Managerial Accounting

Creating value in a Dynamic Business Environment

Tenth Edition

Chapter 8
Variable Costing
and the Costs
of Quality and
Sustainability
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Learning Objective 8-1 – Explain the
accounting treatment of fixed
manufacturing overhead under
absorption and variable costing

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 Absorption Costing
• A system of accounting for costs in which
both fixed costs. and variable production
costs are considered product
• Product
– Fixed Costs
– Variable Costs

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 Variable Costing
• A system of cost accounting that only assigns
the variable cost of production to products.
• Product
– Fixed Costs
– Variable Costs

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 Absorption and Variable Costing
(1 of 2)
• Absorption Costing
– Product costs
 Direct materials
 Direct labor
 Variable mfg. overhead
 Fixed mfg. overhead
– Period costs
 Selling & Admin. exp.

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 Absorption and Variable Costing
(2 of 2)
• Variable Costing
– Product costs
 Direct materials
 Direct labor
 Variable mfg. overhead
– Period costs
 Fixed mfg. overhead
 Selling & Admin. exp.
• The difference between absorption and
variable costing is the treatment of fixed
manufacturing overhead.
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Learning Objective 8-2 – Prepare an
income statement under absorption
costing

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 Absorption and Variable Costing
(1 of 3)
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
(2 of 3)
Mellon Co. had no beginning inventory, produced
25,000 units, and sold 20,000 units this year 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

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 Absorption and Variable Costing
(3 of 3)
Unit product cost is determined as follows:

Absorption Variable
Costing Costing
Direct materials, direct labor, and
variable mfg. overhead
Fixed mfg. overhead ($150,000 ÷ $ 10 $ 10
25,000 units)
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.

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Learning Objective 8-3 – Prepare an
income statement under variable
costing.

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Variable Costing Income Statements
(1 of 2)
• Now let’s look at variable costing by Mellon Co.
• We exclude the fixed manufacturing overhead.

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Variable Costing Income Statements
(2 of 2)

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Comparing Absorption and Variable
Costing
Let’s compare the methods.
Cost of Ending Period
Total
Goods Sold Inventory Expense
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 8-4 – Reconcile
reported income under absorption and
variable costing.

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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

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

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 8-5 – Explain
the implications of absorption and
variable costing for cost-volume-profit
analysis.

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 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 8-6 – Evaluate
absorption and variable costing.

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

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 Mellon Co. Year 2 (1 of 4)
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
$ 10
variable mfg. overhead
Selling & administrative expenses $3
Fixed costs per year:
Mfg. overhead $ 150,000
Selling & administrative expenses $ 100,000
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 Mellon Co. Year 2 (2 of 4)
Unit product cost is determined as follows:
Absorption Variable
Costing Costing
Direct materials, direct labor, and $ 10 $ 10
average mfg. overhead
Fixed mfg. overhead ($150,000÷25,000 6 -
units)
Unit product cost $ 16 $ 10

There has been no change in Mellon’s

cost structure.
Now let’s look at Mellon’s income statement
assuming absorption costing is used.

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 Mellon Co. Year 2 (3 of 4)

5,000: Units in ending inventory from the previous

period.
25,000 units produced in the current period.
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 Mellon Co. Year 2 (4 of 4)
Next, we’ll look at Mellon’s income statement assuming
variable costing is used.

$ 10: Excludes fixed manufacturing overhead.

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 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 units).
• In the second period, production (25,000 units)
was less than sales (30,000 units).
• For the two-year period, total absorption income
and total variable income are the same.
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) (1 of 3)
Total
Production Profit
Inventory Period Expense Effect
versus Sales Effect
Effect

Fixed mfg. costs expensed AC <

Produced > Sold Increase AC > VC
Fixed mfg. costs expensed VC

Fixed mfg. costs expensed AC >

Produced < Sold Decrease AC < VC
Fixed mfg. costs expensed VC

Fixed mfg. costs expensed AC =

Produced = Sold No change AC = VC
Fixed mfg. costs expensed VC

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 Summary Comparison of
Absorption (AC) and Variable
Costing (VC) (2 of 3)
• 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.
• In the second period, sales of 30,000 units
were greater than production of 25,000.

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 Summary Comparison of
Absorption (AC) and Variable
Costing (VC) (3 of 3)
• Inventory decreased from 5,000 units to
zero, and $230,000 absorption income was
less than $260,000 variable income.
• For the two-year period, units produced
equals units sold, so total absorption income
equals total variable income.

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 Evaluation of Variable Costing
• Advantages
– Management finds it easy to understand.
– Consistent with CVP analysis.
– Emphasizes contribution in short-run pricing
decisions.
– Profit for period not affected by changes
– in fixed mfg. overhead.
– Impact of fixed costs on profits emphasized.

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 Evaluation of Absorption Costing
• Advantages
– Fixed manufacturing overhead is treated the
same as the other product costs, direct
material and direct labor.
– Consistent with long-run 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 8-7- Prepare a
quality-cost report.

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 Costs of Assuring Quality
• Grade
– Grade refers to the extent of its capabilities in
performing an intended purpose, in relation to
other products with the same functional use.
• Quality
– Quality of design refers to how well it is
conceived or designed for its intended use.
– Quality of conformance refers to the extent
to which a product meets 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 8-8 – Discuss
two contrasting views of the optimal
level of product quality.

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What is the Optimal Level of Product
Quality?
The optimal level of product quality is reached
when: Prevention costs + Appraisal costs =
Internal failure costs + External failure costs

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 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 8-9 –
Understand the different types of
environmental costs, and discuss the
management of environmental costs.

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 Costs of Environmental
Sustainability (1 of 5)
• 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.

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 Costs of Environmental
Sustainability (2 of 5)
• 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.

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 Costs of Environmental
Sustainability (3 of 5)
• 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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 Costs of Environmental
Sustainability (4 of 5)
• 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.

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 Costs of Environmental
Sustainability (5 of 5)
– 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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