Shahadat HosanFaculty ( Part-time), MBA ProgramStamford University Bangladesh

Variable Costing: A Tool for Managemet

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Overview of Absorption and Variable Costing

The only cost of driving my caron a 200 mile trip today is

$12 for gasoline.

VariableCosting

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Overview of Absorption and Variable Costing

No! You must consider these costs too!

AbsorptionCosting

Cost Per month Per day

Car payment 300.00$ 10.00$

Insurance 60.00 2.00

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Overview of Absorption and Variable Costing

You are wrong. I have the carpayment and the

insurance payment even ifI do not make the trip.

VariableCosting

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Overview of Absorption and Variable Costing

Who’s right?How should we treat the carpayment and the insurance?

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Overview of Absorption and 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

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Variable costing

Balance Sheet Costs Inventories

Note: Manufacturing Cost Flows

Income StatementExpenses

Cost of GoodsSold

Selling andAdministrativePeriod Costs

Work in Process

FinishedGoods

Raw Materials

VariableManufacturing

Overhead

Material Purchases

Direct Labor

Selling andAdministrative

FixedManufacturing

Overhead

Absorption costing

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Let’s put some numbers to theissue and see if it will

sharpen our understanding.

Overview of Absorption and Variable Costing

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Harvey Co. produces a single product with the following information available:

Unit Cost Computations

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Unit product cost is determined as follows:

Selling and administrative expenses arealways treated as period expenses and

deducted from revenue.

Unit Cost Computations

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Absorption CostingSales (20,000 × $30) 600,000$ Less cost of goods sold: Beginning inventory -$ Add COGM (25,000 × $16) 400,000 Goods available for sale 400,000 Ending inventory (5,000 × $16) 80,000 320,000 Gross margin 280,000 Less selling & admin. exp. Variable FixedNet operating income

Harvey Co. had no beginning inventory, produced 25,000 units and sold 20,000 units this year.

Income Comparison of Absorption and Variable Costing

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Harvey Co. had no beginning inventory, produced 25,000 units and sold 20,000 units this year.

Absorption CostingSales (20,000 × $30) 600,000$ Less cost of goods sold: Beginning inventory -$ Add COGM (25,000 × $16) 400,000 Goods available for sale 400,000 Ending inventory (5,000 × $16) 80,000 320,000 Gross margin 280,000 Less selling & admin. exp. Variable (20,000 × $3) 60,000$ Fixed 100,000 160,000 Net operating income 120,000$

Income Comparison of Absorption and Variable Costing

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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$

Now let’s look at variable costing by Harvey Co.Variable

costsonly.

All fixedmanufacturing

overhead isexpensed.

Income Comparison of Absorption and Variable Costing

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Let’s compare the methods.

Income Comparison of Absorption and Variable Costing

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Reconciliation

Variable costing net operating income 90,000$ Add: Fixed mfg. overhead costs deferred in inventory (5,000 units × $6 per unit) 30,000 Absorption costing net opearting income 120,000$

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:

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Harvey Co. Year 2

In its second year of operations, Harvey Co. started with an inventory of 5,000 units, produced 25,000

units and sold 30,000 units.

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Harvey Co. Year 2

Unit product cost is determined as follows:

No change in Harvey’scost structure.

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Harvey Co. Year 2

Now let’s look at Harvey’s income statementassuming absorption costing is used.

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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$

Harvey Co. Year 2

These are the 25,000 unitsproduced in the current period.

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Harvey Co. Year 2

Next, we’ll look at Harvey’s income statementassuming is used.

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Harvey Co. Year 2Variable

costsonly.

All fixedmanufacturing

overhead isexpensed.

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Advantages of the Contribution Approach

Advantages

Management finds it easy to understand.

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.

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Fixed costs arenot really the costs

of any particularproduct.

VariableCosting

Variable versusAbsorption Costing

AbsorptionCosting

All manufacturingAll manufacturingcosts must be assignedcosts must be assignedto products to properlyto products to properlymatch revenues andmatch revenues and

costs.costs.

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AbsorptionCosting

These are capacitycosts and will be

incurred even if nothingis produced.

Variable versusAbsorption Costing

VariableCosting

Depreciation,taxes, insurance andsalaries are just as

essential to productsas variable costs.

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VariableCosting

Absorptioncosting product costs

are misleading fordecision making.

They are the numbers that appear on our

external reports.

AbsorptionCosting

Variable versusAbsorption Costing

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Note on theEffects of Volume

COGS for 10,000 units

$100,000

$150,000

$200,000

Number of units produced

CO

GS

Absorption CostingCost of goods sold decreases because production

exceeds sales, leaving a portion of fixedmanufacturing costs in inventory.

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Impact of JIT Inventory Methods

In a JIT inventory system . . .

Productiontends to equalsales . . .

So, the difference between variable andabsorption income tends to disappear.

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Thank You