Managerial Accounting

Seventh Edition
James Jiambalvo

Chapter 5

Variable Costing

Copyright ©2020 John Wiley & Sons, Inc.

Chapter Outline

Learning Objectives

LO 1 Explain the difference between full (absorption) and

variable costing and prepare an income statement using
variable costing.

LO 2 Discuss the effect of production on full and variable

costing income; explain the impact of JIT (just-in-time)
on the difference between full and variable costing
income; and discuss the benefits of variable costing for
internal reporting purposes.

LO 1 Copyright ©2020 John Wiley & Sons, Inc. 2

Learning Objective 1

Explain the difference between full (absorption) and variable

costing and prepare an income statement using variable
costing.

LO 1 Copyright ©2020 John Wiley & Sons, Inc. 3

Full (Absorption) Costing

• Required by GAAP for external reporting purposes

• Inventory costs include:
o Direct materials used
• Generally variable
o Direct labor incurred
• Generally variable
o Manufacturing overhead
• Includes both fixed and variable costs

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Variable Costing

• Inventory costs includes:

o Direct materials used
o Direct labor incurred
o Variable manufacturing overhead
• Fixed manufacturing overhead treated as a period cost
• Helpful for internal decision making
• Not allowed for GAAP reporting

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Test Your Knowledge 1

Which of the following complies with GAAP for external

reporting purposes?
a. Absolute costing
b. Variable costing
c. Fixed costing
d. Full costing←
Answer:
d. Full costing, also known as absorption costing

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Full Costing Flow of Costs

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Variable Costing Flow of Costs

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Difference Between Full and Variable Costing

• The only difference between full and variable costing is

their treatment of fixed manufacturing overhead
o Under full costing, fixed manufacturing overhead is included
in inventory
• These costs enter into the determination of expense only
when the inventory is sold
o Under variable costing, fixed manufacturing overhead
becomes a period expense in the same way as other period
costs

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Variable Costing Income Statement

• Classifies all expenses in terms of their cost behavior,

either fixed or variable
o With variable and fixed expenses separated, the
contribution margin can be presented
• Contribution margin is revenues minus total variable expenses
o The contribution margin allows users to make reasonable
estimates of how much profit will change with changes in
sales

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Variable Costing Contribution Margin

• Sales are $100,000 and the contribution margin is $65,000

• Calculate the contribution margin ratio:

contibution margin $65,000

= = 0.65 or 65%
sales $100,000

• Calculate the change in contribution margin if sales change

by $10,000,000
$10,000,000 * 0.65 = $6,500,000

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Full Costing Income Statement Example

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Variable Costing Income Statement Example

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Variable Costing vs. Full Costing Income Statement

• The full costing income statement cannot be used to

estimate the increase in profit due to an increase in sales
o The reason is that cost of goods sold includes both fixed and
variable costs
o The fixed costs will not increase when sales increase
• Under full costing we do not know how much of cost of
goods sold is fixed or variable

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Learning Objective 2

Discuss the effect of production on full and variable costing

income; explain the impact of JIT (just-in-time) on the
difference between full and variable costing income; and
discuss the benefits of variable costing for internal reporting
purposes.

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Effects of Production on Income

• Example – ClausenTube
• Selling price $2,000 per unit
• Variable costs (per unit):
o Materials = $600 per unit
o Labor = $225 per unit
o Variable mfg. overhead = $75 per unit
o Variable selling expense = $40 per unit
• Fixed mfg. overhead = $1,200,000
• Fixed selling expense = $100,000
• Fixed administrative expense = $500,000
• Production = 5,000 units
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ClausenTube - Variable Cost per Unit for
5,000 Units
Variable production cost per unit for 5,000 units is calculated
as follows:
Total Material Costs $600 per unit
Total labor costs $225 per unit
Total variable OH $75 per unit
Variable Cost per Unit = $900 per unit

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ClausenTube - Full Cost per Unit for 5,000
Units

Full cost per unit for 5,000 units is calculated as follows:

Total variable costs 5,000 units * $900 per unit $4,500.000

Total fixed production costs $1,200,000
Total production costs $5,700,000
Full Cost per Unit $5,700,000 / 5,000 units = $1,140 per unit

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ClausenTube – Income Statement
Information
• Selling price = $2,000/unit
• Full cost = $1,140/unit
• Variable cost = $900/unit
• Variable selling expense = $40/unit
• Fixed overhead = $1,200,000
• Fixed selling expense = $100,000
• Fixed administrative expense= $500,000

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Full Costing Income Statement – Production
Equals Sales

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Variable Costing Income Statement –
Production Equals Sales

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Quantity Produced Equals Quantity Sold

• When the quantity produced equals the quantity sold,

there is no difference between net income calculated
using full cost versus variable costing
o Since all units produced are sold, no fixed cost ends up in
ending inventory
o The only difference is that variable costing calculates the
contribution margin

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Incremental Analysis – Contribution Margin
Ratio Part 1
• Contribution margin ratio can be helpful in planning and
decision making
o Suppose that ClausenTube is considering an advertising
campaign that will cost $100,000 and increase sales by
$200,000

Contributionmargin $5,300,000
= =0.53
Sales $10,000,000

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Incremental Analysis – Contribution Margin
Ratio part 2
• With this information, we can estimate that if sales
increase by $200,000, incremental profit will be $6,000
Increase in sales $200,000
Contribution margin ratio × 0.53
Increase in contribution margin 106,000
Less increased marketing costs 100,000
Increase in profit $ 6,000

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ClausenTube - Full Cost per Unit for 6,000
Units
• Full cost per unit for 6,000 units is calculated as follows:

Total variable costs 6,000 units * $900 per unit $5,400.000

Total fixed production costs $1,200,000
Total production costs $6,600,000
Full Cost per Unit $6,600,000 / 6,000 units = $1,100 per unit

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Full Costing Income Statement – Production
Greater than Sales

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Variable Costing Income Statement –
Production Greater than Sales

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Quantity Produced is Greater Than Quantity
Sold
• When the quantity produced is greater than the quantity
sold income will be greater under full costing as opposed
to variable costing
o Under full costing, inventory cost includes fixed
manufacturing overhead
o Under variable costing, fixed manufacturing overhead is a
period cost

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Link to Practice - Automakers

Link to Practice
Automakers Overproduce to Meet Short-Term Profit Goals
Accounting researchers find that Big Three automakers (Ford, General Motors
and Chrysler) overproduced relative to demand in order to lower unit costs and
hit short-term performance goals that focus on unit cost and profit. This problem
is a direct result of absorption accounting. With absorption costing, fixed costs
are "buried" in the excess inventory. If variable costing was used, the cost per
unit (which only includes variable costs) wouldn't change with changes in
production.
Source: Marielle Segarra, "Why the Big Three Put Too Many Cars on the Lot,"
CFO.com(February 2, 2012).
http://www.cfo.com/management-accounting/2012/02/why-the-big-three-put-
too-many-cars-on-the-lot/

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ClausenTube - Full Cost per Unit for 6,000
Units (Repeat of 5-23)

Total variable costs 6,000 units * $900 per unit $5,400.000

Total fixed production costs $1,200,000
Total production costs $6,600,000
Full Cost per Unit $6,600,000 / 6,000 units = $1,100 per unit

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Full Costing Income Statement – Production
Less than Sales

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Variable Costing Income Statement –
Production Less than Sales

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Quantity Produced is Less Than Quantity
Sold
• When the quantity produced is less than the quantity sold,
income will be greater under variable costing as opposed
to full costing
o Beginning inventory under fixed costing includes fixed
manufacturing overhead
o When the beginning inventory is charged to cost of goods
sold the charge will be higher under full costing

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Variable Costing for External Reporting

Any Questions?
Q: If variable costing is so great for internal reporting purposes, why isn't it used for
external reporting purposes? Don't external users want useful information?
A: Generally accepted accounting principles (GAAP) imply that variable costing is not
acceptable for external reporting purposes. Since it's not allowed, it isn't used! But that
leads one to wonder why this is the case. Shouldn't GAAP be formulated to provide useful
information? Perhaps a better answer is that company managers may be concerned that
variable cost information will prove helpful to competitors who, with the variable cost
information, will have better insight into a rival company's cost structure. Another reason
is that separating costs into fixed and variable components may be quite subjective. As we
saw in Chapter 4, the most common way of classifying costs as fixed and variable is
account analysis. In that method, costs are simply classified using management's
subjective judgment.

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Test Your Knowledge 2

Summit Manufacturing, Inc. produces snow shovels. The selling

price is $25. Costs are:
Materials  4
Labor  3
Variable overhead  2
Fixed overhead 168,000
Variable selling & admin 1
Fixed selling & sdmin  152,000
Full cost per unit  

Production is 42,000 snow shovels. Calculate full cost per unit.

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Test Your Knowledge 2 Answer

Summit Manufacturing, Inc. produces snow shovels. The selling

price is $25. Costs are:
Full Cost
Materials 4 4
Labor 3 3
Variable overhead 2 2
Fixed overhead 168,000 168,000 / 42,000 4
Variable selling & admin 1
Fixed selling & sdmin 152,000
Full cost per unit   13

Production is 42,000 snow shovels. Full cost is $13 per unit.

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Test Your Knowledge 3

Summit Manufacturing, Inc. produces snow shovels. The selling

price is $25. Costs are:

Materials 4
Labor 3
Variable overhead 2
Fixed overhead 168,000
Variable selling & admin 1
Fixed selling & sdmin 152,000
Full cost per unit  

Production is 42,000 snow shovels. Calculate variable cost per unit.

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Test Your Knowledge 3 Answer

Summit Manufacturing, Inc. produces snow shovels. The selling

price is $25. Costs are:

Variable Cost
Materials 4 4
Labor 3 3
Variable overhead 2 2
Fixed overhead 168,000
Variable selling & admin 1
Fixed selling & sdmin 152,000
Variable cost per unit   9

Production is 42,000 snow shovels. Variable cost is $9 per unit.

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Impact of Method Selection on Income
Statement

Condition Result
Units produced equal units sold No difference in income
Units produced exceed units sold Full costing yields higher income
Units produced are less than units sold Variable costing yields higher income

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Reducing Production

Link to Practice
Cuts in Production at John Deere Likely to Hurt Profit Margin
In 2015, Deere expected poor financial performance due to a decline in crop prices.
Indeed, the company forecasted a 20% decline in agriculture and turf equipment sales,
This, in turn, led to cutting production to match demand. What would be the impact of
the production cut on Deere's profit margin (the ratio of gross profit to sales)? Deere has
large fixed costs and when production decreases, the cost per unit increases. The end
result is a decline in the profit margin.
Source: Trefis Team, "Why 2015 Might Not Be A Good Year For Deere." Forbes (January 2,
2015). https://www.forbes.com/sites/greatspeculations/2015/01/02/why-2015-might-
not-be-a-good-year-for-deere/#6e001a373bb3

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Test Your Knowledge 4

Kincade Faucets produces a variety of faucets. During the year, the

company incurred $400,000 of depreciation expense on its
manufacturing equipment. How much depreciation expense will
be in Finished Goods Inventory under variable costing?
a. $400,000
b. $285,714
c. $0←
d. None of the above
Answer:
c. Depreciation is a fixed cost which is expensed as a period cost
under variable costing.
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Impact of JIT on Income

• Companies using JIT typically have low levels of inventory

• Units produced are approximately equal to units sold
• Difference between full costing and variable costing is
likely to be very small.

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Benefits of Variable Costing for Internal Reporting
(1 of 2)

• Variable costing facilitates cost-volume-profit (CVP)

analysis
o Separates fixed and variable costs
o Allows managers to accurately estimate the impact of
changes in volume on cost and profit
o Impact of changes on cost and profit cannot be answered
using full costing

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Benefits of Variable Costing for Internal Reporting
(2 of 2)

• Variable costing limits management of earnings via

production volume
o Managers are often compensated based on income in their
division
o Full costing produces higher income when production is
greater than sales
o Managers have an incentive to manage earnings under full
costing

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Data Analytics in Action

Data Analytics in Action

Data Analytics with Incorrect Data Leads to Bad Decisions
Suppose a team of data analysts didn't understand that the cost per unit of a
manufactured product was the full cost of the product (including large allocations of fixed
costs) rather than the incremental cost. This could easily be the case if the team members
never studied managerial accounting! Now suppose they analyze the gross margin
(revenue less cost of sales) for each of their company's 15,000 customers and determine
that 10 percent have slightly negative gross margins. They then recommend that these
customers be "fired."
What would be the impact on the overall profitability of the company? Profit would
actually decrease because the sales to the "fired" customers generated positive
contribution margins. This would be obvious if the analysts had calculated revenue less
variable cost of sales for each customer. The lesson here is that if data analysts don't
understand the data they are using, their reports and recommendations can actually hurt
profitability.

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Impact of Changes in Sales on Profit

Decision-Making Insight
A variable costing income statement facilitates decision
making by breaking out the total contribution margin. If we
divide the contribution margin by sales, we have the
contribution margin ratio, and we can use it to analyze the
impact of changes in sales on profit. Since many decisions
affect sales, being able to estimate the impact of changes in
sales on profit greatly facilitates decision making.

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Copyright

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Copyright ©2020 John Wiley & Sons, Inc. 47