Variable Costing:

A Tool for Management

Chapter 7

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 7-2

Learning Objective 1

Explain how variable

costing differs from
absorption costing and
compute unit product
costs under each method.

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 7-3
Overview of Absorption
and Variable Costing

Absorption Variable
Costing Costing
Direct Materials
Product
Product Direct Labor
Costs
Costs Variable Manufacturing Overhead

Fixed Manufacturing Overhead

Period
Period Variable Selling and Administrative Expenses
Costs
Costs Fixed Selling and Administrative Expenses

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 7-4

Quick Check 

Which
Which method
method will
will produce
produce the
the highest
highest values
values for
for
work
work in
in process
process and
and finished
finished goods
goods inventories?
inventories?
a.
a. Absorption
Absorption costing.
costing.
b.
b. Variable
Variable costing.
costing.
c.
c. They
They produce
produce the
the same
same values
values for
for these
these
inventories.
inventories.
d.
d. ItIt depends.
depends. .. ..

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 7-5

Quick Check 

Which
Which method
method will
will produce
produce the
the highest
highest values
values for
for
work
work in
in process
process and
and finished
finished goods
goods inventories?
inventories?
a.
a. Absorption
Absorption costing.
costing.
b.
b. Variable
Variable costing.
costing.
c.
c. They
They produce
produce the
the same
same values
values for
for these
these
inventories.
inventories.
d.
d. ItIt depends.
depends. .. ..

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 7-6

Unit Cost Computations

Harvey Company produces a single product

with the following information available:

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 7-7

Unit Cost Computations

Unit product cost is determined as follows:

Under absorption costing, selling and

administrative expenses are
always treated as period expenses and
deducted from revenue as incurred.
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 7-8

Learning Objective 2

Prepare income
statements using both
variable and absorption
costing.

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 7-9
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 were no units in beginning inventory.

Now, let’s compute net operating

income using both absorption
and variable costing.
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 7-10

Absorption Costing

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 7-11

Variable Costing

Variable
manufacturing
Variable
Variable Costing
Costing
costs only.
Sales
Sales(20,000
(20,000××$30)
$30) $$600,000
600,000
Less
Lessvariable
variableexpenses:
expenses:
Beginning
Beginninginventory
inventory $$ --
Add
All fixed
AddCOGM
COGM(25,000
(25,000××$10)
$10) 250,000
250,000 manufacturing
Goods
Goodsavailable
availableforforsale
sale 250,000
250,000
Less overhead is
Lessending
endinginventory
inventory(5,000
(5,000××$10)
$10) 50,000
50,000
Variable expensed.
Variablecost
costofofgoods
goodssold
sold 200,000
200,000
Variable
Variableselling
selling&&administrative
administrative
expenses
expenses(20,000
(20,000××$3)$3) 60,000
60,000 260,000
260,000
Contribution
Contributionmargin
margin 340,000
340,000
Less
Lessfixed
fixedexpenses:
expenses:
Manufacturing
Manufacturingoverhead
overhead $$150,000
150,000
Selling
Selling&&administrative
administrativeexpenses
expenses 100,000
100,000 250,000
250,000
Net
Netoperating
operatingincome
income $$ 90,000
90,000

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 7-12

Learning Objective 3

Reconcile variable costing

and absorption costing net
operating incomes and
explain why the two
amounts differ.

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 7-13

Comparing the Two Methods

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 7-14

Comparing the Two Methods

We can reconcile the difference between

absorption and variable income as follows:

Variable
Variable costing
costingnet
netoperating
operatingincome
income $$ 90,000
90,000
Add:
Add:Fixed
Fixedmfg.
mfg. overhead
overheadcosts
costs
deferred
deferredin
ininventory
inventory
(5,000
(5,000units
units×× $6
$6per
perunit)
unit) 30,000
30,000
Absorption
Absorptioncosting
costingnet
netoperating
operatingincome
income $$ 120,000
120,000

Fixed mfg. Overhead $150,000

= = $6.00 per unit
Units produced 25,000 units
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 7-15
Extended Comparisons of Income Data
Harvey Company Year Two

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 7-16

Unit Cost Computations

Since there was no change in the variable costs

per unit, total fixed costs, or the number of
units produced, the unit costs remain unchanged.
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 7-17

Absorption Costing

Absorption
AbsorptionCosting
Costing
Sales
Sales(30,000
(30,000×× $30)
$30) $$900,000
900,000
Less
Lesscost
costofofgoods
goodssold:
sold:
Beg.
Beg. inventory
inventory(5,000
(5,000×× $16)
$16) $$ 80,000
80,000
Add
AddCOGM
COGM(25,000
(25,000×× $16)
$16) 400,000
400,000
Goods
Goodsavailable
available for
forsale
sale 480,000
480,000
Less
Lessending
endinginventory
inventory -- 480,000
480,000
Gross
Grossmargin
margin 420,000
420,000
Less
Lessselling
selling&&admin.
admin. exp.
exp.
Variable
Variable (30,000
(30,000×× $3)
$3) $$ 90,000
90,000
Fixed
Fixed 100,000
100,000 190,000
190,000
Net
Netoperating
operatingincome
income $$230,000
230,000
These are the 25,000 units
produced in the current period.
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 7-18

Variable Costing
Variable
manufacturing
costs only.

All fixed
manufacturing
overhead is
expensed.

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 7-19

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

= = $6.00 per unit
Units produced 25,000 units
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 7-20

Comparing the Two Methods

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 7-21

Summary of Key Insights

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 7-22
Effect of Changes in Production
on Net Operating Income

Let’s
Let’s revise
revise the
the Harvey
Harvey Company
Company example.
example.

In the previous example,

25,000 units were produced each year,
but sales increased from 20,000 units in year
one to 30,000 units in year two.

In this revised example,

production will differ each year while
sales will remain constant.
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 7-23
Effect of Changes in Production
Harvey Company Year One

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 7-24

Unit Cost Computations for Year One

Unit product cost is determined as follows:

Since
Since the
the number
number of of units
units produced
produced increased
increased
in
in this
this example,
example, while
while the
the fixed
fixed manufacturing
manufacturing overhead
overhead
remained
remained thethe same,
same, thethe absorption
absorption unit
unit cost
cost is
is less.
less.
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 7-25

Absorption Costing: Year One

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 7-26

Variable Costing: Year One

Variable
manufacturing
Variable
VariableCosting
Costing
costs only.
Sales
Sales(25,000
(25,000××$30)
$30) $$750,000
750,000
Less
Lessvariable
variableexpenses:
expenses:
Beginning
Beginninginventory
inventory $$ --
Add
All fixed
AddCOGM
COGM(30,000
(30,000××$10)
$10) 300,000
300,000 manufacturing
Goods
Goodsavailable
availableforforsale
sale 300,000
300,000
Less overhead is
Lessending
endinginventory
inventory(5,000
(5,000××$10)
$10) 50,000
50,000
Variable expensed.
Variablecost
costofofgoods
goodssold
sold 250,000
250,000
Variable
Variableselling
selling&&administrative
administrative
expenses
expenses(25,000
(25,000××$3)
$3) 75,000
75,000 325,000
325,000
Contribution
Contributionmargin
margin 425,000
425,000
Less
Lessfixed
fixedexpenses:
expenses:
Manufacturing
Manufacturingoverhead
overhead $$150,000
150,000
Selling
Selling&&administrative
administrativeexpenses
expenses 100,000
100,000 250,000
250,000
Net
Netoperating
operatingincome
income $$175,000
175,000

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 7-27
Effect of Changes in Production
Harvey Company Year Two

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 7-28

Unit Cost Computations for Year Two

Unit product cost is determined as follows:

Since
Since the
the number
number of of units
units produced
produced decreased
decreased in in the
the
second
second year,
year, while
while the
the fixed
fixed manufacturing
manufacturing overhead
overhead
remained
remained the
the same,
same, the
the absorption
absorption unit
unit cost
cost is
is now
now higher.
higher.
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 7-29

Absorption Costing: Year Two

Absorption
AbsorptionCosting
Costing
Sales
Sales(25,000
(25,000×× $30)
$30) $$750,000
750,000
Less
Lesscost
costofofgoods
goodssold:
sold:
Beg.
Beg. inventory
inventory(5,000
(5,000×× $15)
$15) $$ 75,000
75,000
Add
Add COGM
COGM (20,000
(20,000×× $17.50)
$17.50) 350,000
350,000
Goods
Goodsavailable
available for
forsale
sale 425,000
425,000
Less
Lessending
endinginventory
inventory -- 425,000
425,000
Gross
Grossmargin
margin 325,000
325,000
Less
Lessselling
selling &&admin.
admin. exp.
exp.
Variable
Variable (25,000
(25,000×× $3)
$3) $$ 75,000
75,000
Fixed
Fixed 100,000
100,000 175,000
175,000
Net
Netoperating
operatingincome
income $$150,000
150,000
These are the 20,000 units produced in the current
period at the higher unit cost of $17.50 each.
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 7-30

Variable Costing: Year Two

Variable
manufacturing
costs only.

All fixed
manufacturing
overhead is
expensed.

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 7-31

Comparing the Two Methods

Conclusions
 Net operating income is not affected by changes in
production using variable costing.
 Net operating income is affected by changes in production
using absorption costing even though the number of units
sold is the same each year.
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 7-32

Learning Objective 4

Understand the
advantages and
disadvantages of both
variable and absorption
costing.

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 7-33

Impact on the Manager

Opponents
Opponentsof of absorption
absorptioncosting
costingargue
arguethat
that
shifting
shiftingfixed
fixed manufacturing
manufacturingoverhead
overheadcosts
costs
between
betweenperiods
periodscan
canlead
leadto
tofaulty
faultydecisions.
decisions.

These
Theseopponents
opponentsargue
arguethat
thatvariable
variablecosting
costingincome
income
statements
statements are
areeasier
easiertotounderstand
understandbecause
becausenet netoperating
operating
income
incomeisisonly
onlyaffected
affectedbybychanges
changesin inunit
unitsales.
sales. This
This
produces
producesnetnet operating
operatingincome
income figures
figures that
that are
are
more
moreconsistent
consistent with
withmanagers’
managers’expectations.
expectations.

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 7-34
CVP Analysis, Decision Making
and Absorption costing

Absorption costing does not support CVP

analysis because it essentially treats fixed
manufacturing overhead as a variable cost by
assigning a per unit amount of the fixed
overhead to each unit of production.
Treating
Treatingfixed
fixedmanufacturing
manufacturingoverhead
overheadas asaa
variable
variablecost
costcan:
can:
•• Lead
Leadto
tofaulty
faultypricing
pricingdecisions
decisionsand andkeep-or-drop
keep-or-drop
decisions.
decisions.
•• Produce
Producepositive
positivenet
net operating
operatingincome
incomeeven
even
when
whenthethenumber
numberof of units
unitssold
sold isisless
lessthan
than the
the
breakeven
breakevenpoint.
point.
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 7-35

External Reporting and Income Taxes

To
Toconform
conformtoto
GAAP
GAAPrequirements,
requirements,
absorption
absorptioncosting
costingmust
mustbebeused
usedfor
for
external
externalfinancial
financialreports
reportsin
inthe
the
United Under
Under thetheTax
Tax
UnitedStates.
States.
Reform
Reform Act
Act of of1986,
1986,
absorption
absorptioncosting
costing mustmust be
be
used
used when
when filing
filing income
income
Since
Sincetop
topexecutives
executives tax
taxreturns.
returns.
are usually evaluated based
are usually evaluated based onon
external
externalreports
reportsto
toshareholders,
shareholders,
they
theymay
mayfeel
feelthat
that decisions
decisions
should
shouldbe
bebased
basedonon
absorption
absorptioncost
cost income.
income.
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 7-36
Advantages of Variable Costing
and the Contribution Approach

Consistent with
CVP analysis.
Management finds Net operating income
it more useful. is closer to
net cash flow.
Consistent with standard
costs and flexible budgeting.
Advantages
Easier to estimate profitability
of products and segments.
Impact of fixed
costs on profits Profit is not affected by
emphasized. changes in inventories.
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 7-37

Variable versus Absorption Costing

Fixed manufacturing
costs must be assigned Fixed manufacturing
to products to properly costs are capacity costs
match revenues and and will be incurred
costs. even if nothing is
produced.

Absorption Variable
Costing Costing
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 7-38
Variable Costing and the
Theory of Constraints (TOC)

Companies
Companies involved involved in in TOC
TOC useuse aa form
form of of variable
variable
costing.
costing. However,
However, oneone difference
difference of of the
the TOC
TOC approach
approach
isis that
that itit treats
treats direct
direct labor
labor asas aa fixed
fixed cost
cost for
for three
three
reasons:
reasons:

 Many
Manycompanies
companieshave
haveaacommitment
commitment to
toguarantee
guarantee
workers
workersaaminimum
minimum number
number of
ofpaid
paidhours.
hours.

 Direct
Directlabor
labor isisusually
usuallynot
not the
theconstraint.
constraint.

 TOC
TOCemphasizes
emphasizesthe therole
roledirect
directlaborers
laborersplay
playin
indriving
driving
continuous
continuousimprovement.
improvement. Since
Sincelayoffs
layoffsoften
oftendevastate
devastate
morale,
morale, managers
managersinvolved
involvedin
inTOC
TOCareareextremely
extremely
reluctant
reluctantto
tolay
layoff
offemployees.
employees.

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 7-39

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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 7-40

End of Chapter 7

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