11th Edition
Chapter 7
McGraw-Hill/Irwin
Copyright © 2006, The McGraw-Hill Companies, Inc.
Variable Costing: A
Tool for Management
Chapter Seven
McGraw-Hill/Irwin
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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
McGraw-Hill/Irwin
Variable Selling and Administrative Expenses
Period
Costs
Fixed Selling and Administrative Expenses
Copyright © 2006, The McGraw-Hill Companies, Inc.
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. .. ..
McGraw-Hill/Irwin
Copyright © 2006, The McGraw-Hill Companies, Inc.
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. .. ..
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Copyright © 2006, The McGraw-Hill Companies, Inc.
Unit Cost Computations
Harvey Company produces a single product
with the following information available:
Number of units produced annually
Variable costs per unit:
Direct materials, direct labor,
and variable mfg. overhead
Selling & administrative expenses
$
$
Fixed costs per year:
Manufacturing overhead
Selling & administrative expenses
$ 150,000
$ 100,000
McGraw-Hill/Irwin
25,000
10
3
Copyright © 2006, The McGraw-Hill Companies, Inc.
Unit Cost Computations
Unit product cost is determined as follows:
Direct materials, direct labor,
and variable mfg. overhead
Fixed mfg. overhead
($150,000 ÷ 25,000 units)
Unit product cost
Absorption
Costing
Variable
Costing
$
10
$
10
$
6
16
$
10
Selling and administrative expenses are
always treated as period expenses and
deducted from revenue as incurred.
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Copyright © 2006, The McGraw-Hill Companies, Inc.
Income Comparison of
Absorption and Variable Costing
Let’s 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, let’s compute net operating
income using both absorption
and variable costing.
McGraw-Hill/Irwin
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Absorption Costing
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
McGraw-Hill/Irwin
$ 600,000
320,000
280,000
160,000
$ 120,000
Copyright © 2006, The McGraw-Hill Companies, Inc.
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
McGraw-Hill/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
Copyright © 2006, The McGraw-Hill Companies, Inc.
Income Comparison of
Absorption and Variable Costing
Let’s compare the methods.
Cost of
Goods
Sold
Ending
Inventory
Period
Expense
Absorption costing
Variable mfg. costs $ 200,000
Fixed mfg. costs
120,000
$ 320,000
$ 50,000
30,000
$ 80,000
$
Variable costing
Variable mfg. costs $ 200,000
Fixed mfg. costs
$ 200,000
$ 50,000
$ 50,000
$
McGraw-Hill/Irwin
$
-
150,000
$ 150,000
Total
$ 250,000
150,000
$ 400,000
$ 250,000
150,000
$ 400,000
Copyright © 2006, The McGraw-Hill Companies, Inc.
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
McGraw-Hill/Irwin
Copyright © 2006, The McGraw-Hill Companies, Inc.
Extended Comparison of Income Data
Harvey Company Year Two
Number of units produced
Number of units sold
Units in beginning inventory
Unit sales price
Variable costs per unit:
Direct materials, direct labor
variable mfg. overhead
Selling & administrative
expenses
Fixed costs per year:
Manufacturing overhead
Selling & administrative
expenses
McGraw-Hill/Irwin
25,000
30,000
5,000
$
30
$
10
$
3
$ 150,000
$ 100,000
Copyright © 2006, The McGraw-Hill Companies, Inc.
Unit Cost Computations
Direct materials, direct labor,
and variable mfg. overhead
Fixed mfg. overhead
($150,000 ÷ 25,000 units)
Unit product cost
Absorption
Costing
Variable
Costing
$
10
$
10
$
6
16
$
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.
McGraw-Hill/Irwin
Copyright © 2006, The McGraw-Hill Companies, Inc.
Absorption Costing
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
-
$ 90,000
100,000
480,000
420,000
190,000
$ 230,000
These are the 25,000 units
produced in the current period.
McGraw-Hill/Irwin
Copyright © 2006, The McGraw-Hill Companies, Inc.
Variable Costing
Variable
manufacturing
costs only. 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
All fixed
Goods available for sale
300,000
manufacturing
Less 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 operating income
$ 260,000
McGraw-Hill/Irwin
Copyright © 2006, The McGraw-Hill Companies, Inc.
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
McGraw-Hill/Irwin
Copyright © 2006, The McGraw-Hill Companies, Inc.
Income Comparison
Costing Method
Absorption
Variable
McGraw-Hill/Irwin
1st Period
$ 120,000
90,000
2nd Period
$ 230,000
260,000
Total
$ 350,000
350,000
Copyright © 2006, The McGraw-Hill Companies, Inc.
Summary
Relation between
production
and sales
Production > Sales
Effect
on
iniventory
Inventory
increases
Production < Sales
Inventory
decreases
Production = Sales
No change
McGraw-Hill/Irwin
Relation between
variable and
absorption income
Absorption
>
Variable
Absorption
<
Variable
Absorption
=
Variable
Copyright © 2006, The McGraw-Hill Companies, Inc.
Effect of Changes in Production
on Net Operating Income
Let’s
Let’s 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.
McGraw-Hill/Irwin
Copyright © 2006, The McGraw-Hill Companies, Inc.
Effect of Changes in Production
Harvey Company Year One
Number of units produced
Number of units sold
Unit sales price
Variable costs per unit:
Direct materials, direct labor
variable mfg. overhead
Selling & administrative
expenses
Fixed costs per year:
Manufacturing overhead
Selling & administrative
expenses
McGraw-Hill/Irwin
30,000
25,000
$
30
$
10
$
3
$ 150,000
$ 100,000
Copyright © 2006, The McGraw-Hill Companies, Inc.
Unit Cost Computations for Year One
Unit product cost is determined as follows:
Direct materials, direct labor,
and variable mfg. overhead
Fixed mfg. overhead
($150,000 ÷ 30,000 units)
Unit product cost
Absorption
Costing
Variable
Costing
$
10
$
10
$
5
15
$
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.
McGraw-Hill/Irwin
Copyright © 2006, The McGraw-Hill Companies, Inc.
Absorption Costing: Year One
Absorption Costing
Sales (25,000 × $30)
Less cost of goods sold:
Beginning inventory
$
Add COGM (30,000 × $15)
450,000
Goods available for sale
450,000
Ending inventory (5,000 × $15)
75,000
Gross margin
Less selling & admin. exp.
Variable (25,000 × $3)
$ 75,000
Fixed
100,000
Net operating income
McGraw-Hill/Irwin
$ 750,000
375,000
375,000
175,000
$ 200,000
Copyright © 2006, The McGraw-Hill Companies, Inc.
Variable Costing: Year One
Variable
manufacturing
Variable
VariableCosting
Costing
costs only.
Sales
Sales(25,000
(25,000××$30)
$30)
Less
Lessvariable
variableexpenses:
expenses:
Beginning
$$
-Beginninginventory
inventory
Add
300,000
AddCOGM
COGM(30,000
(30,000××$10)
$10)
300,000
Goods
300,000
Goodsavailable
availablefor
forsale
sale
300,000
Less
Lessending
endinginventory
inventory(5,000
(5,000××$10)
$10) 50,000
50,000
Variable
250,000
Variablecost
costof
ofgoods
goodssold
sold
250,000
Variable
Variableselling
selling&&administrative
administrative
expenses
75,000
expenses(25,000
(25,000××$3)
$3)
75,000
Contribution
Contributionmargin
margin
Less
Lessfixed
fixedexpenses:
expenses:
Manufacturing
$$150,000
Manufacturingoverhead
overhead
150,000
Selling
Selling&&administrative
administrativeexpenses
expenses 100,000
100,000
Net
Netoperating
operatingincome
income
McGraw-Hill/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
Copyright © 2006, The McGraw-Hill Companies, Inc.
Effect of Changes in Production
Harvey Company Year Two
Number of units produced
Number of units sold
Units in beginning inventory
Unit sales price
Variable costs per unit:
Direct materials, direct labor
variable mfg. overhead
Selling & administrative
expenses
Fixed costs per year:
Manufacturing overhead
Selling & administrative
expenses
McGraw-Hill/Irwin
20,000
25,000
5,000
$
30
$
10
$
3
$ 150,000
$ 100,000
Copyright © 2006, The McGraw-Hill Companies, Inc.