is particularly useful for short-term decisions, such as whether to make or buy a component, and for pricing – especially when variable selling and administrative costs are included. Under variable costing, profit is a function of sales. The classification of costs, as fixed or variable, makes it simple to project the effects that changes in sales volumes and prices have on profit. Managers find this useful for decision making. For many decisions, variable costs provide a good measure of the incremental costs that need to be assessed. Also (as you saw in the last Student Notes), cost volume profit analysis requires a variable costing format for the income statement. However, fixed costs are an important part of the total cost of running a business and must be carefully managed. Variable costing provides a useful perspective of the impact that fixed costs have on profits by bringing them together and highlighting them, instead of having them scattered throughout the statement.

On the other hand, in the modern business environment, with a high level of fixed manufacturing overhead, a relatively small percentage of manufacturing costs may be assigned to products under variable costing. Also, in the longer term a business must cover its fixed costs too, and many managers prefer to use absorption unit cost when they make cost-based pricing decisions. Some argue that fixed manufacturing overhead is a necessary cost incurred in the production process so that when fixed costs are omitted the unit cost of the product is understated and profit per unit is overstated. However, absorption product costs include unitised fixed overhead, which can result in sub-optimal decisions, especially as fixed costs are not incremental costs in the short term. With variable costing, fixed costs are not ‘unitised’, but instead are included in total on the income statement as an expense in the period in which they are incurred. This avoids the costing inaccuracies that can arise from incorrect forecasts of production levels and the amount of fixed cost per unit. With variable costing, a product’s unit cost does not change with changes in production levels. As a result, variable costing is preferable for managerial decision making, even though it is not allowed by Australian accounting standards for profit determination (AASB 102 Inventories requires the use of absorption costing).http://www.yeezyboostadidas.fr

About Prof Janek Ratnatunga 1129 Articles
Professor Janek Ratnatunga is CEO of the Institute of Certified Management Accountants. He has held appointments at the University of Melbourne, Monash University and the Australian National University in Australia; and the Universities of Washington, Richmond and Rhode Island in the USA. Prior to his academic career he worked with KPMG.