Variable Costing:

A Tool for Management

Chapter 7

2010 The McGraw-Hill Companies, Inc.

Learning Objective 1

Explain how variable

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

McGraw-Hill/Irwin

Slide 2

Overview of Absorption and Variable

Costing
Absorption
Costing

Variable
Costing
Direct Materials

Product
Costs

Direct Labor

Product
Costs

Variable Manufacturing Overhead

Fixed Manufacturing Overhead

Period
Costs

McGraw-Hill/Irwin

Variable Selling and Administrative Expenses

Period
Costs

Fixed Selling and Administrative Expenses

Slide 3

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. .. ..

McGraw-Hill/Irwin

Slide 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. .. ..

McGraw-Hill/Irwin

Slide 5

Unit Cost Computations

Harvey Company produces a single product
with the following information available:
Number
Number of
ofunits
unitsproduced
produced annually
annually
Variable
Variable costs
costsper
per unit:
unit:
Direct
Directmaterials,
materials, direct
directlabor,
labor,
and
and variable
variable mfg.
mfg. overhead
overhead
Selling
Selling &&administrative
administrative expenses
expenses

$$
$$

Fixed
Fixed costs
costsper
per year:
year:
Manufacturing
Manufacturing overhead
overhead
Selling
Selling &&administrative
administrative expenses
expenses

$$150,000
150,000
$$100,000
100,000

McGraw-Hill/Irwin

25,000
25,000

10
10
33

Slide 6

Unit Cost Computations

Unit product cost is determined as follows:

Direct
Directmaterials,
materials, direct
directlabor,
labor,
and
and variable
variable mfg.
mfg. overhead
overhead
Fixed
Fixed mfg.
mfg. overhead
overhead
($150,000
($150,00025,000
25,000units)
units)
Unit
Unitproduct
productcost
cost

Absorption
Absorption
Costing
Costing

Variable
Variable
Costing
Costing

$$

10
10

$$

10
10

$$

66
16
16

$$

-10
10

Under absorption costing, all production costs, variable

and fixed, are included when determining unit product
cost. Under variable costing, only the variable
production costs are included in product costs.
McGraw-Hill/Irwin

Slide 7

Learning Objective 2

Prepare income
statements using both
variable and absorption
costing.

McGraw-Hill/Irwin

Slide 8

Income Comparison of
Absorption and Variable Costing
Lets assume the following additional information
for Harvey Company.

20,000 units were sold during the year at a price

of $30 each.
There is no beginning inventory.

Now, lets compute net operating

income using both absorption
and variable costing.

McGraw-Hill/Irwin

Slide 9

Absorption Costing

Fixed manufacturing overhead deferred in

inventory is 5,000 units $6 = $30,000.
McGraw-Hill/Irwin

Slide 10

Variable Costing
Variable
manufacturing
Variable
VariableCosting
Costing
costs only.

Sales
Sales(20,000
(20,000$30)
$30)
Less
Lessvariable
variableexpenses:
expenses:
Beginning
$$
-Beginninginventory
inventory
Add
250,000
AddCOGM
COGM(25,000
(25,000$10)
$10)
250,000
Goods
250,000
Goodsavailable
availablefor
forsale
sale
250,000
Less
Lessending
endinginventory
inventory(5,000
(5,000$10)
$10) 50,000
50,000
Variable
200,000
Variablecost
costof
ofgoods
goodssold
sold
200,000
Variable
Variableselling
selling&&administrative
administrative
expenses
60,000
expenses(20,000
(20,000$3)
$3)
60,000
Contribution
Contributionmargin
margin
Less
Lessfixed
fixedexpenses:
expenses:
Manufacturing
$$150,000
Manufacturingoverhead
overhead
150,000
Selling
Selling&&administrative
administrativeexpenses
expenses 100,000
100,000
Net
Netoperating
operatingincome
income
McGraw-Hill/Irwin

$$600,000
600,000

All fixed
manufacturing
overhead is
expensed.
260,000
260,000
340,000
340,000
250,000
250,000
$$ 90,000
90,000
Slide 11

Learning Objective 3

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

McGraw-Hill/Irwin

Slide 12

Comparing the Two Methods

Cost
Costof
of
Goods
Goods
Sold
Sold

Absorption
Absorptioncosting
costing
Variable
Variable mfg.
mfg.costs
costs $$200,000
200,000
Fixed
120,000
Fixedmfg.
mfg.costs
costs
120,000
$$320,000
320,000
Variable
Variable costing
costing
Variable
Variable mfg.
mfg.costs
costs $$200,000
200,000
Fixed
-Fixedmfg.
mfg.costs
costs
$$200,000
200,000

McGraw-Hill/Irwin

Ending
Ending
Inventory
Inventory

Period
Period
Expense
Expense

$$ 50,000
50,000
30,000
30,000
$$ 80,000
80,000

$$

$$ 50,000
50,000
-$$ 50,000
50,000

$$
-150,000
150,000
$$150,000
150,000

$$

----

Total
Total
$$250,000
250,000
150,000
150,000
$$400,000
400,000

$$250,000
250,000
150,000
150,000
$$400,000
400,000

Slide 13

Comparing the Two Methods

We can reconcile the difference between
absorption and variable income as follows:
Variable
Variable costing
costingnet
netoperating
operatingincome
income
Add:
Add:Fixed
Fixedmfg.
mfg. overhead
overheadcosts
costs
deferred
deferredin
ininventory
inventory
(5,000
(5,000units
units $6
$6per
perunit)
unit)
Absorption
Absorptioncosting
costingnet
netoperating
operatingincome
income

$$

90,000
90,000

30,000
30,000
$$ 120,000
120,000

Fixed mfg. overhead

$150,000
=
= $6 per unit
Units produced
25,000 units
McGraw-Hill/Irwin

Slide 14

Extended Comparisons of Income Data

Harvey Company Year Two
Number
Number of
ofunits
unitsproduced
produced
Number
Number of
ofunits
unitssold
sold
Units
Unitsin
in beginning
beginning inventory
inventory
Unit
Unitsales
salesprice
price
Variable
Variable costs
costsper
per unit:
unit:
Direct
Directmaterials,
materials, direct
directlabor
labor
variable
variable mfg.
mfg. overhead
overhead
Selling
Selling &&administrative
administrative
expenses
expenses
Fixed
Fixed costs
costsper
per year:
year:
Manufacturing
Manufacturing overhead
overhead
Selling
Selling &&administrative
administrative
expenses
expenses
McGraw-Hill/Irwin

25,000
25,000
30,000
30,000
5,000
5,000
$$
30
30

$$

10
10

$$

33

$$150,000
150,000
$$100,000
100,000
Slide 15

Unit Cost Computations

Direct
Directmaterials,
materials, direct
directlabor,
labor,
and
and variable
variable mfg.
mfg. overhead
overhead
Fixed
Fixed mfg.
mfg. overhead
overhead
($150,000
($150,00025,000
25,000units)
units)
Unit
Unitproduct
productcost
cost

Absorption
Absorption
Costing
Costing

Variable
Variable
Costing
Costing

$$

10
10

$$

10
10

$$

66
16
16

$$

-10
10

Since the variable costs per unit, total fixed costs,

and the number of units produced remained
unchanged, the unit cost computations also
remain unchanged.
McGraw-Hill/Irwin

Slide 16

Absorption Costing

Unit product

Sales
Sales(30,000
(30,000 $30)
$30)
Less
Lesscost
costof
ofgoods
goodssold:
sold:
Beg.
Beg. inventory
inventory(5,000
(5,000 $16)
$16)
Add
AddCOGM
COGM (25,000
(25,000 $16)
$16)
Goods
Goodsavailable
available for
forsale
sale
Less
Lessending
endinginventory
inventory
Gross
Grossmargin
margin
Less
Lessselling
selling &&admin.
admin. exp.
exp.
Variable
Variable (30,000
(30,000 $3)
$3)
Fixed
Fixed
Net
Netoperating
operatingincome
income

cost.Absorption
AbsorptionCosting
Costing
$$900,000
900,000
$$ 80,000
80,000
400,000
400,000
480,000
480,000
-$$ 90,000
90,000
100,000
100,000

480,000
480,000
420,000
420,000
190,000
190,000
$$230,000
230,000

Fixed manufacturing overhead released from

inventory is 5,000 units $6 = $30,000.
McGraw-Hill/Irwin

Slide 17

Variable Costing

Variable
manufacturing
costs only. Variable Costing
Variable Costing
Sales
$$900,000
Sales(30,000
(30,000 $30)
$30)
900,000
Less
Lessvariable
variable expenses:
expenses:
Beg.
$$ 50,000
Beg. inventory
inventory(5,000
(5,000 $10)
$10)
50,000
Add
250,000
AddCOGM
COGM(25,000
(25,000 $10)
$10)
250,000
All fixed
Goods
300,000
Goodsavailable
available for
forsale
sale
300,000
manufacturing
Less
-Lessending
endinginventory
inventory
overhead is
Variable
cost
of
goods
sold
300,000
Variable cost of goods sold
300,000
expensed.
Variable
Variable selling
selling&&administrative
administrative
expenses
90,000
390,000
expenses(30,000
(30,000 $3)
$3)
90,000
390,000
Contribution
510,000
Contributionmargin
margin
510,000
Less
Lessfixed
fixedexpenses:
expenses:
Manufacturing
$$150,000
Manufacturingoverhead
overhead
150,000
Selling
250,000
Selling&&administrative
administrative expenses
expenses 100,000
100,000
250,000
Net
$$260,000
Netoperating
operatingincome
income
260,000

McGraw-Hill/Irwin

Slide 18

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 per unit
Units produced
25,000 units
McGraw-Hill/Irwin

Slide 19

Comparing the Two Methods

Costing Method
Absorption
Variable

McGraw-Hill/Irwin

1st Period
$ 120,000
90,000

2nd Period
$ 230,000
260,000

Total
$ 350,000
350,000

Slide 20

Summary of Key Insights

McGraw-Hill/Irwin

Slide 21

Learning Objective 4

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

McGraw-Hill/Irwin

Slide 22

Impact on the Manager

Opponents of absorption costing argue that
shifting fixed manufacturing overhead costs
between periods can lead to faulty decisions.
These opponents argue that variable costing income
statements are easier to understand because net operating
income is only affected by changes in unit sales. This
produces net operating income figures that are
consistent with managers expectations.

McGraw-Hill/Irwin

Slide 23

CVP Analysis, Decision Making

and Absorption costing
Absorption costing does not dovetail with CVP analysis,
nor does it support decision making. It treats fixed
manufacturing overhead as a variable cost. It assigns per
unit fixed manufacturing overhead costs to production.
Treating fixed manufacturing overhead as a
variable
variable cost can:
can:
Lead to faulty pricing decisions and
and faulty
keep-or-drop decisions.
Assigning per unit fixed manufacturing overhead
costs to production can:
Potentially produce positive
positive net operating income
income
even when the number of units sold is
is less than
the breakeven point.
McGraw-Hill/Irwin

Slide 24

External Reporting and Income Taxes

To
To conform
conform to
to
GAAP
GAAP requirements,
requirements,
absorption
absorption costing
costing must
must be
be used
used for
for
external
external financial
financial reports
reports in
in the
the
Under
Under the
the Tax
Tax
United
United States.
States.
Reform
Reform Act
Act of
of 1986,
1986,
absorption
absorption costing
costing must
must be
be
used
used when
when filling
filling out
out
Since
income
Since top
top executives
executives
income tax
tax returns.
returns.
are
are typically
typically evaluated
evaluated based
based on
on
earnings
earnings reported
reported to
to shareholders
shareholders
in
in external
external reports,
reports, they
they may
may feel
feel that
that
decisions
decisions should
should be
be based
based on
on
absorption
absorption costing
costing data.
data.
McGraw-Hill/Irwin

Slide 25

Advantages of Variable Costing

and the Contribution Approach
Management finds
it more useful.

Advantages

Impact of fixed
costs on profits
emphasized.
McGraw-Hill/Irwin

Consistent with
CVP analysis.
Net operating income
is closer to
net cash flow.
Consistent with standard
costs and flexible budgeting.
Easier to estimate profitability
of products and segments.
Profit is not affected by
changes in inventories.
Slide 26

Variable versus Absorption Costing

Fixed manufacturing
costs must be assigned
to products to properly
match revenues and
costs.

Fixed manufacturing
costs are capacity costs
and will be incurred
even if nothing is
produced.

Variable
Costing
McGraw-Hill/Irwin

Slide 27

Variable Costing and the Theory of

Constraints (TOC)
Companies involved in TOC use a form of variable
costing. However, one difference of the TOC approach
is that it treats direct labor as a fixed cost for three
reasons:

Many companies have a commitment to guarantee

workers a minimum number of paid hours.

Direct labor is usually not the constraint.

TOC emphasizes the role direct laborers play in driving

continuous improvement. Since layoffs often devastate
morale, managers involved in TOC are extremely
reluctant to lay off employees.

McGraw-Hill/Irwin

Slide 28

Impact of Lean Production

When companies use Lean Production . . .
Production
tends to equal
sales . . .

So, the difference between variable and

absorption income tends to disappear.
McGraw-Hill/Irwin

Slide 29

End of Chapter 7

McGraw-Hill/Irwin

Slide 30