Variable Costing: A Tool for Management

Copyright © The McGraw-Hill Companies, Inc 2011

VARIABLE COSTING:A TOOL FOR MANAGEMENT

Chapter 6


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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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Harvey Company produces a single productwith the following information available:

Number of units produced annually 25,000 Variable costs per unit:

Direct materials, 4$ Direct labor, 5$ Variable Mfg. overhead 1$ Selling & administrative expenses 3$

Fixed costs per year:Manufacturing overhead 150,000$ Selling & administrative expenses 100,000$

Unit Cost Computations


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Unit product cost is determined as follows:

Under absorption costing, all production costs, variable and fixed, are included when determining unit product

cost. Under variable costing, only the variable production costs are included in product costs.

Absorption Costing

Variable Costing

Direct materials 4$ 4$ Direct labor 5$ 5$ Variable mfg. overhead 1$ 1$ Fixed mfg. overhead ($150,000 ÷ 25,000 units) 6 - Unit product cost 16$ 10$



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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 is no beginning inventory.

Now, let’s compute net operatingincome using both absorptionand variable costing.


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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 (20,000 × $3) 60,000$ Fixed 100,000 160,000 Net operating income 120,000$

Absorption Costing

Fixed manufacturing overhead deferred in inventory is 5,000 units × $6 = $30,000.


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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$

Variablemanufacturing

costs only.

All fixedmanufacturing

overhead isexpensed.

Variable Costing


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Variable costing net operating income 90,000$ Add: Fixed mfg. overhead costs deferred in EI (5,000*$6) 30,000 Ded: Fixed mfg. overhead costs deferred in BI - Absorption costing net operating income 120,000$

Fixed mfg. overhead $150,000 Units produced 25,000 units= = $6 per unit

We can reconcile the difference betweenabsorption and variable income as follows:

Comparing the Two Methods


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Extended Comparisons of Income Data Harvey Company – Year Two

Number of units produced 25,000 Number of units sold 28,000 Units in beginning inventory 5,000 Unit sales price 30$ Variable costs per unit:

Direct materials, direct labor variable mfg. overhead 10$ Selling & administrative expenses 3$

Fixed costs per year:Manufacturing overhead 150,000$ Selling & administrative expenses 100,000$


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Since the variable costs per unit, total fixed costs, and the number of units produced remained unchanged, the unit cost computations also

remain unchanged.

Absorption Costing

Variable Costing

Direct materials, direct labor, and variable mfg. overhead 10$ 10$ Fixed mfg. overhead ($150,000 ÷ 25,000 units) 6 - Unit product cost 16$ 10$


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Absorption CostingSales (28,000 × $30) 840,000$ 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 32,000 448,000 Gross margin 392,000 Less selling & admin. exp. Variable (28,000 × $3) 84,000$ Fixed 100,000 184,000 Net operating income 208,000$

Absorption Costing

Fixed manufacturing overhead released from inventory is 5,000 units × $6 = $30,000.

Unit product

cost.


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Variable CostingSales (28,000 × $30) 840,000$ Less variable expenses: Beg. inventory (5,000 × $10) 50,000$ Add COGM (25,000 × $10) 250,000 Goods available for sale 300,000 Less ending inventory 20,000 Variable cost of goods sold 280,000 Variable selling & administrative expenses (28,000 × $3) 84,000 364,000 Contribution margin 476,000 Less fixed expenses: Manufacturing overhead 150,000$ Selling & administrative expenses 100,000 250,000 Net operating income 226,000$

Variable Costing

All fixedmanufacturing

overhead isexpensed.

Variablemanufacturing

costs only.


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Variable costing net operating income 260,000$ Add: Fixed mfg OH costs from EI (12,000)Ded: Fixed mfg. OH costs from BI 30,000 Absorption costing net operating income 208,000$

We can reconcile the difference betweenabsorption and variable income as follows:

Fixed mfg. overhead $150,000 Units produced 25,000 units= = $6 per unit



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Costing Method 1st Period 2nd Period TotalAbsorption 120,000$ 208,000$ 328,000$ Variable 90,000 226,000 316,000



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Summary of Key Insights

Relation between Effect Relation betweenproduction on variable andand sales iniventories absorption income

Units produced No change Absorption = In =

Units sold inventories Variable Units produced Absorption

> Inventories > Units sold Increase Variable

Units produced Absorption < Inventories <

Units sold decrease Variable


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Absorption Costing vs Variable CostingAbsorption costing (also called full costing) –

CGS includes DM, DL, VOH, and FOH for those units sold (CGS absorbs all manufacturing costs)

Absorption costing I/S (Required by GAAP, IRS for external reporting

Sales Revenue - CGS (DM + DL+FOH+VOH)

Gross Margin - Mktg & Admin Exp (including variable and fixed)

Net income


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Variable CostingVariable costing (also called direct costing) –

CGS includes DM, DL, and VOH for those units sold (CGS includes only variable manufacturing costs)

Variable costing I/SSales revenue

- VC CGS (DM, DL, VOH) - VC Mktg & Admin

Contribution Margin - FC Mfg (FOH) - FC Mktg & Admin

Net income or operating profit


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Advantages and disadvantages of AC vs VC: Impact on the ManagerOpponents of absorption costing argue thatshifting fixed manufacturing overhead costs

between periods can lead to faulty decisions.

These opponents argue that variable costing incomestatements are easier to understand because net operating

income is only affected by changes in unit sales. Thisproduces net operating income figures that are

consistent with managers’ expectations.


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CVP Analysis, Decision Makingand Absorption costing

Absorption costing does not dovetail with CVP analysis, nor does it support decision making. It treats fixed manufacturing

overhead as a variable cost. It assigns per unit fixed manufacturing overhead costs to production.

Treating fixed manufacturing overhead as a variable cost can:• Lead to faulty pricing decisions and faulty

keep-or-drop decisions.

Assigning per unit fixed manufacturing overhead costs to production can:• Potentially produce positive net operating income

even when the number of units sold is less than the breakeven point.


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Benefits of Absorption Costing: External Reporting and Income Taxes

To conform toGAAP requirements,

absorption costing must be used forexternal financial reports in the

United States.Under the Tax

Reform Act of 1986,absorption costing must be

used when filling out income tax returns.Since top executives

are typically evaluated based on earnings reported to shareholders

in external reports, they may feel that decisions should be based on

absorption costing data.


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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.


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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.


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Impact of Lean Production

When companies use Lean Production . . .

Productiontends to equal

sales . . .

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


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Variable Costing and the Theory of Constraints (TOC)

Companies involved in TOC use a form of variable costing. However, one difference of the TOC approach is that it treats direct labor as a fixed cost for three reasons: Many companies have a commitment to guarantee

workers a minimum number of paid hours. Direct labor is usually not the constraint. TOC emphasizes the role direct laborers play in driving

continuous improvement. Since layoffs often devastate morale, managers involved in TOC are extremely reluctant to lay off employees.


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Example: Profit under variable costing vs Absorption costingDM=$3/unit, DL = $5/unit, VOH = $2/unit, FOH = $50 /year, Variable mktg = $2/unit, Fixed

mktg =$10/year, Selling price = $20/unit

20A 20B 20CUnits produced 10 10 10Units sold 10 9 11Under variable costing:

20A(P=S) 20B(P>S) 20C(P<S)Sales $200 $180 $220-VC 120 108 _____CM 80 72 ______-FC 60 60 ______NI 20 12 ______

Under absorption costing:Sales $200 $180 $220-CGS 150 135 ______GM 50 45 ______-Mktg 30 28 ______NI 20 17 ______

Summary:20A 20B 20C

When P=S P>S P<SThen NIAC= NIVC NIAC> NIVC NIAC< NIVC

The difference of NI between VC and AC is due to FOH ;Under VC: All FOH is expensed regardless of sales

Under AC: Allocate FOH between units sold (CGS) and units on hand (INV)


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End of Chapter 6

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Variable Costing: A Tool for Management