Variable Costing: A Tool for · PDF fileExplain how variable costing differs from absorption...

Variable Costing:A Tool for Management

Chapter

7

© McGraw-Hill Ryerson Limited., 2001

7-2

LEARNING OBJECTIVES

1. Explain how variable costing differs fromabsorption costing and compute the unitproduct cost under each method.

2. Describe how fixed manufacturing overheadcosts are deferred in inventory and releasedfrom inventory under absorption costing.

3. Prepare income statements using bothvariable and absorption costing, and reconcilethe two net income figures.

After studying this chapter, you should be able to:


7-3

LEARNING OBJECTIVES

4. Explain the effect of changes in production onthe net income reported under both variableand absorption costing.

5. Explain the advantages and limitations of boththe variable and absorption costing methods.

6. Explain how the use of JIT reduces thedifference in net income reported under thevariable and absorption costing methods.

After studying this chapter, you should be able to:


7-4

Overview of Absorption andVariable Costing

The only cost of driving my caron a 200 mile trip today is

$12 for gasoline.

VariableCosting


7-5


No! You must consider these costs too!

AbsorptionCosting

Cost Per month Per day

Car payment 300.00$ 10.00$

Insurance 60.00 2.00


7-6


Your wrong. I have the carpayment and the

insurance payment even ifI do not make the trip.

VariableCosting


7-7


Who’s right?How should we treat the carpayment and the insurance?


7-8

Absorption Costing

Variable Costing

Direct materialsDirect labour Product costs

Product costs Variable mfg. overhead

Fixed mfg. overheadPeriod costs

Period costs Selling & admin. exp.



7-9

Let’s put some numbers to theissue and see if it will

sharpen our understanding.



7-10

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


7-11

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


7-12

Absorption CostingSales (20,000 × $30) 600,000$Less cost of goods sold: Beginning inventory -$ Add COGM (25,000 × $16) 400,000 Goods availa ble for sale 400,000 Ending inventory (5,000 × $16) 80,000 320,000 Gross margin 280,000 Less se lling & admin. e xp. Varia ble FixedNet income

Harvey Co. had no beginning inventory, produced25,000 units and sold 20,000 units this year.

Income Comparison of Absorptionand Variable Costing


7-13

Harvey Co. had no beginning inventory, produced25,000 units and sold 20,000 units this year.

Absorption CostingSales (20,000 × $30) 600,000$Less cost of goods sold: Beginning inventory -$ Add COGM (25,000 × $16) 400,000 Goods availa ble for sale 400,000 Ending inventory (5,000 × $16) 80,000 320,000 Gross margin 280,000 Less se lling & admin. e xp. Varia ble (20,000 × $3) 60,000$ Fixed 100,000 160,000 Net income 120,000$



7-14

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 × $3) 60,000 260,000 Contribution margin 340,000 Less fixed expenses: Manufacturing overhead 150,000$ Selling & administrative expenses 100,000 250,000 Net income 90,000$

Now let’s look at variable costing by Harvey Co.


Variablecostsonly.

All fixedmanufacturing

overhead isexpensed.


7-15

Cost of Goods Sold

Ending Inventory

Period 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 - -

200,000$ 50,000$

Let’s compare the methods.



7-16

Cost of Goods Sold

Ending Inventory

Period 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$

Let’s compare the methods.



7-17

Reconciliation

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 Units produced 25,000

= = $6.00 per unit

We can reconcile the difference betweenabsorption and variable income as follows:


7-18

Extending the Example

Let’s look at thesecond yearof operations

for HarveyCompany.


7-19

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 labor variable mfg. overhead 10$ Selling & administrative expenses 3$

Fixed costs per year:Manufacturing overhead 150,000$ Selling & administrative expenses 100,000$


7-20

Harvey Co. Year 2

Unit product cost is determined as follows:

No change in Harvey’scost structure.

Absorption Costing

Variable Costing

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


7-21

Harvey Co. Year 2

Now let’s look at Harvey’s income statementassuming absorption costing is 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 480,000 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$

Harvey Co. Year 2

These are the 25,000 unitsproduced in the current period.


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Harvey Co. Year 2

Next, we’ll look at Harvey’s income statementassuming is used.


7-24

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 300,000 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$

Harvey Co. Year 2Variable

costsonly.

All fixedmanufacturing

overhead isexpensed.


7-25

Summary

Income Comparison

Costing Method 1st Period 2nd Period TotalAbsorption 120,000$ 230,000$ 350,000$ Variable 90,000 260,000 350,000


7-26

SummaryRela tion between Effect Rela tion between

production on variable and

Year and sa les iniventory absorption incomeInventory Absorption

1st Production > Sales increases by >

year 25,000 > 20,000 5,000 units. Variable Inventory Absorption

2nd Production < Sales decreases <

year 25,000 < 30,000 to zero. Variable

Both Absorption

years Production = Sales No change =

combined 50,000 = 50,000 Variable


7-27

Advantages of the ContributionApproach

Advantages

Management finds it easy to understand.

Consistent withCVP analysis.

Net income is closerto net cash flow.

Profit is not affected bychanges in inventories.

Impact of fixedcosts on profitsemphasized.

Consistent with standardcosts and flexible budgeting.

Easier to estimate profitabilityof products and segments.


7-28

Variable versus Absorption Costing

Fixed costs arenot really the costs

of any particularproduct.

All manufacturing costsmust be assigned toproducts to properly

match revenues and costs.

AbsorptionCosting

VariableCosting


7-29


Amortization, taxes,insurance and salariesare just as essential to

products as variable costs.

AbsorptionCosting

VariableCosting

These are capacitycosts and will be

incurred if nothingis produced.


7-30

I guess we won’t besolving this controversy

today!



7-31

Impact of JIT Inventory Methods

In a JIT inventory system . . .

Productiontends to equalsales . . .

So, the difference between variable andabsorption income tends to disappear.


7-32

End of Chapter 7

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