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Direct Costing Financial Statements
Purpose
Accounting has evolved slowly over many centuries. The first important complete treatise on the principles of accounting and bookkeeping was a book by Pacoli in the 1490s. The development of accounting principles and procedures are still continuing to evolve. In the early 1900s, many controversial issues were debated and some were resolved. In the 1950s and 1960s here in the USA, the lack of standardization in accounting was of primary concern. One of controversial areas debated extensively in the 1930s and 1940s was the treatment of manufacturing overhead in the costing of inventory and cost of goods sold. The controversy was commonly labeled absorption costing versus direct costing. To understand the issues involved, a good understanding of the principles of cost accounting is helpful. The purpose of this chapter is to provide a conceptual foundation for understanding the effect that absorption costing and direct costing have on net income. In direct costing, fixed manufacturing overhead is treated as an operating expense (period charge). Absorption costing regards fixed manufacturing overhead as a manufacturing cost properly included in inventory and cost of goods sold. Because of the difference in the treatment of fixed manufacturing overhead, a substantial difference in the measurement of net income can result.
Accounting for Manufacturing Overhead
Manufacturing overhead is one of the three major manufacturing costs. For the most part, materials and labor are considered direct costs and can be easily associated with a specific product or job. However, manufacturing overhead tends to be more intangible and difficult to trace to a product or job. For example, utility cost such as power and light is necessary to the production process, but it is not easily assignable to a product, job, or department. The main solution to distributing overhead cost has been the use of overhead rates. Rates are typically determined by dividing estimated overhead cost by some estimated measure of activity. Consequently, the rates are often called predetermined overhead rates. Activity bases for overhead typically used
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are direct labor hours, direct labor cost, machine hours, and units of product. The conventional theory is that direct labor which is easily capable of being measured correlates directly with the amount of overhead being incurred. If product A has labor cost of $100,000 and product B has labor cost of $200,000, then 1/3 of the overhead would be allocated to product A and 2/3 to product B. However, accountants quickly realized that manufacturing overhead varies in nature in that some overhead tends to be fixed and some tends to be variable. Variable cost was recognized to be caused by activity and to vary directly with changes in activity. If production doubled, for example, the variable overhead likewise doubled. However, fixed manufacturing as the term “fixed” implies remained the same regardless of the level of activity. A theory of accounting for fixed manufacturing overhead developed which stated that fixed overhead provides the capacity to produce and that the bases for application of fixed manufacturing overhead should be some estimate of capacity. The cost of buildings, machines, power plants, and some supervisory labor were labeled capacity costs. Consequently, in cost accounting theory four levels of capacity were developed: expected actual, normal, practical, and theoretical. Overhead rates for fixed manufacturing overhead were developed by dividing estimated fixed manufacturing overhead by some estimated capacity level. Because the selected measure of capacity was likely to be much greater than capacity actually utilized, the use of an overhead rate for fixed manufacturing overhead gave rise to under-applied fixed manufacturing overhead. The methods developed for overhead, particularly fixed manufacturing overhead, at times can have a profound effect on net income. The choice of a capacity base and the method of application can cause significant variations in net income. Among cost accountants, it became quickly recognized that net income was not only a product of sales but also of the accounting for overhead. If production exceeded sales, then this difference caused cost of goods sold to be less and net income greater. If the difference between sales and production decreased, then this fact alone could cause net income to decrease compared to the previous year. To illustrate, assume fixed manufacturing overhead is $1,000,000 and the company is debating whether to make 50,000 units or 100,000 units of product. The estimated fixed manufacturing overhead cost per unit of product would, therefore, be either $10.00 or $20.00. If the company were to actually manufacture 50,000 units of product, then income would be less because cost of goods sold would be $10 per product greater. If management is only concerned about short-term maximization of net income, then the obvious decision would be to make 100,000 units. However, if sales are only 50,000 and 100,000 units of product are manufactured, an excess inventory of 50,000 would exist. If the excess inventory is never sold or has to be sold at a big price decrease, then in the long-term the potential inventory loss could easily more than offset any short-term benefit of over producing. The problem is that the excess inventory is subject to a carrying cost which over time can be a significant out of pocket cost. The traditional method of accounting for overhead just described is called absorption costing. The term absorption implies that fixed manufacturing is absorbed
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- The actual level of production then has an impact on net income. The greater the level of production relative to sales the less is under- applied overhead and the greater is net income.
- The cost of inventory properly includes both fixed and variable manu- facturing overhead.
- Manufacturing overhead, except for under-applied overhead, therefore, becomes an expense only when the goods manufactured (finished goods) are sold.
- Under absorption costing, net income is a function of both production and sales.
The advocates of absorption costing, by far the majority viewpoint, argue strenuously that fixed manufacturing cost is a necessary production cost because it makes production possible and, therefore, must be include in determining the cost of inventory. To not include fixed manufacturing overhead means that the cost of inventory is understated. Absorption Costing can be diagramed in T-accounts as follows:
Work in process Finished goods Cost of goods sold Income summary
Material
Variable Overhead
Fixed Overhead
Factory Labor
This diagram shows that before fixed manufacturing can be a deduction from net income it must first flow through the work in process and finished goods account. To the extent that finished goods is not sold, the amount of fixed manufacturing overhead in finished goods has been absorbed off the income statement. Basis Features of Direct Costing - The basic points of direct costing or variable costing as it is often called may be summarized as follows:
- Fixed manufacturing overhead is not considered to be a production cost properly included in the cost of inventory.
- Fixed manufacturing overhead is regarded as a periodic charge, an operating expense. Regardless of the level of activity, it remains the same in a given time period.
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- Fixed manufacturing is not caused by production. Even at zero level of activity, the cost would still remain.
- An overhead rate is only needed for variable overhead.
- Because it is a cost of each accounting period and remains the same independent of production activity, it should be treated as an expense on the income statement.
- The treatment of fixed manufacturing overhead as a periodic charge eliminates the distortion to net income caused by fluctuations in production relative to sales.
- The cost of inventory should only consist of variable manufacturing costs. Variable overhead should be included in inventory, but not fixed manufacturing overhead. Direct Costing can be diagramed in T-accounts as follows:
Work in process Finished goods Cost of goods sold Income summary
Material
Variable Overhead
Fixed Overhead
Factory Labor
This cost flow diagram shows that fixed manufacturing overhead does not flow through inventory but rather is a direct charge against revenue on the income statement. When both cost flow diagrams are compared, the only difference between direct costing and absorption become quite obvious. The observed difference clearly is how fixed manufacturing overhead is handled. The accounting for variable costs including variable manufacturing overhead is also obviously the same as in direct costing. Effect of Variations in Production Units and Sales Units In order to fully understand the difference consequences of using absorption costing as opposed to using direct costing, the effect of production being more or less than units sold needs to be clearly understood. Some important relationships are the following:
- When production units equals sales units, there is no difference in net income between absorption costing and direct costing. Under this
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- Ending inventory is greater under absorption costing than direct costing by $10 per unit, the amount of the fixed overhead rate. In absorption costing, fixed overhead is included in the cost of inventory whereas in direct costing it is excluded.
- The direct costing income statement above was based on cost- volume-profit principles and clearly delineated all variable and fixed expenses. However, the point needs to be made that this separation of fixed and variable expenses is not a requirement and is strictly an optional choice. As a matter of practice when direct costing is used, a separation of fixed and variable cost is made and contribution margin is shown. However, even under absorption costing, variable and fixed costs may be shown.
Absorption Costing Direct Costing I II III IV Production (units) 80 90 100 60 Sales (units) 70 70 70 70
Sales $2,800 $2,800 $2,800 $2,
Expenses Cost of goods.sold $1,400 $1,400 $1,400 $1, Other expenses 50 50 50 50 Under-applied o/h 200 100 0 400
Total expenses $1,650 $1,550 $1,450 $1,
Net income $1,150 $1,250 $1,350 $ –––––––––– –––––––––– –––––––––– ––––––––––
Ending inventory $200 $400 $600 $200) Cost per unit Material $ 3 Direct labor $ 5 Manufacturing: Variable rate $ 2 Fixed rate $
$
I II III IV Production (units) 80 90 100 60 Sales (units) 70 70 70 70
Sales $2,800 $2,800 $2,800 $2, Variable Expenses Cost of goods sold 700 700 700 700 Other variable (^) _____ (^0) _____ (^0) ____ (^0) ____ 0 $ 700 $700 $ 700 $
Contribution margin $2,100 $2,100 $2,100 $ 2,
Fixed expenses Manufacturing $1,000 $1,000 $1,000 $1, Other operating (^) _____ (^50) _____ (^50) ____ (^50) _____ 50 $1,050 $1,050 $1,050 $1,
Net income $1,050 $1,050 $1,050 $1,
Ending inventory $ 100 $ 200 $ 300 ($ 100) Cost per unit Material $ 3 Direct labor $ 5 Manufacturing (variable) $ 2
$
Figure 7.
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Mathematical Equations for Direct Costing Absorption Costing In chapter 7, the principles of cost-volume-profit analysis are presented mathematically. The cost-volume-profit net income equation was presented as follows: I = P(Q s^ ) - V d(Qs^ ) - (F m^ + F ga^ + F s^ ) V d^ = V m^ + V l^ + V o^ + V s^ + V ga V d^ - Variable cost rate in direct costing
This equation is, in fact, the equation for the direct costing viewpoint. In order to easily compute break even point and target income point, it is necessary to adopt a direct costing approach to income measurement. The basic assumption of cost- volume-profit analysis is that during the period of analysis production units equals sales units. Otherwise, it is necessary to assume direct costing when there is a difference in production and sales. A similar equation for absorption may be created; however, because fixed overhead is considered to be a production cost and because there is the possibility of a variation in production units and sales units, the equation is considerably more complex. The mathematical model for absorption costing is: F m I = P(Q s^ ) - V a^ (Q s^ ) - F gas^ - (F m^ - (Q m^ ) –––) Q p V a^ = V m^ + V l^ + V o^ + (F m^ /Q p) + V s^ + V ga
I - net income F m^ - fixed manufacturing P - price F gas^ - fixed gen., admin., and selling expenses Q s^ - quantity sold V a^ - absorption costing Variable cost rate Q m^ - quantity manufactured ( Note: V a^ includes the fixed manufacturing overhead rate) Q p^ - quantity planned (capacity) V m^ - variable material rate V ga^ - variable gen. & admin. exp. rate V o^ - variable overhead rate
V s^ - variable selling exp. rate V d^ - direct costing variable cost rate
The expression, (F m^ - (Q m^ ) ––– )^ F^ m is under-applied fixed manufacturing overhead. Q p Important Concepts in Direct Costing and Absorption Costing The study of absorption costing and direct costing is rich in accounting concepts.
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Period 1 Income Statements Absorption Costing Direct costing Sales -0- Cost of goods sold (^) _____-0- Gross profit -0- Expenses Selling (^) _____-0- -0- Net income (^) __________-0-
Inventory (100 units) $1,
Sales -0- Cost of goods sold (^) _____-0- Gross profit -0- Expenses Selling -0- Fixed manufacturing overhead $1,000 _____ $1, Net income (loss) ($1,000) _____
Inventory -0-
For the period 1, two completely different net income pictures are painted. Absorption costing shows income to be zero and ending inventory to be $1,000. Direct costing shows the business operating at a loss of $1,000 and that the ending inventory has a zero cost. Which point of view is correct many years ago was the subject of considerable debate.
Period 2 Income Statements Absorption Costing Direct costing Sales $ 1, Cost of goods sold (^) _____1, Gross profit 500 Expenses Selling -0- Under-applied fixed overhead (^) _____1,
______^ 1, Net income (loss) ($____________ 500)
Inventory (0 units) -0-
Sales $ 1, Cost of goods sold -0- ––––– Gross profit 1, Expenses Selling -0- Fixed manufacturing overhead 1, ––––– _____^ 1, Net income $ 500 –––––––––– Inventory ( 0 units) -0-
In period 2, direct costing shows net income to be $500 and under absorption costing a net loss of $500 is reported. Absorption costing shows the loss to be greater when the company had sales. As long as it is manufacturing at capacity under absorption costing, the company will not show a loss. Proponents of direct costing would point out this does not seem to be reasonable. However, proponents of absorption costing would argue that in period 1, direct costing shows the value of inventory to be zero. They would argue that a zero value assigned to inventory is unrealistic. Both absorption costing and direct costing show that for the two periods combined the company lost $500.
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Reconciling Absorption Costing and Direct Costing Net Incomes
As the difference between production and sales increases, the difference in net incomes between absorption costing and direct costing increases. The reason, as explained previously, concerns the amount of fixed manufacturing overhead being absorbed into inventory. The difference in net incomes can easily be reconciled by the following procedure:
Step 1 For absorption costing and direct costing separately compute the change in inventory: Absorption costing Direct Costing
Ending inventory $ ____________ $ _____________ Less Beginning inventory $ ____________ $ _____________ Change in inventory $ ____________ $ _____________
Step 2 Compute the difference in the change in inventory: Absorption costing change $______________ Direct costing change $______________ Difference in the change $______________
The difference in the change in inventory will be equal to the difference in net incomes. In short, as the amount of fixed overhead in inventory increases the difference in net income increases. The above calculation is simply a method of computing the amount of fixed manufacturing overhead in inventory.
To illustrate assume the following:
Variable costs (per unit of product) Cost of goods manufactured $ 10 Selling $ 20 Price $ 100 Capacity 2,000 units
Beginning inventory Units 100 Absorption costing $ 3, Direct costing $ 1, Fixed manufacturing overhead $ 50, Production 1,500 units Sales 1,000 units
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than showing fixed manufacturing overhead as a separate line item on the income statement, there is no requirement to show any other costs as fixed or variable. However, the general practice in preparing direct costing is to identify all costs are fixed and variable. Nevertheless, as shown above even with absorption costing, it is also possible to show all costs as either fixed or variable. Which format to use is determined at the discretion of the management accountant and the preference of management.
Summary
The issue of absorption costing versus direct costing for purposes of external reporting has long been settled in favor of absorption costing. Financial reports to stockholders, banks, Internal Revenue Service, and other regulatory agencies are required to be based on absorption costing. However, for purposes of reporting to management, direct costing may be used. If the business in question is subject to considerable variation in production and sales from period to period and the amount of fixed manufacturing overhead is quite large, then management may prefer for internal reporting purposes to have income reported based on direct costing. If there is little or no significant variation in sales and production from operating period to period, then either method will result in approximately the same net incomes. Only when inventory fluctuates greatly will direct costing make a real difference in the amount of net income reported. Whether or not direct costing is used, it is still possible to identify and use fixed and variable cost on the income statement.
Q. 6.1 What are the major characteristics of absorption costing? Q. 6.2 What are the major characteristics of direct costing? Q. 6.3 What is the fundamental weakness of absorption costing, according to the advocates of direct costing? Q. 6.4 What argument is made to support the idea that fixed manufacturing overhead is not a manufacturing cost? Q. 6.5 What is the main difference in the treatment of cost between absorption costing and direct costing? Q. 6.6 Draw a cost flow diagram of absorption costing. Q. 6.7 Draw a cost flow diagram of direct costing. Q. 6.8 In comparing absorption costing and direct costing, explain the effect of the following: a. Production is greater than sales b. Production is equal to sales c. Production is less than sales Q. 6.9 What are the main arguments against direct costing?
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Q. 6.10 The term “absorption” has reference to what specific manufacturing cost? Q. 6.11 Prepare an outline of the income statement for absorption costing: a. Using a conventional format b. Using a cost-volume-profit format Q. 6-12 Prepare an outline of the income statement for direct costing: a. Using a conventional format b. Using a cost-volume-profit format Q. 6.13 Explain why absorption costing causes net income to increase as production become larger relative to sales. Q. 6.14 How can the difference in net income between absorption costing and direct costing be reconciled?
Exercise 6.1 • Direct Costing Versus Absorption Costing
You have been given the following information: Beginning inventory (units) 0 Units sold this year 10, Units manufactured this year 15, Capacity to manufacture 20,
Material used $ 30, Direct factory labor $ 45, Variable manufacturing overhead $ 60, Fixed manufacturing overhead $ 140, Selling expenses $ 60, General and administrative expenses $ 30, Sales $ 400,
Required: Based on the above information, prepare income statements assuming both direct costing and absorption costing. The fixed overhead rate is to be based on capacity to manufacture. Income Statements Direct Costing Absorption Costing
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Acme Manufacturing Company Income Statement
Absorption Costing Direct Costing Sales $2,800 Sales $2, Expenses Variable expenses: Cost of goods sold 1,120 Cost of goods sold 420 Selling 350 Selling 200 U/A fixed mfg. o/h (^) _____ (^200) ______ ––––– (^) _____ 620 Total expenses $1,670 Contribution margin $2, Fixed expenses Fixed mfg. overhead 1, Selling 150 1, ––––– ––––– Net income $1,130 –––––– Net income $1,030––––– –––––– ––––– Ending inventory $ 160 Ending inventory $ 60
The Acme Manufacturing Company started operations on January 1. On December 31, the above comparative income statements were presented by the company’s management accountant to management. The above statements were prepared based on the following data.
Revenue data: Sales 70 units Price $ Beginning inventory: units 0 cost 0 Manufacturing data: Manufacturing costs per unit: Direct material $ Direct labor $ Variable overhead $ Fixed manufacturing overhead $1, Capacity 100 units Units manufactured 80 units Operating expenses: Variable selling (total) $ Fixed selling $
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Required:
- Compare net income under direct costing with absorption costing net income. Which is greater? _________________________________ List all the differences that you observe in the direct costing income statement: ______________________________________________________ ______________________________________________________ ______________________________________________________ ______________________________________________________ ______________________________________________________
- Now use the direct costing/absorption costing tool. Enter the above data as requested by the program. (If the software package is not available, then you will have to manually make the required computations.)
- Change units manufactured to 90 units. What effect did this change have on net income under: a. Absorption costing? __________________________ b. Direct costing? ______________________________
- Now change the units manufactured to 60 units. What effect did this change have on net income under: a. Absorption costing? __________________________ b. Direct costing? ______________________________
- Using the direct costing/absorption costing tool, enter the starting level of activity as 60. Set the increment in production at 10 units.
What happen to net income as production increased but sales remained the same?
- Explain why net income increased under absorption costing?
- What general rules can be stated concerning net income, production, and sales? a. ___________________________________________ b. ___________________________________________ c. ___________________________________________
