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Chapter 6

Variable Costing andPerformance Reporting

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Conceptual LearningObjectives

C1: Describe how absorption costingcan result in over-production.

C2: Explain the role of variable costing inpricing special orders.

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A1: Compute and interpret breakevenvolume in units.

Analytical Learning Objectives

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P1: Compute unit cost under bothabsorption and variable costing.

P2: Prepare and analyze an incomestatement using absorption costingand using variable costing.

P3: Prepare a contribution margin report.P4: Convert income under variablecosting to the absorption cost basis.

Procedural LearningObjectives

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Absorption costing (also called full

costing), assumes that products

absorb all costs incurred toproduce them.

While widely used for f inancial report in g (GAAP), this

cost ing method can resul t in m is leading product co stinformat ion for bus iness decis ions.

Absorption Costing &Variable Costing

C1

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Absorption Costing & VariableCosting

Under variable costing, onlycosts that change in total with

changes in production level

are included in product costs.

C2

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Distinguishing Between Absorption

Costing and Variable Costing: Absorption

Costing

Absorption Costing

Direct

Materials

Direct

Labor

Variable

Overhead

Fixed

Overhead

Product Cost

P1

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Distinguishing Between Absorption

Costing and Variable Costing:

Variable Costing

Variable Costing

Direct

Materials

Direct

Labor

Variable

Overhead

Fixed

Overhead

Product Cost Period Cost

P1

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Difference Between Absorption Costing and Variable

Costing: Computing Unit Cost

Direct materials cost $4 per unit

Direct labor cost $8 per unit

Overhead costVariable overhead cost $180,000

Fixed overhead cost 600,000

Total overhead cost $780,000

Expected units produced60,000 units

Exhibit 6.1 Summary Cost Data

P1

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Difference Between Absorption Costing and Variable

Costing: Computing Unit Cost

Absorption

Costing

Variable

CostingDirect labor cost per unit... $8 $8

Direct materials cost per unit. 4 4

Overhead cost

Variable overhead cost per unit.. 3 3

Fixed overhead cost per unit... 10 -Total product cost per unit. $25 $15

Exhibit 6.2 Unit Cost Computation

P1

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Analysis of Income Reporting for BothAbsorption and Variable Costing

Production Costs

Direct materials cost $4 per unitDirect labor cost $8 per unit

Variable overhead cost $3 per unit

Exhibit 6.3 Summary Cost Information

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

Non-Production Costs

P1

Units Produced Units Sold Units in Ending Inventory2009 60,000 60,000 0

2010 60,000 40,000 20,000

2011 60,000 80,000 0

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Analysis of Income Reporting for VariableCosting: Units Produced Equal Units Sold

Exhibit 6.4 Income for 2009-----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 1,020,000

Contribution margin 1,380,000

Fixed expensesFixed overhead 600,000

Fixed selling and

administrative expense $200,000 $800,000

Net income $580,000

IceAge Company

Income Statement (Variable Costing)

For Year Ended December 31, 2009

P2

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Analysis of Income Reporting for VariableCosting: Units Produced Equal Units Sold




(60,000 x $15*) $900,000


expenses (60,000 x $2) 120,000 1,020,000



Fixed selling and


Net income $580,000

IceAge Company



P2

We can see that the income undervariable costing is also $580,000. Thisis because the number of units

produced are equal to the number ofunits sold.

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Analysis of Income Reporting for BothAbsorption and Variable Costing: Units

Produced Equal Units Sold

Cost of Goods Sold Ending Inventory Period Cost 2009

(Expense) (Asset) (Expense) Expense

Direct materials 60,000 x $4 $ 240,000 0 x $4 $ 0 $240,000

Direct labor 60,000 x $8 480,000 0 x $8 0 480,000Variable overhead 60,000 x $3 180,000 0 x $3 0 180,000

Fixed overhead 60,000 x $10 600,000 0 x $10 0 600,000

Total costs $1,500,000 $0 $1,500,000

Direct materials 60,000 x $4 $ 240,000 0 x $4 $ 0 240,000

Direct labor 60,000 x $8 240,000 0 x $8 0 480,000

Variable overhead 60,000 x $3 180,000 0 x $3 0 180,000Fixed overhead $600,000 600,000

Total costs $900,000 $0 $600,000 $1,500,000

Cost difference 0

Exhibit 6.5 Production Cost Assignment for 2009

Absorption Costing

Variable Costing

A1

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Analysis of Income Reporting for AbsorptionCosting: Units Produced Exceed Units Sold




(60,000 x $15*) $900,000


expenses (60,000 x $2) 120,000 1,020,000



Fixed selling and


Net income $580,000

IceAge Company



P2

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Analysis of Income Reporting for AbsorptionCosting: Units Produced Exceed Units Sold

Exhibit 6.6 Income for 2010----Quantity Produced Exceeds Quantity Sold

Sales (40,000 x $40) $1,600,000Cost of goods sold (40,000 x $25*) 1,000,000

Gross margin 600,000

Selling and administrative expenses [$200,000 + (40,000 x $2)] 280,000

Net income $320,000

See Exhibit 6.2 for unit cost computation under absorption and variable costing.

IceAge Company

Income Statement (Absorption Costing)


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

P2

Income for 2010 is $320,000

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Analysis of Income Reporting for VariableCosting: Units Produced Exceed Units Sold

Sales (40,000 x $40) $1,600,000

Variable expenses


(40,000 x $15*) $600,000


expenses (40,000 x $2) 80,000 680,000

Contribution margin 920,000

Fixed expenses

Fixed overhead 600,000

Fixed selling and

administrative expense 200,000 800,000Net income $120,000

IceAge Company




P2

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Sales (40,000 x $40) $1,600,000

Variable expenses


(40,000 x $15*) $600,000


expenses (40,000 x $2) 80,000 680,000

Contribution margin 920,000Fixed expenses


Fixed selling and


IceAge Company




P2

Under variable costing, the

net income is only $120,000

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Sales (40,000 x $40) $1,600,000

Variable expenses


(40,000 x $15*) $600,000


expenses (40,000 x $2) 80,000 680,000

Contribution margin 920,000Fixed expenses


Fixed selling and


IceAge Company



Exhibit 6.6 Income for 2010 ---Quantity Produced Exceeds Quantity Sold

P2

Under absorptioncosting,$200,000 of fixedoverhead is allocated to the20,000 units in ending inventoryand is not expensed until futureperiods. Variable costingexpenses the entire $600,000 offixed overhead.

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Produced Exceed Units Sold


Cost of Goods Sold Ending Inventory Period Cost 2011


Absorption 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 $8 160,000 320,000

Variable overhead 40,000 x $3 120,000 20,000 x $3 60,000 120,000

Fixed overhead 40,000 x $10 400,000 20,000 x $10 200,000 400,000

Total costs $1,000,000 $500,000 $1,000,000

Variable Costing

Direct materials 40,000 x $4 $ 160,000 20,000 x $4 $ 80,000 $160,000Direct labor 40,000 x $8 320,000 20,000 x $8 160,000 320,000

Variable overhead 40,000 x $3 120,000 20,000 x $3 60,000 120,000

Fixed overhead ________ _______ $600,000 600,000

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

Cost difference ($200,000)

P2

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Analysis of Income Reporting for AbsorptionCosting: Units Produced Are Less Than

Units Sold

Exhibit 6.8 Income for 2011Quantity Produced is Less Than Quantity Sold

Sales (80,000 x $40) $3,200,000

Cost of goods sold (80,000 x $25*) 2,000,000Gross margin 1,200,000

Selling and administrative expenses [$200,000 + (80,000 x $2)] 360,000

Net income $840,000

See Exhibit 6.2 for unit cost computation under absorption and variable

IceA e Com anIncome Statement (Absorption Costing)

For Year Ended December 31 2011

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

P2

Income is now $840,000

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Analysis of Income Reporting for VariableCosting: Units Produced Are Less Than

Units Sold


Variable roduction costs 80,000 x $15* $1,200,000Variable selling and administrative expenses ($80,000 x $2) 160,000 1,360,000


Fixed expenses


Fixed selling and

administrative expense 200,000 800,000

Net income $1,040,000

Exhibit 6.8 Continued

IceAge Company



P2

Income under variable

costing is $1,040,000

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Produced Are Less Than Units Sold

Cost of Good Sold Ending Inventory Period Cost 2011


Absorption Costing

Direct materials 80,000 x $4 $ 320,000 0 x $4 $ 0 $320,000

Direct labor 80,000 x $8 640,000 0 x $8 0 640,000

Variable overhead 80,000 x $3 240,000 0 x $3 0 240,000

Fixed overhead 80,000 x $10 800,000 0 x $10 0 800,000

Total costs $2,000,000 $0 $2,000,000

Variable Costing

Direct materials 80,000 x $4 $ 320,000 0 x $4 $ 0 $320,000Direct labor 80,000 x $8 640,000 0 x $8 0 640,000

Variable overhead 80,000 x $3 240,000 0 x $3 0 240,000

Fixed overhead ________ ___ $600,000 600,000

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

Cost difference $200,000


P2

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Income Reporting Summarized

Units Produced

and Sold Difference

Units produced: 60,000Units sold: 60,000

Units produced: 60,000

Units sold: 40,000

Units produced: 60,000

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

Units sold: 180,000

Exhibit 6.10 Summary of Income Statements

Totals

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

2011

840,000 1,040,000 -200,000

$0

Income for

Absorption Costing

Income for

Variable Costing

2009$580,000 $580,000

2010

320,000 120,000 200,000

P2

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Planning ProductionC1

Producing toomuch inventory

Excessinventory

Higher storageand financing

costs

Greater risk of

obsolescence

Producing toolittle inventory

Lost sales

Customerdissatisfaction

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Planning Production

Exhibit 6.12 Unit Cost Under Absorption Costing

When 60,000 Units are Produced When 100,000 Units are Produced

Direct materials cost $4 per unit Direct materials $4 per unitDirect labor cost 8 per unit Direct labor 8 per unit

Variable overhead 3 per unit Variable overhead 3 per unit

Total variable cost 15 per unit Total variable cost 15 per unit

Fixed overhead ($600,000/60,000 units) 10 per unit Fixed overhead ($600,000/100,000 units) 6 per unit

Total production cost $25 per unit Total production cost $21 per unit

C1

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Pl i P d ti I U d

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Planning Production: Income UnderAbsorption 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**) 1,260,000

Gross margin 900,000 Gross margin 1,140,000

Selling and administrative expenses Selling and administrative expensesVariable (60,000 x $2) $120,000 Variable (60,000 x $2) $120,000

Fixed 200,000 320,000 Fixed 200,000 320,000

Net income $580,000 Net income $820,000

IceAge Company



[60,000 Units Produced; 60,000 Units Sold]

IceAge Company




C1

Exhibit 6.13

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Pl i P d ti I U d

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Planning Production: Income UnderAbsorption 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 1,020,000

Contribution margin 1,380,000 Contribution margin 1,380,000

Fixed 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 200,000 800,000

Net income $580,000 Net income $580,000





C1

Exhibit 6.14

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Setting Prices

Over the Long Run:

Price must be high enough to cover allcosts, including variable costs and

fixed costs, and still provide an

acceptable return to owners

C2

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Setting Prices

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

plant capacity do not change with changes inproduction levels.

With excess capacity, increases in production levelwould increase variable production costs, but notfixed costs.

While managers try to maintain the long-run priceon existing orders, which covers all productioncosts, managers should accept special ordersprovided the special order price exceeds variablecost.

C2

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Setting Prices

Rejecting Special Order Accepting Special Order

Incremental 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 6.14 Computing Incremental Income for a Special Order

C2

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Contribution Margin ReportP3

Precision Tech

Contribution Margin Report

For the year ended December 31, 2011

Sales 18,000$Variable Expenses

Variable production costs 3,600$

Variable selling expenses 6,800 10,400Contribution margin 7,600$

Contributionmargin is the

excess ofsales overtotal variableexpensesContribution margin contributes to

covering fixed costs and earning

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Contribution Margin ReportP3

Precision Tech


For the year ended December 31, 2009 %of sales

Sales 18,000$ 100.0%

Variable ExpensesVariable production costs 3,600$

Variable selling expenses 6,800 10,400 57.8%

Contribution margin 7,600$ 42.2%

TheContributionMargin Ratiois contribution

margindivided bysales

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Limitations of Reports Using Variable CostingP3

Absorption costing is almost exclusivelyused for external reporting (GAAP).

For income tax purposes, absorptioncosting is the only acceptable basis forfilings with the Internal Revenue Service(IRS) under the Tax Reform Act of 1986.

Absorption costing is the only acceptablebasis for both external reporting and taxreporting.

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Converting Reports Under Variable

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Converting Reports Under Variable

Costing to Absorption Costing

2009 2010 2011

Variable costing income $580,000 $120,000 $1,040,000

Add: Fixed overhead cost deferred in ending inventory (20,000 $10) 0 200,000 0

Less: Fixed overhead cost recognized from beginning inventory (20,000 $10) 0 0 -200,000

Absorption costing income $580,000 $320,000 $840,000

Exhibit 6.15 Converting Variable Costing Income to Absorption Costing Income

P4

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Calculating Break-Even

We can use the data in the following contribution marginformat for IceAge to help us determine break-even point.

A1

IceAge Company


For the year ended December 31, 2009 Per

Unit

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$

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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

A1

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Calculating Break-EvenA1

Precision Techs Break-Even Volume in Units

Total fixed costsCM per unit =

$800,000

$23 per unit

= 34,783 units

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End of Chapter 6

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MGR_Ch06