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CHAPTER 7 VARIABLE COSTING: A DECISION-MAKING PROCESS

CHAPTER 7 VARIABLE COSTING: A DECISION-MAKING PROCESS. Explain the difference between absorption costing and variable costing. Discuss the effect that changes in production level and sales level have on net income measured under absorption costing versus variable costing.

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CHAPTER 7 VARIABLE COSTING: A DECISION-MAKING PROCESS

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  1. CHAPTER 7 VARIABLE COSTING: A DECISION-MAKING PROCESS • Explain the difference between absorption costing and variable costing. • Discuss the effect that changes in production level and sales level have on net income measured under absorption costing versus variable costing. Study Objectives

  2. Study Objectives: Continued Discuss the relative merits of absorption costing versus variable costing for management decision making. Explain the term sales mix and its effect on break-even sales.

  3. ABSORPTION COSTING VERSUS VARIABLE COSTINGStudy Objective 1 • Full or Absorption Costing • Assigns all variable and fixed manufacturing costs to the product • Required for external reporting • Variable Costing • Assigns only variable manufacturing costs to the product • Direct material, direct labor, variable manufacturing overhead

  4. ABSORPTION COSTING VERSUS VARIABLE COSTINGCOMPARISON Primary Difference Under variable costing, fixed manufacturing overhead is an expense in the current period.

  5. ABSORPTION COSTING VERSUS VARIABLE COSTINGCOMPARISON - Continued • Variable costing does not defer fixed manufacturing overhead to the future - i.e., they are not inventoried • Net income under absorption costing compared to net income under variable costing: • Higher when units produced exceed units sold • Lower when units produced are less than units sold • Equal when units produced and sold are the same: • There is no ending inventory so fixed costs are not deferred into the future

  6. ABSORPTION COSTING VERSUS VARIABLE COSTING Example – Premium Products • Manufactures Fix-it, a sealant for car windows • Relevant data for the first month of production:

  7. ABSORPTION COSTING VERSUS VARIABLE COSTING Example - Continued • Per unit manufacturing cost under each approach: • Manufacturing costs are $4 ($13 - $9) higher for absorption costing because fixed manufacturing costs are product costs.

  8. ABSORPTION COSTING VERSUS VARIABLE COSTINGAbsorption Costing Income Statement

  9. ABSORPTION COSTING VERSUS VARIABLE COSTINGVariable Costing Income Statement

  10. ABSORPTION vs VARIABLE COSTING Extended Example – Overbay Inc – Basic DataStudy Objective 2 Manufacturing cost per airplane drone $300,000 : $240,000 variable and $60,000 fixed Selling and administrative costs $130,000: $50,000 variable and $80,000 fixed

  11. ABSORPTION vs VARIABLE COSTING Extended Example – Overbay Inc – Continued Absorption Costing Income Statement - 2005 Net Income under Absorption Costing: $870,000

  12. ABSORPTION vs VARIABLE COSTING Extended Example – Overbay Inc – Continued Variable Costing Income Statement • Follows CVP format • Manufacturing costs include only the variable manufacturing costs - $240,000 in 2005 • Expense all fixed manufacturing cost - $600,000 in 2005 • Reports same net income in 2005 as the Absorption Costing Income Statement

  13. ABSORPTION vs VARIABLE COSTING Extended Example – Overbay Inc – Continued Variable Costing Income Statement - 2005 Net Income under Variable Costing: $870,000

  14. ABSORPTION vs VARIABLE COSTING Extended Example – Overbay Inc – Continued • 10 drones produced; 8 drones sold; 2 drones in ending inventory • Each unit in ending inventory includes $60,000 of fixed manufacturing overhead • $120,000 ($60,000 X 2) of fixed manufacturing costs are deferred until a future period Absorption Costing - 2006

  15. ABSORPTION vs VARIABLE COSTING Extended Example – Overbay Inc – Continued Absorption Costing Income Statement - 2006 Net Income under Absorption Costing: $680,000

  16. ABSORPTION vs VARIABLE COSTING Extended Example – Overbay Inc – Continued Variable Costing Income Statement - 2006 Net Income under Variable Costing: $560,000

  17. ABSORPTION vs VARIABLE COSTING Extended Example – Overbay Inc – Continued 2006 Conclusions When units produced (10) exceeds units sold (8), net income under absorption costing ($680,000) is higher than net income under variable costing ($560,000). Why? Cost of ending inventory is higher under absorption costing than under variable costing.

  18. ABSORPTION vs VARIABLE COSTING Extended Example – Overbay Inc – Continued Absorption Costing - 2007 • 10 drones produced; 12 drones sold - 10 from current year production and 2 from inventory • Fixed manufacturing overhead of $ 720,000 expensed • $120,000 from 2006 and included in beginning inventory • $600,000 incurred in 2007 • When units produced (10) are less than units sold (12), net income under absorption costing is lessthan net income under variable costing by the amount of fixed manufacturing costs included in beginning inventory.

  19. ABSORPTION vs VARIABLE COSTING Extended Example – Overbay Inc – Continued Absorption Costing Income Statement - 2007 Net Income under Absorption Costing: $1,060,000

  20. ABSORPTION vs VARIABLE COSTING Extended Example – Overbay Inc – Continued Variable Costing Income Statement - 2007 Net Income under Variable Costing: $1,180,000

  21. ABSORPTION vs VARIABLE COSTING Extended Example – Overbay Inc – Continued Comparison of Net Income under the Two Approaches

  22. ABSORPTION vs VARIABLE COSTING Summary of Income Effects

  23. DECISION-MAKING CONCERNS • Generally Accepted Accounting Principles (GAAP) • Must be followed for external reporting • Requires absorption costing for inventory • Does not differentiate between fixed and variable costs • Poor business decisions may result • Thus, variable costing used for internal decision making

  24. DECISION-MAKING CONCERNS Example - Basic Data for Lighting Division Decision: Produce 20,000 or 30,000 units?

  25. DECISION-MAKING CONCERNSExample – Continued • At 20,000 units, net income is $85,000. • At 30,000 units, net income is $105,000 with 10,000 unit ending inventory. • Difference in income due to $20,000 fixed costs assigned to ending inventory. Comparative Absorption Costing Income Statements Based on these statements, should production be increased?

  26. DECISION-MAKING CONCERNSExample – Continued • At both levels, net income is $85,000. • Fixed costs treated as a period expense. • 10,000 units of ending inventory include only variable costs. Comparative Variable Costing Income Statements Based on these statements, should production be increased?

  27. ADVANTAGES OF VARIABLE COSTINGStudy Objective 3 • Consistent with CVP and incremental analysis • Net income unaffected by changes in production levels • Net income closely tied to changes in sales levels – not production levels • Easier to identify fixed and variable costs and their effect on company

  28. SALES MIXStudy Objective 4 • Companies often sell more than one product • Critical decision: what mix of products to sell • Relative percentage in which each product is sold when more than one product is sold • Important because different products have substantially different contribution margins

  29. SALES MIXBreak-Even Sales In Units Steps for a mix of two or more products: • Compute the weighted-average unit contribution margin of all the products: Product 1 Unit Contribution Margin X Percentage of Sales + Product 2 Unit Contribution Margin X Percentage of Sales = Weighted Average Unit Contribution Margin • Compute the break-even point in units: Fixed Costs÷Weighted Average = Break-even Unit Contribution Point Margin in Units

  30. SALES MIXBreak-Even Sales In Units Example – Vargo Video Basic Data • Sells both DVD players and TVs • Fixed costs of $200,000

  31. SALES MIX - Break-Even Sales In Units Example – Vargo Video Continued • Determine weighted-average unit contribution margin for the sales mix of 75 percent DVDs and 25 percent TVs: • Determine the break-even point in units:

  32. SALES MIX - Break-Even Sales In Units Example – Vargo Video (Continued) • Verify the number of DVDs and TVs to be sold to break even with a sales mix of 75 % DVDs and 25 % TVs and with fixed costs of $200,000:

  33. SALES MIXBreak-Even Sales In Units At any level of units sold, net income will be greater if more high contribution margin units are sold than low contribution margin units.

  34. SALES MIXBreak-Even Sales In Dollars Steps for a mix of many products in two or more product lines or divisions: • Compute the weighted-average unit contribution margin ratio of all product lines or divisions: Division 1 Contribution Margin Ratio X Percentage of Sales + Division 2 Contribution Margin Ratio X Percentage of Sales = Weighted Average Contribution Margin Ratio • Compute the break-even point in dollars: Fixed Costs÷Weighted Average = Break-even Contribution Point Margin Ratio in Dollars

  35. SALES MIXBreak-Even Sales In Dollars Example – Kale Garden Supply Co. Basic Data • Total fixed costs $300,000 • Two Product Divisions: Indoor Plants: Sales Mix Ratio 20% Contribution Margin Ratio 40% Outdoor Plants: Sales Mix Ratio 80% Contribution Margin Ratio 30%

  36. SALES MIX - Break-Even Sales In Dollars Example – Kale Garden Supply (Continued) • Determine weighted-average contribution margin ratio for all divisions: • Determine the break-even point in dollars:

  37. SALES MIX -Break-Even Sales In DollarsExample – Kale Garden Supply (Continued) • Using Kale’s sales mix of 20 percent and 80 percent, break-even sales from each division: • Indoor Plant Division: $187,500 (.20 X $937,500) • Outdoor Plant Division: $750,000 (.80 X $937,500)

  38. SALES MIX -Break-Even Sales In DollarsExample – Kale Garden Supply (Continued) • Break-even point affected by a shift in sales from one division to another • Shift sales to the Indoor Plant Division: • Division’s higher contribution margin ratio increases weighted average contribution margin ratio • Results in a lower break-even point in sales dollars • Shift sales to the Outdoor Plant Division: • Opposite effect occurs due to Division’s lower contribution margin ratio

  39. SALES MIX Understanding and managing sales mix is critical to company success

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