Module 6: Absorption and variable costing and budgeting

Required reading
Chapter 8, pages 317-334
Chapter 9, pages 369-397
Overview
The module starts by presenting the merits and applications of absorption and variable costing. It explains the method of
variable costing in detail, including the issue of reconciling absorption costing with variable costing. The module looks at the
impact of lean production on absorption and variable costing and describes the uses of different types of budgets in the
planning process. You have a chance to work through budget preparation steps and learn about the preparation of master
budgets. Module 6 concludes with a discussion of the flexible budget and how it can be used for performance evaluation.
Computer illustration 6.8-1 demonstrates the use of a spreadsheet program to prepare a sales budget and cash collections
schedule. It also demonstrates a basic what-if analysis of the response to changes in selling price and sales volume.
Computer illustration 6.10-1 demonstrates the use of a spreadsheet program to prepare the and use the flexible budget to
break down the variances between actual results and the static budget.
Assignment reminder
Assignment 2 (see Module 7) is due at the end of week 7 (see Course Schedule). You may wish to take a look at it now in
order to familiarize yourself with the requirements and to prepare for any necessary work in advance.
Topic outline and learning objectives
6.1 Absorption and variable costing Explain how absorption costing differs from variable
costing, and compute the unit product cost under
each method. (Level 1)
6.2 Absorption and variable costing income
statements
Prepare income statements using both absorption and
variable costing, and reconcile the two net income
figures by observing the effect of deferred
manufacturing overhead costs. (Level 1)
6.3 Advantages and disadvantages of absorption
and variable costing
Explain the advantages and limitations of both the
absorption and variable costing methods. (Level 1)
6.4 Impact of lean production Explain how the use of lean production methods
decreases or eliminates the difference in net income
reported under the absorption and variable costing
methods. (Level 1)
6.5 Basic framework of budgeting Define budgeting, and explain the difference between
planning and control. (Level 2)
6.6 Advantages of budgets List the principle advantages of budgeting. (Level 2)

6.7 Preparing the master budget Prepare the following budgets: (Level 1)
Sales budget
Production budget
Direct materials budget
Manufacturing overhead budget
Selling and administrative expense budget
Cash budget
Budgeted income statement and balance sheet
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6.8 Computer illustration 6.8-1: Sales budget
and cash collection schedule
Design a worksheet to conduct a what-if analysis of
changes to selling price and sales volume on a sales
budget and a schedule of cash collections. (Level 1)
6.9 Flexible budgets Prepare a flexible budget, and explain the advantages
of the flexible budget approach over the static budget
approach. (Level 1)
6.10 Computer illustration 6.10-1: Determining
flexible budget and sales volume variances
Design a worksheet to calculate the flexible budget
and sales volume variances. (Level 1)
Module summary
Print this module
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6.1 Absorption and variable costing
Learning objective
Explain how absorption costing differs from variable costing, and calculate the unit product cost under each method.
(Level 1)
LEVEL 1
Inventory valuation using variable costing uses only variable manufacturing costs: direct materials, direct labour, and variable
manufacturing overhead. Though they are used to calculate contribution margin, variable selling and administrative expenses
are not part of inventory valuation. Absorption costing charges direct materials, direct labour, and all manufacturing overhead
to inventory. In the Boley Company example in the text, the only difference between total cost per unit under variable
costing ($7) and absorption costing ($12) is fixed manufacturing overhead. In the example, it is allocated to each product
unit on the basis of $30,000 total fixed manufacturing overhead divided by 6,000 units of product produced, or $5 per unit.
Note: Under either absorption or variable costing, all selling and administrative expenses (both fixed and variable) are
always treated as period costs and not product costs. This is highlighted in Exhibit 8-1.
The controversy over fixed manufacturing overhead cost is a financial accounting argument. Management can move costs
between variable and absorption costing almost at will. However, while the variable costing approach is often used for
managerial decision-making purposes, the absorption approach must be used for reporting purposes. IAS 2 paragraph 12
states:
The costs of conversion of inventories include costs directly related to the units of production such as direct labour.
They also include a systematic allocation of fixed and variable production overheads that are incurred in converting
materials into finished goods. Fixed production overheads are those indirect costs of production that remain relatively
constant regardless of the volume of production such as depreciation and maintenance of factory buildings and
equipment, and the cost of factory management and administration.
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6.2 Absorption and variable costing income statements
Learning objective
Prepare income statements using both absorption and variable costing, and reconcile the two net income figures by
observing the effect of deferred manufacturing overhead costs. (Level 1)
LEVEL 1
Exhibit 8-2 presents a simplified comparison of the difference in net income before taxes as determined using absorption
costing or variable costing. Analyze the outcome. If a beginning inventory of Work in process and Finished goods are
presented, the difference is as follows:
Ending inventories (expressed in equivalent units multiplied by fixed overhead per unit)
Less: Beginning inventories (expressed in equivalent units multiplied by fixed overhead per unit)
= Amount of net income before taxes by which absorption costing exceeds variable costing
Increasing inventory levels cause absorption costing income to exceed variable costing income. Decreasing inventory levels
have the opposite effect. This analysis works for all cases, but care must be exercised if the overhead variance has been
prorated to inventory.
In Exhibit 8-2, the cost of goods manufactured of $72,000 under the absorption costing method equals the variable
manufacturing costs of $42,000 plus the fixed manufacturing overhead costs of $30,000 under the variable costing method.
This is why you need only use the inventory amounts to reconcile the differences. If an overhead variance exists under
absorption costing, simply add it to the cost of goods manufactured to achieve the equality. Under variable costing, the profit
depends only on the quantity sold. Under absorption costing, the profit depends on both the quantity produced and the
quantity sold.
Exhibit 8-3 provides a more extensive data set for comparative evaluation. Notice in Exhibit 8-4 how fluctuations in
production affect profits. Exhibit 8-5 reconciles absorption costing to variable costing.
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6.3 Advantages and disadvantages of absorption and variable costing
Learning objective
Explain the advantages and limitations of both the absorption and variable costing methods. (Level 1)
LEVEL 1
Here are the main advantages of the contribution approach with variable costing:
availability of cost-volume-profit (CVP) information on the income statement
elimination of the potential for being misled by profits earned solely from production fluctuations, which occurs under
absorption costing (important for bonuses)
ease of understanding by users
Activity 6.3-1 Absorption versus variable costing
Work through this activity to reinforce your understanding of the differences between absorption and variable costing.
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6.4 Impact of lean production
Learning objective
Explain how the use of lean production methods decreases or eliminates the difference in net income reported under
the absorption and variable costing methods. (Level 1
LEVEL 1
In a lean production system, inventory production is based on customer orders, resulting in minimal inventories of raw
materials and work in process. This substantially reduces the difference between variable and absorption costing results.
Changing inventory costs carried over to the next accounting period are almost non-existent under lean production.
Therefore, the difference in net income under variable and absorption costing is reduced or eliminated.
J IT purchasing, part of lean production, deals with the acquisition of materials and supplies. Lean production deals with the
efficient use of materials and supplies, and can be used to eliminate waste at all levels of an organization.
Chapter summary
This topic marks the end of the textbook coverage of absorption and variable costing. To ensure you understand this material
and the corresponding terminology, read the summary on page 343, and work through Review Problem 1 on pages 343-345.
(Remember to omit material that relates to pages on segment reporting.)
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6.5 Basic framework of budgeting
Learning objective
Define budgeting, and explain the difference between planning and control. (Level 2)
LEVEL 2
A budget is a formal plan for the future, expressed in quantitative terms. Chapter 9 focuses on the use of budgeting as a
planning tool for the management of an organization. It is the job of top management to formulate strategy for the
organization. Management must set the overall mission and objectives for the business unit. The objectives of the company
and the ways in which the company plans to achieve its objectives are often described in the company's business plan.
Management must decide on the product-market strategy (what to sell and to whom) and the competitive strategy (what
methods to use to attract customers, for example, advertising, reputation, pricing, quality, service, product attributes). Any
strategy selected must be consistent with the company's resources (financial, managerial, tangible, and intangible),
organization structure, and management values. Numerous alternatives may be considered. The alternatives that best take
advantage of the opportunities in the environment and that are also feasible in relation to the company's strengths and
weaknesses may be selected for inclusion in the company's plans for the period.
After strategies have been formulated, they must be implemented by such methods as organization structure, policies,
resource allocation, budgets, politics, motivation systems, shared values, leadership, information systems, reporting systems,
and controls. Budgets, therefore, represent one of the means available to management to implement strategies.
Note the relationship between planning and control. Plans often serve as the criteria against which actual results can be
evaluated and control exercised. This implies that control must be achieved through budgets but, in reality, plans and
objectives might not be controlled through budgets. For example, some organizations might not need the formality of
budgets because simple or informal plans may be sufficient.
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6.6 Advantages of budgets
Learning objective
List the principal advantages of budgeting. (Level 2)
LEVEL 2
Here are some of major advantages of budgeting:
Budgets may be used as corporate models to forecast the results of proposed changes in strategy during the strategy
formulation stage.
Budgets provide a mechanism to ensure that all factors have been considered
Budgets assist in coordinating the activities of managers involved.
Budgets help communicate organizational goals, since they reflect the forecast results of strategic choices made by
top management.
Budgets are used in the process of resource allocation to planned strategic programs, such as a new product
introduction.
Some research indicates that the product life cycle of the product lines should influence the budgeting of resources.
Different budget periods are defined on page 371. Consider how quarterly or monthly budgets are formed. What are the
implications of such budgets for the overhead variances referred to in Module 2?
Participative or self-imposed budgets can be effective if used properly. People and groups throughout the organization
have relevant yet different information and the goal is to blend all of the data.
Participation is the term usually applied to this process. However, note the potential for
disrupting the organizational plans if participation is considered to have no meaning.
The budget committee and the manuals it prepares are at the centre of the budgeting process.
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6.7 Preparing the master budget
Learning objective
Prepare the following budgets: (Level 1)
H Sales budget
H Production budget
H Direct materials budget
H Manufacturing overhead budget
H Selling and administrative expense budget
H Cash budget
H Budgeted income statement and balance sheet
LEVEL 1
Preparation of the master budget usually begins with the sales budget. This is an example of when the forecasting described
in Module 4 is used. The budgeting process is simplified in the textbook by assuming a single-product, single-division
company. Note how the cash budget and the income statement are necessary to develop the budgeted balance sheet.
An excellent way to learn how to develop a budget is to set up the schedules provided in the textbook, using computer
spreadsheets. You can later use the spreadsheets to solve particular problems or do analyses.
If Schedule 2 (page 379) is rearranged, it is similar to the calculation of the cost of goods sold in units. Note how inventory
requirements would need to be forecasted in real life. The forecast of 101,000 units to be produced (as calculated in
Schedule 2) is used as follows:
in Schedule 3, to calculate material purchase needs
in Schedule 4, to calculate direct labour-hours and cost
in Schedules 5 and 6, to calculate the manufacturing overhead cost and the manufacturing overhead cost per hour
Schedule 3 is the calculation of direct materials inverted and converted to raw material units.
Schedule 4 is the direct labour budget, which depends on the calculation in Schedule 2 of the number of units to produce for
sale. The direct labour used to produce units in ending inventory is included in a separate calculation in Schedule 6.
Schedule 5 simplifies overhead. Budgeted labour-hours are carried forward from Schedule 4 (based in turn on units to be
produced from Schedule 2).
Schedule 6 calculates manufacturing overhead per hour by using total budgeted overhead cost divided by budgeted direct
labour-hours (both numbers come from Schedule 5). This is the procedure you studied in Module 2.
Note that cash receipts and payments require forecasts of the timing involved.
Schedule 8 shows the cash budget. Note that the budgeted balance sheet, as shown in Schedule 10, is the last schedule
prepared.
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6.8 Computer illustration 6.8-1: Sales budget and cash collection
schedule
Learning objective
Design a worksheet to conduct a what-if analysis of changes to selling price and sales volume on a sales budget and
a schedule of cash collections. (Level 1)
LEVEL 1
You have studied the preparation of a sales budget and a schedule of expected cash collections. In this illustration, you learn
how to use a spreadsheet program to prepare a sales budget and cash collections schedule. All the information required to
complete this illustration is provided for you. Other aspects of the master budget in this case are covered in the computer
question of the self-test for this module.
Material provided
A prebuilt worksheet M6P1
A completed solution worksheet M6P1S
Description
You have just been hired as a new management trainee by Quik-Flik Sales Company, a nationwide distributor of a
revolutionary new cigarette lighter. The company has an exclusive franchise on distribution of the lighter, and sales have
grown so rapidly over the last few years that it has become necessary to add new members to the management team. You
have been given direct responsibility for all planning and budgeting. Your first assignment is to prepare a master budget for
the next three months, starting April 1. You are anxious to make a favourable impression on the president and have
assembled the following information.
The company desires a minimum ending cash balance each month of $10,000. The lighters are forecast to sell for $15 each.
Recent and forecast sales in units are
The large buildup in sales before and during the month of J une is due to Fathers Day. Ending inventories are supposed to
equal 80% of the next months sales in units. The lighters cost the company $9 each.
Purchases are paid for as follows: 60% in the month of purchase and the remaining 40% in the following month. All sales are
on credit, with no discount, and payable within 15 days. The company has found, however, that only 30% of a months sales
are collected by month-end. An additional 50% is collected in the month following, and the remaining 20% is collected in the
second month following. Bad debts have been negligible.
The companys monthly operating expenses are
Variable:
Sales commissions $
1 per
lighter
Fixed:
Wages and salaries $ 36,000
Utilities 1,000
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Insurance expired 1,200
Depreciation 1,500
Miscellaneous 2,000
All operating expenses are paid during the month, in cash, with the exception of depreciation and insurance expired. New
capital assets will be purchased during May for $25,000 cash. The company declares dividends of $12,000 each quarter,
payable in the first month of the following quarter. The companys balance sheet at March 31 follows.
Assets
Cash $ 14,000
Accounts receivable ($36,000 February sales; $147,000 March sales)
$147,000 March sales) 183,000
Inventory (14,000 units) 126,000
Unexpired insurance 14,400
Capital assets, net of depreciation 172,700
Total assets $510,100
Liabilities and Shareholders' Equity
Accounts payable (40% of inventory purchases) $ 63,000
Dividends payable 12,000
Capital stock, no par 300,000
Retained earnings 135,100
Total liabilities and shareholders' equity $510,100
The company can borrow money from its bank at 12% annual interest. All borrowing must be done at the beginning of the
month, and repayments must be made at the end of the month. Repayments, borrowing (and payments of interest) can be
in any amount.
Interest is computed and paid at the end of each quarter on all loans outstanding during the quarter. Round all interest
payments to the nearest whole dollar and calculate interest on whole months (1/12, 2/12, and so forth). The company plans
to use any excess cash to pay loans off as rapidly as possible.
Required
1. In the process of preparing a master budget for the three-month period ending J une 30, you have been asked by the
controller to provide

a. a sales budget by month and in total
b. a schedule of budgeted cash collections from sales and accounts receivable, by month and in total

2. Prepare the required components of the master budget by entering appropriate formulas in rows 24, 25, and 29 to 33
to complete worksheet M6P1.

3. What happens to the budgeted sales and cash collections if the unit sales price is increased to $9 and the receipts
pattern changes to 30% for the first month and 45% for the second month?
Procedure
1. Open the file MA1M6P1.

2. Click the sheet tab M6P1 and study the layout of the worksheet. Observe that rows 6 to 17 have been set up as a
data table. This data table contains information relevant only to the construction of a sales budget and cash
collections schedule. Other information described in the problem has not been included.

3. Display rows 20 to 33. Notice that with the exception of rows 23 and 28, values and formulas are missing from the
sales budget and cash collection schedule.

4. Examine the formulas in row 23 and observe that they refer to the appropriate values in the data table. Examine the
formulas in row 28 and observe how the cash collection of the February sales is recorded for April.

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5. Complete the sales budget in rows 22 to 25 and the budgeted cash collections schedule in rows 27 to 33.

6. Save your completed worksheet and print a copy (range B20 to E33).

7. Click the M6P1S sheet tab and compare the results you obtained in step 6 with those in the solution worksheet. If
you do not have the same results, follow steps 8 and 9. Otherwise proceed to step 10.

8. Print the formulas from your worksheet (range B24 to E33).

9. Click the M6P1S sheet tab and compare the worksheet with your formula printout. Correct any errors.

10. With the M6P1S worksheet on-screen, proceed to the next step for the what-if analysis.

11. For the what-if analysis for part 2, change the unit sales price to $9, and the receipts pattern to 30% for the first
month and 45% for the second month.
You should obtain the following results:
April May June Quarter
Budgeted sales $157,500 $202,500 $270,000 $630,000
Cash collections $125,550 $156,825 $203,625 $486,000
Source: Ray H. Garrison, Eric W. Noreen, G.R. Chesley, and Raymond F. Carroll, Solutions Manual to accompany
Managerial Accounting , Sixth Canadian Edition. Copyright 2004, by
McGraw-Hill Ryerson Limited. Adapted with permission.
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6.9 Flexible budgets
Learning objective
Prepare a flexible budget, and explain the advantages of the flexible budget approach over the static budget
approach. (Level 1)
LEVEL 1
The master budget is also called a static budget because it is based on a planned level of activity, which is
usually the level of sales forecast by the marketing department. This provides an overview for planning for the period and is
a benchmark to help in achieving the companys goals. However, it isnt effective in controlling if the actual level of activity is
different from the planned level of activity.
Schedule 9 on page 389 illustrates the revenues and expenses at a budgeted level of 100,000 units. What happens if the
company sells 110,000 units instead? Revenues will show a favorable variance because more units were sold, but variable
costs will show an unfavorable variance because more units had to be produced than planned. This unfavorable variance
does not require management control because it is driven by a favorable sales variance. Management needs to remove the
variances that naturally take place due to a change in sales.
A flexible budget allows the variance of actual cost from budget to be broken down into volume as well as spending
components the sales-volume variance and the flexible-budget variance. Exhibit 9-6 illustrates how this is done, and
Computer illustration 6.10-1 demonstrates how this report can be developed using a spreadsheet. It identifies variable and
fixed costs and adjusts variable costs based on the actual level of activity (sales). Note that the flexible budget is prepared
using the variable costing approach. It expresses a formula for cost that gives a total consistent with any activity level
registered. Although the problems in the text tend to use direct labour-hours, base measures such as units of production or
machine-hours may also be used.
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6.10 Computer illustration 6.10-1: Determining flexible budget and sales
volume variances
Learning objective
Design a worksheet to calculate the flexible budget and sales volume variances (Level 1)
LEVEL 1
Chapter 9 of the textbook explains how to prepare flexible budgets and perform overhead analysis. This computer illustration
demonstrates how to prepare a flexible budget that contains fixed costs as well as variable costs. This illustration uses the
data from Exhibit 9-6 and demonstrates the preparation of the flexible budget using a spreadsheet program. Study Exhibit 9-
6 carefully before working through this illustration.
Material provided
A partially completed worksheet M6P2
A solution worksheet M6P2S
Required
Complete the worksheet M6P2 by entering appropriate formulas. Compare the results you obtain with the Comprehensive
performance report in Exhibit 9-6.
Procedure
1. Open the file MA1M6P2.

2. Click the M6P-2 sheet tab and study the structure of the worksheet. Column B contains the budgeted unit revenue
and variable costs. Columns C and I contain the Actual and Static Budget amounts for the year. Totals and subtotals
have been set to calculate for these columns only. Rows 8 and 9 contain the sales figures (units and dollars), Rows
10 through 15 contain the variable expense information, and rows 19 through 22 contain the fixed expense
information. Cells F25 and G25 are set up to calculate the static budget variance.

3. Enter the appropriate formulas in column B to calculate the unit cost and sales amount. (use the static budget as a
base) Then enter the formulas in column F to calculate the flexible budget. Once this is complete, prepare the flexible
budget variances and the sales volume variances; columns D and G. Remember to create the formulas in such a way
that any unfavorable variance shows as a negative number.

4. Enter the appropriate formulas in columns E and H to determine if the variance is favorable or unfavorable. Use the
nested =IF statement for this purpose as any number below 0 should be represented with U, any number above 0
should be F and any number that is equal to 0 should be left blank. As an example, the formula for cell E9 which
compares the actual and flexible budget revenues would be:
=IF(D9=0,"",IF(D9<0,"U","F"))
5. When you have completed the worksheet check the final figures with worksheet M6P2S or Exhibit 9-6 in the
textbook. If you do not obtain the same results, print the formulas from your worksheet. Compare your formulas with
those in the solution worksheet. Resolve any discrepancies.
Chapter summary
This topic marks the end of the textbook coverage of budgeting. To ensure you understand this material and the
corresponding terminology, read the summary on pages 397-398, and work through the review problems on pages 398-402.
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Module 6 summary
Module 6 discusses the two generic methods of determining unit product costs absorption and variable costing and the
concept of budgeting.
Topic 6.1 explains the rationale that underlies each of the two alternative costing methods.
Because of the differing treatments of fixed manufacturing overhead, the two methods yield different net operating income
figures. Topic 6.2 addresses this issue and explains the difference between the two net operating income figures.
Topic 6.3 proceeds with an evaluation of both costing methods and highlights the likelihood of making correct decisions with
the CVP analysis using the variable costing approach.
Topic 6.4 explains how lean production can lessen or even eliminate the need for reconciliation of net operating income
figures. It also describes the J IT system, which is part of lean production, in more depth.
The next three topics examine the concept of budgeting. Topic 6.5 establishes the relationships between budgeting,
planning, and control.
Topic 6.6 emphasizes the importance of budgeting and makes connections between goal, strategy, and budget-driven
operations. The budgeting process culminates with the preparation of the master budget which is the object of Topic 6.7.
Topic 6.8 introduces sensitivity analysis into the budgeting process by creating sales budget and budgeted cash collections
schedules and performing a what-if analysis.
Topic 6.9 discusses the importance of using a flexible budget for controlling when the actual level of activity is different from
the planned level of activity.
Finally, Topic 6.10 introduces the use of a spreadsheet that demonstrates the use of the flexible budget to split the static
budget variances into flexible budget and sales volume variances.
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