Variable Costing

and the Costs of

Quality and
Sustainability
Chapter 8
McGraw-Hill/I rwin
Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Learning Objective 1
8-2
8-2
Absorption Costing
A system of accounting for costs in which both fixed
and variable production costs are considered
product costs.
Fixed
Costs
Variable
Costs
Product
8-3
Variable Costing
A system of cost accounting that only assigns the
variable cost of production to products.
Fixed
Costs
Variable
Costs
Product
8-4
Absorption and Variable Costing
Absorption
Costing
Variable
Costing
Direct materials
Direct labor Product costs
Product costs Variable mfg. overhead
Fixed mfg. overhead
Period costs
Period costs Selling & Admin. exp.
8-5
Absorption and Variable Costing
Absorption
Costing
Variable
Costing
Direct materials
Direct labor Product costs
Product costs Variable mfg. overhead
Fixed mfg. overhead
Period costs
Period costs Selling & Admin. exp.
The difference between absorption and variable
costing is the treatment of fixed manufacturing overhead.
8-6
Learning Objective 2
8-7
Lets put some numbers to an example and
see what we can learn about the difference
between absorption and variable costing.

Absorption and Variable Costing
8-8
Absorption and Variable Costing
Mellon Co. produces a single product with the
following information available:
Number of units produced annually 25,000
Variable costs per unit:
Direct materials, direct labor
and variable mfg. overhead 10 $
Selling & administrative
expenses 3 $
Fixed costs per year:
Mfg. overhead 150,000 $
Selling & administrative
expenses 100,000 $
8-9
Absorption and Variable Costing
Unit product cost is determined as follows:
Absorption
Costing
Variable
Costing
Direct materials, direct labor, 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.
8-10
Absorption Costing
Income Statements
Mellon Co. had no beginning inventory, produced 25,000 units,
and sold 20,000 units this year at $30 each.
Absorption Costing
Sales (20,000 $30) 600,000 $
Less cost of goods sold:
Beginning inventory
Add COGM
Goods available for sale
Ending inventory
Gross margin
Less selling & admin. exp.
Variable
Fixed
Net income
8-11
Absorption Costing
Sales (20,000 $30) 600,000 $
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) 80,000 320,000
Gross margin 280,000 $
Less selling & admin. exp.
Variable
Fixed
Net income
Absorption Costing
Income Statements
Mellon Co. had no beginning inventory, produced 25,000 units,
and sold 20,000 units this year at $30 each.
8-12
Absorption Costing
Sales (20,000 $30) 600,000 $
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) 80,000 320,000
Gross margin 280,000 $
Less selling & admin. exp.
Variable (20,000 $3) 60,000 $
Fixed 100,000 160,000
Net income 120,000 $
Absorption Costing
Income Statements
Mellon Co. had no beginning inventory, produced 25,000 units,
and sold 20,000 units this year at $30 each.
8-13
Learning Objective 3
8-14
Variable Costing
Income Statements
Now lets look at variable costing by Mellon Co.
Variable Costing
Sales (20,000 $30) 600,000 $
Less variable expenses:
Beginning inventory - $
Add COGM
Goods available for sale
Ending inventory
Variable cost of goods sold
Variable selling & administrative
expenses
Contribution margin
Less fixed expenses:
Manufacturing overhead
Selling & administrative expenses
Net income
8-15
Variable Costing
Income Statements
Now lets look at variable costing by Mellon Co.
Variable Costing
Sales (20,000 $30) 600,000 $
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
Contribution margin
Less fixed expenses:
Manufacturing overhead
Selling & administrative expenses
Net income
We exclude the
fixed manufacturing
overhead.
8-16
Variable Costing
Sales (20,000 $30) 600,000 $
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) 60,000 260,000
Contribution margin 340,000 $
Less fixed expenses:
Manufacturing overhead 150,000 $
Selling & administrative expenses 100,000 250,000
Net income 90,000 $
Variable Costing
Income Statements
Now lets look at variable costing by Mellon Co.
8-17
Cost of
Goods
Sold
Ending
Inventory
Period
Expense Total
Absorption costing
Variable mfg. costs 200,000 $
Fixed mfg. costs 120,000
320,000 $
Variable costing
Variable mfg. costs 200,000 $
Fixed mfg. costs -
200,000 $
Comparing Absorption and
Variable Costing
Lets compare the methods.
8-18
Comparing Absorption and
Variable Costing
Lets compare the methods.
Cost of
Goods
Sold
Ending
Inventory
Period
Expense Total
Absorption costing
Variable mfg. costs 200,000 $ 50,000 $ - $
Fixed mfg. costs 120,000 30,000 -
320,000 $ 80,000 $ - $
Variable costing
Variable mfg. costs 200,000 $ 50,000 $ - $
Fixed mfg. costs - - 150,000
200,000 $ 50,000 $ 150,000 $
8-19
Cost of
Goods
Sold
Ending
Inventory
Period
Expense Total
Absorption costing
Variable mfg. costs 200,000 $ 50,000 $ - $ 250,000 $
Fixed 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 $
Fixed mfg. costs - - 150,000 150,000
200,000 $ 50,000 $ 150,000 $ 400,000 $
Comparing Absorption and
Variable Costing
Lets compare the methods.
8-20
Learning Objective 4
8-21
Reconciling Income Under Absorption
and Variable Costing
We can reconcile the difference between
absorption and variable net 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
Units produced 25,000
= $6.00 per unit =
8-22
Learning Objective 5
8-23
Cost-Volume-Profit Analysis
CVP includes all fixed costs to compute breakeven.
Variable costing and CVP are consistent as both treat
fixed costs as a lump sum.
Absorption costing defers fixed costs into inventory.
Absorption costing is inconsistent with CVP because
absorption costing treats fixed costs on a per unit basis.
8-24
Learning Objective 6
8-25
Extending the Example
Lets look at
the second
year of
operations
for Mellon
Company.
8-26
Mellon Co. Year 2
In its second year of operations, Mellon Co. started with an
inventory of 5,000 units, produced 25,000 units, and sold
30,000 units at $30 each.
Number of units produced annually 25,000
Variable costs per unit:
Direct materials, direct labor
and variable mfg. overhead 10 $
Selling & administrative
expenses 3 $
Fixed costs per year:
Mfg. overhead 150,000 $
Selling & administrative
expenses 100,000 $
8-27
Mellon Co. Year 2
Unit product cost is determined as follows:
Absorption
Costing
Variable
Costing
Direct materials, direct labor,
and variable mfg. overhead 10 $ 10 $
Fixed mfg. overhead
($150,000 25,000 units) 6 -
Unit product cost 16 $ 10 $
There has been no
change in Mellons
cost structure.
8-28
Mellon Co. Year 2
Now lets look at Mellons income statement
assuming absorption costing is used.
8-29
Absorption Costing
Sales (30,000 $30) 900,000 $
Less cost of goods sold:
Beg. inventory (5,000 x $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 $
Mellon Co. Year 2
Units in ending inventory from the previous period.
8-30
Absorption Costing
Sales (30,000 $30) 900,000 $
Less cost of goods sold:
Beg. inventory (5,000 x $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 $
Mellon Co. Year 2
25,000 units produced in the current period.
8-31
Mellon Co. Year 2
Next, well look at Mellons income statement
assuming variable costing is used.
8-32
Variable Costing
Sales (30,000 $30) 900,000 $
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) 90,000 390,000
Contribution margin 510,000 $
Less fixed expenses:
Manufacturing overhead 150,000 $
Selling & administrative expenses 100,000 250,000
Net income 260,000 $
Mellon Co. Year 2
Excludes fixed manufacturing overhead.
8-33
Summary
In the first period, production (25,000 units)
was greater than sales (20,000).
Income Comparison
Costing Method 1st Period 2nd Period Total
Absorption 120,000 $ 230,000 $ 350,000 $
Variable 90,000 260,000 350,000
In the second period, production (25,000 units)
was less than sales (30,000).
8-34
Summary
For the two-year period, total absorption
income and total variable income are the same.
Income Comparison
Costing Method 1st Period 2nd Period Total
Absorption 120,000 $ 230,000 $ 350,000 $
Variable 90,000 260,000 350,000
8-35
Summary
Lets see if we can get an overview of what
we have done.
8-36
Summary Comparison of Absorption
(AC) and Variable Costing (VC)
Production versus
Sales
Total
Inventory
Effect Period Expense Effect Profit Effect
Fixed mfg. Fixed mfg.
Produced > Sold Increase costs expensed < costs expensed AC > VC
AC VC
Fixed mfg. Fixed mfg.
Produced < Sold Decrease costs expensed > costs expensed AC < VC
AC VC
Fixed mfg. Fixed mfg.
Produced = Sold No change costs expensed = costs expensed AC = VC
AC VC
This was the case in the first period when production
of 25,000 units was greater than sales of 20,000 units.
Inventory increased from zero to 5,000 units and
$120,000 absorption income was greater than
$90,000 variable income.
8-37
Production versus
Sales
Total
Inventory
Effect Period Expense Effect Profit Effect
Fixed mfg. Fixed mfg.
Produced > Sold Increase costs expensed < costs expensed AC > VC
AC VC
Fixed mfg. Fixed mfg.
Produced < Sold Decrease costs expensed > costs expensed AC < VC
AC VC
Fixed mfg. Fixed mfg.
Produced = Sold No change costs expensed = costs expensed AC = VC
AC VC
Summary Comparison of Absorption
(AC) and Variable Costing (VC)
In the second period sales of 30,000 units
were greater than production of 25,000.
8-38
Production versus
Sales
Total
Inventory
Effect Period Expense Effect Profit Effect
Fixed mfg. Fixed mfg.
Produced > Sold Increase costs expensed < costs expensed AC > VC
AC VC
Fixed mfg. Fixed mfg.
Produced < Sold Decrease costs expensed > costs expensed AC < VC
AC VC
Fixed mfg. Fixed mfg.
Produced = Sold No change costs expensed = costs expensed AC = VC
AC VC
Summary Comparison of Absorption
(AC) and Variable Costing (VC)
Inventory decreased from 5,000 units to zero,
and $230,000 absorption income was less
than $260,000 variable income.
8-39
Production versus
Sales
Total
Inventory
Effect Period Expense Effect Profit Effect
Fixed mfg. Fixed mfg.
Produced > Sold Increase costs expensed < costs expensed AC > VC
AC VC
Fixed mfg. Fixed mfg.
Produced < Sold Decrease costs expensed > costs expensed AC < VC
AC VC
Fixed mfg. Fixed mfg.
Produced = Sold No change costs expensed = costs expensed AC = VC
AC VC
Summary Comparison of Absorption
(AC) and Variable Costing (VC)
For the two-year period, units produced
equals units sold, so total absorption income
equals total variable income.
8-40
Advantages
Management finds it
easy to understand.
Consistent with
CVP analysis.
Emphasizes contribution in
short-run pricing decisions.
Profit for period not
affected by changes
in fixed mfg. overhead.
Impact of fixed
costs on profits
emphasized.
Evaluation of Variable Costing
8-41
Advantages
Consistent with long-run
pricing decisions that must
cover full cost.
External reporting
and income tax law
require absorption costing.
Evaluation of Absorption Costing
Fixed manufacturing overhead is
treated the same as the other product
costs, direct material and direct labor.
8-42
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.
8-43
Learning Objective 7
8-44
Costs of Assuring Quality
Grade Quality
8-45
Grade refers to the
extent of its
capabilities in
performing an
intended purpose, in
relation to other
products with the
same functional use.
Quality of design refers
to how well it is conceived
or designed for its
intended use.
Quality of conformance
refers to the extent to
which a product meets
the specification of its
design.
There are four types of quality costs.

Prevention costs are the costs of preventing
defects.

Appraisal costs are the costs of determining
whether defects exist.

Internal failure costs are the costs of repairing
defects found prior to product delivery.

External failure costs are those costs incurred
after product delivery.

8-46
Learning Objective 8
8-47
8-47
What is the Optimal Level
of Product Quality?


The optimal level of product quality is reached when:

Prevention costs = Internal failure costs
+ Appraisal costs + External failure costs

8-48
ISO 9000 Standards
ISO 9000 standards require that a
company have a well-defined quality
control system in place and that the target
level of product quality is consistently
maintained.
These standards have been
adopted in the US and other
countries.

8-49
Learning Objective 9
8-50
Costs of Environmental
Sustainability
Sustainable development includes business
activity that produces the goods and services
needed in the present without limiting the ability of
future generations to meet their meets.
Environmental costs are the costs of dealing with
environmental issues, such as BPs costs in
cleaning up the companys spill in the Gulf of
Mexico.
Environmental cost management is the strategic
implantation of systems for identifying, measuring,
controlling, and reducing the private environmental
costs borne by a company or other organization.

8-51
Environmental costs may be
categorized in several ways:

Private environmental costs are those borne by a
company or individual. Social environmental costs
are those borne by the public at large.
Visible environmental costs are those that are
known and clearly identified as tied to
environmental issues. Hidden social
environmental costs cannot be clearly tied to
environmental issues.

8-52
Visible and hidden environmental costs may be
further classified into one of three types.

Monitoring costs include the costs of monitoring the
regulatory environmental as well as monitoring the
production process to determine if pollution is being
generated.
Abatement costs include costs to reduce or eliminate
pollution.
Remediation costs include on-site and off-site remediation
costs. On-site remediation includes costs of reducing or
preventing the discharge into the environment of pollutants
that have been generated in the production process. Off-
site remediation includes the costs of reducing or
eliminating pollutants from the environment after they have
been discharged.

8-53
End of Chapter 8
8-54