Chapter 8

Variable Costing and the

Costs of Quality and
Sustainability

McGraw-Hill/Irwin Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Learning Objective 1

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8-2
Absorption Costing
A system of accounting for costs in which both fixed and variable
production costs are considered product costs.

Fixed
Costs
Product
Variable
Costs

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Variable Costing
A system of cost accounting that only assigns the variable cost of
production to products.

Fixed
Costs
Product
Variable
Costs

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 Absorption and Variable Costing
Absorption Variable
Costing Costing

Direct materials
Direct labor Product costs
Product costs Variable mfg. overhead

Fixed mfg. overhead

Period costs
Period costs Selling & Admin. exp.

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 Absorption and Variable Costing
Absorption Variable
Costing Costing

Direct materials
Direct labor Product costs
Product costs Variable mfg. overhead

Fixed mfg. overhead

Period costs
Period costs Selling & Admin. exp.

The difference between absorption and variable

costing is the treatment of fixed manufacturing overhead.
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Learning Objective 2

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Absorption and Variable Costing
Let’s put some numbers to an example and
see what we can learn about the difference
between absorption and variable costing.

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Absorption and Variable Costing
Mellon Co. produces a single product with the following
information available:

Number of units produced annually 25,000

Variable costs per unit:
Direct materials, direct labor
and variable mfg. overhead $ 10
Selling & administrative
expenses $ 3
Fixed costs per year:
Mfg. overhead $ 150,000
Selling & administrative
expenses $ 100,000

8-9
Absorption and Variable Costing
Unit product cost is determined as follows:

Absorption Variable
Costing Costing
Direct materials, direct labor, and
variable mfg. overhead $ 10 $ 10
Fixed mfg. overhead
($150,000 ÷ 25,000 units) 6 -
Unit product cost $ 16 $ 10

Selling and administrative expenses are

always treated as period expenses and
deducted from revenue.
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Absorption Costing
Income Statements
Mellon Co. had no beginning inventory, produced 25,000 units, and sold
20,000 units this year at $30 each.

Absorption Costing
Sales (20,000 × $30) $ 600,000
Less cost of goods sold:
Beginning inventory
Add COGM
Goods available for sale
Ending inventory
Gross margin
Less selling & admin. exp.
Variable
Fixed
Net income

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Absorption Costing
Income Statements
Mellon Co. had no beginning inventory, produced 25,000 units, and sold
20,000 units this year at $30 each.
Absorption Costing
Sales (20,000 × $30) $ 600,000
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) 80,000 320,000
Gross margin $ 280,000
Less selling & admin. exp.
Variable
Fixed
Net income

8-12
Absorption Costing
Income Statements
Mellon Co. had no beginning inventory, produced 25,000 units, and sold
20,000 units this year at $30 each.
Absorption Costing
Sales (20,000 × $30) $ 600,000
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) 80,000 320,000
Gross margin $ 280,000
Less selling & admin. exp.
Variable (20,000 × $3) $ 60,000
Fixed 100,000 160,000
Net income $ 120,000

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Learning Objective 3

8-14
Variable Costing
Income Statements
Now let’s look at variable costing by Mellon Co.
Variable Costing
Sales (20,000 × $30) $ 600,000
Less variable expenses:
Beginning inventory $ -
Add COGM
Goods available for sale
Ending inventory
Variable cost of goods sold
Variable selling & administrative
expenses
Contribution margin
Less fixed expenses:
Manufacturing overhead
Selling & administrative expenses
Net income

8-15
Variable Costing
Income Statements
Now let’s look at variable costing by Mellon Co.
We exclude the
fixed manufacturing
Variable Costing
Sales (20,000 × $30) $ 600,000
Less variable expenses: overhead.
Beginning inventory $ -
Add COGM (25,000 × $10) 250,000
Goods available for sale $ 250,000
Ending inventory (5,000 × $10) 50,000
Variable cost of goods sold $ 200,000
Variable selling & administrative
expenses
Contribution margin
Less fixed expenses:
Manufacturing overhead
Selling & administrative expenses
Net income

8-16
Variable Costing
Income Statements
Now let’s look at variable costing by Mellon Co.
Variable Costing
Sales (20,000 × $30) $ 600,000
Less variable expenses:
Beginning inventory $ -
Add COGM (25,000 × $10) 250,000
Goods available for sale $ 250,000
Ending inventory (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 fixed expenses:
Manufacturing overhead $ 150,000
Selling & administrative expenses 100,000 250,000
Net income $ 90,000

8-17
Comparing Absorption and
Variable Costing
Let’s compare the methods.
Cost of
Goods Ending Period
Sold Inventory Expense Total
Absorption costing
Variable mfg. costs $ 200,000
Fixed mfg. costs 120,000
$ 320,000

Variable costing
Variable mfg. costs $ 200,000
Fixed mfg. costs -
$ 200,000

8-18
Comparing Absorption and
Variable Costing
Let’s compare the methods.
Cost of
Goods Ending Period
Sold Inventory Expense Total
Absorption costing
Variable mfg. costs $ 200,000 $ 50,000 $ -
Fixed mfg. costs 120,000 30,000 -
$ 320,000 $ 80,000 $ -

Variable costing
Variable mfg. costs $ 200,000 $ 50,000 $ -
Fixed mfg. costs - - 150,000
$ 200,000 $ 50,000 $ 150,000

8-19
Comparing Absorption and
Variable Costing
Let’s compare the methods.
Cost of
Goods Ending Period
Sold Inventory Expense Total
Absorption costing
Variable mfg. costs $ 200,000 $ 50,000 $ - $ 250,000
Fixed mfg. costs 120,000 30,000 - 150,000
$ 320,000 $ 80,000 $ - $ 400,000

Variable costing
Variable mfg. costs $ 200,000 $ 50,000 $ - $ 250,000
Fixed mfg. costs - - 150,000 150,000
$ 200,000 $ 50,000 $ 150,000 $ 400,000

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Learning Objective 4

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Reconciling Income Under Absorption and
Variable Costing
We can reconcile the difference between absorption and
variable net income as follows:

Variable costing net income $ 90,000

Add: Fixed mfg. overhead costs
deferred in inventory
(5,000 units × $6 per unit) 30,000
Absorption costing net income $ 120,000

Fixed mfg. overhead $150,000

= = $6.00 per unit
Units produced 25,000
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Learning Objective 5

8-23
Cost-Volume-Profit Analysis
CVP includes all fixed costs to compute breakeven.
Variable costing and CVP are consistent as both treat fixed costs as a
lump sum.
Absorption costing defers fixed costs into inventory.
Absorption costing is inconsistent with CVP because absorption
costing treats fixed costs on a per unit basis.

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Learning Objective 6

8-25
Extending the Example

Let’s look at
the second
year of
operations
for Mellon
Company.

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Mellon Co. Year 2
In its second year of operations, Mellon Co. started with an inventory of
5,000 units, produced 25,000 units, and sold 30,000 units at $30 each.

Number of units produced annually 25,000

Variable costs per unit:
Direct materials, direct labor
and variable mfg. overhead $ 10
Selling & administrative
expenses $ 3
Fixed costs per year:
Mfg. overhead $ 150,000
Selling & administrative
expenses $ 100,000

8-27
Mellon Co. Year 2
Unit product cost is determined as follows:

Absorption Variable
Costing Costing
Direct materials, direct labor,
and variable mfg. overhead $ 10 $ 10
Fixed mfg. overhead
($150,000 ÷ 25,000 units) 6 -
Unit product cost $ 16 $ 10

There has been no

change in Mellon’s
cost structure. 8-28
Mellon Co. Year 2
Now let’s look at Mellon’s income statement
assuming absorption costing is used.

8-29
Mellon Co. Year 2
Units in ending inventory from the previous period.
Absorption Costing
Sales (30,000 × $30) $ 900,000
Less cost of goods sold:
Beg. inventory (5,000 x $16) $ 80,000
Add COGM (25,000 × $16) 400,000
Goods available for sale $ 480,000
Ending inventory - 480,000
Gross margin $ 420,000
Less selling & admin. exp.
Variable (30,000 × $3) $ 90,000
Fixed 100,000 190,000
Net income $ 230,000

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Mellon Co. Year 2
Absorption Costing
Sales (30,000 × $30) $ 900,000
Less cost of goods sold:
Beg. inventory (5,000 x $16) $ 80,000
Add COGM (25,000 × $16) 400,000
Goods available for sale $ 480,000
Ending inventory - 480,000
Gross margin $ 420,000
Less selling & admin. exp.
Variable (30,000 × $3) $ 90,000
Fixed 100,000 190,000
Net income $ 230,000

25,000 units produced in the current period.

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Mellon Co. Year 2
Next, we’ll look at Mellon’s income statement
assuming variable costing is used.

8-32
Mellon Co. Year 2
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
Goods available for sale $ 300,000
Ending inventory -
Variable cost of goods sold $ 300,000
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 income $ 260,000

Excludes fixed manufacturing overhead.

8-33
Summary
Income Comparison

Costing Method 1st Period 2nd Period Total

Absorption $ 120,000 $ 230,000 $ 350,000
Variable 90,000 260,000 350,000

In the first period, production (25,000 units)

was greater than sales (20,000).

In the second period, production (25,000 units)

was less than sales (30,000).
8-34
Summary
Income Comparison

Costing Method 1st Period 2nd Period Total

Absorption $ 120,000 $ 230,000 $ 350,000
Variable 90,000 260,000 350,000

For the two-year period, total absorption

income and total variable income are the same.

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Summary
Let’s see if we can get an overview of what we have
done.

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 Summary Comparison of Absorption (AC)
and Variable Costing (VC)

This was the case in the first period when production

of 25,000 units was greater than sales of 20,000 units.

Inventory increased from zero to 5,000 units and

$120,000 absorption income was greater than
$90,000 variable income. 8-37
Summary Comparison of Absorption (AC)
and Variable Costing (VC)

In the second period sales of 30,000 units

were greater than production of 25,000.
8-38
Summary Comparison of Absorption (AC)
and Variable Costing (VC)

Inventory decreased from 5,000 units to zero,

and $230,000 absorption income was less
than $260,000 variable income. 8-39
 Summary Comparison of Absorption (AC)
and Variable Costing (VC)
Total
Production versus Inventory
Sales Effect Period Expense Effect Profit Effect

Fixed mfg. Fixed mfg.

Produced > Sold Increase costs expensed < costs expensed AC > VC
AC VC

For the two-year period,

Fixed mfg. unitsFixed
produced
mfg.
Produced < Sold Decrease costs expensed > costs expensed AC < VC
equals units sold, so total AC absorption VC income
equals total variable income.
Fixed mfg. Fixed mfg.
Produced = Sold No change costs expensed = costs expensed AC = VC
AC VC
8-40
Evaluation of Variable Costing
Management finds it Consistent with
easy to understand. CVP analysis.

Emphasizes contribution in
Advantages short-run pricing decisions.

Impact of fixed Profit for period not

costs on profits affected by changes
emphasized. in fixed mfg. overhead.
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Evaluation of Absorption Costing
Fixed manufacturing overhead is
treated the same as the other product
costs, direct material and direct labor.

Consistent with long-run

Advantages pricing decisions that must
cover full cost.

External reporting
and income tax law
require absorption costing.
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Impact of JIT Inventory Methods
In a JIT inventory system . . .

Production tends
to equal sales . . .

So, the difference between variable and

absorption income tends to disappear.
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Learning Objective 7

8-44
 Costs of Assuring Quality
Grade Quality

Grade refers to the

extent of its Quality of design refers
capabilities in to how well it is conceived
or designed for its
performing an intended use.
intended purpose, in Quality of conformance
relation to other refers to the extent to
products with the which a product meets
same functional use. the specification of its
design.

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There are four types of quality costs.

Prevention costs are the costs of preventing

defects.

Appraisal costs are the costs of determining

whether defects exist.

Internal failure costs are the costs of repairing

defects found prior to product delivery.

External failure costs are those costs incurred

after product delivery.
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Learning Objective 8

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8-47
What is the Optimal Level
of Product Quality?

The optimal level of product quality is reached when:

Prevention costs = Internal failure costs

+ Appraisal costs + External failure costs

8-48
ISO 9000 Standards
ISO 9000 standards require that a
company have a well-defined quality
control system in place and that the target
level of product quality is consistently
maintained.

These standards have been

adopted in the US and other
countries.

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Learning Objective 9

8-50
Costs of Environmental
Sustainability
Sustainable development includes business activity that
produces the goods and services needed in the present without
limiting the ability of future generations to meet their meets.
Environmental costs are the costs of dealing with
environmental issues, such as BP’s costs in cleaning up the
company’s spill in the Gulf of Mexico.
Environmental cost management is the strategic
implantation of systems for identifying, measuring,
controlling, and reducing the private environmental costs
borne by a company or other organization.

8-51
Environmental costs may be
categorized in several ways:
Private environmental costs are those borne by a company or
individual. Social environmental costs are those borne by the
public at large.
Visible environmental costs are those that are known and
clearly identified as tied to environmental issues. Hidden
social environmental costs cannot be clearly tied to
environmental issues.

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 Visible and hidden environmental costs may be further
classified into one of three types.
 Monitoring costs include the costs of monitoring the regulatory
environmental as well as monitoring the production process to
determine if pollution is being generated.
 Abatement costs include costs to reduce or eliminate pollution.
 Remediation costs include on-site and off-site remediation costs. On-site
remediation includes costs of reducing or preventing the discharge into
the environment of pollutants that have been generated in the production
process. Off-site remediation includes the costs of reducing or
eliminating pollutants from the environment after they have been
discharged.

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End of Chapter 8

The End

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