Absorption and Direct Costing

Question 1

Absorption and Direct costing

Answer 1

Two methods of assigning manufacturing cost to inventory

Absorption costing - assigns all 3 factors of production (DM, DL, Variable and Fixed MOH) to inventory;

Direct costing - (variable) assigns only variable manufacturing cost (DM, DL, and Variable MOH) to inventory

Absorption costing is required for external reporting purposes

Direct costing used for internal decision-making but CANNOT be used external

Question 2

Income Statement Cost Classifications

Answer 2

Manufacturing company’s income statement typically displays 2 types of costs : product costs and period costs

Principle difference between absorption model and the dirt costing model rests on which costs are assigned to products

1) Absorption model assigns all manufacturing costs to products
2) Direct model assigns only variable manufacturing costs to products

Question 3

EXAM QUE

Answer 3

Inventory valuation, calculation of variable cost/absorption

Question 4

ABSORPTION COSTING INCOME STATEMENT

Answer 4

Sales - Variable Manufacturing Costs - Fixed Manufacturing Costs = GROSS MARGIN

• Variable Selling and Administrative - Fixed Selling and Administrative = Operating Income

Question 5

Direct Costing Income Statement

Answer 5

Sales - Variable Manufacturing Costs - Variable Selling and Administrative Costs = Contribution Margin

• Fixed Manufacturing Costs - Fixed Selling and Administrative = Operating Income

** Although variable selling and administrative costs are listed along with the variable manufacturing costs (direct material, direct labor, variable manufacturing overhead) and are subtracted from sales to arrive at the contribution margin, the variable selling and administrative costs are not product costs and are not considered part of Cost of Goods Sold. Instead, they are always recognized as a period cost and are completely expensed each period. Fixed Manufacturing Costs are treated as period costs.

** Fixed Manufacturing Costs are FOR TOTAL COSTS in DIRECT COST vs FOR UNITS SOLD ONLY in ABSORPTION

Question 6

Effect of Product Costing Model on Operating Income

Answer 6

Absorption costing and direct (variable) costing assign different costs to inventory. Direct costing does not include fixed manufacturing cost as part of product costs, inventory valuation under absorption costing will always be greater than under direct costing. DIRECT COSTING UNDERSTATES ASSETS ON BALANCE SHEET

Question 7

Income Reconciliation

Answer 7

1) when the number of units sold equals the number of units produced, absorption costing and direct costing produce identical incomes
2) Difference between 2 measures of income due to different treatment of FIXED MANUFACTURING COSTS. Direct costing deducts ALL fixed manufacturing cost as a lump sum period cost. Absorption costing assigns fixed manufacturing costs to products and only deducts fixed manufacturing costs WHEN THE UNITS ARE SOLD.

Difference an be calculated as

Ending inventory x fixed cost per unit - beginning inventory x fixed cost per unit
^ INCOME RECONCILIATION RULE