Ch7 Variable Costing

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April 17, 2009

McGraw-Hill/Irwin

Chapter 7

Variable Costing:A Tool for Management

I Made R. Natawidnyana, Ak., CPMAManagerial Accounting VariableCosting

7-2

Learning Objective 1

Explain how variable

costing differs fromabsorption costing andcompute unit product

costs under each method.


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7-3 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


7-4

Quick Check

Which method will produce the highest values forwork in process and finished goods inventories?

a. Absorption costing.

b. Variable costing.

c. They produce the same values for theseinventories.

d. It depends. . .


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7-5

Which method will produce the highest values forwork 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


7-6

Harvey Company produces a single productwith the following information available:

Number of units produced annually 25,000

Variable costs per unit:

Direct materials, direct labor,

and variable mfg. overhead 10$

Selling & administrative expenses 3$

Fixed costs per year:

Manufacturing overhead 150,000$

Selling & administrative expenses 100,000$

Number of units produced annually 25,000

Variable costs per unit:Direct materials, direct labor,

and variable mfg. overhead 10$

Selling & administrative expenses 3$



Selling & administrative expenses 100,000$

Unit Cost Computations


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7-7

Unit product cost is determined as follows:

Under absorption costing, selling andadministrative expenses are

always treated as period expenses anddeducted from revenue as incurred.

Absorption

Costing

Variable

Costing


and variable mfg. overhead 10$ 10$

Fixed mfg. overhead

($150,000 25,000 units) 6 -

Unit product cost 16$ 10$

Absorption

Costing

Variable

Costing



Fixed mfg. overhead

($150,000 25,000 units) 6 -




7-8


Prepare income

statements using bothvariable and absorption

costing.


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7-9 Income Comparison oAbsorption and Variable Costing

Lets assume the following additionalinformation for Harvey Company.

w 20,000 units were sold during the year at a price of$30 each.

w There were no units in beginning inventory.

Now, lets compute net operatingincome using both absorptionand variable costing.


7-10

Absorption CostingSales (20,000 $30) 600,000$

Less cost of goods sold:

Beginning inventory -$

Add COGM (25,000 $16) 400,000Goods 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$




Add COGM (25,000 $16) 400,000Goods available for sale 400,000




Variable (20,000 $3) 60,000$

Fixed 100,000 160,000


Absorption Costing


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7-11

Variable Costing

Sales (20,000 $30) 600,000$

Less variable expenses:


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) 60,000 260,000Contribution margin 340,000

Less fixed expenses:


Selling & administrative expenses 100,000 250,000


Variable

manufacturing

costs only.

All fixed

manufacturing

overhead is

expensed.

Variable Costing


7-12


Reconcile variable costing

and absorption costing netoperating incomes andexplain why the two

amounts differ.


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7-13

Cost of

Goods

Sold

Ending

Inventory

Period

Expense Total

Absorption costing

Variable mfg. costs 200,000$ 50,000$ -$ 250,000$

Fixed mfg. costs 120,000 30,000 - 150,000

320,000$ 80,000$ -$ 400,000$

Variable costingVariable mfg. costs 200,000$ 50,000$ -$ 250,000$

Fixed mfg. costs - - 150,000 150,000

200,000$ 50,000$ 150,000$ 400,000$

Cost of

Goods

Sold

Ending

Inventory

Period

Expense Total

Absorption costing


Fixed mfg. costs 120,000 30,000 - 150,000

320,000$ 80,000$ -$ 400,000$

Variable costing


Fixed mfg. costs - - 150,000 150,000

200,000$ 50,000$ 150,000$ 400,000$

Comparing the Two Methods


7-14

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$


Add: Fixed mfg. overhead costs

deferred in inventory

(5,000 units $6 per unit) 30,000


Fixed mfg. Overhead $150,000Units produced 25,000 units

= = $6.00 per unit

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



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7-15 Extended Comparisons of Income DataHarvey Company Year Two

Number of units produced 25,000

Number of units sold 30,000

Units in beginning inventory 5,000

Unit sales price 30$


Direct materials, direct labor

variable mfg. overhead 10$

Selling & administrative

expenses 3$Fixed costs per year:



expenses 100,000$












expenses 100,000$


7-16


Since there was no change in the variable costs

per unit, total fixed costs, or the number ofunits produced, the unit costs remain unchanged.

Absorption

Costing

Variable

Costing



Fixed mfg. overhead

($150,000 25,000 units) 6 -


Absorption

Costing

Variable

Costing



Fixed mfg. overhead($150,000 25,000 units) 6 -



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7-17



Beg. inventory (5,000 $16) 80,000$

Add COGM (25,000 $16) 400,000


Less ending inventory - 480,000



Variable (30,000 $3) 90,000$Fixed 100,000 190,000




Beg. inventory (5,000 $16) 80,000$

Add COGM (25,000 $16) 400,000





Variable (30,000 $3) 90,000$Fixed 100,000 190,000


Absorption Costing

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


7-18

Variable CostingSales (30,000 $30) 900,000$


Beg. inventory (5,000 $10) 50,000$

Add COGM (25,000 $10) 250,000

Goods avai lable for sale 300,000Less ending inventory -



expenses (30,000 $3) 90,000 390,000

Contribution margin 510,000







Beg. inventory (5,000 $10) 50,000$

Add COGM (25,000 $10) 250,000




expenses (30,000 $3) 90,000 390,000






Variable Costing

All fixed

manufacturingoverhead isexpensed.

Variable

manufacturing

costs only.


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7-19


Deduct: Fixed manufacturing overhead

costs released from inventory

(5,000 units $6 per unit) 30,000


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

Fixed mfg. Overhead $150,000Units produced 25,000 units

= = $6.00 per unit



7-20

Costing Method 1st Period 2nd Period Total

Absorption 120,000$ 230,000$ 350,000$

Variable 90,000 260,000 350,000



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7-21

Summary of Key Insights

Relation between Effect Relation between

production on variable and

and sales iniventory absorption income

Inventory Absorption

Production >Sales increases >

Variable

Inventory Absorption

Production


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7-23 Effect of Changes in ProductionHarvey Company Year One











expenses 100,000$








expenses 3$




expenses 100,000$


7-24


Absorption

Costing

Variable

Costing

Direct materials, direct labor,and variable mfg. overhead 10$ 10$

Fixed mfg. overhead

($150,000 30,000 units) 5 -


Absorption

Costing

Variable

Costing



Fixed mfg. overhead

($150,000 30,000 units) 5 -


Unit Cost Computations for Year One

Since the number of units produced increased

in this example, while the fixed manufacturing overheadremained the same, the absorption unit cost is less.


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7-25




Add COGM (30,000 $15) 450,000




Less selling & admin. exp.Variable (25,000 $3) 75,000$

Fixed 100,000 175,000





Add COGM (30,000 $15) 450,000




Less selling & admin. exp.Variable (25,000 $3) 75,000$

Fixed 100,000 175,000


Absorption Costing: Year One


7-26

Variable Costing

Sales (25,000 $30) 750,000$



Add COGM (30,000 $10) 300,000


Less ending inventory (5,000 $10) 50,000



expenses (25,000 $3) 75,000 325,000






Variable Costing: Year One

Variable

manufacturing

costs only.

All fixed

manufacturingoverhead is

expensed.


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7-27












expenses 100,000$












expenses 100,000$

Effect of Changes in ProductionHarvey Company Year Two


7-28


Absorption

Costing

Variable

Costing

Direct materials, direct labor,and variable mfg. overhead 10$ 10$

Fixed mfg. overhead

($150,000 20,000 units) 7.50 -

Unit product cost 17.50$ 10$

Absorption

Costing

Variable

Costing



Fixed mfg. overhead

($150,000 20,000 units) 7.50 -

Unit product cost 17.50$ 10$

Unit Cost Computations for Year Two

Since the number of units produced decreased in the

second year, while the fixed manufacturing overheadremained the same, the absorption unit cost is now higher.


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7-29



Beg. inventory (5,000 $15) 75,000$

Add COGM (20,000 $17.50) 350,000





Variable (25,000 $3) 75,000$Fixed 100,000 175,000




Beg. inventory (5,000 $15) 75,000$

Add COGM (20,000 $17.50) 350,000




Less sel ling & admin. exp.

Variable (25,000 $3) 75,000$Fixed 100,000 175,000


Absorption Costing: Year Two

These are the 20,000 units produced in the currentperiod at the higher unit cost of $17.50 each.


7-30



Beg. inventory (5,000 $10) 50,000$

Add COGM (20,000 $10) 200,000




expenses (25,000 $3) 75,000 325,000








Beg. inventory (5,000 $10) 50,000$

Add COGM (20,000 $10) 200,000




expenses (25,000 $3) 75,000 325,000






Variable Costing: Year Two

All fixed

manufacturingoverhead isexpensed.

Variable

manufacturing

costs only.


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7-31

Costing Method Year One Year Two Total

Absorption 200,000$ 150,000$ 350,000$

Variable 175,000 175,000 350,000

Net operating income is not affected by changes inproduction using variable costing.

Net operating income is affected by changes in productionusing absorption costing even though the number of unitssold is the same each year.

Conclusions



7-32


Understand the

advantages anddisadvantages of bothvariable and absorption

costing.


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7-33

Impact on the Manager

Opponents of absorption costing argue thatshifting fixed manufacturing overhead costs

between periods can lead to faulty decisions.

These opponents argue that variable costing income

statements are easier to understand because net operatingincome is only affected by changes in unit sales. This

produces net operating income figures that are

more consistent with managers expectations.


7-34 CVP Analysis, Decision Makingand Absorption costing

Absorption costing does not support CVPanalysis because it essentially treats fixed

manufacturing overhead as a variable cost byassigning a per unit amount of the fixed

overhead to each unit of production.Treating fixed manufacturing overhead as avariable cost can:

Lead to faulty pricing decisions and keep-or-dropdecisions.

Produce positive net operating income evenwhen the number of units sold is less than thebreakeven point.


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7-35

External Reporting and Income Taxes

To conform to

GAAP requirements,absorption costing must be used for

external financial reports in theUnited States. Under the Tax

Reform Act of 1986,absorption costing must be

used when filing income

tax returns.

Since top executives

are usually evaluated based onexternal reports to shareholders,

they may feel that decisionsshould be based on

absorption cost income.


7-36 Advantages of Variable Costingand the Contribution Approach

Advantages

Management findsit more useful.

Consistent withCVP analysis.

Net operating incomeis 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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7-37

VariableCosting

Variable versus Absorption Costing

AbsorptionCosting

Fixed manufacturingcosts must be assignedto products to properlymatch revenues and

costs.

Fixed manufacturingcosts are capacity costs

and will be incurredeven if nothing is

produced.


7-38 Variable Costing and theTheory of Constraints (TOC)

Companies involved in TOC use a form of variablecosting. However, one difference of the TOC approach

is that it treats direct labor as a fixed cost for threereasons:

Many companies have a commitment to guaranteeworkers a minimum number of paid hours.

Direct labor is usually not the constraint.

TOC emphasizes the role direct laborers play in drivingcontinuous improvement. Since layoffs often devastatemorale, managers involved in TOC are extremelyreluctant to lay off employees.


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7-39

Impact of J IT Inventory Methods

In a J IT inventory system . . .

Productiontends to equal

sales . . .

So, the difference between variable and

absorption income tends to disappear.


7-40

End of Chapter 7

Ch7 Variable Costing

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