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Variable Costing:A Tool for Management
Chapter
7
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McGraw-Hill Ryerson Limited., 2004
LEARNING OBJECTIVES
1. Explain how variable costing differs fromabsorption costing and compute unit product costsunder each method.
2. Prepare income statements using both variable and
absorption costing.3. Reconcile variable costing and absorption costing
net operating incomes, and explain why the twoamounts differ.
4. Understandthe advantages and disadvantages ofboth variable and absorption costing.
5. Explain how the use of JIT reduces the differencein reported net operating income under the variableand absorption costing methods.
After studying this chapter, you should be able to:
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Overview of Absorption and
Variable Costing
The only cost of driving my caron a 200 kilometre trip today is
$12 for gasoline.
VariableCosting
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Overview of Absorption and
Variable Costing
No! You must consider these costs too!
AbsorptionCosting
Cost Per month Per day
Car payment 300.00$ 10.00$
Insurance 60.00 2.00
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Overview of Absorption and
Variable Costing
Youre wrong. I have the carpayment and the insurance
payment even if I do
not make the trip.
VariableCosting
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Overview of Absorption and
Variable Costing
Whos right?How should we treat the car
payment and the insurance?
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McGraw-Hill Ryerson Limited., 2004
Absorption
Costing
Variable
Costing
Direct materials
Direct labour Product costs
Product costs Variable mfg. overhead
Fixed mfg. overhead
Period costsPeriod costs Selling & admin. exp.
Overview of Absorption and
Variable Costing
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Lets put some numbers to theissue and see if it sharpens
our understanding.
Overview of Absorption and
Variable Costing
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Harvey Co. produces a single product withthe following information available:
Number of units produced annually 25,000
Variable costs per unit:Direct materials, direct labour,
and variable mfg. overhead 10$
Selling & administrative expenses 3$
Fixed costs per year:
Manufacturing overhead 150,000$
Selling & administrative expenses 100,000$
Unit Cost Computations
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Unit product cost is determined as follows:
Selling and administrative expenses arealways treated as period expenses and
deducted from revenue.
Absorption
Costing
Variable
Costing
Direct materials, direct labour,and variable mfg. overhead 10$ 10$
Fixed mfg. overhead
($150,000 25,000 units) 6 -
Unit product cost 16$ 10$
Unit Cost Computations
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McGraw-Hill Ryerson Limited., 2004
Absorption CostingSales (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 280,000Less selling & admin. exp.
Variable
Fixed
Net income
Harvey Co. had no beginning inventory, produced
25,000 units, and sold 20,000 units this year.
Income Comparison of Absorption
and Variable Costing
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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 280,000Less 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
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McGraw-Hill Ryerson Limited., 2004
Variable CostingSales (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 $3) 60,000 260,000Contribution margin 340,000
Less fixed expenses:
Manufacturing overhead 150,000$
Selling & administrative expenses 100,000 250,000
Net income 90,000$
Now lets look at variable costing by Harvey Co.
Income Comparison of Absorption
and Variable Costing
Variablecostsonly.
All fixedmanufacturing
overhead isexpensed.
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Cost of
Goods
Sold
Ending
Inventory
Period
Expense Total
Absorption costingVariable mfg. costs 200,000$ 50,000$
Fixed mfg. costs 120,000 30,000
320,000$ 80,000$
Variable costingVariable mfg. costs 200,000$ 50,000$
Fixed mfg. costs - -
200,000$ 50,000$
Lets compare the methods.
Income Comparison of Absorption
and Variable Costing
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Cost of
Goods
Sold
Ending
Inventory
Period
Expense Total
Absorption costingVariable mfg. costs 200,000$ 50,000$ -$ 250,000$
Fixed mfg. costs 120,000 30,000 - 150,000
320,000$ 80,000$ -$ 400,000$
Variable costingVariable mfg. costs 200,000$ 50,000$ -$ 250,000$
Fixed mfg. costs - - 150,000 150,000
200,000$ 50,000$ 150,000$ 400,000$
Lets compare the methods.
Income Comparison of Absorption
and Variable Costing
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Reconciliation
Variable costing net income 90,000$Add: Fixed mfg. overhead costs
deferred in ending inventory
(5,000 units $6 per unit) 30,000
Absorption costing net income 120,000$
Fixed mfg. overhead $150,000Units produced 25,000
= = $6.00 per unit
We can reconcile the difference betweenabsorption and variable income as follows:
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Extending the Example
Lets look at thesecond year
of operationsfor HarveyCompany.
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Harvey Co. Year 2
In its second year of operations, Harvey Co.started with an inventory of 5,000 units,produced 25,000 units, and sold 30,000 units.
Number of units produced annually 25,000
Variable costs per unit:
Direct materials, direct labour,variable mfg. overhead 10$
Selling & administrative
expenses 3$Fixed costs per year:
Manufacturing overhead 150,000$Selling & administrative
expenses 100,000$
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Harvey Co. Year 2
Unit product cost is determined as follows:
No change in Harveyscost structure.
Absorption
Costing
Variable
Costing
Direct materials, direct labour,and variable mfg. overhead 10$ 10$
Fixed mfg. overhead
($150,000 25,000 units) 6 -
Unit product cost 16$ 10$
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McGraw-Hill Ryerson Limited., 2004
Harvey Co. Year 2
Now lets look at Harveys income statementassuming absorption costingis used.
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Absorption 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 480,000Ending inventory - 480,000
Gross margin 420,000
Less selling & admin. exp.
Variable (30,000 $3) 90,000$
Fixed 100,000 190,000Net income 230,000$
Harvey Co. Year 2
These are the 25,000 unitsproduced in the current period.
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McGraw-Hill Ryerson Limited., 2004
Harvey Co. Year 2
Next, well look at Harveys income statementassuming is used.
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McGraw-Hill Ryerson Limited., 2004
Variable CostingSales (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 300,000Ending inventory -
Variable cost of goods sold 300,000
Variable selling & administrative
expenses (30,000 $3) 90,000 390,000
Contribution margin 510,000Less fixed expenses:
Manufacturing overhead 150,000$
Selling & administrative expenses 100,000 250,000
Net income 260,000$
Harvey Co. Year 2Variable
costsonly.
All fixed
manufacturingoverhead isexpensed.
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McGraw-Hill Ryerson Limited., 2004
Reconciliation
Variable costing net income 260,000$Less: Fixed mfg. overhead costs
released from beginning inventory
(5,000 units $6 per unit) (30,000)
Absorption costing net income 230,000$
Fixed mfg. overhead $150,000Units produced 25,000
= = $6.00 per unit
We can reconcile the difference betweenabsorption and variable income as follows:
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Summary
Income Comparison
Costing Method 1st Period 2nd Period Total
Absorption 120,000$ 230,000$ 350,000$Variable 90,000 260,000 350,000
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SummaryRelation between Effect Relation between
production on variable andYear and sales iniventory absorption income
Inventory Absorption
1st Production > Sales increases by >
year 25,000 > 20,000 5,000 units. VariableInventory Absorption
2nd Production < Sales decreases