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5. Plantwide versus Departmental Overhead Rates.
a. Because companies may produce many types of products, a single plantwide overhead rate
b. Text Exhibit 3.8 (p. 73) illustrates the significant differences in unit costs that can occur
c. Departmental overhead rates can provide more useful information by using the most
i. A company with multiple departments that use significantly different types of work effort
ii. Furthermore, the use of separate variable and fixed categories within each department
LO 6 How do absorption and variable costing differ?
D. Overview of Absorption and Variable Costing
1. General
a. Cost accumulation involves determining which manufacturing costs are recorded as product
b. Cost presentation involves determining how costs are shown on external financial statements
2. Absorption costing, also known as full costing, is a cost accumulation and reporting method
that treats the costs of all manufacturing components (direct material, direct labor, variable
a. Absorption costing presents expenses on an income statement according to their functional
classifications.
i. A functional classification is a group of costs that were all incurred for the same
ii. Thus, as shown on the right side of text Exhibit 3.9, the absorption costing income
statement format is as follows:
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b. Non-manufacturing costs (selling and administrative) are considered to be period costs and
3. Variable costing, also known as direct costing, is a cost accumulation and reporting method
a. As shown on the right side of text Exhibit 3.10, the variable costing income statement
presents expenses according to cost behavior (variable and fixed):
i. Cost of goods sold is more appropriately called variable cost of goods sold since it is
b. Product contribution margin is the difference between selling price and variable cost of
c. Total contribution margin is the difference between revenue and all variable costs
d. See text Exhibit 3.11 (p. 76) for a diagram of variable costing relationships.
4. Thus, two differences exist between absorption and variable costing: one relates to cost
a. The cost accumulation difference is that absorption costing treats fixed overhead as a
i. Absorption costing advocates contend that fixed overhead costs should be considered
ii. Variable costing advocates contend that fixed overhead costs would be incurred whether
b. The cost presentation difference is that absorption costing classifies expenses by function
5. Absorption costing is the traditional approach to product costing and must be used for external
financial statements and tax returns.
i. Authoritative accounting bodies such as the FASB and the SEC believe absorption
ii. Variable costing is not acceptable for external reporting and tax returns.
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6. Since variable costing distinguishes costs by behavior, variable costing reports are more useful
7. Absorption and Variable Costing Illustrations
a. Text Exhibit 3.12 (p. 77) provides unit production costs, annual budgeted nonmanufacturing
costs, and other basic operating data needed to illustrate the differences between absorption
and variable costing. The case assumptions include:
i. All costs remain constant over the three years in question;
b. Text Exhibit 3.13 (p. 78) presents absorption and variable costing income statements for the
three years.
c. Although production and operating costs were equal to standard costs and budgeted costs
i. The volume variance is the monetary impact of a difference between the budgeted
ii. There was no change in inventory in Year 1, but ending inventory increased by 20,000
d. Phantom profits are temporary absorption costing profits caused by producing more
inventory than is sold.
i. Absorption costing creates phantom profits when more inventory is produced than is sold
LO.7 How do changes in sales or production levels affect net income computed under absorption
and variable costing?
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a. As summarized in text Exhibit 3.14 (p. 79), absorption costing income will equal variable
i. Absorption costing income will be greater than variable costing income if production is
greater than sales as some fixed overhead cost is deferred as part of inventory cost on
b. Absorption costing income will be less than variable costing income if production is less than
sales.
i. Absorption costing expenses all of the current period fixed overhead cost as well as
ii. Variable costing shows on the income statement only current period fixed overhead, so
c. The differences in income between the two methods are only timing differences based on
d. The process of deferring and releasing fixed overhead costs into and from inventory does
make it possible to manipulate income under absorption costing by adjusting levels of
e. To plan, control, and make decisions, managers need to understand and be able to project
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Multiple Choice Questions
1. (LO.1) All of the following are reasons for using predetermined overhead rates in product costing
except:
a. to overcome the problem of fluctuations in activity levels that have no impact on fixed
2. (LO.2) What is the best method for disposing of significant underapplied factory overhead?
a. Charge the underapplied amount to cost of goods sold
3. (LO.2) Select the incorrect statement concerning overapplied overhead.
a. The overhead control account will have a debit balance.
b. The amount of overhead transferred to WIP from the overhead control account exceeded the
4. (LO.3) In determining cost behavior in business, the cost function is often expressed as y = a +
bx. What does the “a” term represent?
5. (LO3) M Company derived the following cost equation to explain its monthly manufacturing
overhead cost:
The standard time required to manufacture one unit is 4 machine hours. The company applies
manufacturing overhead to production on the basis of machine hours and its normal annual
6. (LO.4 & LO.8) Which method of separating mixed costs ensures the best fitting regression line?
a. High-low method
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7. (LO.4) W Company is working on its annual profit plan for the coming year. The company wants
to determine the cost behavior pattern of its maintenance costs. The prior year’s data regarding
maintenance hours and costs are as follows.
Hours of Maintenance
Activity Costs
January 480 $ 4,200
February 320 3,000
March 400 3,600
Using the high-low method, estimate the amount of maintenance cost per hour.
a. $2,781
8. (LO.8) X Company uses simple regression to separate its selling costs (y) into fixed and variable
components based on units sold (x). A computer software program generated the following
regression analysis results:
Average x 400
Average y 3600
a 684.65
What equation should X Company use to estimate its selling costs?
a. y = $3,600 + 400x
9. (LO.5) In applying overhead, individual department rates would be used instead of a plant wide
rate if
a. the manufactured products differ in the resources consumed from the individual departments
in the plant.
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10. (LO.6) Which cost accumulation and reporting system treats the costs of all manufacturing
components (direct material, direct labor, and both variable and fixed overhead) as product
costs?
a. Absorption costing
11. (LO.6) Which cost accumulation and reporting system reports the total contribution margin?
a. Absorption costing
12. (LO.6) Which cost accumulation and reporting system is required for external reporting and tax
purposes?
a. Absorption costing
13. (LO.7) The primary difference between absorption and variable costing lies in the treatment of:
a. variable selling and administrative costs.
14. (LO.7) Which cost accumulation and reporting system provides management an incentive to
over-produce (i.e., produce more units than can be sold)?
a. Absorption costing
15. (LO.7) In a period in which there is no change in inventory, which cost accumulation and reporting
system will report higher profits?
a. Absorption costing
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Multiple Choice Solutions
1. b
2. b
3. a
4. b
6. d
7. c (CMA Adapted)
Unit variable cost = ($4,470 – $2,820) / (520 – 300) = $7.50