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Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Variable Costing: ATool for Management
Chapter Seven
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Income Statement
Year 1 Year 2 Year 3Sales in Quantity 50,000 40,000 50,000Sales $1,000,000 $800,000 $1,000,000Cost of goods sold: Beginning inventory 0 0 280,000 Add cost of goods manufactured 800,000 840,000 760,000 Goods available for sale 800,000 840,000 1,040,000 Less ending inventory 0 280,000 190,000Cost of goods sold 800,000 560,000 850,000Gross margin 200,000 240,000 150,000Less selling and administrative costs 170,000 150,000 170,000Net operating income (loss) $30,000 $90,000 ($20,000)
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Overview of Absorptionand Variable Costing
Direct Materials
Direct Labor
Variable Manufacturing Overhead
Fixed Manufacturing Overhead
Variable Selling and Administrative Expenses
Fixed Selling and Administrative Expenses
VariableCosting
AbsorptionCosting
ProductCosts
PeriodCosts
ProductCosts
PeriodCosts
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Quick Check
Which method will produce the highest values for work in process and finished goods inventories?
a. Absorption costing.
b. Variable costing.
c. They produce the same values for these inventories.
d. It depends. . .
Which method will produce the highest values for work in process and finished goods inventories?
a. Absorption costing.
b. Variable costing.
c. They produce the same values for these inventories.
d. It depends. . .
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Which method will produce the highest values for work in process and finished goods inventories?
a. Absorption costing.
b. Variable costing.
c. They produce the same values for these inventories.
d. It depends. . .
Which method will produce the highest values for work in process and finished goods inventories?
a. Absorption costing.
b. Variable costing.
c. They produce the same values for these inventories.
d. It depends. . .
Quick Check
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Harvey Company produces a single productwith the following information available:
Unit Cost Computations
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Unit product cost is determined as follows:
Selling and administrative expenses arealways treated as period expenses and
deducted from revenue as incurred.
Unit Cost Computations
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Income Comparison ofAbsorption and Variable Costing
Let’s assume the following additional information for Harvey Company. 20,000 units were sold during the year at a price of
$30 each. There were no units in beginning inventory.
Now, let’s compute net operatingincome using both absorptionand variable costing.
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Variable CostingSales (20,000 × $30) 600,000$ Less variable expenses: Beginning inventory -$ Add COGM (25,000 × $10) 250,000 Goods available for sale 250,000 Less ending inventory (5,000 × $10) 50,000 Variable cost of goods sold 200,000 Variable selling & administrative expenses (20,000 × $3) 60,000 260,000 Contribution margin 340,000 Less fixed expenses: Manufacturing overhead 150,000$ Selling & administrative expenses 100,000 250,000 Net operating income 90,000$
Variable CostingSales (20,000 × $30) 600,000$ Less variable expenses: Beginning inventory -$ Add COGM (25,000 × $10) 250,000 Goods available for sale 250,000 Less ending inventory (5,000 × $10) 50,000 Variable cost of goods sold 200,000 Variable selling & administrative expenses (20,000 × $3) 60,000 260,000 Contribution margin 340,000 Less fixed expenses: Manufacturing overhead 150,000$ Selling & administrative expenses 100,000 250,000 Net operating income 90,000$
Variablemanufacturing
costs only.
All fixedmanufacturing
overhead isexpensed.
Variable Costing
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Income Comparison ofAbsorption and Variable Costing
Let’s compare the methods.
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Reconciliation
Variable costing net operating income 90,000$ Add: Fixed mfg. overhead costs deferred in inventory (5,000 units × $6 per unit) 30,000 Absorption costing net operating income 120,000$
Variable costing net operating income 90,000$ Add: Fixed mfg. overhead costs deferred in inventory (5,000 units × $6 per unit) 30,000 Absorption costing net operating income 120,000$
Fixed mfg. Overhead $150,000 Units produced 25,000 units
= = $6.00 per unit
We can reconcile the difference betweenabsorption and variable income as follows:
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Extended Comparison of Income Data Harvey Company Year Two
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Unit Cost Computations
Since there was no change in the variable costsper unit, total fixed costs, or the number of
units produced, the unit costs remain unchanged.
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Absorption CostingSales (30,000 × $30) 900,000$ Less cost of goods sold: Beg. inventory (5,000 × $16) 80,000$ Add COGM (25,000 × $16) 400,000 Goods available for sale 480,000 Less ending inventory - 480,000 Gross margin 420,000 Less selling & admin. exp. Variable (30,000 × $3) 90,000$ Fixed 100,000 190,000 Net operating income 230,000$
Absorption CostingSales (30,000 × $30) 900,000$ Less cost of goods sold: Beg. inventory (5,000 × $16) 80,000$ Add COGM (25,000 × $16) 400,000 Goods available for sale 480,000 Less ending inventory - 480,000 Gross margin 420,000 Less selling & admin. exp. Variable (30,000 × $3) 90,000$ Fixed 100,000 190,000 Net operating income 230,000$
Absorption Costing
These are the 25,000 unitsproduced in the current period.
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Variable Costing
All fixedmanufacturing
overhead isexpensed.
Variablemanufacturing
costs only.
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Reconciliation
Variable costing net operating income 260,000$ Deduct: Fixed manufacturing overhead costs released from inventory (5,000 units × $6 per unit) 30,000 Absorption costing net operating income 230,000$
We can reconcile the difference betweenabsorption and variable income as follows:
Fixed mfg. Overhead $150,000 Units produced 25,000 units
= = $6.00 per unit
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Effect of Changes in Productionon Net Operating Income
Let’s revise the Harvey Company example.Let’s revise the Harvey Company example.
In the previous example,25,000 units were produced each year,
but sales increased from 20,000 units in yearone to 30,000 units in year two.
In this revised example,production will differ each year while
sales will remain constant.
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Effect of Changes in ProductionHarvey Company Year One
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Unit product cost is determined as follows:
Unit Cost Computations for Year One
Since the number of units produced increasedin this example, while the fixed manufacturing overhead
remained the same, the absorption unit cost is less.
Since the number of units produced increasedin this example, while the fixed manufacturing overhead
remained the same, the absorption unit cost is less.
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Variable CostingSales (25,000 × $30) 750,000$ Less variable expenses: Beginning inventory -$ Add COGM (30,000 × $10) 300,000 Goods available for sale 300,000 Less ending inventory (5,000 × $10) 50,000 Variable cost of goods sold 250,000 Variable selling & administrative expenses (25,000 × $3) 75,000 325,000 Contribution margin 425,000 Less fixed expenses: Manufacturing overhead 150,000$ Selling & administrative expenses 100,000 250,000 Net operating income 175,000$
Variable CostingSales (25,000 × $30) 750,000$ Less variable expenses: Beginning inventory -$ Add COGM (30,000 × $10) 300,000 Goods available for sale 300,000 Less ending inventory (5,000 × $10) 50,000 Variable cost of goods sold 250,000 Variable selling & administrative expenses (25,000 × $3) 75,000 325,000 Contribution margin 425,000 Less fixed expenses: Manufacturing overhead 150,000$ Selling & administrative expenses 100,000 250,000 Net operating income 175,000$
Variable Costing: Year One
Variablemanufacturing
costs only.
All fixedmanufacturing
overhead isexpensed.
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Effect of Changes in ProductionHarvey Company Year Two
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Unit product cost is determined as follows:
Unit Cost Computations for Year Two
Since the number of units produced decreased in thesecond year, while the fixed manufacturing overhead
remained the same, the absorption unit cost is now higher.
Since the number of units produced decreased in thesecond year, while the fixed manufacturing overhead
remained the same, the absorption unit cost is now higher.
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Absorption CostingSales (25,000 × $30) 750,000$ Less cost of goods sold: Beg. inventory (5,000 × $15) 75,000$ Add COGM (20,000 × $17.50) 350,000 Goods available for sale 425,000 Less ending inventory - 425,000 Gross margin 325,000 Less selling & admin. exp. Variable (25,000 × $3) 75,000$ Fixed 100,000 175,000 Net operating income 150,000$
Absorption CostingSales (25,000 × $30) 750,000$ Less cost of goods sold: Beg. inventory (5,000 × $15) 75,000$ Add COGM (20,000 × $17.50) 350,000 Goods available for sale 425,000 Less ending inventory - 425,000 Gross margin 325,000 Less selling & admin. exp. Variable (25,000 × $3) 75,000$ Fixed 100,000 175,000 Net operating income 150,000$
Absorption Costing: Year Two
These are the 20,000 units produced in the currentperiod at the higher unit cost of $17.50 each.
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Variable Costing: Year Two
All fixedmanufacturing
overhead isexpensed.
Variablemanufacturing
costs only.
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Income Comparison
Net operating income is not affected by changes in production using variable costing.
Net operating income is affected by changes in production using absorption costing even though the number of units sold is the same each year.
Conclusions
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Impact on the Manager
Opponents of absorption costing argue that shiftingfixed manufacturing overhead costs between periodscan lead to misinterpretations and faulty decisions.
Opponents of absorption costing argue that shiftingfixed manufacturing overhead costs between periodscan lead to misinterpretations and faulty decisions.
Those who favor variable costing argue that the incomestatements are easier to understand because net operating
income is only affected by changes in unit sales. Theresulting income amounts are more consistent with
managers’ expectations.
Those who favor variable costing argue that the incomestatements are easier to understand because net operating
income is only affected by changes in unit sales. Theresulting income amounts are more consistent with
managers’ expectations.
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
CVP Analysis, Decision Makingand Absorption costing
Absorption costing does not support CVP analysis because it essentially treats fixed
manufacturing overhead as a variable cost by assigning a per unit amount of the fixed
overhead to each unit of production.
Treating fixed manufacturing overhead as a variable cost can:
• Lead to faulty pricing decisions and keep/drop decisions.
• Produce positive net operating income even when the number of units sold is less than the breakeven point.
Treating fixed manufacturing overhead as a variable cost can:
• Lead to faulty pricing decisions and keep/drop decisions.
• Produce positive net operating income even when the number of units sold is less than the breakeven point.
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
External Reporting and Income Taxes
To conform toGAAP requirements,
absorption costing must be used forexternal financial reports in the
United States.
To conform toGAAP requirements,
absorption costing must be used forexternal financial reports in the
United States. Under the TaxReform Act of 1986,
absorption costing must beused when filing income
tax returns.
Under the TaxReform Act of 1986,
absorption costing must beused when filing income
tax returns.Since top executivesare usually evaluated based on
external reports to shareholders,they may feel that decisions
should be based on absorption cost income.
Since top executivesare usually evaluated based on
external reports to shareholders,they may feel that decisions
should be based on absorption cost income.
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Advantages of Variable Costingand the Contribution Approach
Advantages
Management findsit more useful.
Consistent withCVP analysis.
Net operating income is closer to
net cash flow.
Profit is not affected bychanges in inventories.
Consistent with standardcosts and flexible budgeting.
Impact of fixedcosts on profitsemphasized.
Easier to estimate profitabilityof products and segments.
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
VariableCosting
Variable versus Absorption Costing
AbsorptionCosting
Fixed manufacturingcosts must be assignedto products to properlymatch revenues and
costs.
Fixed manufacturing costs are capacity costs
and will be incurredeven if nothing is
produced.
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Variable Costing and theTheory of Constraints (TOC)
Companies involved in TOC use a form of variable costing, but treating direct labor as a fixed cost for three reasons: Many companies have a commitment to guarantee
workers a minimum number of paid hours.
TOC emphasizes the role of direct labor in continuous improvement. Fluctuating levels of direct labor can devastate morale and defeat the role of employees in continuous improvement efforts.
Direct labor is usually not the constraint.
Companies involved in TOC use a form of variable costing, but treating direct labor as a fixed cost for three reasons: Many companies have a commitment to guarantee
workers a minimum number of paid hours.
TOC emphasizes the role of direct labor in continuous improvement. Fluctuating levels of direct labor can devastate morale and defeat the role of employees in continuous improvement efforts.
Direct labor is usually not the constraint.
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Impact of JIT Inventory Methods
In a JIT inventory system . . .
Productiontends to equal
sales . . .
So, the difference between variable andabsorption income tends to disappear.
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