Variable Costing: A Tool for Management Chapter 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 7-21 ... 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