Chapter 7

Variable Costing: A Tool for Management

3/17/04

Absorption Costing
Treats all manufacturing costs as product costs, and non-manufacturing costs as period costs Unit costs consist of direct material and direct labor and both variable and fixed manufacturing overhead. Fixed manufacturing overhead is allocated to each unit of production GAAP
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Variable Costing
Only those costs of manufacturing that vary with output (variable costs) are treated as product costs This would include direct material, direct labor and variable manufacturing overhead Fixed manufacturing overhead is expensed during the current period Variable costing is used for internal planning and control only; its not GAAP!
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Overview of Absorption and Variable(Marginal) Costing

The only cost of driving my car on a 200 mile trip today is $12 for gasoline.

Variable Costing
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Overview of Absorption and Variable Costing

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

Absorption Costing
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Overview of Absorption and Variable (Marginal) Costing

You are wrong. I have the car payment and the insurance payment even if I do not make the trip.

Variable Costing
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Overview of Absorption and Variable Costing

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

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Marginal Costing
Provides a useful tool for evaluating marginal business propositions Example, WTT exhibit Marginal costs versus fixed costs

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Overview of Absorption and Variable Costing

Absorption Costing
Direct Materials

Variable Costing
Product Costs

Product Costs

Direct Labor Variable Manufacturing Overhead Fixed Manufacturing Overhead

Period Costs

Variable Selling and Administrative Expenses Fixed Selling and Administrative Expenses

Period Costs

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Note: Manufacturing Cost Flows

Costs
Material Purchases Direct Labor Variable Manufacturing Overhead Fixed Manufacturing Overhead Selling and Administrative
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Balance Sheet Inventories

Raw Materials
Work in Process

Income Statement Expenses

Finished Goods

Cost of Goods Sold

Fixed Mfrg OH Selling and Period Costs Administrative The McGraw-Hill Companies, Inc., 2003

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. . .

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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. . .

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Quick Check
Which method will produce the highest retained earnings? (Hint: Remember the balance sheet equation.) a. Absorption costing b. Variable costing c. There would be no difference in retained earnings under the two methods. d. It depends ...

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Quick Check
Which method will produce the highest retained earnings? (Hint: Remember the balance sheet equation.)
a. Absorption costing, because some fixed costs stay in inventory until the product is sold b. Variable costing c. There would be no difference in retained earnings under the two methods.

Assets d. It depends ... = Liabilities + Owners Equity

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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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Unit Cost Computations

Harvey Co. produces a single product with the following information available:

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Unit Cost Computations

Unit product cost is determined as follows:

Selling and administrative expenses are always treated as period expenses and deducted from revenue.
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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) Less cost of goods sold: Beginning inventory $ Add COGM (25,000 $16) 400,000 Goods available for sale 400,000 Ending inventory (5,000 $16) 80,000 Gross margin Less selling & admin. exp. Variable Fixed Net operating income
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$ 600,000

320,000 280,000

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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) Less cost of goods sold: Beginning inventory $ Add COGM (25,000 $16) 400,000 Goods available for sale 400,000 Ending inventory (5,000 $16) 80,000 Gross margin Less selling & admin. exp. Variable (20,000 $3) $ 60,000 Fixed 100,000 Net operating income
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$ 600,000

320,000 280,000

160,000 $ 120,000

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Income Comparison of Absorption and Variable Costing

Now lets look at variable costing by Harvey Co.
Sales (20,000 $30) Less variable expenses: Beginning inventory $ 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 selling & administrative expenses (20,000 $3) 60,000 Contribution margin Less fixed expenses: Manufacturing overhead $ 150,000 Selling & administrative expenses 100,000 Net operating income
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Variable costs only.

Variable Costing
$ 600,000

All fixed manufacturing overhead is expensed.

260,000 340,000

250,000 $ 90,000

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Quick Check
The net operating income under absorption costing was $120,000 and under variable costing it was $90,000 because of higher expenses. Where is the missing $30,000 under absorption costing? a. It has disappeared into an accounting black hole. b. It is in ending inventories. c. It represents taxes that have been saved. d. The $30,000 wasnt a real cost, so nothing is really missing.
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Quick Check
The net operating income under absorption costing was $120,000 and under variable costing it was $90,000 because of higher expenses. Where is the missing $30,000 under absorption costing? a. It has disappeared into an accounting black hole. b. It is in ending inventories. c. It represents taxes that have been saved. d. The $30,000 wasnt a real cost, so nothing is really missing.
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Income Comparison of Absorption and Variable Costing

Lets compare the methods.

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Reconciliation
We can reconcile the difference between absorption and variable income as follows:
Variable costing net operating income $ 90,000 Add: Fixed mfg. overhead costs deferred in inventory (5,000 units $6 per unit) 30,000 Absorption costing net operating income $ 120,000

Fixed mfg. overhead $150,000 = = $6.00 per unit Units produced 25,000 units
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Extending the Example

Lets look at the second year of operations for Harvey Company.

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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.

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Harvey Co. Year 2

Unit product cost is determined as follows:

No change in Harveys cost structure.

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Harvey Co. Year 2

Absorption Costing
Sales (30,000 $30) Less cost of goods sold: Beg. inventory (5,000 $16) Add COGM (25,000 $16) Goods available for sale Less ending inventory Gross margin Less selling & admin. exp. Variable (30,000 $3) Fixed Net operating income $ 900,000 $ 80,000 400,000 480,000 -

480,000 420,000

$ 90,000 100,000

190,000 $ 230,000

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

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Harvey Co. Year 2

Variable costs only.

All fixed manufacturing overhead is expensed.

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Reconciliation
We can reconcile the difference between absorption and variable income as follows:
Variable costing net operating income $ 260,000 Deduct: 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
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Summary

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Comparative Income Effects

Exhibit 7-4 Production = Sales No change in inventory; income the same for both absorption and variable costing Production > Sales Inventories increase; Absorption Income higher than Variable Cost income due to more fixed cost retained in inventory Production < Sales Inventories decrease; Absorption Income lower than Variable Cost income as more fixed costs are released from inventory
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Advantages of the Variable Cost Approach

Management finds it easy to understand. Consistent with CVP analysis. Can be used for marginal Cost analysis.

Advantages
Easier to estimate profitability of products and segments.
Impact of fixed costs on profits emphasized.
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Profit is not affected by changes in inventories.

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Variable versus Absorption Costing

All manufacturing costs must be assigned to products to properly match revenues and costs.

Fixed costs are not really the costs of any particular product.

Absorption Costing
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Variable Costing
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Variable versus Absorption Costing

Depreciation, taxes, insurance and salaries are just as essential to products as variable costs.

These are capacity costs and will be incurred even if nothing is produced.

Absorption Costing
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Variable Costing
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Variable versus Absorption costing

Absorption costing product costs are misleading for decision making. They are the numbers that appear on our external reports.

Variable Costing
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Absorption Costing
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End of Chapter 7

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