AF2110

Management Accounting 1
Lecture 5

Variable Costing: A Tool for

Management
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Learning Objective 1

Explain how variable costing

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

1. This chapter uses actual costing rather than the
normal costing approach that was used in the job-
order costing chapters.
2. This chapter always uses the actual number of units
produced as the allocation base for assigning actual
fixed manufacturing overhead costs to products.
3. This chapter always assumes that the variable
manufacturing costs per unit and the total fixed
manufacturing overhead cost per period remain
constant.
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Overview of Variable and Absorption Costing

Variable Absorption
Costing Costing
Direct Materials
Product
Direct Labor Product
Costs
Variable Manufacturing Overhead Costs
Fixed Manufacturing Overhead
Period
Variable Selling and Administrative Expenses Period
Costs
Fixed Selling and Administrative Expenses Costs
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Quick Check 1

Which method will produce the highest values for

work in process and finished goods inventories?
a. Absorption costing.
b. Variable costing.
c. They produce the same values for these
inventories.
d. It depends…
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Unit Cost Computations – Part 1

Harvey Company produces a single product with the
following information available:
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Unit Cost Computations–

Computations– Part 2
Unit product cost is determined as follows:

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.
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Learning Objective 2

Prepare income statements

using both variable and
absorption costing.
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Variable and Absorption Costing Income

Statements
Let’s 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, let’s compute net operating income using

both absorption and variable costing.
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Variable Costing Contribution Format

Income Statement
Variable
manufacturing
Variable Costing
costs only.
Sales (20,000 × $30) $ 600,000
Less variable expenses:
Beginning inventory $ -
Add COGM (25,000 × $10) 250,000
All fixed
Goods available for sale 250,000
manufacturing
Less 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 operating income $ 90,000
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Absorption Costing Income Statement

Unit product
cost.
Absorption Costing

Sales (20,000 × $30) $ 600,000

Cost of goods sold (20,000 × $16) 320,000
Gross margin 280,000
Less selling & administrative expenses:
Variable (20,000 × $3) $ 60,000
Fixed 100,000 160,000
Net operating income $ 120,000

Fixed manufacturing overhead deferred in inventory is

5,000 units × $6 = $30,000.
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Learning Objective 3

Reconcile variable costing and

absorption costing net
operating incomes and
explain why the two amounts
differ.
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Comparing the Two Methods – Part 1

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Comparing the Two Methods – Part 2

We can reconcile the difference between
absorption and variable income as follows:

Variable costing net operating income $ 90,000

Add: Fixed mfg. overhead costs
deferred in inventory
(5,000 units × $6 per unit) 30,000
Absorption costing net operating income $ 120,000

Fixed mfg. overhead $150,000

= = $6 per unit
Units produced 25,000 units
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Extended Comparisons of Income Data

Harvey Company – Year Two
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Unit Cost Computations

Since the variable costs per unit, total fixed costs, and
the number of units produced remained unchanged,
the unit cost computations also remain unchanged.
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Variable Costing All fixed

manufacturing
Variable
overhead is
manufacturing
expensed.
costs only.

Variable Costing
Sales (30,000 × $30) $ 900,000
Less variable expenses:
Variable cost of goods sold (30,000 × $10) $ 300,000
Variable selling & administrative
expenses (30,000 × $3) 90,000
Total variable expenses 390,000
Contribution margin 900,000
Less fixed expenses:
Fixed manufacturing overhead $ 150,000
Fixed selling & administrative expenses 100,000 250,000
Net operating income $ 650,000
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Absorption Costing
Unit product
cost.
Absorption Costing

Sales (30,000 × $30) $ 900,000

Cost of goods sold (30,000 × $16) 480,000
Gross margin 420,000
Less selling & administrative expenses:
Variable (30,000 × $3) $ 90,000
Fixed 100,000 190,000
Net operating income $ 230,000

Fixed manufacturing overhead released from

inventory is 5,000 units × $6 = $30,000.
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Reconciling the Difference – Part 1

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
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Reconciling the Difference – Part 2

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Summary of Key Insights

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Effect of Changes in Production

on Net Operating Income

Let’s revise the Harvey Company example.

In the previous example,

25,000 units were produced each year,
but sales increased from 20,000 units in year
one to 30,000 units in year two.

In this revised example,

production will differ each year while
sales will remain constant.
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Effect of Changes in Production

Harvey Company Year One
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Unit Cost Computations for Year One

Unit product cost is determined as follows:

Since the number of units produced increased

in this example, while the fixed manufacturing overhead
remained the same, the absorption unit cost is less.
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Absorption Costing: Year One

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Variable Costing: Year One

Variable
manufacturing
Variable Costing
costs only.
Sales (25,000 × $30) $ 750,000
Less variable expenses:
Beginning inventory $ -
Add COGM (30,000 × $10) 300,000
All fixed
Goods available for sale 300,000
manufacturing
Less ending inventory (5,000 × $10) 50,000
overhead is
Variable cost of goods sold 250,000 expensed.
Variable selling & administrative
expenses (25,000 × $3) 75,000 325,000
Contribution margin 425,000
Less fixed expenses:
Manufacturing overhead $ 150,000
Selling & administrative expenses 100,000 250,000
Net operating income $ 175,000
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Effect of Changes in Production

Harvey Company Year Two
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Unit Cost Computations for Year Two

Unit product cost is determined as follows:

Since the number of units produced decreased in the

second year, while the fixed manufacturing overhead
remained the same, the absorption unit cost is now higher.
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Absorption Costing: Year Two

Absorption Costing
Sales (25,000 × $30) $ 750,000
Less cost of goods sold:
Beg. inventory (5,000 × $15) $ 75,000
Add COGM (20,000 × $17.50) 350,000
Goods available for sale 425,000
Less ending inventory - 425,000
Gross margin 325,000
Less selling & admin. exp.
Variable (25,000 × $3) $ 75,000
Fixed 100,000 175,000
Net operating income $ 150,000

These are the 20,000 units produced in the current

period at the higher unit cost of $17.50 each.
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Variable Costing: Year Two

Variable
manufacturing
costs only.

All fixed
manufacturing
overhead is
expensed.
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Income Comparison

Conclusions
 Net operating income is not affected by changes in
production using variable costing.
 Net operating income is affected by changes in production
using absorption costing even though the number of units
sold is the same each year.
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Impact on the Manager

Opponents of absorption costing argue that shifting
fixed manufacturing overhead costs between periods
can lead to misinterpretations and faulty decisions.
Those who favor variable costing argue that the income
statements are easier to understand because net operating
income is only affected by changes in unit sales. The
resulting income amounts are more consistent with
managers’ expectations.
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Enabling CVP Analysis

Variable costing categorizes costs as variable and fixed
so it is much easier to use this income statement format
for CVP analysis.

Because absorption costing assigns fixed manufacturing

overhead costs to units produced ($6 per unit for Harvey
Company), a portion of fixed manufacturing overhead
resides in inventory when units remain unsold.

The potential result is positive operating income when

the number of units sold is less than the breakeven point.
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Explaining Changes in Net Operating

Income
Variable costing income is only affected by
changes in unit sales. It is not affected by the
number of units produced. As a general rule,
when sales go up, net operating income goes up,
and vice versa.

Absorption costing income is influenced by

changes in unit sales and units of production.
Net operating income can be increased simply
by producing more units even if those units are
not sold.
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Supporting Decision Making

Variable costing correctly identifies the additional variable
costs incurred to make one more unit ($10 per unit for
Harvey Company). It also emphasizes the impact of total
fixed costs on profits.
Because absorption costing assigns fixed manufacturing
overhead costs to units produced ($6 per unit for Harvey
Company), it gives the impression that fixed manufacturing
overhead is variable with respect to the number of units
produced, but it is not.
The result can be inappropriate pricing decisions and product
discontinuation decisions.
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Advantages of Variable Costing

and the Contribution Approach
Consistent with
CVP analysis.
Management finds Net operating income
it more useful. is closer to
net cash flow.
Consistent with standard
costs and flexible budgeting.
Advantages
Easier to estimate profitability
of products and segments.
Impact of fixed
costs on profits Profit is not affected by
emphasized. changes in inventories.
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Variable versus Absorption Costing

Fixed manufacturing
costs must be assigned Fixed manufacturing
to products to properly costs are capacity costs
match revenues and and will be incurred
costs. even if nothing is
produced.

Absorption Variable
Costing Costing
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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.
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End of Lecture 5