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Chapter

7
Variable Costing:
A Tool for Management
7-2

LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1. Explain how variable costing differs from
absorption costing and compute the unit
product cost under each method.
2. Describe how fixed manufacturing overhead
costs are deferred in inventory and released
from inventory under absorption costing.
3. Prepare income statements using both
variable and absorption costing, and reconcile
the two net income figures.

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7-3

LEARNING OBJECTIVES
After studying this chapter, you should be able to:
4. Explain the effect of changes in production on
the net income reported under both variable
and absorption costing.
5. Explain the advantages and limitations of both
the variable and absorption costing methods.
6. Explain how the use of JIT reduces the
difference in net income reported under the
variable and absorption costing methods.

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7-4

Overview of Absorption and


Variable Costing

The only cost of driving my car


on a 200 mile trip today is
$12 for gasoline.

Variable
Costing

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7-5

Overview of Absorption and


Variable Costing
No! You must consider these costs too!
Cost Per month Per day
Car payment $ 300.00 $ 10.00
Insurance 60.00 2.00

Absorption
Costing

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7-6

Overview of Absorption and


Variable Costing
Your wrong. I have the car
payment and the
insurance payment even if
I do not make the trip.

Variable
Costing

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7-7

Overview of Absorption and


Variable Costing
Whos right?
How should we treat the car
payment and the insurance?

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7-8

Overview of Absorption and


Variable Costing

Absorption Variable
Costing Costing

Direct materials
Direct labour Product costs
Product costs Variable mfg. overhead

Fixed mfg. overhead


Period costs
Period costs Selling & admin. exp.

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7-9

Overview of Absorption and


Variable Costing
Lets put some numbers to the
issue and see if it will
sharpen our understanding.

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7-10

Unit Cost Computations


Harvey Co. produces a single product with
the 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

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7-11

Unit Cost Computations

Unit product cost is determined as follows:


Absorption Variable
Costing 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

Selling and administrative expenses are


always treated as period expenses and
deducted from revenue.
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7-12

Income Comparison of Absorption


and Variable Costing
Harvey Co. had no beginning inventory, produced
25,000 units and sold 20,000 units 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
Gross m argin 280,000
Less se lling & adm in. e xp.
Varia ble
Fixed
Net incom e

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7-13

Income Comparison of Absorption


and Variable Costing
Harvey Co. had no beginning inventory, produced
25,000 units and sold 20,000 units 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
Gross m argin 280,000
Less se lling & adm in. e xp.
Varia ble (20,000 $3) $ 60,000
Fixed 100,000 160,000
Net incom e $ 120,000

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7-14

Income Comparison of Absorption


and Variable Costing
Now lets look at variable costing by Harvey Co.
Variable
Variable Costing
Sales (20,000 $30)
costs $ 600,000
Less variable expenses: only.
Beginning inventory $ - All fixed
Add COGM (25,000 $10) 250,000
manufacturing
Goods available for sale 250,000
Ending inventory (5,000 $10) 50,000 overhead is
Variable cost of goods sold 200,000 expensed.
Variable selling & administrative
expenses (20,000 $3) 60,000 260,000
Contribution margin 340,000
Less fixed expenses:
Manufacturing overhead $ 150,000
Selling & administrative expenses 100,000 250,000
Net income $ 90,000

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7-15

Income Comparison of Absorption


and Variable Costing
Lets compare the methods.
Cost of
Goods Ending Period
Sold Inventory Ex pe nse Tota l
Absorption costing
Variable mfg. costs $ 200,000 $ 50,000
Fix ed mfg. costs 120,000 30,000
$ 320,000 $ 80,000

Variable costing
Variable mfg. costs $ 200,000 $ 50,000
Fix ed mfg. costs - -
$ 200,000 $ 50,000

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7-16

Income Comparison of Absorption


and Variable Costing
Lets compare the methods.
Cost of
Goods Ending Period
Sold Inventory Ex pe nse Tota l
Absorption costing
Variable mfg. costs $ 200,000 $ 50,000 $ - $ 250,000
Fix ed 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
Fix ed mfg. costs - - 150,000 150,000
$ 200,000 $ 50,000 $ 150,000 $ 400,000

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7-17

Reconciliation

We can reconcile the difference between


absorption and variable income as follows:

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 $150,000


= = $6.00 per unit
Units produced 25,000
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7-18

Extending the Example

Lets look at the


second year
of operations
for Harvey
Company.

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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 25,000 units and sold 30,000 units.
Number of units produced a nnually 25,000
Va ria ble costs pe r unit:
Dire ct m ate rials, direct la bor
varia ble mfg. ove rhea d $ 10
Se lling & a dministrative
ex pe nses $ 3
Fix ed costs per ye ar:
Manufa cturing ove rhea d $ 150,000
Se lling & a dministrative
ex pe nses $ 100,000
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7-20

Harvey Co. Year 2

Unit product cost is determined as follows:


Absorption Variable
Costing Costing
Direct materials, direct labor,
and variable mfg. overhead $ 10 $ 10
Fixed mfg. overhead
($150,000 25,000 units) 6 -
Unit product cost $ 6 $ 10

No change in Harveys
cost structure.

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7-21

Harvey Co. Year 2

Now lets look at Harveys income statement


assuming absorption costing is used.

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7-22

Harvey Co. Year 2


Absorption Costing
Sales (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
Gross margin 420,000
Less selling & admin. exp.
Variable (30,000 $3) $ 90,000
Fixed 100,000 190,000
Net income $ 230,000

These are the 25,000 units


produced 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

Harvey Co. Year 2


Variable
costs Variable Costing
Sales (30,000 $30) only. $ 900,000
Less variable expenses:
Beg. inventory (5,000 $10) $ 50,000
Add COGM (25,000 $10) 250,000 All fixed
Goods available for sale 300,000 manufacturing
Ending inventory - overhead is
Variable cost of goods sold 300,000 expensed.
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

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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

Summary
Rela tion betwe en Effect Rela tion betwe en
production on variable and
Ye ar and sa les inive ntory absorption income
Inve ntory Absorption
1st Production > Sales increa ses by >
year 25,000 > 20,000 5,000 units. Variable
Inve ntory Absorption
2nd Production < Sales de crea ses <
year 25,000 < 30,000 to ze ro. Variable
Both Absorption
years Production = Sales No cha nge =
combine d 50,000 = 50,000 Variable

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7-27

Advantages of the Contribution


Approach Consistent with
CVP analysis.
Management finds it Net income is closer
easy to understand. to net cash flow.

Consistent with standard


Advantages costs and flexible budgeting.

Easier to estimate profitability


of products and segments.
Impact of fixed
costs on profits Profit is not affected by
emphasized. changes in inventories.
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7-28

Variable versus Absorption Costing


All manufacturing costs Fixed costs are
must be assigned to not really the costs
products to properly of any particular
match revenues and costs. product.

Absorption Variable
Costing Costing
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7-29

Variable versus Absorption Costing


Amortization, taxes, These are capacity
insurance and salaries costs and will be
are just as essential to incurred if nothing
products as variable costs. is produced.

Absorption Variable
Costing Costing
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7-30

Variable versus Absorption Costing

I guess we wont be
solving this controversy
today!

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7-31

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.
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7-32

End of Chapter 7

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