Ch7 Variable Costing

April 17, 2009
Variable Costing: A Tool for Management

Chapter 7
McGraw -Hill/Irwin
7-2
Learning Objective 1
Explain how variable costing differs from absorption costing and compute unit product costs under each method.
Managerial Accounting Variab le Costing
I Made R. Natawidnyana, Ak., CPMA
http://natawidnyana.wordpress.com
April 17, 2009
7-3
Overview of Absorption and Variable Costing

Variable Costing
Direct Materials
Absorption Costing
Product Costs
Direct Labor Variable Manufacturing Overhead Fixed Manufacturing Overhead
Product Costs
Period Costs
Variable Selling and Administrati ve Expenses Fixed Selling and Administrati ve Expenses
Period Costs
7-4
Quick Check
Which method will produce the highest values for work in process and finished goods inventories? a. Absorption costing. b. Variable costing. c. They produce the same values for these inventories. d. It depends. . .
April 17, 2009
7-5
Quick Check
Which method will produce the highest values for work in process and finished goods inventories? a. Absorption costing. b. Variable costing. c. They produce the same values for these inventories. d. It depends. . .
7-6
Unit Cost Computations

Harvey Company produces a single product with the following information available:
Number Number of ofunits unitsproduced produceda annually nnually Variable Variable costs costsper per unit: unit: Direct Directmaterials, materials, direct direct labor, labor, and variable mfg. overhead and variable mfg. overhead Selling Selling & &administrative administrative expenses expenses Fixe Fixed dcosts costsper peryea year: r: Manufacturing overhead Manufacturing overhead Selling Selling & &administrative administrative expenses expenses
25,000 25,000
$ $ $ $
10 10 3 3
$ $150,000 150,000 $ 100,000 $ 100,000
April 17, 2009
7-7

Unit product cost is determined as follows:
Absorption Absorption Costing Costing Direct Directmaterials, materials,direct directlabor, labor, and va riable mfg. and va riable mfg.overhead overhead Fixed Fixedm mfg. fg. overhead overhead ($150,000 ($150,000 25,000 25,000units) units) Unit product cost Unit product cost $ $ 10 10 6 6 16 16 Va Variable riable Costing Costing $ $ 10 10 -10 10
$ $
$ $
Under absorption costing, selling and administrative expenses are always treated as period expenses and deducted from revenue as incurred.
7-8
Prepare income statements using both variable and absorption costing.
April 17, 2009
7-9
Income Comparison of Absorption and Variable Costing

Lets assume the following additional information 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 operating income using both absorption and variable costing.
7-10
Absorption Costing
Absorption AbsorptionCosting Costing

Sales Sales(20,000 (20,000 $30) $30) Less cost of goods Less cost of goodssold: sold: Beginning Beginninginventory inventory Add AddCOGM COGM(25,000 (25,000 $16) $16) Goods available for Goods available forsale sale Ending Endinginventory inventory(5,000 (5,000 $16) $16) Gross margin Gross margin Less Lessselling selling& &admin. admin. exp. exp. Variable Variable (20,000 (20,000 $3) $3) Fixed Fixed Net Netoperating operatingincome income $ $600,000 600,000 $ -$ 400,000 400,000 400,000 400,000 80,000 80,000
320,000 320,000 280,000 280,000
$ $ 60,000 60,000 100,000 100,000
160,000 160,000 $ 120,000 $ 120,000
April 17, 2009
7-11
Variable Costing
Variable manufacturing Variable Costing costs only.
Sales (20,000 $30) Less variable expenses: Beginning inven tory $ 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 se lling & administrative ex penses (20,000 $3) 60,000 Contribution margin Less fixed ex penses: Manufacturing overhead $ 150,000 Selling & administrative expenses 100,000 Net operating income
$ 600,000
All fixed manufacturing overhead is expensed.

260,000 340,000
250,000 $ 90,000
7-12
Reconcile variable costing and absorption costing net operating incomes and explain why the two amounts differ.
April 17, 2009
7-13
Comparing the Two Methods
Cost Costof of Goods Goods Sold Sold Absorption Absorption costing costing Variable 200,000 Variable mfg. mfg. costs costs $ $ 200,000 Fixed mfg. costs 120,000 Fixed mfg. costs 120,000 $ 320,000 $ 320,000 Variable Variable costing costing Variable 200,000 Variable mfg. mfg. costs costs $ $ 200,000 Fixed mfg. costs -Fixed mfg. costs $ 200,000 $ 200,000
Ending Ending Inventory Inventory $ $ 50,000 50,000 30,000 30,000 $ $ 80,000 80,000
Period Period Expense Expense $ $ $ $ ----
Total Total $ 250,000 $ 250,000 150,000 150,000 $ 400,000 $ 400,000
$ $ 50,000 50,000 -$ $ 50,000 50,000
$ -$ 150,000 150,000 $ $150,000 150,000
$ 250,000 $ 250,000 150,000 150,000 $ 400,000 $ 400,000
7-14

We can reconcile the difference between absorption and variable income as follows:
Variable Variable costing costingnet netoperating operatingincome income Add: Fixed mfg. overhead costs Add: Fixed mfg. overhead costs deferred deferred in in inventory inventory (5,000 (5,000units units $6 $6 per perunit) unit) Absorption costing ne t operating Absorption costing ne t operatingincome income $ $ 90,000 90,000
30,000 30,000 $ 120,000 $ 120,000
Fixed mfg. Overhead $150,000 = = $6.00 per unit Units produced 25,000 units
April 17, 2009
7-15
Extended Comparisons of Income Data Harvey Company Year Two

Number Numberof ofunits unitsproduced produced Number of units sold Number of units sold Units Unitsin in beginning beginninginventory inventory Unit sales Unit salesprice price Variable Variable costs costsper perunit: unit: Dire Direct ctmaterials, materials, direct directlabor labor variable mfg. overhead variable mfg. overhead Selling Selling & &administrative administrative expense expenses s Fixed costs per year: Fixed costs per year: Manufa Manufacturing cturing overhead overhead Selling & administrative Selling & administrative expense expenses s 25,000 25,000 30,000 30,000 5,000 5,000 $ 30 $ 30
$ $ $ $
10 10 3 3
$ $150,000 150,000 $ $100,000 100,000

7-16
Absorption Absorption Costing Costing Direct Directmaterials, materials,direct directlabor, labor, and va riable mfg. and va riable mfg.overhead overhead Fixed Fixedm mfg. fg. overhead overhead ($150,000 ($150,000 25,000 25,000units) units) Unit product cost Unit product cost $ $ 10 10 6 6 16 16
Va Variable riable Costing Costing $ $ 10 10 -10 10
$ $
$ $
Since there was no change in the variable costs per unit, total fixed costs, or the number of units produced, the unit costs remain unchanged.
April 17, 2009
7-17
Absorption Costing
Sales Sales(30,000 (30,000 $30) $30) Less cost of goods Less cost of goodssold: sold: Beg. Beg. inventory inventory(5,000 (5,000 $16) $16) Add Add COGM COGM(25,000 (25,000 $16) $16) Goods Goodsavaila available ble for for sale sale Less ending inventory Less ending inventory Gross Grossmargin margin Less Lessselling selling & &admin. admin.e exp. xp. Variable (30,000 $3) Variable (30,000 $3) Fixe Fixed d Net Netope operating rating income income $ 900,000 $ 900,000 $ $ 80,000 80,000 400,000 400,000 480,000 480,000 --
480,000 480,000 420,000 420,000
$ $ 90,000 90,000 100,000 100,000
190,000 190,000 $ 230,000 $ 230,000
These are the 25,000 units produced in the current period.

7-18
Variable Costing
Variable manufacturing costs only. Variable Variable Costing Costing Sa les (30,000 $30) $ Sa les (30,000 $30) $900,000 900,000 Le Less ssvariable variable expenses: expenses: Beg. $ Beg.inventory inventory(5,000 (5,000 $10) $10) $ 50,000 50,000 Add COGM (25,000 $10) 250,000 Add COGM (25,000 $10) 250,000 All fixed Goods e 300,000 Goodsavai available lable for forsal sal e 300,000 manufacturing Less -Lessending ending inventory inventory overhead is Variable cost of goods sold 300,000 Variable cost of goods sold 300,000 expensed. Variable Variable se selling lling& &administrative administrative expenses 90,000 390,000 expenses(30,000 (30,000 $3) $3) 90,000 390,000 Contribution m argin 510,000 Contribution m argin 510,000 Le Less ssfixed fixedex expenses: penses: Manufacturing $ Manufacturingoverhea overhead d $150,000 150,000 Selling & administrative expenses 250,000 Selling & administrative expenses 100,000 100,000 250,000 Ne t operating income $ Ne t operating income $260,000 260,000
April 17, 2009
7-19

We can reconcile the difference between absorption and variable income as follows:
Va riable costing net operating income $ 260,000 De duct: Fixed manufacturing overhead costs released from inventory (5,000 units $6 per unit) 30,000 Absorption costing net operating income $ 230,000
Fixed mfg. Overhead $150,000 = = $6.00 per unit Units produced 25,000 units
7-20
Costing Method Absorption Variable
1st Period $ 120,000 90,000
2nd Period $ 230,000 260,000
Total $ 350,000 350,000
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April 17, 2009
7-21
Summary of Key Insights
Rela tion between production a nd sale s Production > Sale s
Effect on iniventory Inventory increa ses Inventory decrea ses
Production < Sale s
Production = Sale s
No change
Rela tion between va riable and a bsorption income Absorption > Varia ble Absorption < Varia ble Absorption = Varia ble
7-22
Effect of Changes in Production on Net Operating Income

Lets revise the Harvey Company example.
In the previous example, 25,000 units were produced each year, but sales increased from 20,000 units in year one to 30,000 units in year two.
In this revised example, production will differ each year while sales will remain constant.
11
April 17, 2009
7-23
Effect of Changes in Production Harvey Company Year One

Number Numberof of units unitsproduced produced Number Numberof of units unitssold sold Unit sa les price Unit sa les price Variable Variable costs costsper per unit: unit: Direct Directmaterials, materials, dire direct ctla labor bor varia ble mfg. overhea d varia ble mfg. overhea d Selling Selling & &administrative administrative expe nses expe nses Fixed Fixed costs costsper peryear: year: Manufacturing Manufacturing overhea overhead d Selling & administrative Selling & administrative expe expenses nses 30,000 30,000 25,000 25,000 $ 30 $ 30
$ $ $ $
10 10 3 3
$ $150,000 150,000 $ $100,000 100,000

7-24
Unit Cost Computations for Year One

Absorption Absorption Costing Costing Direct Directmaterials, materials,direct directlabor, labor, and va riable mfg. overhead and va riable mfg. overhead Fixed Fixedm mfg. fg. overhead overhead ($150,000 ($150,000 30,000 30,000units) units) Unit Unitproduct product cost cost $ $ 10 10 5 5 15 15 Va Variable riable Costing Costing $ $ 10 10 -10 10
$ $
$ $
Since the number of units produced increased in this example, while the fixed manufacturing overhead remained the same, the absorption unit cost is less.
12
April 17, 2009
7-25
Absorption Costing: Year One

Sales Sales(25,000 (25,000 $30) $30) Less Lesscost costof ofgoods goodssold: sold: Beginning inventory Beginning inventory Add AddCOGM COGM(30,000 (30,000 $15) $15) Goods available for Goods available forsale sale Ending Endinginventory inventory(5,000 (5,000 $15) $15) Gross Grossmargin margin Less Lessselling selling& &admin. admin. exp. exp. Variable (25,000 $3) Variable (25,000 $3) Fixed Fixed Net Netoperating operating income income $ $750,000 750,000 $ -$ 450,000 450,000 450,000 450,000 75,000 75,000
375,000 375,000 375,000 375,000
$ $ 75,000 75,000 100,000 100,000
175,000 175,000 $ $200,000 200,000
7-26
Variable Costing: Year One

Variable manufacturing Variable Costing costs only.
Sales (25,000 $30) Less varia ble e xpenses: Beginning inven tory $ Add COGM (30,000 $10) 300,000 Goods a vai la ble for sale 300,000 Less ending inventory (5,000 $10) 50,000 Variable cost of goods sold 250,000 Variable se lli ng & administrative ex penses (25,000 $3) 75,000 Contribution margin Less fixed ex penses: Manufacturing overhead $ 150,000 Sel ling & administrative e xpenses 100,000 Net operating income
$ 750,000
All fixed manufacturing overhead is expensed.

325,000 425,000
250,000 $ 175,000
13
April 17, 2009
7-27
Effect of Changes in Production Harvey Company Year Two

Number Numberof ofunits unitsproduced produced Number of units sold Number of units sold Units Unitsin in beginning beginninginventory inventory Unit sales Unit salesprice price Variable Variable costs costsper perunit: unit: Dire Direct ctmaterials, materials, direct directlabor labor variable mfg. overhead variable mfg. overhead Selling Selling & &administrative administrative expense expenses s Fixed costs per year: Fixed costs per year: Manufa Manufacturing cturing overhead overhead Selling & administrative Selling & administrative expense expenses s 20,000 20,000 25,000 25,000 5,000 5,000 $ 30 $ 30
$ $ $ $
10 10 3 3
$ $150,000 150,000 $ $100,000 100,000

7-28
Unit Cost Computations for Year Two

Absorption Absorption Costing Costing Direct Directmaterials, materials,direct directlabor, labor, and va riable mfg. overhead and va riable mfg. overhead Fixed Fixedm mfg. fg. overhead overhead ($150,000 ($150,000 20,000 20,000units) units) Unit Unitproduct product cost cost $ $ 10 10 7.50 7.50 17.50 17.50 Va Variable riable Costing Costing $ $ 10 10 -10 10
$ $
$ $
Since the number of units produced decreased in the second year, while the fixed manufacturing overhead remained the same, the absorption unit cost is now higher.
14
April 17, 2009
7-29
Absorption Costing: Year Two

Sale s Sale s(25,000 (25,000 $30) $30) Less cost of goods Less cost of goodssold: sold: Beg. Beg. inventory inventory(5,000 (5,000 $15) $15) Add Add COGM COGM (20,000 (20,000 $17.50) $17.50) Goods vaila Goodsa a vailable ble for for sale sale Less e nding inventory Less e nding inventory Gross Grossmargin margin Less ling Lesssel sel ling & &admin. admin.e exp. xp. Variable (25,000 $3) Variable (25,000 $3) Fixe Fixed d Net Netope operating rating income income $ 750,000 $ 750,000 $ $ 75,000 75,000 350,000 350,000 425,000 425,000 --
425,000 425,000 325,000 325,000
$ $ 75,000 75,000 100,000 100,000
175,000 175,000 $ 150,000 $ 150,000
These are the 20,000 units produced in the current period at the higher unit cost of $17.50 each.
7-30
Variable Costing: Year Two

Variable manufacturing costs only. Variable Variable Costing Costing Sa les (25,000 $30) $ Sa les (25,000 $30) $750,000 750,000 Le Less ssvariable variable expenses: expenses: Beg. $ Beg.inventory inventory(5,000 (5,000 $10) $10) $ 50,000 50,000 Add COGM (20,000 $10) 200,000 Add COGM (20,000 $10) 200,000 All fixed Goods 250,000 Goodsavai available lable for forsa sale le 250,000 manufacturing Less -Lessending ending inventory inventory overhead is Variable cost of goods sold 250,000 Variable cost of goods sold 250,000 expensed. Variable Variable se selling lling& &administrative administrative expenses 75,000 325,000 expenses(25,000 (25,000 $3) $3) 75,000 325,000 Contribution 425,000 Contributionm margin argin 425,000 Le ss fixed ex penses: Le ss fixed ex penses: Manufacturing $ Manufacturingoverhea overhead d $150,000 150,000 Selling & administrative expenses 250,000 Selling & administrative expenses 100,000 100,000 250,000 Ne t operating income $ Ne t operating income $175,000 175,000
15
April 17, 2009
7-31
Costing Method Absorption Variable
Year One $ 200,000 175,000
Yea r Two $ 150,000 175,000
Total $ 350,000 350,000
Conclusions
Net operating income is not affected by changes in production using variable costing. Net operating income is affected by changes in production using absorption costing even though the number of units sold is the same each year.
7-32
Understand the advantages and disadvantages of both variable and absorption costing.
16
April 17, 2009
7-33
Impact on the Manager

Opponents of absorption costing argue that shifting 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 operating income 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 Making and Absorption costing

Absorption costing does not support CVP analysis because it essentially treats fixed manufacturing overhead as a variable cost by assigning a per unit amount of the fixed overhead to each unit of production.
Treating fixed manufacturing overhead as a variable cost can: Lead to faulty pricing decisions and keep-or-drop decisions. Produce positive net operating income even when the number of units sold is less than the breakeven point.
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April 17, 2009
7-35
External Reporting and Income Taxes

To conform to GAAP requirements, absorption costing must be used for external financial reports in the United States.
Since top executives are usually evaluated based on external reports to shareholders, they may feel that decisions should be based on absorption cost income.
Under the Tax Reform Act of 1986, absorption costing must be used when filing income tax returns.
7-36
Advantages of Variable Costing and the Contribution Approach

Consistent with CVP analysis. Net operating income is closer to net cash flow. Consistent with standard costs and flexible budgeting. Easier to estimate profitability of products and segments. Impact of fixed costs on profits emphasized. Profit is not affected by changes in inventories.
Management finds it more useful.
Advantages
18
April 17, 2009
7-37
Variable versus Absorption Costing

Fixed manufacturing costs must be assigned to products to properly match revenues and costs.
Fixed manufacturing costs are capacity costs and will be incurred even if nothing is produced.
Absorption Costing
Variable Costing
7-38
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.
19
April 17, 2009
7-39
Impact of JIT Inventory Methods
In a JIT inventory system . . .

Production tends to equal sales . . .
So, the difference between variable and absorption income tends to disappear.
7-40
End of Chapter 7
20

Ch7 Variable Costing

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Ch7 Variable Costing

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April 17, 2009

Variable Costing: A Tool for Management

Managerial Accounting Variab le Costing

I Made R. Natawidnyana, Ak., CPMA

April 17, 2009

Overview of Absorption and Variable Costing

Direct Labor Variable Manufacturing Overhead Fixed Manufacturing Overhead

Managerial Accounting Variab le Costing

I Made R. Natawidnyana, Ak., CPMA

Managerial Accounting Variab le Costing

I Made R. Natawidnyana, Ak., CPMA

April 17, 2009

Managerial Accounting Variab le Costing

I Made R. Natawidnyana, Ak., CPMA

Unit Cost Computations

$ $150,000 150,000 $ 100,000 $ 100,000

I Made R. Natawidnyana, Ak., CPMA

April 17, 2009

Unit Cost Computations

I Made R. Natawidnyana, Ak., CPMA

Prepare income statements using both variable and absorption costing.

Managerial Accounting Variab le Costing

I Made R. Natawidnyana, Ak., CPMA

April 17, 2009

Income Comparison of Absorption and Variable Costing

I Made R. Natawidnyana, Ak., CPMA

Absorption AbsorptionCosting Costing

320,000 320,000 280,000 280,000

$ $ 60,000 60,000 100,000 100,000

160,000 160,000 $ 120,000 $ 120,000

Managerial Accounting Variab le Costing

I Made R. Natawidnyana, Ak., CPMA

April 17, 2009

All fixed manufacturing overhead is expensed.

Managerial Accounting Variab le Costing

I Made R. Natawidnyana, Ak., CPMA

April 17, 2009

Comparing the Two Methods

Period Period Expense Expense $ $ $ $ ----

Total Total $ 250,000 $ 250,000 150,000 150,000 $ 400,000 $ 400,000

$ $ 50,000 50,000 -$ $ 50,000 50,000

$ -$ 150,000 150,000 $ $150,000 150,000

$ 250,000 $ 250,000 150,000 150,000 $ 400,000 $ 400,000

Managerial Accounting Variab le Costing

I Made R. Natawidnyana, Ak., CPMA

Comparing the Two Methods

30,000 30,000 $ 120,000 $ 120,000

I Made R. Natawidnyana, Ak., CPMA

April 17, 2009

Extended Comparisons of Income Data Harvey Company Year Two

$ $150,000 150,000 $ $100,000 100,000

Managerial Accounting Variab le Costing

Unit Cost Computations

Va Variable riable Costing Costing $ $ 10 10 -10 10

I Made R. Natawidnyana, Ak., CPMA

April 17, 2009

480,000 480,000 420,000 420,000

$ $ 90,000 90,000 100,000 100,000

190,000 190,000 $ 230,000 $ 230,000

These are the 25,000 units produced in the current period.

I Made R. Natawidnyana, Ak., CPMA

I Made R. Natawidnyana, Ak., CPMA

April 17, 2009