WarrenReeveDuchac
Financial and Managerial Accounting 13e
Variable Costing for Management Analysis20
C H A P T E R
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Absorption Costing
• Absorption costing is required under generally accepted accounting principles.
• Under absorption costing, the cost of goods manufactured consists of the following:o Direct materialso Direct laboro Fixed and variable factory overhead
• In the financial statements, these costs are included in the cost of goods sold (income statement) and inventory (balance sheet).
Variable Costing(slide 1 of 2)
• Under variable costing, sometimes called direct costing, the cost of goods manufactured consists of the following:o Direct materialso Direct laboro Variable factory overhead
• Under variable costing, fixed factory overhead costs are treated as a period expense.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Variable Costing(slide 2 of 2)
• The reporting of income from operations under variable costing is as follows:
o Manufacturing margin is the excess of sales over variable cost of goods sold:
o Variable cost of goods sold consists of direct materials, direct labor, and variable factory overhead for the units sold.
o Contribution margin is the excess of manufacturing margin over variable selling and administrative expenses:
o Subtracting fixed costs from contribution margin yields income from operations:
Units Manufactured versus Units Sold
• When the number of units manufactured equals the number of units sold, income from operations will be the same under both methods.
• When units manufactured exceed the units sold, the variable costing income from operations will be less than it is for absorption costing.
• When units manufactured are less than the number of units sold, the variable costing income from operations will be greater than that of absorption costing.
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Effects on Income from Operations under Absorption and Variable Costing(slide 1 of 3)
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Effects on Income from Operations under Absorption and Variable Costing(slide 2 of 3)
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Effects on Income from Operations under Absorption and Variable Costing(slide 3 of 3)
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Income Analysis Under Absorption and Variable Costing(slide 1 of 4)
• When the units manufactured are greater than the units sold, finished goods inventory increases.o Under absorption costing, a portion of this
increase is related to the allocation of fixed manufacturing overhead to ending inventory.
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Income Analysis Under Absorption and Variable Costing(slide 2 of 4)
• Assume that Frand Manufacturing Company has no beginning inventory and sales are estimated to be 20,000 units at $75 per unit. Also, assume that sales will not change if more than 20,000 units are manufactured.
• Frand’s management is evaluating whether to manufacture 20,000 units (Proposal 1) or 25,000 units (Proposal 2). The costs and expenses related to each proposal appear on the following slide.
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Absorption Costing Income Statements for Two Production Levels
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Income Analysis Under Absorption and Variable Costing(slide 3 of 4)
• The income statements on the previous slide shows that Frand Manufacturing Company can increase income from operations by $80,000 ($280,000 – $200,000) by simply increasing finished goods inventory by 5,000 units.
• The $80,000 increase in income from operations under Proposal 2 is caused by the allocation of the fixed manufacturing costs of $400,000 over a greater number of units manufactured.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Income Analysis Under Absorption and Variable Costing(slide 4 of 4)
• Under variable costing, income from operations is $200,000, regardless of whether 20,000 units or 25,000 units are manufactured. o This is because no fixed manufacturing costs
are allocated to the units manufactured. Instead, all fixed manufacturing costs are treated as a
period expense.
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Controlling Costs(slide 1 of 2)
• All costs are controllable in the long run by someone within a business.
• However, not all costs are controllable at the same level of management.
• For a level of management, controllable costs are costs that can be influenced (increased or decreased) by management at that level.
• Noncontrollable costs are costs that another level of management controls.
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Controlling Costs(slide 2 of 2)
• Variable manufacturing costs are controlled by operating management.
• In contrast, fixed manufacturing overhead costs are normally controlled at a higher level of management.
• Since fixed costs and expenses are reported separately under variable costing, variable costing reports are normally more useful than absorption costing reports for controlling costs.
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Pricing Products(slide 1 of 2)
• Many factors enter into determining the selling price of a product. However, the cost of making the product is significant in all pricing decisions.
• In the short run, fixed costs cannot be avoided. Thus, the selling price of a product should at least be equal to the variable costs of making and selling it.
• Since variable costing reports variable and fixed costs and expenses separately, it is often more useful than absorption costing for setting short-run prices.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Pricing Products(slide 2 of 2)
• In the long run, a company must set its selling price high enough to cover all costs and expenses (variable and fixed) and generate income.
• Since absorption costing includes fixed and variable costs in the cost of manufacturing a product, absorption costing is often more useful than variable costing for setting long-term prices.
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Planning Production
• In the short run, planning production is limited to existing capacity. In many cases, operating decisions must be made quickly before opportunities are lost. o For example, a company with seasonal demand for its
products may have an opportunity to obtain an off-season order.
The relevant factors for such a short-run decision are the additional revenues and the additional variable costs associated with the order.
o Since variable costing reports contribution margin, it is often more useful than absorption costing in such cases.
• In the long run, planning production can include expanding existing capacity. Thus, when analyzing and evaluating long-run sales and operating decisions, absorption costing, which considers fixed and variable costs, is often more useful.
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Analyzing Market Segments
• A market segment is a portion of a company that can be analyzed using sales, costs, and expenses to determine its profitability. o Examples of market segments include sales
territories, products, salespersons, and customers.
• Absorption costing is often used for long-term analysis of market segments, while variable costing is often used for short-term analysis of market segments.
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©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Sales Territory Profitability Analysis
• Sales territory profitability analysis may lead management to do the following:o Reduce costs in lower-profit sales territorieso Increase sales efforts in higher-profit
territories
• The contribution margin ratio is computed as follows:
Product Profitability Analysis
• A company should focus its sales efforts on products that will provide the maximum total contribution margin.
• Product profitability analysis is often used by management in making decisions regarding product sales and promotional efforts.
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Salesperson Profitability Analysis
• A salesperson profitability report is useful in evaluating sales performance.o Such a report normally includes total sales,
variable cost of goods sold, variable selling expenses, contribution margin, and contribution margin ratio for each salesperson.
• Other factors should also be considered in evaluating salespersons’ performance.
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Contribution Margin Analysis(slide 1 of 2)
• Contribution margin analysis focuses on explaining the differences between planned and actual contribution margins.
• A difference between the planned and actual contribution margin may be caused by an increase or a decrease in:o Saleso Variable costs
• An increase or a decrease in sales or variable costs may in turn be due to an increase or a decrease in the:o Number of units soldo Unit sales price or unit cost
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Contribution Margin Analysis(slide 2 of 2)
• Quantity factor is the effect of a difference in the number of units sold, assuming no change in unit sales price or unit cost.
• Unit price factor, or unit cost factor, is the effect of a difference in unit sales price or unit cost on the number of units sold.
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Reporting Income from Operations Using Variable Costing for a Service Company
• Unlike a manufacturing company, a service company does not make or sell a product. o Since service companies have no inventory,
they do not use absorption costing to allocate fixed costs.
o In addition, variable costing reports of service companies do not report a manufacturing margin.
• A cost is classified as a fixed or variable cost according to how it changes relative to an activity base.o A common activity for a manufacturing firm is
the number of units produced.o Most service firms use several activity bases.
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