Managerial accounting by garrison noreen13th chap007

Variable Costing:
A Tool for Management
Chapter 7

McGraw­Hill/Irwin

   Copyright © 2010 by The McGraw­Hill Companies, Inc. All rights reserved.


Overview of Absorption and Variable Costing
Absorption
Costing

Variable
Costing
Direct Materials

Product
Costs

Direct Labor

Product
Costs

Variable Manufacturing Overhead
Fixed Manufacturing Overhead

Period
Costs

Variable Selling and Administrative Expenses

Period
Costs

Fixed Selling and Administrative Expenses

7-2


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

25,000
25,000

$$
$$

Fixed
Fixed costs
costsper
per year:
year:
Manufacturing
Manufacturing overhead
overhead
Selling
Selling &&administrative
administrative expenses
expenses

$$150,000
150,000

$$100,000
100,000

10
10
33

7-3


Unit Cost Computations
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
($150,000÷÷25,000
25,000units)

units)
Unit
Unitproduct
productcost
cost

Absorption
Absorption
Costing
Costing

Variable
Variable
Costing
Costing

$$

10
10

$$

10
10

$$

66
16

16

$$

-10
10

Under absorption costing, all production costs, variable
and fixed, are included when determining unit product
cost. Under variable costing, only the variable
production costs are included in product costs.
7-4


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 is no beginning inventory.

Now, let’s compute net operating
income using both absorption
and variable costing.

7-5

Absorption Costing

Fixed manufacturing overhead deferred in
inventory is 5,000 units × $6 = $30,000.
7-6


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

$$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
7-7


Comparing the Two 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

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

7-8


Comparing the Two Methods
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 per unit
Units produced
25,000 units
7-9


Extended Comparisons 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
Selling &&administrative
administrative
expenses
expenses
Fixed
Fixed costs
costsper
per year:
year:
Manufacturing
Manufacturing overhead
overhead

Selling
Selling &&administrative
administrative
expenses
expenses

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
7-10

Unit Cost Computations

Direct
Directmaterials,
materials, direct
directlabor,
labor,
and
and variable
variable mfg.
mfg. overhead
overhead
Fixed
Fixed mfg.
mfg. overhead
overhead
($150,000
($150,000÷÷25,000
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 the variable costs per unit, total fixed costs,
and the number of units produced remained

unchanged, the unit cost computations also
remain unchanged.
7-11


Absorption Costing

Unit product

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

cost.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

Fixed manufacturing overhead released from
inventory is 5,000 units × $6 = $30,000.
7-12


Variable Costing

Variable

manufacturing
costs only.
Variable
Variable Costing
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
selling&&administrative
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
$$150,000
Manufacturingoverhead
overhead
150,000
Selling
250,000
Selling&&administrative
administrative expenses
expenses 100,000
100,000
250,000
Net
$$260,000
Netoperating
operatingincome
income

260,000
7-13


Comparing the Two Methods
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 per unit
Units produced
25,000 units
7-14


Comparing the Two Methods

Costing Method
Absorption
Variable

1st Period
$ 120,000
90,000

2nd Period
$ 230,000
260,000

Total
$ 350,000
350,000

7-15


Summary of Key Insights

7-16


CVP Analysis, Decision Making
and Absorption costing
Absorption costing does not dovetail with CVP analysis,
nor does it support decision making. It treats fixed
manufacturing overhead as a variable cost. It assigns per
unit fixed manufacturing overhead costs to production.
Treating fixed
fixed manufacturing
manufacturing overhead
overhead as a

variable cost can:
• Lead
Lead to
to faulty
faulty pricing
pricing decisions
decisions and faulty
faulty
keep-or-drop decisions.
Assigning
Assigning per unit
unit fixed manufacturing
manufacturing overhead
costs
costs to
to production
production can:
•• Potentially produce
produce positive net
net operating income
income
even when the number of units sold is less than
the breakeven point.
7-17


External Reporting and Income Taxes
To
To conform
conform to

to
GAAP
GAAP requirements,
requirements,
absorption
absorption costing
costing must
must be
be used
used for
for
external
external financial
financial reports
reports in
in the
the
Under
Under the
the Tax
Tax
United
United States.
States.
Reform
Reform Act
Act of
of 1986,
1986,
absorption

absorption costing
costing must
must be
be
used
used when
when filling
filling out
out
Since
top
executives
Since top executives
income
income tax
tax returns.
returns.
are
typically
evaluated
based
on
are typically evaluated based on
earnings
earnings reported
reported to
to shareholders
shareholders
in
in external

external reports,
reports, they
they may
may feel
feel that
that
decisions
decisions should
should be
be based
based on
on
absorption
absorption costing
costing data.
data.
7-18


Advantages of Variable Costing
and the Contribution Approach
Management finds
it more useful.

Advantages

Impact of fixed
costs on profits
emphasized.

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.
7-19


Impact of Lean Production
When companies use Lean Production . . .
Production
tends to equal
sales . . .

So, the difference between variable and
absorption income tends to disappear.
7-20


End of Chapter 7

7-21