Variable Costing:A Tool for Management

Chapter

7

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Absorption Costing

Variable Costing

Direct materialsDirect labor Product costs

Product costs Variable mfg. overhead

Fixed mfg. overheadPeriod costs

Period costs Selling & admin. exp.

Overview of Absorption and Variable Costing

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Harvey Co. produces a single product with the following information available:

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.

Unit Cost Computations

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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 280,000 Less selling & admin. exp. Variable FixedNet 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 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 280,000 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

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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.

Income Comparison of Absorption and Variable Costing

Variablecostsonly.

All fixedmanufacturing

overhead isexpensed.

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Let’s compare the methods.

Income Comparison of Absorption and Variable Costing

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Let’s 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 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:

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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.

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Harvey Co. Year 2

Unit product cost is determined as follows:

No change in Harvey’scost structure.

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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 2Variable

costsonly.

All fixedmanufacturing

overhead isexpensed.

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Let’s compare the methods.

Income Comparison of Absorption and Variable Costing

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Reconciliation

Variable costing net income 260,000$ Less: Fixed Mfg. Overhead released from inventory to COGS (5,000 units × $6 per unit) 30,000 Absorption costing net income 230,000$

Fixed mfg. overhead $150,000 Units produced 25,000

= = $6.00 per unit

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

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Summary

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Summary

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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

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Variable versus Absorption Costing

Depreciation, taxes, insurance and salariesare just as essential to

products as variable costs.

AbsorptionCosting

VariableCosting

These are capacitycosts and will be

incurred if nothingis produced.

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Advantages of the Contribution Approach

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.

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Impact of JIT Inventory Methods

In a JIT inventory system . . .

Productiontends to equalsales . . .

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

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End of Chapter 7