Variable Costing: A Tool for

Management
 Learning Objectives
• Explain how variable costing differs from absorption costing
• Compute the unit product cost under each method
• Prepare income statements using variable and absorption
costing, and reconcile the two income figures
• Describe how fixed overhead costs are deferred in, and
released from, inventory under absorption costing
• Explain the advantages and limitations of variable and
absorption costing
• Prepare a segmented income statement and use it.
• Compute companywide and segment break-even points.
• Prepare income statements using super-variable costing and
reconcile this approach with variable costing.
 Variable Vs. 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
 Quick Test

• 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. . .
 Quick Test

• 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. . .
 Variable Vs. Absorption Costing Example

Mickey produces a product with a selling price of $100/unit.

The following information is available for the first year.
 Unit Cost Calculations

Selling and administrative expenses are

always treated as period costs.
Income Statement – Absorption Costing
Fixed
Full mfg.
manufacturing
costs
Sales (35,000 × $100) overhead is
$ 3,500,000
Less cost of goods sold: allocated
Beginning inventory $ -
Add COGM (40,000 × $65) 2,600,000
Goods available for sale 2,600,000
Ending inventory (5,000 × $65) 325,000 2,275,000
Gross margin 1,225,000
Less selling & admin. exp.
Variable (35,000 x $6) $ 210,000
Fixed 290,000 500,000
Net income $ 725,000
Income Statement – Variable Costing
Variable
mfg. costs
Sales (35,000 × $100) only $ 3,500,000
Less variable costs:
Beginning inventory $ -
Add COGM (40,000 × $40) 1,600,000 All fixed
Goods available for sale 1,600,000 manufacturing
Ending inventory (5,000 × $40) 200,000 overhead is
Variable cost of goods sold 1,400,000 expensed
Variable selling & administrative
expenses (35,000 × $6) 210,000 1,610,000
Contribution margin 1,890,000
Less fixed costs:
Manufacturing overhead $ 1,000,000
Selling & administrative expenses 290,000 1,290,000
Net income $ 600,000
Variable Vs. Absorption Costing Example

In its second year of operation, Mickey accumulated

the following information:
 Unit Cost Calculations

Selling and administrative expenses are

always treated as period costs.
Income Statement – Absorption Costing
Full mfg. Fixed
costs manufacturing
Sales (42,000 × $100) overhead is
$ 4,200,000
Less cost of goods sold: allocated
Beginning inven. (5,000 x $65) $ 325,000
Add COGM (40,000 × $65) 2,600,000
Goods available for sale 2,925,000
Ending inven. (3,000 × $65) 195,000 2,730,000
Gross margin 1,470,000
Less selling & admin. exp.
Variable (42,000 x $6) $ 252,000
Fixed 290,000 542,000
Net income $ 928,000
Income Statement – Variable Costing
Variable
mfg. costs
Sales (42,000 × $100) only $ 4,200,000
Less variable costs:
Beginning inven. (5,000 x $40) $ 200,000
Add COGM (40,000 × $40) 1,600,000 All fixed
Goods available for sale 1,800,000 manufacturing
Ending inven. (3,000 × $40) 120,000 overhead is
Variable cost of goods sold 1,680,000 expensed
Variable selling & administrative
expenses (42,000 × $6) 252,000 1,932,000
Contribution margin 2,268,000
Less fixed costs:
Manufacturing overhead $ 1,000,000
Selling & administrative expenses 290,000 1,290,000
Net income $ 978,000
 Notes
• If production > sales (inventory level increases),
income (absorption) > income (variable).
– Fixed overhead is partially deferred in
inventory under absorption costing.
• If production < sales (inventory level decreases),
income (absorption) < income (variable).
– Deferred fixed overhead is released to income
statement under absorption costing.
• If production = sales (inventory level is the same),
Income (absorption) = Income (variable).
 Reconciliation
• In general, the difference in income between
absorption and variable costing is the change in
inventory value under absorption minus the
change in inventory value under variable costing.
• However, if unit cost does not change (or if there
is no beginning inventory), then:
– Income (absorption) - Income (variable) =
Fixed overhead per unit * Change in inventory
level
– where, change in inventory level =
production - sales, or EI - BI, in units.
 Reconciliation
We can reconcile the difference between
absorption and variable income as follows:

Year 1: Absorption Variable Difference

Ending inventory $ 325,000 $ 200,000
Beginning inventory - -
Change in inventory $ 325,000 - $ 200,000 = $ 125,000

Year 2:
Ending inventory 195,000 120,000

Beginning inventory 325,000 200,000

Change in inventory $ (130,000) - $ (80,000) = $ (50,000)
 Reconciliation
Alternatively, we can reconcile the differences
between absorption and variable income as follows:

Variable costing net income $ 600,000

Add: Fixed mfg. overhead costs
deferred in inventory
(5,000 units × $25 per unit) 125,000
Absorption costing net income $ 725,000

Variable costing net income $ 978,000

Deduct: Fixed mfg. overhead
costs released from inventory
(2,000 units × $25 per unit) 50,000
Absorption costing net income $ (928,000)
 Arguments For Variable Costing
• Should we allocate Fixed overhead to units of
output?
– Is fixed overhead a product cost (an asset) or a
period cost (an expense)?
• Variable costing approach blends well (ties in) with
CVP analysis, budgeting, segment reporting, etc.
• Income under absorption costing may be
manipulated by changing the production level.
• In 1970s and 1980s, variable costing was used for
internal use, but the trend is reversing because fixed
overhead is becoming a major part of product cost.