Variable Cosng and Performance Repor,ng...Absorption Costing Variable Costing 19-15 P 2 Analysis of...

VariableCos,ngandPerformanceRepor,ng

19-1

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19-P1: Compute unit cost under both absorption and variable costing.

19-3

Absorption costing (also called full costing), assumes that products absorb all costs incurred to produce them.

•  While widely used for financial reporting (GAAP), this costing method can result in misleading product cost information for managers’ business decisions.

Absorption Costing & Variable Costing

19-3

P 1

Absorption Costing & Variable Costing

Under variable costing, only costs that change in total with changes in production level are included in product costs.

19-4

P 1

Distinguishing between Absorption Costing and Variable Costing: Absorption Costing

(Based on Exhibit 19.1)

Absorption Costing

Direct Materials

Direct Labor

Variable Overhead

Fixed Overhead

Product Cost

19-5

P 1

Variable Costing

Direct Materials

Direct Labor

Variable Overhead

Fixed Overhead

Product Cost Period Cost

19-6

Distinguishing between Absorption Costing and Variable Costing: Variable Costing

(Based on Exhibit 19.1)

P 1

Difference between Absorption Costing and Variable Costing: Computing Unit Cost

Direct materials cost…………………………………………. $4 per unitDirect labor cost…………………………………………. $8 per unitOverhead cost Variable overhead cost…………………………………….. $180,000 Fixed overhead cost………………………………………….. 600,000 Total overhead cost…………………………………………..$780,000Expected units produced………………………………….. 60,000 units

Exhibit 19.2 Summary Product Cost Data

19-7

P 1

Difference between Absorption Costing and Variable Costing: Computing Unit Cost

Absorption Costing

VariableCosting

Direct materials cost per unit……………... $4 $4Direct labor cost per unit…………. 8 8Overhead cost Variable overhead cost per unit….. 3 3 Fixed overhead cost per unit……... 10 - Total product cost per unit……………. $25 $15

Exhibit 19.3 Unit Cost Computation

19-8

Direct materials cost…………………………………………. $4 per unitDirect labor cost…………………………………………. $8 per unitOverhead cost Variable overhead cost…………………………………….. $180,000 Fixed overhead cost………………………………………….. 600,000 Total overhead cost…………………………………………..$780,000Expected units produced………………………………….. 60,000 units

Exhibit 19.2 Summary Product Cost Data

$180,000/ 60,000 units = $3/unit

$600,000/ 60,000 units = $10/unit

Variable OH cost per unit:

Fixed OH cost per unit:

P 1

Copyright © 2015 McGraw-Hill Education

NEED-TO-KNOW A manufacturer reports the following data. Direct materials $6.00 per unit Direct labor $14.00 per unit Overhead costs:

Variable overhead $220,000 per year Fixed overhead $680,000 per year

Expected units produced 20,000 units 1) Compute the total product cost per unit under absorption costing.

$220,000 / 20,000 units = $11 per unit $680,000 / 20,000 units = $34 per unit

2) Compute the total product cost per unit under variable costing.

$6.00

$14.00

$11.00

$34.00

$6.00

$14.00

$11.00

$34.00

$65.00 per unit $31.00 per unit

P 1 19-9

Analysis of Income Reporting for Both Absorption and Variable Costing

Manufacturing CostsDirect materials cost $4 per unitDirect labor cost $8 per unitVariable overhead cost $3 per unitFixed overhead cost $600,000 per year

Summary Cost Information for 2013-2015

Variable expenses $2 per unit Fixed expenses $200,000 per year

Selling and Administrative Expenses

Units Produced Units Sold Units in Ending Inventory2013 60,000 60,000 02014 60,000 40,000 20,0002015 60,000 80,000 0

19-10

P 1

19-P2: Prepare and analyze an income statement using absorption costing and using variable costing.

19-11

Analysis of Income Reporting for Absorption Costing: Units Produced Equal Units Sold

Sales (60,000 x $40)………………………………………………………….. $2,400,000Cost of goods sold (60,000 x $25*)…………………………………………… 1,500,000Gross margin…………………………………………………………………… 900,000Selling and administrative expenses [$200,000 + (60,000 x $2)]………… 320,000Net income……………………………………………………………………….. $580,000

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

Exhibit 19.4 Income for 2013 ----Quantity Produced Equals Quantity Sold†

† See Exhibit 19.3 for unit cost computation under absorption and variable costing.

IceAge CompanyIncome Statement (Absorption Costing)

For Year Ended December 31, 2013

Notice that the net income is $580,000

19-12

P 2

Analysis of Income Reporting for Variable Costing: Units Produced Equal Units Sold

Exhibit 19.4 Income for 2013-----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 1,020,000Contribution margin 1,380,000Fixed expenses Fixed overhead 600,000 Fixed selling and administrative expense 200,000 $800,000Net income $580,000

IceAge CompanyIncome Statement (Variable Costing)For Year Ended December 31, 2013

19-13

P 2

A performance report that excludes fixed expenses and net income is a contribution margin report. It’s bottom line is contribution margin.

We can see that the income under variable costing is also $580,000. This is because the number of units produced are equal to

the number of units sold.

Contribution Margin Report

IceAge CompanyContribution Margin Report

For the Year Ended December 31, 2013Sales 2,400,000$ Variable Expenses Variable production costs $900,000 Variable selling expenses 120,000 1,020,000 Contribution margin 1,380,000$

Sales - Variable expenses = Contribution margin

**Contribution margin contributes to covering fixed costs and earning

income

19-14

P 2

Analysis of Income Reporting for Both Absorption and Variable Costing: Units Produced Equal Units Sold

Cost of Goods Sold Ending Inventory Period Cost Total

(Expense) (Asset) (Expense) Expense

Direct materials 60,000 x $4 $ 240,000 0 x $4 $0 $240,000Direct labor 60,000 x $8 480,000 0 x $8 0 480,000Variable overhead 60,000 x $3 180,000 0 x $3 0 180,000Fixed overhead 60,000 x $10 600,000 0 x $10 0 600,000Total costs 1,500,000 0 $1,500,000

Direct materials 60,000 x $4 $ 240,000 0 x $4 $0 $240,000Direct labor 60,000 x $8 480,000 0 x $8 0 480,000Variable overhead 60,000 x $3 180,000 0 x $3 0 180,000Fixed overhead $600,000 600,000Total costs $900,000 0 $600,000 $1,500,000

Cost difference $0

Exhibit 19.5 Production Cost Assignment for 2013

Absorption Costing

Variable Costing

19-15

P 2

Analysis of Income Reporting for Variable Costing: Units Produced Exceed Units Sold

Exhibit 19.6 Income for 2014-----Quantity Produced Equals Quantity Sold

Sales (40,000 x $40) $1,600,000Variable expenses Variable production costs (40,000 x $15*) $600,000 Variable selling and administrative expenses (40,000 x $2) 80,000 680,000Contribution margin 920,000Fixed expenses Fixed overhead 600,000 Fixed selling and administrative expense $200,000 $800,000Net income $120,000


19-16

P 2

Analysis of Income Reporting for Absorption Costing: Units Produced Exceed Units Sold

Exhibit 19.6 Income for 2014----Quantity Produced Exceeds Quantity Sold†

Sales (40,000 x $40) $1,600,000Cost of goods sold (40,000 x $25*) 1,000,000Gross margin 600,000Selling and administrative expenses [$200,000 + (40,000 x $2)] 280,000Net income $320,000





Income for 2014 is $320,000

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P 2


Sales (40,000 x $40) $1,600,000Variable expenses Variable production costs (40,000 x $15*) $600,000 Variable selling and administrative expenses (40,000 x $2) 80,000 680,000Contribution margin 920,000Fixed expenses Fixed overhead 600,000 Fixed selling and administrative expense 200,000 800,000Net income $120,000


Exhibit 19.6 Income for 2014----Quantity Produced Exceeds Quantity Sold

Under variable costing, the net income is only $120,000

19-18 P 2


Sales (40,000 x $40) $1,600,000Variable expenses Variable production costs (40,000 x $15*) $600,000 Variable selling and administrative expenses (40,000 x $2) 80,000 680,000Contribution margin 920,000Fixed expenses Fixed overhead 600,000 Fixed selling and administrative expense 200,000 800,000Net income $120,000


Exhibit 19.6 Income for 2014 ---Quantity Produced Exceeds Quantity Sold

Under absorption costing,$200,000 of fixed overhead is allocated to the 20,000 units in ending inventory and is not expensed until future periods. Variable costing expenses the entire $600,000 of fixed overhead.

19-19 P 2

Analysis of Income Reporting for Both Absorption and Variable Costing: Units

Produced Exceed Units Sold

Exhibit 19.7 Production Cost Assignment for 2014Cost of Goods Sold Ending Inventory Period Cost Total

(Expense) (Asset) (Expense) ExpenseAbsorption CostingDirect 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 $8 160,000 320,000Variable overhead 40,000 x $3 120,000 20,000 x $3 60,000 120,000Fixed overhead 40,000 x $10 400,000 20,000 x $10 200,000 400,000Total costs $1,000,000 $500,000 $1,000,000

Variable CostingDirect 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 $8 160,000 320,000Variable overhead 40,000 x $3 120,000 20,000 x $3 60,000 120,000Fixed overhead ________ _______ $600,000 600,000Total costs $600,000 $300,000 $600,000 $1,200,000

Cost difference ($200,000)

19-20

P 2

Analysis of Income Reporting for Absorption Costing: Units Produced Are Less Than Units Sold

Exhibit 19.8 Income for 2015—Quantity 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 1,200,000Selling and administrative expenses [$200,000 + (80,000 x $2)] 360,000Net income $840,000





Income is now $840,000

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P 2

Sales (80,000 x $40) $3,200,000 Variable expenses Variable production costs (80,000 x $15*) $1,200,000 Variable selling and administrative expenses ($80,000 x $2) 160,000 1,360,000Contribution margin 1,840,000Fixed expenses Fixed overhead 600,000 Fixed selling and administrative expense 200,000 800,000Net income $1,040,000

Exhibit 19.8 ContinuedIceAge Company

Income Statement (Variable Costing)For Year Ended December 31, 2015

Income under variable costing is $1,040,000

19-22

Analysis of Income Reporting for Variable Costing: Units Produced Are Less Than Units Sold

P 2

Analysis of Income Reporting for Both Absorption and Variable Costing: Units

Produced Are Less Than Units Sold

Cost of Good Sold Ending Inventory Period Cost Total(Expense) (Asset) (Expense) Expense

Absorption CostingDirect materials 80,000 x $4 $ 320,000 0 x $4 $ 0 $ 320,000 Direct labor 80,000 x $8 640,000 0 x $8 0 640,000Variable overhead 80,000 x $3 240,000 0 x $3 0 240,000Fixed overhead 80,000 x $10 800,000 0 x $10 0 800,000Total costs $2,000,000 $0 $ 2,000,000

Variable CostingDirect materials 80,000 x $4 $ 320,000 0 x $4 $ 0 $320,000 Direct labor 80,000 x $8 640,000 0 x $8 0 640,000Variable overhead 80,000 x $3 240,000 0 x $3 0 240,000Fixed overhead ________ ___ $600,000 600,000Total costs $1,200,000 $0 $600,000 $1,800,000

Cost difference $ 200,000

Exhibit 19.9 Production Cost Assignment for 2015

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P 2

Summarizing Income Reporting

Units Producedand Sold Difference

Units produced: 60,000Units sold: 60,000Units produced: 60,000Units sold: 40,000Units produced: 60,000Units sold: 80,000Units produced: 180,000Units sold: 180,000

Exhibit 19.10 Summary of Income Statements

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

2015840,000 1,040,000 -200,000

$0 2014

320,000 120,000 200,000

Income for Absorption Costing

Income for Variable Costing

2013$580,000 $580,000

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P 2


NEED-TO-KNOW Zbest Manufacturing reports the following costing data for the current year. 20,000 units were produced, and 14,000 units were sold.

Direct materials per unit $6 per unit Direct labor per unit $11 per unit Variable overhead per unit $3 per unit Fixed overhead for the year $680,000 per year Sales price $80 per unit Variable selling and administrative cost per unit $2 per unit Fixed selling and administrative cost per year $112,000 per year

1. Prepare an income statement for the year using absorption costing. Product cost per unit using Absorption Costing:

Direct materials per unit Direct labor per unit Variable overhead per unit Fixed overhead per unit ($680,000 / 20,000 units produced)

Cost per unit

Sales (14,000 units @ $80 per unit) $1,120,000 Cost of goods sold (14,000 units @ $54 per unit) 756,000 Gross margin 364,000 Selling, general and administrative expenses:

Variable selling and administrative expenses (14,000 x $2) $28,000 Fixed selling and administrative expenses 112,000 Total selling, general and administrative expenses 140,000

Net income (loss) $224,000

34.00 $54.00

Zbest Manufacturing Absorption Costing Income Statement

$6.00 11.00

3.00

19-25

P 2

NEED-TO-KNOW

2. Prepare an income statement for the year using variable costing. Product cost using Variable Costing:

Direct materials per unit Direct labor per unit Variable overhead per unit

Cost per unit

Sales (14,000 units @ $80 per unit) $1,120,000 Less: Variable costs

Variable production costs (14,000 x $20 per unit) $280,000 Variable selling and administrative expenses (14,000 x $2) 28,000

Total variable costs 308,000 Contribution margin 812,000 Less: Fixed expenses

Fixed overhead costs 680,000 Fixed selling and administrative expenses 112,000 Total fixed expenses 792,000


Zbest Manufacturing Variable Costing Income Statement

$6.00 11.00

3.00 $20.00

Zbest Manufacturing reports the following costing data for the current year. 20,000 units were produced, and 14,000 units were sold.

Direct materials per unit $6 per unit Direct labor per unit $11 per unit Variable overhead per unit $3 per unit Fixed overhead for the year $680,000 per year Sales price $80 per unit Variable selling and administrative cost per unit $2 per unit Fixed selling and administrative cost per year $112,000 per year

19-26

P 2


NEED-TO-KNOW

Sales (14,000 units @ $80 per unit) $1,120,000 Less: Variable costs

Variable production costs (14,000 x $20 per unit) $280,000 Variable selling and administrative expenses (14,000 x $2) 28,000

Total variable costs 308,000 Contribution margin 812,000 Less: Fixed expenses

Fixed overhead costs 680,000 Fixed selling and administrative expenses 112,000 Total fixed expenses 792,000


Number of units added to inventory 6,000 Fixed overhead per unit ($680,000 / 20,000 units) $34.00 Change in income (Absorption vs. Variable) $204,000

Zbest Manufacturing Variable Costing Income Statement

Sales (14,000 units @ $80 per unit) $1,120,000 Cost of goods sold (14,000 units @ $54 per unit) 756,000 Gross margin 364,000 Selling, general and administrative expenses:

Variable selling and administrative expenses (14,000 x $2) 28,000 Fixed selling and administrative expenses 112,000 Total selling, general and administrative expenses 140,000


Zbest Manufacturing Absorption Costing Income Statement

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P 2

19-P3: Convert income under variable costing to the absorption cost basis.

19-28

Converting Reports under Variable Costing to Absorption Costing

19-29

Income under Absorption costing = Income under variable costing + Fixed overhead cost in ending inventory

▬Fixed overhead cost in beginning inventory

Incomeundervariablecos,ngisrestatedtothatunderabsorp,oncos,ngu,lizingthefollowingformula:

Exhibit 19.11 Converting Variable Costing Income to Absorption Costing Income

P 3

Converting Reports under Variable Costing to Absorption Costing

19-30

2013 2014 2015Variable costing income (from exhibit 19.10) $580,000 $120,000 $1,040,000 Add: Fixed overhead cost deferred in ending inventory (20,000 × $10) 0 200,000 0Less: Fixed overhead cost recognized from beginning inventory (20,000 × $10) 0 0 -200,000Absorption costing income $580,000 $320,000 $840,000

Exhibit 19.12 Converting Variable Costing Income to Absorption Costing Income

To restate variable costing income to absorption costing income for 2014, we must add back the fixed overhead cost deferred in ending inventory.

Similarly, to restate variable costing income to absorption costing income for 2015, we must deduct the fixed overhead cost recognized from beginning inventory, which was incurred in 2014, but expensed in the 2015 cost of goods sold when the inventory was sold.

P 3

19-C1: Describe how absorption costing can result in

overproduction.

19-31

Planning Production

Producing too much inventory

Excess inventory

Higher storage and financing

costs

Greater risk of obsolescence

Producing too little inventory

Lost sales

Customer dissatisfaction

19-32

C 1

Planning Production: Income under Absorption Costing for Different Production

Levels Why is income under absorption costing

affected by the production level when

that for variable costing is not?

The answer lies in the different

treatment of fixed overhead

costs within the two methods.

19-33

So…under absorption costing, if excess units are produced, the fixed overhead cost allocated to those units is not expensed until a future period when those units

are sold.

Exactly! C 1

C 1

Planning Production

Exhibit 19.13 Unit Cost Under Absorption CostingWhen 60,000 Units are Produced When 100,000 Units are ProducedDirect materials cost $4 per unit Direct materials $4 per unitDirect labor cost 8 per unit Direct labor 8 per unitVariable overhead 3 per unit Variable overhead 3 per unitTotal variable cost 15 per unit Total variable cost 15 per unitFixed overhead ($600,000/60,000 units) 10 per unit Fixed overhead ($600,000/100,000 units) 6 per unitTotal production cost $25 per unit Total production cost $21 per unit

19-34

When 60,000 units are produced:

Fixed overhead per unit is: $600,000/ 60,000 units = $10/unit

When 100,000 units are produced:

Fixed overhead per unit is: $600,000/ 100,000 units = $6/unit

What would happen if IceAge’s manager decided to produce 100,000 units instead of 60,000?

The 40,000 extra units would be stored in inventory and the total production cost PER UNIT is $4 less!

Planning Production: Income under Absorption 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) 1,260,000Gross margin 900,000 Gross margin 1,140,000Selling and administrative expenses Selling and administrative expenses Variable (60,000 x $2) $120,000 Variable (60,000 x $2) $120,000 Fixed 200,000 320,000 Fixed 200,000 320,000Net income $580,000 Net income $820,000


For Year Ended December 31, 2013[60,000 Units Produced; 60,000 Units Sold]


For Year Ended December 31, 2013[100,000 Units Produced; 60,000 Units Sold]

Exhibit 19.14

19-35

Note: Income under absorption costing is $240,000 greater if management produces 40,000 more units than necessary and builds up ending inventory.

This shows that a manager can report increased income merely by producing

more and disregarding whether the excess units can be sold or not.

C 1

Planning Production: Income under Variable 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 1,020,000Contribution margin 1,380,000 Contribution margin 1,380,000Fixed 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 200,000 800,000Net income $580,000 Net income $580,000

[60,000 Units Produced; 60,000 Units Sold] [100,000 Units Produced; 60,000 Units Sold]

Exhibit 19.15

19-36

Under variable costing, even if I produce more units, it doesn’t effect the reported net income.

I actually have to SELL more units to increase my net income. C 1

19-P4: Determine product selling price based on

absorption costing.

19-37

How does management determine the sales price of a product?

Although many factors impact

pricing, cost is a crucial factor!

Over the long run, price must be high enough to cover all costs.

Absorption cost information is useful because it reflects the full costs that

sales must exceed for the company to be profitable.

P 4 19-38

We can use a three-step process to determine product selling prices:

•  Step 1: Determine the product cost per unit using absorption costing.

•  Step 2: Determine the target markup on product cost per unit.

•  Step 3: Add the target markup to the product cost to find the target selling price

P 4 19-39

Example: IceAge will use absorption costing to determine a target selling price.

Exhibit 19.16 Determining Selling Price with Absorption Costing Step 1 Absorption cost per unit (from Exhibit 19.3) $25 Step 2 Target markup per unit ($25 times 60%) 15 Step 3 Target selling price per unit $40

Start with product cost.

Then, management needs to determine a target markup.

In this example, they chose a markup of 60% of cost. So the target selling price is $40 per unit.

P 4 19-40

Controllable vs. Uncontrollable Costs?

•  Managers are responsible for their controllable costs. •  A cost is controllable if a manager has the

power to determine the amount incurred. •  Examples vary depending on the manager’s

level in the company. •  Uncontrollable costs are not within the

manager’s control or influence. •  Example would be production capacity.

P 4 19-41

Limitations of Reports Using Variable Costing

19-42

• For income tax purposes, absorption costing is the only acceptable basis for filings with the Internal Revenue Service (IRS) under the Tax Reform Act of 1986.

• Absorption costing is the only acceptable basis for external reporting under both U.S. GAAP and IFRS. • Top executives are often awarded bonuses based on income computed using absorption costing.

Realities that contribute to the widespread use of absorption costing by companies:

P 4

19-A1: Use variable costing in pricing special orders.

19-43

Setting Prices

Over the Long Run: •  Price must be high enough to cover all

costs, including variable costs and fixed costs, and still provide an acceptable return to owners

19-44

A 1

Setting Prices

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

plant capacity do not change with changes in production levels.

•  With excess capacity, increases in production level would increase variable production costs, but not fixed costs.

•  While managers try to maintain the long-run price on existing orders, which covers all production costs, managers should accept special orders provided the special order price exceeds variable cost.

19-45

A 1

A 1

Setting Prices (Special Orders Illustration)

Rejecting Special Order Accepting Special OrderIncremental sales $ 0 Incremental sales (1,000 x $22) $22,000Incremental costs 0 Incremental costs:

Variable production cost (1,000 x $15) 5,000 Variable selling expense (1,000 x $2) 2,000

Incremental income $ 0 Incremental income $ 5,000

Exhibit 19.17 Computing Incremental Income for a Special Order

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Absorption Costing

Direct materials cost per unit……………... $4Direct labor cost per unit…………. 8Overhead cost Variable overhead cost per unit….. 3 Fixed overhead cost per unit……... 10Total product cost per unit……………. $25

From Exhibit 19.3 Unit Cost Computation at 60,000 units

Should the company accept a special order for 1,000 pairs of skates at an offer price of $22 per pair?

Variable production cost = $15 ($4DM + $8DL + $3 VOH)

Order should be accepted because the $22 order price exceeds the $15 variable cost of the product.

End of Chapter 19

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