Financial and Managerial Accounting

John J. Wild

Third Edition

John J. Wild

Third Edition

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All

rights reserved.

Chapter 19

Variable Costing and Performance Reporting

19-3

Conceptual Learning Objectives

C1: Distinguish between absorption costing and variable costing.

C2: Describe how absorption costing can result in over-production.

C3: Explain the role of variable costing in pricing special orders.

19-4

A1: Analyze income reporting for both absorption and variable costing.

A2: Compute and interpret breakeven volume in units.

Analytical Learning Objectives

19-5

P1: Compute unit cost under both absorption and variable costing.

P2: Prepare an income statement using absorption costing and using variable costing.

P3: Prepare a contribution margin report.P4: Convert income under variable

costing to the absorption cost basis.

Procedural Learning Objectives

19-6

Absorption costing (also called full costing), assumes that products absorb all costs incurred to produce them.

While widely used for financial reporting (GAAP), this costing method can result in misleading product cost information for business decisions.

Absorption costing (also called full costing), assumes that products absorb all costs incurred to produce them.

While widely used for financial reporting (GAAP), this costing method can result in misleading product cost information for business decisions.

Absorption Costing & Variable Costing

C1

19-7

Absorption Costing & Variable Costing

Under variable costing, only costs that change in total with changes in production level are included in product costs.

C1

19-8

Distinguishing Between Absorption Costing and Variable Costing: Absorption Costing

Absorption Costing

Direct Materials

Direct Labor

Variable Overhead

Fixed Overhead

Product Cost

C1

19-9

Distinguishing Between Absorption Costing and Variable Costing:

Variable Costing

Variable Costing

Direct Materials

Direct Labor

Variable Overhead

Fixed Overhead

Product Cost Period Cost

C1

19-10

Difference Between Absorption Costing and Variable Costing: Computing Unit Cost

Direct materials cost…………………………………………. $4 per unitDirect labor cost…………………………………………. $8 per unitOverhead cost Variable overhead cost…………………………………….. $180,000 Fixed overhead cost………………………………………….. 600,000 Total overhead cost…………………………………………..$780,000Expected units produced………………………………….. 60,000 units

Exhibit 19.1 Summary Cost Data

P1

19-11

Difference Between Absorption Costing and Variable Costing: Computing Unit Cost

Absorption Costing

VariableCosting

Direct labor cost per unit……………... $8 $8Direct materials cost per unit…………. 4 4Overhead cost Variable overhead cost per unit….. 3 3 Fixed overhead cost per unit……... 10 - Total product cost per unit……………. $25 $15

Exhibit 19.2 Unit Cost Computation

P1

19-12

Analysis of Income Reporting for Both Absorption and Variable Costing

Production CostsDirect materials cost $4 per unitDirect labor cost $8 per unitVariable overhead cost $3 per unit

Exhibit 19.3 Summary Cost Information for 2007-2009

Variable selling and administrative expenses $2 per unitFixed selling and administrative expenses $200,000 per year

Non-Production Costs

A1

Units Produced Units Sold Units in Ending Inventory2007 60,000 60,000 02008 60,000 40,000 20,0002009 60,000 80,000 0

19-13

Analysis of Income Reporting for Absorption Costing: Units Produced Equal Units Sold

Sales (60,000 x $40)………………………………………………………….. $2,400,000Cost of goods sold (60,000 x $25*)…………………………………………… 1,500,000Gross margin…………………………………………………………………… 900,000Selling and administrative expenses [$200,000 + (60,000 x $2)]………… 320,000Net income……………………………………………………………………….. $580,000

*Units produced equal 60,000; units sold equal 60,000.

Exhibit 19.4 Income for 2007-----Quantity Produced Equals Quantity Sold

† See Exhibit 19.2 for unit cost computation under absorption and variable costing.

IceAge CompanyIncome Statement (Absorption Costing)

For Year Ended December 31, 2007

A1

P2

Notice that the net income is $580,000

19-14

Analysis of Income Reporting for Variable Costing: Units Produced Equal Units Sold

Exhibit 19.4 Income for 2007-----Quantity Produced Equals Quantity Sold

Sales (60,000 x $40) $2,400,000Variable expenses Variable production costs (60,000 x $15*) $900,000 Variable selling and administrative expenses (60,000 x $2) 120,000 1,020,000Contribution margin 1,380,000Fixed expenses Fixed overhead 600,000 Fixed selling and administrative expense $200,000 $800,000Net income $580,000

IceAge CompanyIncome Statement (Variable Costing)For Year Ended December 31, 2007

A1

P2

19-15

Analysis of Income Reporting for Variable Costing: Units Produced Equal Units Sold

Exhibit 19.4 Income for 2007-----Quantity Produced Equals Quantity Sold

Sales (60,000 x $40) $2,400,000Variable expenses Variable production costs (60,000 x $15*) $900,000 Variable selling and administrative expenses (60,000 x $2) 120,000 1,020,000Contribution margin 1,380,000Fixed expenses Fixed overhead 600,000 Fixed selling and administrative expense $200,000 $800,000Net income $580,000

IceAge CompanyIncome Statement (Variable Costing)For Year Ended December 31, 2007

A1

P2

We can see that the income under variable costing is also $580,000. This is because the number of units produced are equal to the number of units sold.

19-16

Analysis of Income Reporting for Both Absorption and Variable Costing: Units

Produced Equal Units Sold

Cost of Goods Sold Ending Inventory Period Cost 2,007(Expense) (Asset) (Expense) Expense

Direct materials 60,000 x $4 $ 240,000 0 x $4 $ 0 $240,000Direct labor 60,000 x $8 480,000 0 x $8 0 480,000Variable overhead 60,000 x $3 180,000 0 x $3 0 180,000Fixed overhead 60,000 x $10 600,000 0 x $10 0 600,000Total costs $1,500,000 $0 $1,500,000

Direct materials 60,000 x $4 $ 240,000 0 x $4 $ 0 240,000Direct labor 60,000 x $8 240,000 0 x $8 0 480,000Variable overhead 60,000 x $3 180,000 0 x $3 0 180,000Fixed overhead $600,000 600,000Total costs $900,000 $0 $600,000 $1,500,000

Cost difference 0

Exhibit 19.4A Production Cost Assignment for 2007

Absorption Costing

Variable Costing

A1

19-17

Analysis of Income Reporting for Absorption Costing: Units Produced Exceed Units Sold

Exhibit 19.5 Income for 2008----Quantity Produced Exceeds Quantity Sold†

Sales (40,000 x $40) $1,600,000Cost of goods sold (40,000x$25*) 1,000,000Gross margin 600,000Selling and administrative expenses [$200,000 + (40,000 x $2)] 280,000Net income $320,000

† See Exhibit 19.2 for unit cost computation under absorption and variable costing.

IceAge CompanyIncome Statement (Absorption Costing)

For Year Ended December 31, 2008

*Units produced equal 60,000; units sold equal 40,000.

A1

P2

19-18

Analysis of Income Reporting for Absorption Costing: Units Produced Exceed Units Sold

Exhibit 19.5 Income for 2008----Quantity Produced Exceeds Quantity Sold†

Sales (40,000 x $40) $1,600,000Cost of goods sold (40,000x$25*) 1,000,000Gross margin 600,000Selling and administrative expenses [$200,000 + (40,000 x $2)] 280,000Net income $320,000

† See Exhibit 19.2 for unit cost computation under absorption and variable costing.

IceAge CompanyIncome Statement (Absorption Costing)

For Year Ended December 31, 2008

*Units produced equal 60,000; units sold equal 40,000.

A1

P2

Income for 2008 is $320,000

19-19

Analysis of Income Reporting for Variable Costing: Units Produced Exceed Units Sold

Sales (40,000 x $40) $1,600,000Variable expenses Variable production costs (40,000 x $15*) $600,000 Variable selling and administrative expenses (40,000 x $2) 80,000 680,000Contribution margin 920,000Fixed expenses Fixed overhead 600,000 Fixed selling and administrative expense 200,000 800,000Net income $120,000

IceAge CompanyIncome Statement (Variable Costing)For Year Ended December 31, 2008

Exhibit 19.5 Income for 2008----Quantity Produced Exceeds Quantity Sold†

A1

P2

19-20

Analysis of Income Reporting for Variable Costing: Units Produced Exceed Units Sold

Sales (40,000 x $40) $1,600,000Variable expenses Variable production costs (40,000 x $15*) $600,000 Variable selling and administrative expenses (40,000 x $2) 80,000 680,000Contribution margin 920,000Fixed expenses Fixed overhead 600,000 Fixed selling and administrative expense 200,000 800,000Net income $120,000

IceAge CompanyIncome Statement (Variable Costing)For Year Ended December 31, 2008

Exhibit 19.5 Income for 2008----Quantity Produced Exceeds Quantity Sold†

A1

P2

Under variable costing, the net income is only $120,000

19-21

Analysis of Income Reporting for Variable Costing: Units Produced Exceed Units Sold

Sales (40,000 x $40) $1,600,000Variable expenses Variable production costs (40,000 x $15*) $600,000 Variable selling and administrative expenses (40,000 x $2) 80,000 680,000Contribution margin 920,000Fixed expenses Fixed overhead 600,000 Fixed selling and administrative expense 200,000 800,000Net income $120,000

IceAge CompanyIncome Statement (Variable Costing)For Year Ended December 31, 2008

Exhibit 19.5 Income for 2008 ---Quantity Produced Exceeds Quantity Sold†

A1

P2

Under absorption costing,$200,000 of fixed overhead is allocated to the 20,000 units in ending inventory and is not expensed until future periods. Variable costing expenses the entire $600,000 of fixed overhead.

19-22

Analysis of Income Reporting for Both Absorption and Variable Costing: Units

Produced Exceed Units Sold

Exhibit 19.5A Production Cost Assignment for 2008Cost of Goods Sold Ending Inventory Period Cost 2008

(Expense) (Asset) (Expense) ExpenseAbsorption Costing

Direct materials 40,000 x $4 $ 160,000 20,000 x $4 $ 80,000 $160,000 Direct labor 40,000 x $8 320,000 20,000 x $8 160,000 320,000Variable overhead 40,000 x $3 120,000 20,000 x $3 60,000 120,000Fixed overhead 40,000 x $10 400,000 20,000 x $10 200,000 400,000Total costs $1,000,000 $500,000 $1,000,000

Variable CostingDirect materials 40,000 x $4 $ 160,000 20,000 x $4 $ 80,000 $160,000 Direct labor 40,000 x $8 320,000 20,000 x $8 160,000 320,000Variable overhead 40,000 x $3 120,000 20,000 x $3 60,000 120,000Fixed overhead ________ _______ $600,000 600,000

Total costs $600,000 $300,000 $600,000 $1,200,000

Cost difference ($200,000)

A1

19-23

Analysis of Income Reporting for Absorption Costing: Units Produced Are Less Than

Units Sold

Exhibit 19.6 Income for 2009—Quantity Produced is Less Than Quantity Sold†

Sales (80,000 x $40) $3,200,000 Cost of goods sold (80,000x$25*) 2,000,000Gross margin 1,200,000Selling and administrative expenses [$200,000 + (80,000 x $2)] 360,000Net income $840,000

† See Exhibit 19.2 for unit cost computation under absorption and variable

IceAge CompanyIncome Statement (Absorption Costing)

For Year Ended December 31, 2009

*Units produced equal 60,000; units sold equal 80,000.

A1

P2

Income is now $840,000

19-24

Analysis of Income Reporting for Variable Costing: Units Produced Are Less Than

Units Sold

Sales (80,000 x $40) $3,200,000 Variable expenses Variable production costs (80,000 x $15*) $1,200,000 Variable selling and administrative expenses ($80,000 x $2) 160,000 1,360,000Contribution margin 1,840,000Fixed expenses Fixed overhead 600,000 Fixed selling and administrative expense 200,000 800,000Net income $1,040,000

Exhibit 19.6 Continued

IceAge CompanyIncome Statement (Variable Costing)For Year Ended December 31, 2009

A1

P2

Income under variable costing is $1,040,000

19-25

Analysis of Income Reporting for Both Absorption and Variable Costing: Units

Produced Are Less Than Units Sold

Cost of Good Sold Ending Inventory Period Cost 2009(Expense) (Asset) (Expense) Expense

Absorption CostingDirect materials 80,000 x $4 $ 320,000 0 x $4 $ 0 $320,000 Direct labor 80,000 x $8 640,000 0 x $8 0 640,000Variable overhead 80,000 x $3 240,000 0 x $3 0 240,000Fixed overhead 80,000 x $10 800,000 0 x $10 0 800,000Total costs $2,000,000 $0 $2,000,000

Variable CostingDirect materials 80,000 x $4 $ 320,000 0 x $4 $ 0 $320,000 Direct labor 80,000 x $8 640,000 0 x $8 0 640,000Variable overhead 80,000 x $3 240,000 0 x $3 0 240,000Fixed overhead ________ ___ $600,000 600,000

Total costs $1,200,000 $0 $600,000 $1,800,000

Cost difference $200,000

Exhibit 19.6A Production Cost Assignment for 2009

A1

19-26

Income Reporting Summarized

Units Producedand Sold Difference

Units produced: 60,000Units sold: 60,000Units produced: 60,000Units sold: 40,000Units produced: 60,000Units sold: 80,000Units produced: 180,000Units sold: 180,000

Exhibit 19.7 Summary of Income Statements

Totals $1,740,000 $1,740,000 $0

2009840,000 1,040,000 -200,000

$0 2008

320,000 120,000 200,000

Income for Absorption Costing

Income for Variable Costing

2007$580,000 $580,000

A1

19-27

Planning ProductionC2

Producing too much inventory

Excess inventory

Higher storage and financing

costs

Greater risk of obsolescence

Producing too little inventory

Lost sales

Customer dissatisfaction

19-28

Planning Production

Exhibit 19.8 Unit Cost Under Absorption CostingWhen 60,000 Units are Produced When 100,000 Units are ProducedDirect materials cost $4 per unit Direct materials $4 per unitDirect labor cost 8 per unit Direct labor 8 per unitVariable overhead 3 per unit Variable overhead 3 per unitTotal variable cost 15 per unit Total variable cost 15 per unitFixed overhead ($600,000/60,000 units) 10 per unit Fixed overhead ($600,000/100,000 units) 6 per unitTotal production cost $25 per unit Total production cost $21 per unit

C2

19-29

Planning Production: Income Under Absorption

Costing for Different Production Levels

Sales (60,000 x $40) $2,400,000 Sales (60,000 x $40) $2,400,000 Cost of goods sold (60,000 x $25*) 1,500,000 Cost of goods sold (60,000 x $21**) 1,260,000Gross margin 900,000 Gross margin 1,140,000Selling and administrative expenses Selling and administrative expenses Variable (60,000 x $2) $120,000 Variable (60,000 x $2) $120,000 Fixed 200,000 320,000 Fixed 200,000 320,000Net income $580,000 Net income $820,000

IceAge CompanyIncome Statement (Absorption Costing)

For Year Ended December 31, 2007[60,000 Units Produced; 60,000 Units Sold]

IceAge CompanyIncome Statement (Absorption Costing)

For Year Ended December 31, 2007[100,000 Units Produced; 60,000 Units Sold]

C2

Exhibit 19.9

19-30

Planning Production: Income Under Absorption Costing for Different Production Levels

Sales (60,000 x $40) $2,400,000 Sales (60,000 x $40) $2,400,000 Variable expenses Variable expenses Variable production costs Variable production costs (60,000 x $15) $900,000 (60,000 x $15) $900,000 Variable selling and administrative Variable selling and administrative expenses (60,000 x $2) 120,000 1,020,000 expenses (60,000 x $2) 120,000 1,020,000Contribution margin 1,380,000 Contribution margin 1,380,000Fixed expenses Fixed expenses Fixed overhead 600,000 Fixed overhead 600,000 Fixed selling and Fixed selling and administrative expense 200,000 800,000 administrative expense 200,000 800,000Net income $580,000 Net income $580,000

For Year Ended December 31, 2007[60,000 Units Produced; 60,000 Units Sold]

For Year Ended December 31, 2007[100,000 Units Produced; 60,000 Units Sold]

C2

Exhibit 19.10

19-31

Planning Production: Income Under Absorption Costing for Different Production Levels

C2

Why is income under absorption costing

affected by the production level

when that for variable costing is

not?

The answer lies in the different

treatment of fixed overhead

costs for the two method.

19-32

Setting Prices

Over the Long Run: Price must be high enough to cover all

costs, including variable costs and fixed costs, and still provide an acceptable return to owners

C3

19-33

Setting Prices

Over the Short Run: Fixed production costs such as the cost to maintain

plant capacity do not change with changes in production levels.

With excess capacity, increases in production level would increase variable production costs, but not fixed costs.

While managers try to maintain the long-run price on existing orders, which covers all production costs, managers should accept special orders provided the special order price exceeds variable cost.

C3

19-34

Setting Prices

Rejecting Special Order Accepting Special OrderIncremental sales $ 0 Incremental sales (1,000 x $22) $22,000Incremental costs 0 Incremental costs

Variable production cost (1,000 x $15) 15,000____ Variable selling expense (1,000 x $2) 2,000

Incremental income $ 0 Incremental income $ 5,000

Exhibit 19.11 Computing Incremental Income for a Special Order

C3

19-35

Contribution Margin ReportP3

Precision TechContribution Margin Report

For the year ended December 31, 2009Sales 18,000$ Variable Expenses Variable production costs 3,600$ Variable selling expenses 6,800 10,400

Contribution margin 7,600$

Contribution margin is the excess of sales over total variable expenses

Contribution margin contributes to covering fixed costs and earning

income

19-36

Contribution Margin ReportP3

Precision TechContribution Margin Report

For the year ended December 31, 2007 %of sales

Sales 18,000$ 100.0%Variable Expenses Variable production costs 3,600$ Variable selling expenses 6,800 10,400 57.8%Contribution margin 7,600$ 42.2%

The Contribution Margin Ratio is contribution margin divided by sales

19-37

Limitations of Reports Using Variable CostingP3

•Absorption costing is almost exclusively used for external reporting (GAAP). •For income tax purposes, absorption costing is the only acceptable basis for filings with the Internal Revenue Service (IRS) under the Tax Reform Act of 1986.

•Absorption costing is the only acceptable basis for both external reporting and tax reporting.

19-38

Converting Reports Under Variable Costing to Absorption Costing

2007 2008 2009Variable costing income $580,000 $120,000 $1,040,000 Add: Fixed overhead cost deferred in ending inventory (20,000 × $10) 0 200,000 0Less: Fixed overhead cost recognized from beginning inventory (20,000 × $10) 0 0 -200,000Absorption costing income $580,000 $320,000 $840,000

Exhibit 19.15 Converting Variable Costing Income to Absorption Costing Income

P4

19-39

Calculating Break-EvenWe can use the data in the following contribution margin format for IceAge to help us determine break-even point.

A2

IceAge CompanyContribution Margin Report

For the year ended December 31, 2009 PerUnit

Sales 2,400$ 40$ Variable Expenses Variable production costs 900$ Variable selling expenses 120 1,020 17 Contribution margin 1,380$ 23$

Fixed expenses 800 Net income 580$

19-40

Calculating Break-Even

Break-Even Volume in Units =

Total Fixed Costs

Contribution Margin per Unit

Where: Contribution margin per unit =

Sales price per unit – Variable cost per unit

A2

19-41

Calculating Break-EvenA2

Precision Tech’s Break-Even Volume in Units

Total fixed costs

CM per unit =$800,000

$23 per unit

= 34,783 units

19-42

End of Chapter 19