07 Variable Costing A Tool For Management

11th Edition
Chapter 7
McGrawHill/Irwin
Copyright2006,TheMcGrawHillCompanies,Inc.
Variable Costing: A
Tool for Management
Chapter Seven
McGrawHill/Irwin
Overview of Absorption
and Variable Costing
Absorption
Costing
Variable
Costing
Direct Materials
Product
Costs
Product
Costs
Direct Labor
Variable Manufacturing Overhead
Fixed Manufacturing Overhead
Period
Costs
McGrawHill/Irwin
Variable Selling and Administrative Expenses
Period
Costs
Fixed Selling and Administrative Expenses
Quick Check
Which
Which method
method will
will produce
produce the
the highest
highest values
values for
for
work
work in
in process
process and
and finished
finished goods
goods inventories?
inventories?
a.
a. Absorption
Absorption costing.
costing.
b.
b. Variable
Variable costing.
costing.
c.
c. They
They produce
produce the
the same
same values
values for
for these
these
inventories.
inventories.
d.
d. ItIt depends.
depends. .. ..
McGrawHill/Irwin
Quick Check
Which
Which method
method will
will produce
produce the
the highest
highest values
values for
for
work
work in
in process
process and
and finished
finished goods
goods inventories?
inventories?
a.
a. Absorption
Absorption costing.
costing.
b.
b. Variable
Variable costing.
costing.
c.
c. They
They produce
produce the
the same
same values
values for
for these
these
inventories.
inventories.
d.
d. ItIt depends.
depends. .. ..
McGrawHill/Irwin
Unit Cost Computations

Harvey Company produces a single product
with the following information available:
Number
Number of
ofunits
unitsproduced
produced annually
annually
Variable
Variable costs
costsper
per unit:
unit:
Direct
Directmaterials,
materials, direct
directlabor,
labor,
and
and variable
variable mfg.
mfg. overhead
overhead
Selling
Selling &&administrative
administrative expenses
expenses
$$
$$
Fixed
Fixed costs
costsper
per year:
year:
Manufacturing
Manufacturing overhead
overhead
Selling
expenses
$$150,000
150,000
$$100,000
100,000
McGrawHill/Irwin
25,000
25,000
10
10
33

Unit product cost is determined as follows:
Direct
Directmaterials,
materials, direct
directlabor,
labor,
and
and variable
variable mfg.
mfg. overhead
overhead
Fixed
Fixed mfg.
mfg. overhead
overhead
($150,000
($150,00025,000
25,000units)
units)
Unit
Unitproduct
productcost
cost
Absorption
Absorption
Costing
Costing
Variable
Variable
Costing
Costing
$$
10
10
$$
10
10
$$
66
16
16
$$
-10
10
Selling and administrative expenses are

always treated as period expenses and
deducted from revenue as incurred.
McGrawHill/Irwin
Income Comparison of
Absorption and Variable Costing
Lets assume the following additional
information for Harvey Company.
20,000 units were sold during the year at a price of
$30 each.
There were no units in beginning inventory.
Now, lets compute net operating

income using both absorption
and variable costing.
McGrawHill/Irwin
Absorption Costing
Sales
Sales(20,000
(20,000$30)
$30)
Less
Lesscost
costof
ofgoods
goodssold:
sold:
Beginning
Beginninginventory
inventory
Add
AddCOGM
COGM(25,000
(25,000 $16)
$16)
Goods
Goodsavailable
available for
forsale
sale
Ending
Endinginventory
inventory(5,000
(5,000 $16)
$16)
Gross
Grossmargin
margin
Less
Lessselling
selling&&admin.
admin.exp.
exp.
Variable
Variable (20,000
(20,000$3)
$3)
Fixed
Fixed
Net
Netoperating
operatingincome
income
McGrawHill/Irwin
Absorption
AbsorptionCosting
Costing
$$600,000
600,000
$$
-400,000
400,000
400,000
400,000
80,000
80,000
$$ 60,000
60,000
100,000
100,000
320,000
320,000
280,000
280,000
160,000
160,000
$$120,000
120,000
Variable Costing
Variable
manufacturing
Variable
VariableCosting
Costing
costs only.
Sales
Sales(20,000
(20,000$30)
$30)
Less
Lessvariable
variableexpenses:
expenses:
Beginning
$$
-Beginninginventory
inventory
Add
250,000
AddCOGM
COGM(25,000
(25,000$10)
$10)
250,000
Goods
250,000
Goodsavailable
availablefor
forsale
sale
250,000
Less
Lessending
endinginventory
inventory(5,000
(5,000$10)
$10) 50,000
50,000
Variable
200,000
Variablecost
costof
ofgoods
goodssold
sold
200,000
Variable
Variableselling
selling&&administrative
administrative
expenses
60,000
expenses(20,000
(20,000$3)
$3)
60,000
Contribution
Contributionmargin
margin
Less
Lessfixed
fixedexpenses:
expenses:
Manufacturing
$$150,000
Manufacturingoverhead
overhead
150,000
Selling
Selling&&administrative
administrativeexpenses
expenses 100,000
100,000
Net
Netoperating
operatingincome
income
McGrawHill/Irwin
$$600,000
600,000
All fixed
manufacturing
overhead is
expensed.
260,000
260,000
340,000
340,000
250,000
250,000
$$ 90,000
90,000
Income Comparison of
Absorption and Variable Costing
Lets compare the methods.
Cost
Costof
of
Goods
Goods
Sold
Sold
Absorption
Absorptioncosting
costing
Variable
Variable mfg.
mfg.costs
costs $$200,000
200,000
Fixed
120,000
Fixedmfg.
mfg.costs
costs
120,000
$$320,000
320,000
Variable
Variable costing
costing
Variable
Variable mfg.
mfg.costs
costs $$200,000
200,000
Fixed
-Fixedmfg.
mfg.costs
costs
$$200,000
200,000
McGrawHill/Irwin
Ending
Ending
Inventory
Inventory
Period
Period
Expense
Expense
$$ 50,000
50,000
30,000
30,000
$$ 80,000
80,000
$$
$$ 50,000
50,000
-$$ 50,000
50,000
$$
-150,000
150,000
$$150,000
150,000
$$
----
Total
Total
$$250,000
250,000
150,000
150,000
$$400,000
400,000
$$250,000
250,000
150,000
150,000
$$400,000
400,000
Reconciliation
We can reconcile the difference between
absorption and variable income as follows:
Variable
Variable costing
costingnet
netoperating
operatingincome
income
Add:
Add:Fixed
Fixedmfg.
mfg. overhead
overheadcosts
costs
deferred
deferredin
ininventory
inventory
(5,000
(5,000units
units $6
$6per
perunit)
unit)
Absorption
Absorptioncosting
costingnet
netoperating
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
McGrawHill/Irwin
Extended Comparison of Income Data

Harvey Company Year Two
Number
Number of
ofunits
unitsproduced
produced
Number
Number of
ofunits
unitssold
sold
Units
Unitsin
in beginning
beginning inventory
inventory
Unit
Unitsales
salesprice
price
Variable
Variable costs
costsper
per unit:
unit:
Direct
Directmaterials,
materials, direct
directlabor
labor
variable
variable mfg.
mfg. overhead
overhead
Selling
administrative
expenses
expenses
Fixed
Fixed costs
costsper
per year:
year:
Manufacturing
overhead
Selling
administrative
expenses
expenses
McGrawHill/Irwin
25,000
25,000
30,000
30,000
5,000
5,000
$$
30
30
$$
10
10
$$
33
$$150,000
150,000
$$100,000
100,000
Direct
Directmaterials,
materials, direct
directlabor,
labor,
and
and variable
variable mfg.
mfg. overhead
overhead
Fixed
Fixed mfg.
mfg. overhead
overhead
($150,000
($150,00025,000
25,000units)
units)
Unit
Unitproduct
productcost
cost
Absorption
Absorption
Costing
Costing
Variable
Variable
Costing
Costing
$$
10
10
$$
10
10
$$
66
16
16
$$
-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.
McGrawHill/Irwin
Absorption Costing
Sales
Sales(30,000
(30,000 $30)
$30)
Less
Lesscost
costof
ofgoods
goodssold:
sold:
Beg.
Beg. inventory
inventory(5,000
(5,000 $16)
$16)
Add
AddCOGM
COGM (25,000
(25,000 $16)
$16)
Goods
Goodsavailable
available for
forsale
sale
Less
Lessending
endinginventory
inventory
Gross
Grossmargin
margin
Less
Lessselling
selling &&admin.
admin. exp.
exp.
Variable
Variable (30,000
(30,000 $3)
$3)
Fixed
Fixed
Net
Netoperating
operatingincome
income
Absorption
AbsorptionCosting
Costing
$$900,000
900,000
$$ 80,000
80,000
400,000
400,000
480,000
480,000
-$$ 90,000
90,000
100,000
100,000
480,000
480,000
420,000
420,000
190,000
190,000
$$230,000
230,000
These are the 25,000 units

produced in the current period.
McGrawHill/Irwin
Variable Costing
Variable
manufacturing
costs only. Variable Costing
Variable Costing
Sales
$$900,000
Sales(30,000
(30,000 $30)
$30)
900,000
Less
Lessvariable
variable expenses:
expenses:
Beg.
$$ 50,000
Beg. inventory
inventory(5,000
(5,000 $10)
$10)
50,000
Add
250,000
AddCOGM
COGM(25,000
(25,000 $10)
$10)
250,000
All fixed
Goods
300,000
Goodsavailable
available for
forsale
sale
300,000
manufacturing
Less
-Lessending
endinginventory
inventory
overhead is
Variable
cost
of
goods
sold
300,000
Variable cost of goods sold
300,000
expensed.
Variable
Variable selling
administrative
expenses
90,000
390,000
expenses(30,000
(30,000 $3)
$3)
90,000
390,000
Contribution
510,000
Contributionmargin
margin
510,000
Less
Lessfixed
fixedexpenses:
expenses:
Manufacturing
$$150,000
overhead
150,000
Selling
250,000
expenses 100,000
100,000
250,000
Net
$$260,000
Netoperating
operatingincome
income
260,000
McGrawHill/Irwin
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
McGrawHill/Irwin
Income Comparison
Costing Method
Absorption
Variable
McGrawHill/Irwin
1st Period
$ 120,000
90,000
2nd Period
$ 230,000
260,000
Total
$ 350,000
350,000
Summary
Relation between
production
and sales
Production > Sales
Effect
on
iniventory
Inventory
increases
Production < Sales
Inventory
decreases
Production = Sales
No change
McGrawHill/Irwin
Relation between
variable and
absorption income
Absorption
>
Variable
Absorption
<
Variable
Absorption
=
Variable
Effect of Changes in Production

on Net Operating Income
Lets
Lets revise
revise the
the Harvey
Harvey Company
Company example.
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.
McGrawHill/Irwin

Harvey Company Year One
Number
Number of
ofunits
unitsproduced
produced
Number
Number of
ofunits
unitssold
sold
Unit
Unitsales
salesprice
price
Variable
Variable costs
costsper
perunit:
unit:
Direct
Directmaterials,
materials, direct
directlabor
labor
variable
variable mfg.
mfg. overhead
overhead
Selling
administrative
expenses
expenses
Fixed
Fixed costs
costsper
per year:
year:
Manufacturing
overhead
Selling
administrative
expenses
expenses
McGrawHill/Irwin
30,000
30,000
25,000
25,000
$$
30
30
$$
10
10
$$
33
$$150,000
150,000
$$100,000
100,000
Unit Cost Computations for Year One

Direct
Directmaterials,
materials, direct
directlabor,
labor,
and
and variable
variable mfg.
mfg. overhead
overhead
Fixed
Fixed mfg.
mfg. overhead
overhead
($150,000
($150,00030,000
30,000units)
units)
Unit
Unitproduct
productcost
cost
Absorption
Absorption
Costing
Costing
Variable
Variable
Costing
Costing
$$
10
10
$$
10
10
$$
55
15
15
$$
-10
10
Since
Since the
the number
number of
of units
units produced
produced increased
increased
in
in this
this example,
example, while
while the
the fixed
fixed manufacturing
manufacturing overhead
overhead
remained
remained the
the same,
same, the
the absorption
absorption unit
unit cost
cost is
is less.
less.
McGrawHill/Irwin
Absorption Costing: Year One
Sales
Sales(25,000
(25,000$30)
$30)
Less
Lesscost
costof
ofgoods
goodssold:
sold:
Beginning
Beginninginventory
inventory
Add
AddCOGM
COGM(30,000
(30,000 $15)
$15)
Goods
Goodsavailable
available for
forsale
sale
Ending
Endinginventory
inventory(5,000
(5,000 $15)
$15)
Gross
Grossmargin
margin
Less
Lessselling
selling&&admin.
admin.exp.
exp.
Variable
Variable (25,000
(25,000$3)
$3)
Fixed
Fixed
Net
Netoperating
operatingincome
income
McGrawHill/Irwin
Absorption
AbsorptionCosting
Costing
$$750,000
750,000
$$
-450,000
450,000
450,000
450,000
75,000
75,000
$$ 75,000
75,000
100,000
100,000
375,000
375,000
375,000
375,000
175,000
175,000
$$200,000
200,000
Variable Costing: Year One

Variable
manufacturing
Variable
VariableCosting
Costing
costs only.
Sales
Sales(25,000
(25,000$30)
$30)
Less
Lessvariable
variableexpenses:
expenses:
Beginning
$$
-Beginninginventory
inventory
Add
300,000
AddCOGM
COGM(30,000
(30,000$10)
$10)
300,000
Goods
300,000
Goodsavailable
availablefor
forsale
sale
300,000
Less
Lessending
endinginventory
inventory(5,000
(5,000$10)
$10) 50,000
50,000
Variable
250,000
Variablecost
costof
ofgoods
goodssold
sold
250,000
Variable
Variableselling
administrative
expenses
75,000
expenses(25,000
(25,000$3)
$3)
75,000
Contribution
Contributionmargin
margin
Less
Lessfixed
fixedexpenses:
expenses:
Manufacturing
$$150,000
overhead
150,000
Selling
administrativeexpenses
expenses 100,000
100,000
Net
Netoperating
operatingincome
income
McGrawHill/Irwin
$$750,000
750,000
All fixed
manufacturing
overhead is
expensed.
325,000
325,000
425,000
425,000
250,000
250,000
$$175,000
175,000

Harvey Company Year Two
Number
Number of
ofunits
unitsproduced
produced
Number
Number of
ofunits
unitssold
sold
Units
Unitsin
in beginning
beginning inventory
inventory
Unit
Unitsales
salesprice
price
Variable
Variable costs
costsper
per unit:
unit:
Direct
Directmaterials,
materials, direct
directlabor
labor
variable
variable mfg.
mfg. overhead
overhead
Selling
administrative
expenses
expenses
Fixed
Fixed costs
costsper
per year:
year:
Manufacturing
overhead
Selling
administrative
expenses
expenses
McGrawHill/Irwin
20,000
20,000
25,000
25,000
5,000
5,000
$$
30
30
$$
10
10
$$
33
$$150,000
150,000
$$100,000
100,000
Unit Cost Computations for Year Two

Direct
Directmaterials,
materials, direct
directlabor,
labor,
and
and variable
variable mfg.
mfg. overhead
overhead
Fixed
Fixed mfg.
mfg. overhead
overhead
($150,000
($150,00020,000
20,000units)
units)
Unit
Unitproduct
productcost
cost
Absorption
Absorption
Costing
Costing
Variable
Variable
Costing
Costing
$$
10
10
$$
10
10
$$
7.50
7.50
17.50
17.50
$$
-10
10
Since
Since the
the number
number of
of units
units produced
produced decreased
decreased in
in the
the
second
second year,
year, while
while the
the fixed
fixed manufacturing
manufacturing overhead
overhead
remained
remained the
the same,
same, the
the absorption
absorption unit
unit cost
cost is
is now
now higher.
higher.
McGrawHill/Irwin
Absorption Costing: Year Two
Sales
Sales(25,000
(25,000 $30)
$30)
Less
Lesscost
costof
ofgoods
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
Goodsavailable
available for
forsale
sale
Less
Lessending
endinginventory
inventory
Gross
Grossmargin
margin
Less
Lessselling
selling &&admin.
admin. exp.
exp.
Variable
Variable (25,000
(25,000 $3)
$3)
Fixed
Fixed
Net
Netoperating
operatingincome
income
Absorption
AbsorptionCosting
Costing
$$750,000
750,000
$$ 75,000
75,000
350,000
350,000
425,000
425,000
--
$$ 75,000
75,000
100,000
100,000
425,000
425,000
325,000
325,000
175,000
175,000
$$150,000
150,000
These are the 20,000 units produced in the current

period at the higher unit cost of $17.50 each.
McGrawHill/Irwin
Variable Costing: Year Two

Variable
manufacturing
costs only. Variable Costing
Variable Costing
Sales
$$750,000
Sales(25,000
(25,000 $30)
$30)
750,000
Less
Lessvariable
variable expenses:
expenses:
Beg.
$$ 50,000
Beg. inventory
inventory(5,000
(5,000 $10)
$10)
50,000
Add
200,000
AddCOGM
COGM(20,000
(20,000 $10)
$10)
200,000
All fixed
Goods
250,000
Goodsavailable
available for
forsale
sale
250,000
manufacturing
Less
-Lessending
endinginventory
inventory
overhead is
Variable
cost
of
goods
sold
250,000
Variable cost of goods sold
250,000
expensed.
Variable
Variable selling
administrative
expenses
75,000
325,000
expenses(25,000
(25,000 $3)
$3)
75,000
325,000
Contribution
425,000
Contributionmargin
margin
425,000
Less
Lessfixed
fixedexpenses:
expenses:
Manufacturing
$$150,000
overhead
150,000
Selling
250,000
expenses 100,000
100,000
250,000
Net
$$175,000
Netoperating
operatingincome
income
175,000
McGrawHill/Irwin
Income Comparison
Costing Method
Absorption
Variable
Year One
$ 200,000
175,000
Year 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.
McGrawHill/Irwin
Impact on the Manager

Opponents
Opponentsof
ofabsorption
absorptioncosting
costingargue
arguethat
thatshifting
shifting
fixed
fixedmanufacturing
manufacturingoverhead
overheadcosts
costsbetween
betweenperiods
periods
can
canlead
leadto
tomisinterpretations
misinterpretationsand
andfaulty
faultydecisions.
decisions.
Those
Thosewho
whofavor
favor variable
variable costing
costingargue
arguethat
that the
theincome
income
statements
statementsare
areeasier
easier to
tounderstand
understandbecause
becausenet
net operating
operating
income
incomeisisonly
onlyaffected
affectedby
bychanges
changesin
inunit
unit sales.
sales. The
The
resulting
resultingincome
incomeamounts
amountsare
aremore
moreconsistent
consistentwith
with
managers
managersexpectations.
expectations.
McGrawHill/Irwin
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
Treatingfixed
fixedmanufacturing
manufacturingoverhead
overheadas
asaa
variable
variablecost
cost can:
can:
Lead
Leadto
tofaulty
faultypricing
pricingdecisions
decisionsand
and keep/drop
keep/drop
decisions.
decisions.
Produce
Producepositive
positivenet
net operating
operatingincome
income even
even
when
whenthe
thenumber
numberof
ofunits
unitssold
soldisisless
lessthan
thanthe
the
breakeven
breakevenpoint.
point.
McGrawHill/Irwin
External Reporting and Income Taxes

To
Toconform
conform to
to
GAAP
GAAPrequirements,
requirements,
absorption
absorptioncosting
costing must
mustbe
be used
usedfor
for
external
externalfinancial
financialreports
reportsin
inthe
the
United
UnitedStates.
States.
Under
Underthe
theTax
Tax
Reform
ReformAct
Actof
of1986,
1986,
absorption
absorption costing
costing must
must be
be
used
when
filing
income
used
when
filing
income
Since
Sincetop
topexecutives
executives
tax
taxreturns.
returns.
are
usually
evaluated
based
on
are usually evaluated based on
external
externalreports
reportsto
toshareholders,
shareholders,
they
theymay
mayfeel
feelthat
thatdecisions
decisions
should
shouldbe
bebased
basedon
on
absorption
absorptioncost
cost income.
income.
McGrawHill/Irwin
Advantages of Variable Costing

and the Contribution Approach
Management finds
it more useful.
Advantages
Impact of fixed
costs on profits
emphasized.
McGrawHill/Irwin
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.
Profit is not affected by
changes in inventories.
Variable versus Absorption Costing

Fixed manufacturing
costs must be assigned
to products to properly
match revenues and
costs.
Absorption
Costing
McGrawHill/Irwin
Fixed manufacturing
costs are capacity costs
and will be incurred
even if nothing is
produced.
Variable
Costing
Variable Costing and the

Theory of Constraints (TOC)
Companies
Companies involved
involved in
in TOC
TOC use
use aa form
form of
of
variable
variable costing,
costing, but
but treating
treating direct
direct labor
labor as
as aa
fixed
fixed cost
cost for
for three
three reasons:
reasons:
Many
Many companies
companies have
have aa commitment
commitment to
to guarantee
guarantee
workers
workers aa minimum
minimum number
number of
of paid
paid hours.
hours.
TOC
TOC emphasizes
emphasizes the
the role
role of
of direct
direct labor
labor in
in
continuous
continuous improvement.
improvement. Fluctuating
Fluctuating levels
levels of
of
direct
direct labor
labor can
can devastate
devastate morale
morale and
and defeat
defeat
the
the role
role of
of employees
employees in
in continuous
continuous improvement
improvement
efforts.
efforts.
Direct
Direct labor
labor isis usually
usually not
not the
the constraint.
constraint.
McGrawHill/Irwin
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.
McGrawHill/Irwin
End of Chapter 7
McGrawHill/Irwin

07 Variable Costing A Tool For Management

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11th Edition

Variable Selling and Administrative Expenses

Fixed Selling and Administrative Expenses

Unit Cost Computations

Unit Cost Computations

Selling and administrative expenses are

Now, lets compute net operating

Fixed mfg. Overhead

Extended Comparison of Income Data

Unit Cost Computations

Since there was no change in the variable costs

These are the 25,000 units

Fixed mfg. Overhead

Production < Sales

Effect of Changes in Production

In this revised example,

Effect of Changes in Production

Unit Cost Computations for Year One

Absorption Costing: Year One

Variable Costing: Year One

Effect of Changes in Production

Unit Cost Computations for Year Two

Absorption Costing: Year Two

These are the 20,000 units produced in the current

Variable Costing: Year Two

Impact on the Manager

CVP Analysis, Decision Making

External Reporting and Income Taxes

Advantages of Variable Costing

Variable versus Absorption Costing

Variable Costing and the

Impact of JIT Inventory Methods

So, the difference between variable and

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