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 Variable
Costing Costing
Direct Materials
Product
Product Direct Labor
Costs
Costs Variable Manufacturing Overhead

Fixed Manufacturing Overhead

Period
Period Variable Selling and Administrative Expenses
Costs
Costs Fixed Selling and Administrative Expenses

McGraw-Hill/Irwin 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
 GROSS MARGIN (FAC) FORMAT

 SALES
 LESS COGS (DM; DL; VMOH; FMOH)
__________________________________________
 GROSS MARGIN
 LESS VMKT; FMKT; VADM; FADM
 __________________________________________
 OPERATING INCOMEFAC

McGraw-Hill/Irwin Slide 6
 CONTRIBUTION MARGIN FORMAT
 SALES
 LESS DM; DL; VMOH; VMKT; VADM
 __________________________________________
 CONTRIBUTION MARGIN
 LESS FMOH; FMKT; FADM
 __________________________________________
 OPERATING INCOMEVC

McGraw-Hill/Irwin Slide 7
 Unit Cost Computations

Harvey Company produces a single product

with the following information available:

McGraw-Hill/Irwin Slide 8
 Unit Cost Computations
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.

McGraw-Hill/Irwin Slide 9
 Learning Objective 2

Prepare income
statements using both
variable and absorption
costing.

McGraw-Hill/Irwin Slide 10
 Income Comparison of
Absorption and Variable Costing

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.

McGraw-Hill/Irwin Slide 11
 Absorption Costing

Fixed manufacturing overhead deferred in

inventory is 5,000 units × $6 = $30,000.
McGraw-Hill/Irwin Slide 12
 Variable Costing
Variable
manufacturing
Variable
Variable Costing
Costing
costs only.
Sales
Sales(20,000
(20,000××$30)
$30) $$600,000
600,000
Less
Lessvariable
variableexpenses:
expenses:
Beginning
Beginninginventory
inventory $$ --
Add
All fixed
AddCOGM
COGM(25,000
(25,000××$10)
$10) 250,000
250,000 manufacturing
Goods
Goodsavailable
availableforforsale
sale 250,000
250,000
Less overhead is
Lessending
endinginventory
inventory(5,000
(5,000××$10)
$10) 50,000
50,000
Variable expensed.
Variablecost
costofofgoods
goodssold
sold 200,000
200,000
Variable
Variableselling
selling&&administrative
administrative
expenses
expenses(20,000
(20,000××$3)$3) 60,000
60,000 260,000
260,000
Contribution
Contributionmargin
margin 340,000
340,000
Less
Lessfixed
fixedexpenses:
expenses:
Manufacturing
Manufacturingoverhead
overhead $$150,000
150,000
Selling
Selling&&administrative
administrativeexpenses
expenses 100,000
100,000 250,000
250,000
Net
Netoperating
operatingincome
income $$ 90,000
90,000

McGraw-Hill/Irwin Slide 13
 Learning Objective 3

Reconcile variable costing

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

McGraw-Hill/Irwin Slide 14
 Comparing the Two Methods

McGraw-Hill/Irwin Slide 15
 Comparing the Two Methods

We can reconcile the difference between

absorption and variable income as follows:

Variable
Variable costing
costingnet
netoperating
operatingincome
income $$ 90,000
90,000
Add:
Add:Fixed
Fixedmfg.
mfg. overhead
overheadcosts
costs
deferred
deferredin
ininventory
inventory
(5,000
(5,000units
units×× $6
$6per
perunit)
unit) 30,000
30,000
Absorption
Absorptioncosting
costingnet
netoperating
operatingincome
income $$ 120,000
120,000

Fixed mfg. overhead $150,000

= = $6 per unit
Units produced 25,000 units
McGraw-Hill/Irwin Slide 16
 Extended Comparisons of Income Data
Harvey Company – Year Two

McGraw-Hill/Irwin Slide 17
 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.

McGraw-Hill/Irwin Slide 18
 Absorption Costing Unit product

cost.Absorption
AbsorptionCosting
Costing
Sales
Sales(30,000
(30,000×× $30)
$30) $$900,000
900,000
Less
Lesscost
costofofgoods
goodssold:
sold:
Beg.
Beg. inventory
inventory(5,000
(5,000×× $16)
$16) $$ 80,000
80,000
Add
AddCOGM
COGM(25,000
(25,000×× $16)
$16) 400,000
400,000
Goods
Goodsavailable
available for
forsale
sale 480,000
480,000
Less
Lessending
endinginventory
inventory -- 480,000
480,000
Gross
Grossmargin
margin 420,000
420,000
Less
Lessselling
selling&&admin.
admin. exp.
exp.
Variable
Variable (30,000
(30,000×× $3)
$3) $$ 90,000
90,000
Fixed
Fixed 100,000
100,000 190,000
190,000
Net
Netoperating
operatingincome
income $$230,000
230,000

Fixed manufacturing overhead released from

inventory is 5,000 units × $6 = $30,000.
McGraw-Hill/Irwin Slide 19
 Variable Costing Variable
manufacturing
costs only.

All fixed
manufacturing
overhead is
expensed.

McGraw-Hill/Irwin Slide 20
 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 21
 Comparing the Two Methods

McGraw-Hill/Irwin Slide 22
 Summary of Key Insights

McGraw-Hill/Irwin Slide 23
 Learning Objective 4

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

McGraw-Hill/Irwin Slide 24
 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 25
 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 cost can:
• Lead to faulty pricing decisions and faulty
keep-or-drop decisions.
decisions.

Assigning
Assigning per
per unit fixed
fixed manufacturing overhead
overhead
costs to production can:
•• Potentially
Potentially produce positive net
net operating income
even when the number of units sold is less than
the breakeven point.

McGraw-Hill/Irwin Slide 26
 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
Since top
top executives
executives income
income tax
tax returns.
returns.
are
are typically
typically evaluated
evaluated based
based onon
earnings
earnings reported
reported toto shareholders
shareholders
in
in external
external reports,
reports, they
they may
may feel
feel that
that
decisions
decisions should
should bebe based
based onon
absorption
absorption costing
costing data.
data.
McGraw-Hill/Irwin Slide 27
 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.
McGraw-Hill/Irwin Slide 28
 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.

Variable
Costing
McGraw-Hill/Irwin Slide 29
 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 30
 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 31
  
PRACTICE PROBLEM 1
PREPARE I/S USING BOTH FORMATS

McGraw-Hill/Irwin Slide 32
 PRACTICE PROBLEM 2
PREPARE I/S USING BOTH FORMATS

McGraw-Hill/Irwin Slide 33
 PRACTICE PROBLEM 3
PREPARE I/S USING BOTH FORMATS

McGraw-Hill/Irwin Slide 34
 End of Chapter 7

McGraw-Hill/Irwin Slide 35