7 Variable Costing a Tool for Management Compatibility Mode

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Variable Costing:A Tool for Management

Chapter 7

McGraw-Hill/Irwin Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.


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Overview of Absorption and Variable Costing

Direct Materials

Direct Labor

Variable Manufacturing Overhead

Fixed Manufacturing Overhead

Variable Selling and Administrative Expenses

Fixed Selling and Administrative Expenses

Variable

Costing

Absorption

Costing

Product

Costs

Period

Costs

ProductCosts

Period

Costs

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Harvey Company produces a single productwith the following information available:

Unit Cost Computations

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Unit product cost is determined as follows:

Under absorption costing, all production costs, variable

and fixed, are included when determining unit productcost. Under variable costing, only the variable

production costs are included in product costs.


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Income Comparison ofAbsorption and Variable Costing

Lets assume the following additional informationfor Harvey Company. 20,000 units were sold during the year at a price

of $30 each.

There is no beginning inventory.

Now, lets compute net operatingincome using both absorption

and variable costing.

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Absorption Costing

Fixed manufacturing overhead deferred ininventory is 5,000 units $6 = $30,000.

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Variable CostingSales (20,000 $30) 600,000$

Less variable ex penses:

Beginning inventory -$

Add COGM (25,000 $10) 250,000

Goods avai lable for sale 250,000Less ending i nventory (5,000 $10) 50,000

Variable cost of goods sold 200,000

Variable selling & administrative

expenses (20,000 $3) 60,000 260,000

Contribution margin 340,000

Less fix ed ex penses: Manufacturing overhead 150,000$

Sell ing & administrative expenses 100,000 250,000

Net operating income 90,000$

Variablemanufacturingcosts only.

All fixedmanufacturing

overhead isexpensed.

Variable Costing

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Comparing the Two Methods

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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 $150,000Units produced 25,000 units

= = $6 per unit

We can reconcile the difference betweenabsorption and variable income as fol lows:


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Extended Comparisons of Income DataHarvey Company Year Two

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Since the variable costs per unit, total fixed costs,Since the variable costs per unit, total fixed costs,

and the number of units produced remainedand the number of units produced remainedunchanged, the unit cost computations alsounchanged, the unit cost computations alsoremain unchanged.remain unchanged.

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Absorpt ion CostingSales (30,000 $30) 900,000$

Less cost of goods sold:

Beg. inventory (5,000 $16) 80,000$

Add COGM (25,000 $16) 400,000

Goods available for sale 480,000

Less ending inventory - 480,000Gross margin 420,000

Less sell ing & admin. exp.

Variable (30,000 $3) 90,000$

Fixed 100,000 190,000

Net operating income 230,000$

Absorption Costing

Fixed manufacturing overhead released frominventory is 5,000 units $6 = $30,000.

Unit productcost.

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Variable Costing

All fixed

manufacturingoverhead isexpensed.

Variablemanufacturing

costs only.

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Variable costing net operating income 260,000$

Deduct: Fix ed manufacturing overhead

costs released from inventory

(5,000 units $6 per unit) 30,000

Absorption costing net operating income 230,000$

We can reconcile the difference betweenabsorption and variable income as fol lows:

Fixed mfg. overhead $150,000Units produced 25,000 units

= = $6 per unit


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Summary of Key Insights

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CVP Analysis, Decision Makingand Absorption costingAbsorption costing does not dovetail with CVP analysis,

nor does it support decision making. It treats fixedmanufacturing overhead as a variable cost. It assigns per

unit fixed manufacturing overhead costs to production.

Treating fixed manufacturing overhead as a

variable cost can: Lead to faulty pricing decisions and faulty

keep-or-drop decisions.

Assigning per unit fixed manufacturing overheadcosts to production can:

Potentially produce positive net operating incomeeven when the number of units sold is less thanthe breakeven point.

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External Reporting and Income Taxes

To conform toTo conform toGAAP requirements,GAAP requirements,

absorption costing must be used forabsorption costing must be used forexternal financial reports in theexternal financial reports in the

United States.United States.

Under the TaxReform Act of 1986,

absorption costing must beused when filling outincome tax returns.Since top executives

are typically evaluated based onearnings reported to shareholders

in external reports, they may feel thatdecisions should be based onabsorption costing data.

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Advantages of Variable Costingand the Contribution Approach

Advantages

Management findsit more useful.

Consistent withCVP analysis.Net operating income

is closer tonet cash flow.

Profit is not affected bychanges in inventories.

Consistent with standardcosts and flexible budgeting.

Impact of fixedcosts on profitsemphasized.

Easier to estimate profitabilityof products and segments.

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Impact of Lean Production

When companies use Lean Production . . .

Productiontends to equal

sales . . .

So, the difference between variable andabsorption income tends to disappear.

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End of Chapter 7

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7 Variable Costing a Tool for Management Compatibility Mode

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