Chapter Variable Costing—A Tool for Management Learning Objectives LO1 Explain how variable costing differs from absorption costing and compute unit product costs under each method LO2 Prepare income statements using both variable and absorption costing LO3 Reconcile variable costing and absorption costing net operating incomes and explain why the two amounts differ LO4 Understand the advantages and disadvantages of both variable and absorption costing New in this Edition • Additional exercises have been created Chapter Overview A Overview of Variable and Absorption Costing At least two methods can be used in manufacturing companies to value units of product for accounting purposes—absorption costing and variable costing These methods differ only in how they treat fixed manufacturing overhead costs Variable Costing Variable costing includes only variable production costs in product costs Direct materials, direct labor and variable manufacturing overhead costs would ordinarily be included in product costs under variable costing Fixed manufacturing overhead is not treated as a product cost under this method Rather, fixed manufacturing overhead is treated as a period cost and is charged against income each period Absorption Costing Absorption costing treats all production costs as product costs, regardless of whether they are variable or fixed Under absorption costing, a portion of fixed manufacturing overhead is allocated to each unit of product B Comparison of Absorption and Variable Costing (Exercises 7-3, 7-5, 7-6, 7-8, and 7-9.) When comparing absorption costing and variable costing income statements, a number of points should be noted: Deferral of fixed manufacturing costs under absorption costing Under absorption costing, if inventories increase then a portion of the fixed manufacturing overhead costs of the current period is deferred to future periods in the inventory account When the units are later taken out of inventory and sold, the deferred fixed costs flow through to the income statement as part of cost of goods sold 395 Differences in inventories under the two methods The ending inventory figures under the variable costing and absorption costing methods are different Under variable costing, only the variable manufacturing costs are included in inventory Under absorption costing, both variable and fixed manufacturing costs are included in inventory Suitability for CVP analysis An absorption costing income statement is not well suited for providing data for CVP computations since it makes no distinction between fixed and variable costs In contrast, the variable costing method classifies costs by behavior and is very useful in setting-up CVP computations C Extended Comparison of Income Data (Exercises 7-2 and 7-6.) Exhibit 7-3 in the text presents a comparison of absorption costing and variable costing income statements over three years in which production is constant but sales vary Exhibit 7-6 in the text also presents comparative income statements over three years but holds annual sales constant and varies annual production From these Exhibits, several generalizations can be drawn (All of these generalizations assume the LIFO inventory flow assumption is being used The generalizations may not hold in some rare cases if a company uses an inventory flow assumption other than LIFO.) Production equals sales (no change in inventories) When production equals sales, inventories not change If inventories not change, then there is no change in the fixed manufacturing overhead costs in inventories under absorption costing Therefore, under both costing methods all of the current fixed manufacturing overhead will flow through to the income statement as an expense In the case of absorption costing it will be part of cost of goods sold In the case of variable costing, it will be a period expense Production exceeds sales (inventories increase) When production exceeds sales, inventories grow If inventories grow, then some of the current fixed manufacturing overhead costs will be deferred in inventories under absorption costing Since all of the current fixed manufacturing overhead costs are expensed under variable costing, the net operating income reported under absorption costing will be greater than the net operating income reported under variable costing Sales exceed production (inventories decrease) When sales exceed production, inventories shrink If inventories decrease, then some of the fixed manufacturing overhead costs that had been deferred in inventories in previous periods will be released to the income statement as part of cost of goods sold as well as all of the current fixed manufacturing overhead costs Since only the current fixed manufacturing overhead costs are expensed under variable costing, the net operating income reported under absorption costing will be less than the net operating income reported under variable costing Long-term differences in income Over an extended period of time, the cumulative net operating income figures reported under absorption costing and variable costing will be about the same; they will differ only by the amount of fixed manufacturing overhead cost in ending inventories under absorption costing Cumulative net operating income figures will be identical whenever ending inventories are reduced to zero Changes in production volume Variable costing net operating income is not affected by changes in production volume On the other hand, absorption costing net operating 396 income is affected by changes in production volume For any given level of sales, net operating income under absorption costing will increase as the level of output increases and hence inventories increase D The Matching Principle Accountants and managers have been arguing for decades concerning the relative merits of absorption and variable costing In practice, absorption costing is used far more than variable costing even for internal reports The reasons for this are not entirely clear, although the perception that absorption costing is required for external reporting undoubtedly plays a key role The argument for using absorption costing in external reports seems to be based on the matching principle Argument for absorption costing Advocates of absorption costing argue that all manufacturing costs must be assigned to units of product so as to properly match costs with revenues They argue that fixed manufacturing overhead costs are essential to the production process and must be included when costing units of product, regardless of how the cost behaves Argument for variable costing Advocates of variable costing argue that fixed manufacturing overhead costs are incurred in order to have the capacity to produce Moreover, they will be incurred regardless of whether anything is actually produced Since these costs are not caused by any particular unit of product and are incurred to provide capacity for a particular period, the matching principle would dictate that fixed manufacturing overhead costs must be expensed in the current period E Advantages of the Contribution Approach (Exercises 7-4 and 7-7.) There are a number of advantages to using variable costing (and the contribution approach) in internal reports and analysis More useful for CVP analysis Variable costing statements provide data that are immediately useful for CVP analysis since they categorize costs on the basis of their behavior In contrast, it is often difficult to rework absorption costing data so that they can be used in CVP analysis and in decisions Income is not affected by changes in production volume Under absorption costing, reported net operating income is affected by changes in production since fixed costs are spread across more or fewer units This can distort income and may even result in income moving in an opposite direction from sales This does not occur under variable costing Avoids misunderstandings concerning unit product costs Absorption costing unit product costs can be easily misinterpreted as variable costs since they are stated on a per unit basis Such a misperception can lead to serious errors in making decisions Variable costing avoids this problem since unit costs include only variable costs Fixed costs are more visible The impact of fixed costs on profits is emphasized because the total amount of such costs for the period appears separately and is highlighted in the income statement rather than being buried in cost of goods sold and ending inventory 397 Understandability Managers should find it easier to understand variable costing reports because data are organized by behavior and because variable costing is much closer to cash flow Control is facilitated Variable costing ties in with cost control methods such as flexible budgets Incremental analysis is more straight-forward Variable cost corresponds closely with the current out-of-pocket expenditure necessary to produce and sell products and services and can therefore be used more readily in incremental analysis than absorption costing data And since variable costing net operating income is closer to net cash flow than absorption costing net operating income, it is likely to be more useful to companies that have cash flow problems However, variable costing is not generally accepted by auditors for external financial reports and is not permitted by the IRS in the United States and by tax authorities in many other countries for income tax calculations There is some question about whether variable costing is actually prohibited in the United States by official pronouncements and some companies use some form of variable costing in their external reports, but absorption costing must be considered the most generally accepted practice F Impact of JIT Inventory Methods When companies use JIT methods for controlling their operations, the distortions of income that can occur under absorption costing largely (or completely) disappear The cause of distortions in net operating income Erratic movements in net operating income under absorption costing and the differences in net operating income between absorption and variable costing can be traced to changing levels of inventory When inventory levels are constant or negligible, absorption costing and variable costing methods yield the essentially same net operating income The JIT solution Under an ideally functioning JIT system, goods are produced strictly to customers’ orders Finished goods inventories almost disappear and work in process inventories are kept to a minimum With little or no inventories, fixed manufacturing overhead costs cannot be shifted between periods under absorption costing As a result, both variable and absorption costing will show essentially the same net operating income figure, and the net operating income under absorption costing will move in the same direction as movements in sales 398 Assignment Materials Assignment Exercise 7-1 Exercise 7-2 Exercise 7-3 Exercise 7-4 Exercise 7-5 Exercise 7-6 Exercise 7-7 Exercise 7-8 Exercise 7-9 Problem 7-10 Problem 7-11 Problem 7-12 Problem 7-13 Problem 7-14 Problem 7-15 Problem 7-16 Problem 7-17 Case 7-18 Case 7-19 Case 7-20 Level of Topic Difficulty Variable and absorption unit product costs Basic Variable costing income statement; explanation of difference in net operating income Basic Reconciliation of absorption and variable costing net operating incomes Basic Evaluating absorption and variable costing as alternative costing methods Medium Variable and absorption costing unit product costs and income statements Basic Variable costing income statement; reconciliation Basic Inferring costing method; unit product costs Basic Variable costing unit product cost and income statement; break-even Basic Absorption costing unit product cost and income statement Basic Variable and absorption costing unit product costs and income statements; explanation of difference in net operating income Basic Variable costing income statement; reconciliation Basic Absorption and variable costing; production constant, sales fluctuate Medium Comprehensive problem with labor fixed Medium Preparation and reconciliation of variable costing statements Medium Variable costing statements; sales constant, production varies; JIT impact Difficult Incentives created by absorption costing; ethics and the manager Difficult Prepare and interpret statements; changes in both sales and production; JIT impact Difficult Absorption and variable costing; uneven production; breakeven analysis; JIT impact Difficult Ethics and the manager; absorption costing income statements Difficult The case of the plummeting profits Difficult Suggested Time 15 30 20 30 30 20 20 30 20 45 30 60 45 45 45 30 75 90 120 90 Essential Problems: Problem 7-10 or Problem 7-13, Problem 7-11, Problem 7-14 Supplementary Problems: Problem 7-12, Problem 7-15, Problem 7-16, Problem 7-17, Case 7-18, Case 7-19, Case 7-20 Linked problems and exercises: Exercise 7-9 should be assigned after Exercise 7-8 Exercise 7-2 should be assigned after Exercise 7-1 399 400 Chapter Lecture Notes Helpful Hint: Before beginning the lecture, show students the fifth segment from the first tape of the McGraw-Hill/Irwin Managerial/Cost Accounting video library This segment introduces students to many of the concepts discussed in chapter The lecture notes reinforce the concepts introduced in the video I Chapter theme: Two general approaches are used for valuing inventories and cost of goods sold One approach, called absorption costing, is generally used for external reporting purposes The other approach, called variable costing, is preferred by some managers for internal decision making and must be used when an income statement is prepared in the contribution format This chapter shows how these two methods differ from each other Overview of absorption and variable costing A Absorption costing (also called the full cost method) treats all costs of production as product costs, regardless of whether they are variable or fixed Since no distinction is made between variable and fixed costs, absorption costing is not well suited for CVP computations i The cost of a unit of product consists of direct materials, direct labor, and both variable and fixed overhead 401 402 ii Variable and fixed selling and administrative expenses are treated as period costs and are deducted from revenue as incurred B Variable costing (also called direct costing or marginal costing) treats only those costs of production that vary with output as product costs This approach dovetails with the contribution approach income statement and supports CVP analysis because of its emphasis on separating variable and fixed costs i The cost of a unit of product consists of direct materials, direct labor, and variable overhead Helpful Hint: For simplicity, nearly all examples, exhibits, problems, and exercises in this chapter treat direct labor as a variable cost However, students should be reminded that labor is essentially a fixed cost in some companies This is a growing phenomenon as pointed out in earlier chapters Under variable costing, direct labor would not be included in product costs when it is a fixed cost This point is reinforced in the discussion on theory of constraints at the end of the chapter “In Business Insights” To piggyback on the Helpful Hint above, there are many companies that treat direct labor as a fixed cost For example: “Direct Labor – A Fixed Cost in China” (page 280) 403 404 TM 7-1 AGENDA: VARIABLE AND ABSORPTION COSTING Variable costing and absorption costing are alternative methods of determining unit product costs They affect: • Inventory valuations • Net operating income Key elements of variable and absorption costing Classification of costs under variable and absorption costing Unit product cost comparison Income statement comparison Extended example—fluctuating sales Comparative income effects Extended example—fluctuating production JIT and absorption costing Advantages of variable costing © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 7-2 KEY ELEMENTS ABSORPTION COSTING • Absorption costing was used in earlier chapters and is generally considered to be required for external financial reports and is clearly required for tax reporting • Under absorption costing, product costs include all manufacturing costs: • Direct materials • Direct labor • Variable manufacturing overhead • Fixed manufacturing overhead • Under absorption costing, the following costs are treated as period expenses and are excluded from product costs: • Variable selling and administrative costs • Fixed selling and administrative costs VARIABLE COSTING • Variable costing is an alternative for internal management reports • Under variable costing, product costs include only the variable manufacturing costs: • Direct materials • Direct labor (unless fixed) • Variable manufacturing overhead • Under variable costing, the following costs are treated as period expenses and are excluded from product costs: • Fixed manufacturing overhead • Variable selling and administrative costs • Fixed selling and administrative costs © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 7-3 CLASSIFICATION OF COSTS UNDER VARIABLE AND ABSORPTION COSTING © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 7-4 UNIT PRODUCT COST COMPARISON • Unit product costs differ between variable and absorption costing EXAMPLE: Harvey Company produces a single product Number of units produced annually Variable costs per unit: Direct materials, direct labor, and variable manufacturing overhead Selling and administrative expense Fixed costs per year: Fixed manufacturing overhead Fixed selling & administrative expense 25,000 $10 $3 $150,000 $100,000 Unit product costs are computed as follows: Direct materials, direct labor, and variable manufacturing overhead Fixed manufacturing overhead ($150,000 ÷ 25,000 units) Total unit product cost Absorption Costing Variable Costing $10 $10 $16 $10 • Selling and administrative expenses are always treated as period costs and are expensed in the current period; they are not treated as product costs under either costing method © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 7-5 INCOME STATEMENT COMPARISON Harvey Company had no beginning inventory, produced 25,000 units, and sold 20,000 units last year Absorption Costing Sales (20,000 units × $30 per unit) Less cost of goods sold: Beginning inventory Add COGM (25,000 units × $16 per unit) Goods available for sale Less ending inventory (5,000 units × $16 per unit) Gross margin Less selling and administrative expense (20,000 units × $3 per unit + $100,000) Net operating income $600,000 $ 400,000 400,000 80,000 160,000 $120,000 Variable Costing Sales (20,000 units × $30 per unit) Less variable expenses: Variable cost of goods sold: Beginning inventory Add variable manufacturing costs (25,000 units × $10 per unit) Goods available for sale Less ending inventory (5,000 × $10 per unit) Variable cost of goods sold Variable selling and administrative expense (20,000 units × $3 per unit) Contribution margin Less fixed expenses: Fixed manufacturing overhead Fixed selling and administrative expense Net operating income 320,000 280,000 $600,000 $ 250,000 250,000 50,000 200,000 60,000 150,000 100,000 © The McGraw-Hill Companies, Inc., 2006 All rights reserved 260,000 340,000 250,000 $ 90,000 TM 7-6 INCOME STATEMENT COMPARISON (cont’d) Absorption costing Variable manufacturing costs (20,000 units × $10 per unit) (5,000 units × $10 per unit) Fixed manufacturing overhead (20,000 units × $6 per unit) (5,000 units × $6 per unit) Total Cost of Goods Sold Ending Inventory $200,000 $50,000 120,000 30,000 $80,000 $320,000 Variable costing Variable manufacturing costs (20,000 units × $10 per unit) (5,000 units × $10 per unit) Total $200,000 $50,000 $50,000 $200,000 RECONCILIATION OF NET OPERATING INCOMES: Variable costing net operating income Add: Fixed manufacturing overhead cost deferred in inventory under absorption costing (5,000 units × $6 per unit) Absorption costing net operating income $ 90,000 30,000 $120,000 © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 7-7 EXTENDED EXAMPLE—FLUCTUATING SALES EXAMPLE: Holland Company produces a single product Number of units produced annually Variable costs per unit: Direct materials, direct labor, and variable manufacturing overhead Selling and administrative expense Fixed costs per year: Fixed manufacturing overhead Fixed selling and administrative expense 5,000 $5 $1 $15,000 $21,000 Unit product costs are computed as follows: Direct materials, direct labor, and variable manufacturing overhead Fixed manufacturing overhead ($15,000 ÷ 5,000 units) Total unit product cost Absorption Variable Costing Costing $5 $5 $8 $5 Income statements using both costing methods over a three-year period are provided on the following transparency (Note the computation of the variable cost of goods sold on the variable costing income statements The method used is simpler than the method used in the previous example.) © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 7-8 FLUCTUATING SALES (cont’d) Units Units Units Units in beginning inventory produced sold in ending inventory Absorption costing Sales (@ $15 per unit) Less cost of goods sold: Beginning inventory (@ $8 per unit) Add COGM (@ $8 per unit) Goods available for sale Less ending inventory (@ $8 per unit) Cost of goods sold Gross margin Less selling and administrative expense Net operating income Variable costing Sales (@ $15 per unit) Less variable expenses: Variable COGS (@ $5 per unit) Variable selling and administrative expenses (@ $1 per unit) Total variable expenses Contribution margin Less fixed expenses: Fixed manufacturing overhead Fixed selling and administrative expense Total fixed expenses Net operating income Year Year Year $75,000 $60,000 $90,000 40,000 40,000 40,000 35,000 26,000 $ 9,000 40,000 40,000 8,000 32,000 28,000 25,000 $ 3,000 8,000 40,000 48,000 48,000 42,000 27,000 $15,000 $75,000 $60,000 $90,000 25,000 20,000 30,000 5,000 30,000 45,000 4,000 24,000 36,000 6,000 36,000 54,000 15,000 15,000 15,000 21,000 36,000 $ 9,000 21,000 36,000 $ 21,000 36,000 $18,000 5,000 5,000 0 5,000 4,000 1,000 © The McGraw-Hill Companies, Inc., 2006 All rights reserved 1,000 5,000 6,000 TM 7-9 FLUCTUATING SALES (cont’d) RECONCILING NET OPERATING INCOME: Variable costing net operating income Add: Fixed manufacturing overhead cost deferred in inventory under absorption costing (1,000 units × $3 per unit) Deduct: Fixed manufacturing overhead cost released from inventory under absorption costing (1,000 units × $3 per unit) Absorption costing net operating income Year $9,000 Year $ Year $18,000 3,000 $9,000 © The McGraw-Hill Companies, Inc., 2006 All rights reserved $3,000 (3,000) $15,000 TM 7-10 COMPARATIVE INCOME EFFECTS — VARIABLE AND ABSORPTION COSTING Relation Between Production and Sales Relation Between Variable and Absorption Costing Net Operating Incomes Production = Sales (No change in inventory) Production > Sales (Inventory increases) Production < Sales (Inventory decreases) Absorption costing NI = Variable costing NI Absorption costing NI > Variable costing NI * Absorption costing NI < Variable costing NI # * Net operating income will be higher under absorption costing since fixed manufacturing overhead cost will be deferred in inventory under absorption costing # Net operating income will be lower under absorption costing since fixed manufacturing overhead cost will be released from inventory under absorption costing © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 7-11 EXTENDED EXAMPLE—FLUCTUATING PRODUCTION EXAMPLE: Suppose all of the facts are the same as in the previous example of Holland Company except that production and sales are as follows: Units Units Units Units in beginning inventory produced sold in ending inventory Year Year Year Year Year Year $5.00 $5.00 $5.00 5,000 5,000 0 6,000 5,000 1,000 1,000 4,000 5,000 Unit product costs are computed as follows: Absorption costing Direct materials, direct labor, and variable manufacturing overhead Fixed manufacturing overhead ($15,000 ÷ 5,000 units) ($15,000 ÷ 6,000 units) ($15,000 ÷ 4,000 units) Unit product cost 3.00 2.50 $8.00 $7.50 3.75 $8.75 $5.00 $5.00 $5.00 $5.00 $5.00 $5.00 Variable costing Direct materials, direct labor, and variable manufacturing overhead Unit product cost © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 7-12 FLUCTUATING PRODUCTION (cont’d) Absorption costing Year Year Sales (@ $15 per unit) $75,000 $75,000 Less cost of goods sold: Beginning inventory 0 Add COGM 40,000 45,000 Goods available for sale 40,000 45,000 Less ending inventory 7,500 Cost of goods sold 40,000 37,500 Gross margin 35,000 37,500 Less selling and administrative expense 26,000 26,000 Net operating income $ 9,000 $11,500 Variable costing Sales (@ $15 per unit) $75,000 $75,000 Less variable expenses: Variable COGS (@ $5 per unit) 25,000 25,000 Variable selling and administrative expense (@ $1 per unit) 5,000 5,000 Total variable expenses 30,000 30,000 Contribution margin 45,000 45,000 Less fixed expenses: Fixed manufacturing overhead 15,000 15,000 Fixed selling and administrative expense 21,000 21,000 Total fixed expenses 36,000 36,000 Net operating income $ 9,000 $ 9,000 © The McGraw-Hill Companies, Inc., 2006 All rights reserved Year $75,000 7,500 35,000 42,500 42,500 32,500 26,000 $6,500 $75,000 25,000 5,000 30,000 45,000 15,000 21,000 36,000 $ 9,000 TM 7-13 FLUCTUATING PRODUCTION (cont’d) RECONCILING NET OPERATING INCOME: Variable costing net operating income Add: Fixed manufacturing overhead cost deferred in inventory under absorption costing (1,000 units × $2.50 per unit) Deduct: Fixed manufacturing overhead cost released from inventory under absorption costing (1,000 units × $2.50 per unit) Absorption costing net operating income Year $9,000 Year $9,000 Year $9,000 2,500 $9,000 $11,500 © The McGraw-Hill Companies, Inc., 2006 All rights reserved (2,500) $6,500 TM 7-14 JIT AND ABSORPTION COSTING • Differences in net operating income between absorption and variable costing occur when production doesn’t equal sales • Under true JIT, production isn’t started until a customer order is received As a result, inventories are reduced drastically and changes in inventories are small • As a consequence, the difference between absorption and variable costing net operating incomes is reduced under JIT • Under JIT, it is also less likely that absorption costing income will move in the opposite direction from sales due to changes in inventories © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 7-15 ADVANTAGES OF VARIABLE COSTING + Variable costing is easy to use with CVP analysis + With variable costing, changes in levels of inventories not affect net operating income + Absorption costing unit product costs may be misinterpreted by managers as variable costs + In variable costing, fixed costs are highlighted rather than buried in cost of goods sold and inventories + Variable costing is usually easier to understand than absorption costing + Variable costing is easier to use in controlling costs as will be discussed in later chapters + Variable costing net operating income is closer to net cash flow than absorption costing net operating income This is particularly important in companies experiencing difficulties with cash flows - But, variable costing is usually not considered acceptable for external financial reports If absorption costing must be used for mandatory external reports is it worth the trouble to maintain a different costing system for internal reports? © The McGraw-Hill Companies, Inc., 2006 All rights reserved [...]... The net operating income is $120,000 Helpful Hint: Explain that under absorption costing, the recognition of fixed costs as an expense is really a timing issue When the items are sold, the fixed costs 407 9 10 408 11 will be reflected on the income statement as part of cost of goods sold iii 1 The unit product cost is $10 2 All $150,000 of fixed manufacturing cost is expensed in the current period 3... (page 287) • Al Dunlap was hired to turn around Sunbeam Corp with his well-known cost-cutting and disregard for the welfare of existing employees • Three years later, Dunlap left a legacy of questionable accounting practices and excess inventories • Dunlap’s successors complain that eliminating those excess inventories has required the company to keep production levels well under capacity • Since Sunbeam... Nissan brand While Toyota stood for quality, customers came to Nissan to get a better deal.” 415 19 20 416 IV Effect of changes in production on net operating income A The Harvey Co example revisited i Overview of revised example: 1 In the previous Harvey Co example: a Units of production was constant b Sales in units fluctuated 2 In the forthcoming example: a Units of production will fluctuate b Sales... reports in the United States “In Business Insights” Absorption costing is also prevalent around the world For example: 31 “Absorption Costing Around the World” (page 291) • After the fall of communism, accounting methods were changed in Russia to bring them into better alignment with methods used in the West One result was the adoption of absorption costing ii Under the Tax Reform Act of 1986, a form