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11th Edition

Chapter 7

McGrawHill/Irwin

Copyright2006,TheMcGrawHillCompanies,Inc.

Variable Costing: A
Tool for Management
Chapter Seven

McGrawHill/Irwin

Copyright2006,TheMcGrawHillCompanies,Inc.

Overview of Absorption
and Variable Costing
Absorption
Costing

Variable
Costing
Direct Materials

Product
Costs

Product
Costs

Direct Labor
Variable Manufacturing Overhead
Fixed Manufacturing Overhead

Period
Costs

McGrawHill/Irwin

Variable Selling and Administrative Expenses

Period
Costs

Fixed Selling and Administrative Expenses

Copyright2006,TheMcGrawHillCompanies,Inc.

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. .. ..

McGrawHill/Irwin

Copyright2006,TheMcGrawHillCompanies,Inc.

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. .. ..

McGrawHill/Irwin

Copyright2006,TheMcGrawHillCompanies,Inc.

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

McGrawHill/Irwin

25,000
25,000

10
10
33

Copyright2006,TheMcGrawHillCompanies,Inc.

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

Selling and administrative expenses are


always treated as period expenses and
deducted from revenue as incurred.
McGrawHill/Irwin

Copyright2006,TheMcGrawHillCompanies,Inc.

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 were no units in beginning inventory.

Now, lets compute net operating


income using both absorption
and variable costing.
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Copyright2006,TheMcGrawHillCompanies,Inc.

Absorption Costing

Sales
Sales(20,000
(20,000$30)
$30)
Less
Lesscost
costof
ofgoods
goodssold:
sold:
Beginning
Beginninginventory
inventory
Add
AddCOGM
COGM(25,000
(25,000 $16)
$16)
Goods
Goodsavailable
available for
forsale
sale
Ending
Endinginventory
inventory(5,000
(5,000 $16)
$16)
Gross
Grossmargin
margin
Less
Lessselling
selling&&admin.
admin.exp.
exp.
Variable
Variable (20,000
(20,000$3)
$3)
Fixed
Fixed
Net
Netoperating
operatingincome
income

McGrawHill/Irwin

Absorption
AbsorptionCosting
Costing

$$600,000
600,000

$$
-400,000
400,000
400,000
400,000
80,000
80,000
$$ 60,000
60,000
100,000
100,000

320,000
320,000
280,000
280,000
160,000
160,000
$$120,000
120,000

Copyright2006,TheMcGrawHillCompanies,Inc.

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
McGrawHill/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

Copyright2006,TheMcGrawHillCompanies,Inc.

Income Comparison of
Absorption and Variable Costing
Lets compare the 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

McGrawHill/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

Copyright2006,TheMcGrawHillCompanies,Inc.

Reconciliation
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
=
= $6.00 per unit
Units produced
25,000 units
McGrawHill/Irwin

Copyright2006,TheMcGrawHillCompanies,Inc.

Extended Comparison 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
McGrawHill/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
Copyright2006,TheMcGrawHillCompanies,Inc.

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

McGrawHill/Irwin

Absorption
Absorption
Costing
Costing

Variable
Variable
Costing
Costing

$$

10
10

$$

10
10

$$

66
16
16

$$

-10
10

Copyright2006,TheMcGrawHillCompanies,Inc.

Absorption Costing

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

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

These are the 25,000 units


produced in the current period.
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Copyright2006,TheMcGrawHillCompanies,Inc.

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
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Copyright2006,TheMcGrawHillCompanies,Inc.

Reconciliation
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
=
= $6.00 per unit
Units produced
25,000 units
McGrawHill/Irwin

Copyright2006,TheMcGrawHillCompanies,Inc.

Income Comparison

Costing Method
Absorption
Variable

McGrawHill/Irwin

1st Period
$ 120,000
90,000

2nd Period
$ 230,000
260,000

Total
$ 350,000
350,000

Copyright2006,TheMcGrawHillCompanies,Inc.

Summary
Relation between
production
and sales
Production > Sales

Effect
on
iniventory
Inventory
increases

Production < Sales

Inventory
decreases

Production = Sales

No change

McGrawHill/Irwin

Relation between
variable and
absorption income
Absorption
>
Variable
Absorption
<
Variable
Absorption
=
Variable
Copyright2006,TheMcGrawHillCompanies,Inc.

End of Chapter 7

McGrawHill/Irwin

Copyright2006,TheMcGrawHillCompanies,Inc.