Variable Costing:

A Tool for Management

 LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1. Explain how variable costing differs from
absorption costing and compute the unit
product cost under each method.
2. Describe how fixed manufacturing overhead
costs are deferred in inventory and released
from inventory under absorption costing.
3. Prepare income statements using both
variable and absorption costing, and reconcile
the two net income figures.
 LEARNING OBJECTIVES
After studying this chapter, you should be able to:
4. Explain the effect of changes in production on
the net income reported under both variable
and absorption costing.
5. Explain the advantages and limitations of both
the variable and absorption costing methods.
6. Explain how the use of JIT reduces the
difference in net income reported under the
variable and absorption costing methods.
Overview of Absorption and Variable
Costing

The only cost of driving my car

on a 200 mile trip today is
$12 for gasoline.

Variable
Costing
Overview of Absorption and Variable
Costing

No! You must consider these costs too!

Cost Per month Per day
Car payment $ 300.00 $ 10.00
Insurance 60.00 2.00

Absorption
Costing
Overview of Absorption and Variable
Costing

Your wrong. I have the car

payment and the
insurance payment even if
I do not make the trip.

Variable
Costing
Overview of Absorption and Variable
Costing

Who’s right?
How should we treat the car
payment and the insurance?
Overview of Absorption and Variable
Costing

Absorption Variable
Costing Costing

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

Fixed mfg. overhead

Period costs
Period costs Selling & admin. exp.
Overview of Absorption and Variable
Costing

Let’s put some numbers to the

issue and see if it will
sharpen our understanding.
Unit Cost Computations

Harvey Co. produces a single product with

the following information available:
Unit Cost Computations

Unit product cost is determined as follows:

Selling and administrative expenses are

always treated as period expenses and
deducted from revenue.
Income Comparison of Absorption and
Variable Costing

Harvey Co. had no beginning inventory, produced

25,000 units and sold 20,000 units this year.
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
Income Comparison of Absorption and
Variable Costing

Harvey Co. had no beginning inventory, produced

25,000 units and sold 20,000 units this year.
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
Income Comparison of Absorption and
Variable Costing
Now let’s look at variable costing by Harvey Co.
Variable
Variable Costing
Sales (20,000 × $30)
costs $ 600,000
Less variable expenses: only.
Beginning inventory $ - All fixed
Add COGM (25,000 × $10) 250,000 manufacturing
Goods available for sale 250,000
Ending inventory (5,000 × $10) 50,000
overhead is
Variable cost of goods sold 200,000 expensed.
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
Income Comparison of Absorption and
Variable Costing

Let’s compare the methods.

Income Comparison of Absorption and
Variable Costing

Let’s compare the methods.

Reconciliation

We can reconcile the difference between

absorption and variable 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
Extending the Example

Let’s look at the

second year
of operations
for Harvey
Company.
Harvey Co. Year 2

In its second year of operations, Harvey Co. started with an

inventory of 5,000 units, produced 25,000 units and sold
30,000 units.
Harvey Co. Year 2

Unit product cost is determined as follows:

No change in Harvey’s
cost structure.
Harvey Co. Year 2

Now let’s look at Harvey’s income statement

assuming absorption costing is used.
Harvey Co. Year 2

Absorption Costing
Sales (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
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

These are the 25,000 units

produced in the current period.
Harvey Co. Year 2

Next, we’ll look at Harvey’s income statement

assuming is used.
Harvey Co. Year 2
Variable
costs
only.

All fixed
manufacturing
overhead is
expensed.
Summary
Summary
Advantages of the Contribution
Approach
Consistent with
CVP analysis.
Management finds it Net income is closer
easy to understand. to net cash flow.

Consistent with standard

Advantages costs and flexible budgeting.

Easier to estimate profitability

of products and segments.
Impact of fixed
costs on profits Profit is not affected by
emphasized. changes in inventories.
Variable versus Absorption Costing

All manufacturing costs Fixed costs are

must be assigned to not really the costs
products to properly of any particular
match revenues and costs. product.

Absorption Variable
Costing Costing
Variable versus Absorption Costing

Amortization, taxes, These are capacity

insurance and salaries costs and will be
are just as essential to incurred if nothing
products as variable costs. is produced.

Absorption Variable
Costing Costing
Variable versus Absorption Costing

I guess we won’t be
solving this controversy
today!
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.
End of Presentation