Absorption Costing and Operating Profit/Loss Calculation

Overview

• Example of using absorption costing to calculate a company's operating profit or loss.
• Focus on cost data, sales data, and the impact of fixed manufacturing overhead on profits.

Key Data Points

• Sales Price per Unit: $55
• Units Sold per Period: 10,000
• Direct Materials Cost per Unit: $4
• Direct Labor, Variable Manufacturing Overhead, Fixed SGA:
  • Direct Labor: Not specified
  • Variable Manufacturing Overhead: $25/unit
  • Fixed SGA: $60,000 every period
• Fixed Manufacturing Overhead: $150,000 total for the period.

Yearly Breakdown

Year 2019

• Revenue: $55 x 10,000 = $550,000
• Direct Materials Cost: 10,000 units x $4 = $40,000
• Variable Manufacturing Overhead: 10,000 x $25 = $250,000
• Fixed Manufacturing Overhead Allocated: $150,000 (all recognized, no inventory)
• Operating Profit/Loss: Loss of $10,000.

Year 2020

• Revenue: $550,000 (same sales)
• Direct Materials Cost: $40,000 (same cost)
• Variable Manufacturing Overhead: $250,000 (same cost)
• Units Produced: 15,000 units
• Fixed Manufacturing Overhead Per Unit: $150,000 / 15,000 = $10/unit
• Fixed Manufacturing Overhead Recognized: 10,000 x $10 = $100,000
• Deferred Fixed Manufacturing Overhead: $150,000 - $100,000 = $50,000 (added to inventory)
• Operating Profit/Loss: Profit of $40,000.

Year 2021

• Revenue: $550,000 (same sales)
• Direct Materials Cost: $40,000 (same cost)
• Variable Manufacturing Overhead: $250,000 (same cost)
• Units Produced: 5,000 units (due to beginning inventory of 5,000)
• Fixed Manufacturing Overhead Allocated: All $200,000 recognized (includes $50,000 deferred from 2020)
• Operating Profit/Loss: Loss of $60,000.

Key Takeaways

• Impact of Fixed Manufacturing Overhead:
  • Absorption costing defers some fixed manufacturing overhead in periods when production exceeds sales, affecting profit.
  • In the year where production equals sales, operating profit aligns with variable costing.
  • In years where production exceeds sales, profits can appear inflated due to deferred costs.
  • Conversely, when sales exceed production, previously deferred costs can lead to lower profits.
• Profitability Comparison:
  • Absorption costing can make profits appear better in certain scenarios and worse in others compared to variable costing.
  • Total losses over the periods in both costing methods remain the same ($30,000), but timing differences affect reported profits.

Conclusion

• Understanding absorption vs. variable costing is critical as it affects managerial decisions around production planning and profit reporting.