Chapter

7
Variable Costing: A Tool for Management

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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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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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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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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 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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Overview of Absorption and Variable Costing

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

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Overview of Absorption and Variable Costing

Absorption Costing Direct materials Direct labour Variable mfg. overhead Fixed mfg. overhead Period costs Period costs Selling & admin. exp. Variable Costing

Product costs

Product costs

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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:
Number of units produced annually Variable costs per unit: Direct materials, direct labour, and variable mfg. overhead Selling & administrative expenses Fixed costs per year: Manufacturing overhead Selling & administrative expenses 25,000

$ $

10 3

$ 150,000 $ 100,000

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Unit Cost Computations

Unit product cost is determined as follows:
Absorption Costing Direct materials, direct labour, and variable mfg. overhead Fixed mfg. overhead ($150,000 25,000 units) Unit product cost $ 10 6 16 Variable Costing $ 10 10

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 availa ble for sale 400,000 Ending inventory (5,000 $16) 80,000 Gross m argin Less se lling & adm in. e xp. Varia ble Fixed Net incom e $ 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 availa ble for sale 400,000 Ending inventory (5,000 $16) 80,000 Gross m argin Less se lling & adm in. e xp. Varia ble (20,000 $3) $ 60,000 Fixed 100,000 Net incom e $ 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 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 income

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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Income Comparison of Absorption and Variable Costing

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

$ 50,000 $ 50,000

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Income Comparison of Absorption and Variable Costing

Lets compare the methods.
Cost of Goods Sold Absorption costing Variable mfg. costs $ 200,000 Fix ed mfg. costs 120,000 $ 320,000 Variable costing Variable mfg. costs $ 200,000 Fix ed mfg. costs $ 200,000 Ending Inventory $ 50,000 30,000 $ 80,000 Period Ex pe nse $ $ Tota l $ 250,000 150,000 $ 400,000

$ 50,000 $ 50,000

150,000 $ 150,000

$ 250,000 150,000 $ 400,000

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

30,000 $ 120,000

Fixed mfg. overhead $150,000 = = $6.00 per unit Units produced 25,000
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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.
Number of units produced a nnually Va ria ble costs pe r unit: Dire ct m ate rials, direct la bor varia ble mfg. ove rhea d Se lling & a dministrative ex pe nses Fix ed costs per ye ar: Manufa cturing ove rhea d Se lling & a dministrative ex pe nses 25,000

$ $

10 3

$ 150,000 $ 100,000
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Harvey Co. Year 2

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

No change in Harveys cost structure.

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Harvey Co. Year 2

Now lets look at Harveys income statement assuming absorption costing is used.

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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 Ending inventory Gross margin Less selling & admin. exp. Variable (30,000 $3) Fixed Net 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

Next, well look at Harveys income statement assuming is used.

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Harvey Co. Year 2

Sales (30,000 $30) Less variable expenses: Beg. inventory (5,000 $10) $ 50,000 Add COGM (25,000 $10) 250,000 Goods available for sale 300,000 Ending inventory Variable cost of goods sold 300,000 Variable selling & administrative expenses (30,000 $3) 90,000 Contribution margin Less fixed expenses: Manufacturing overhead $ 150,000 Selling & administrative expenses 100,000 Net income

Variable costs only.

Variable Costing
$ 900,000

All fixed manufacturing overhead is expensed.

390,000 510,000

250,000 $ 260,000

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

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Advantages of the Contribution Approach Consistent with

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

Advantages

Consistent with standard costs and flexible budgeting. Easier to estimate profitability of products and segments. Profit is not affected by changes in inventories.
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Impact of fixed costs on profits emphasized.

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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

Variable Costing
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Variable versus Absorption Costing

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

Absorption Costing

Variable Costing
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Variable versus Absorption Costing

I guess we wont be solving this controversy today!

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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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End of Chapter 7

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