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Variable Costing:A Tool for Management

Chapter

7

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McGraw-Hill Ryerson Limited., 2001

7-3

LEARNING OBJECTIVES

4. Explainthe effect of changes in production on

the net income reported under both variableand absorption costing.

5. Explainthe advantages and limitations of both

the variable and absorption costing methods.6. Explainhow the use of JIT reduces the

difference in net income reported under the

variable and absorption costing methods.

After studying this chapter, you should be able to:

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7-4

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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7-5


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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7-6


Variable Costing

Your wrong. I have the carpayment and the

insurance payment even ifI do not make the trip.

VariableCosting

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7-7


Variable Costing

Whos right?How should we treat the carpayment and the insurance?

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7-8

Absorption

Costing

Variable

Costing

Direct materials

Direct labour Product costs

Product costs Variable mfg. overhead

Fixed mfg. overhead

Period costs

Period costs Selling & admin. exp.


Variable Costing

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7-9

Lets put some numbers to theissue and see if it will

sharpen our understanding.


Variable Costing

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7-10

Harvey Co. produces a single product withthe following information available:

Number of units produced annually 25,000

Variable costs per unit:

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

Selling & administrative expenses 3$

Fixed costs per year:Manufacturing overhead 150,000$

Selling & administrative expenses 100,000$

Unit Cost Computations

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7-11

Unit product costis determined as follows:

Selling and administrative expenses arealways treated as period expensesand

deducted from revenue.

Absorption

Costing

Variable

Costing

Direct materials, direct labour,

and variable mfg. overhead 10$ 10$Fixed mfg. overhead

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

Unit product cost 16$ 10$

Unit Cost Computations

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7-12

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

Less cost of goods sold:

Beginning inventory -$Add COGM (25,000 $16) 400,000

Goods availa ble for sale 400,000

Ending inventory (5,000 $16) 80,000 320,000

Gross margin 280,000

Less se lling & admin. e xp. Variable

Fixed

Net income

Harvey Co. had no beginning inventory, produced

25,000units and sold 20,000units this year.

Income Comparison of Absorption

and Variable Costing

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7-13

Harvey Co. had no beginning inventory, produced

25,000units and sold 20,000units this year.Absorption Costing

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

Less cost of goods sold:

Beginning inventory -$Add COGM (25,000 $16) 400,000

Goods availa ble for sale 400,000

Ending inventory (5,000 $16) 80,000 320,000


Less se lling & admin. e xp. Varia ble (20,000 $3) 60,000$

Fixed 100,000 160,000

Net income 120,000$



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7-14

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

Less variable expenses:

Beginning inventory -$

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

Goods available for sale 250,000Ending 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 340,000Less fixed expenses:

Manufacturing overhead 150,000$

Selling & administrative expenses 100,000 250,000

Net income 90,000$

Now lets look at variable costing by Harvey Co.



Variablecostsonly.

All fixed

manufacturingoverhead isexpensed.

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7-15

Cost of

Goods

Sold

Ending

Inventory

Period

Expense Total

Absorption costing

Variable mfg. costs 200,000$ 50,000$Fixed mfg. costs 120,000 30,000

320,000$ 80,000$

Variable costing

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

Fixed mfg. costs - -

200,000$ 50,000$

Lets compare the methods.



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7-16

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 costing

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

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

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

Lets compare the methods.



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7-17

Reconciliation

Variable costing net income 90,000$

Add: Fixed mfg. overhead costs

deferred in inventory

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

Absorption costing net income 120,000$

Fixed mfg. overhead $150,000Units produced 25,000

= = $6.00 per unit

We can reconcile the difference between

absorption and variable income as follows:

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7-18

Extending the Example

Lets look at thesecond yearof operations

for HarveyCompany.

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7-19

Harvey Co. Year 2 In its second year of operations, Harvey Co.

started with an inventory of 5,000 units,

produced 25,000units and sold 30,000units.

Number of units produced annually 25,000

Variable costs per unit:

Direct materials, direct laborvariable mfg. overhead 10$

Selling & administrative

expenses 3$

Fixed costs per year:Manufacturing overhead 150,000$

Selling & administrative

expenses 100,000$

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7-21

Harvey Co. Year 2

Now lets look at Harveys income statement

assuming absorption costingis used.

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7-22

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

Ending inventory - 480,000


Less selling & admin. exp.

Variable (30,000 $3) 90,000$

Fixed 100,000 190,000

Net income 230,000$

Harvey Co. Year 2

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

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7-23

Harvey Co. Year 2

Next, well look at Harveys income statement

assuming is used.

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7-24

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

Less variable expenses: Beg. inventory (5,000 $10) 50,000$

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

Goods available for sale 300,000

Ending inventory -

Variable cost of goods sold 300,000

Variable selling & administrative

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

Contribution margin 510,000

Less fixed expenses: Manufacturing overhead 150,000$

Selling & administrative expenses 100,000 250,000

Net income 260,000$

Harvey Co. Year 2Variablecostsonly.

All fixedmanufacturing

overhead isexpensed.

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7-25

Summary

Income Comparison

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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7-26

SummaryRelation between Effect Rela tion betweenproduction on variable and

Year and sa les iniventory absorption income

Inventory Absorption

1st Production > Sales increases by >

year 25,000 > 20,000 5,000 units. Variable

Inventory Absorption2nd Production < Sales decreases

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