Variable Costing: A Tool for Management

1. Chapter 6 Variable Costing:A Tool for Management

2. ProductCosts Direct Materials ProductCosts Direct Labor Variable Manufacturing Overhead Fixed Manufacturing Overhead PeriodCosts PeriodCosts Variable Selling and Administrative Expenses Fixed Selling and Administrative Expenses Overview of Absorption and Variable Costing AbsorptionCosting VariableCosting

3. Unit Cost Computations Harvey Company produces a single productwith the following information available:

4. 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.

5. Income Comparison ofAbsorption and Variable Costing Let’s assume the following additional information for Harvey Company. • 20,000 units were sold during the year at a priceof $30 each. • There is no beginning inventory. Now, let’s compute net operatingincome using both absorptionand variable costing.

6. Absorption Costing Fixed manufacturing overhead deferred in inventory is 5,000 units × $6 = $30,000.

7. Variablemanufacturing costs only. All fixedmanufacturingoverhead isexpensed. Variable Costing

8. Fixed mfg. overhead $150,000 Units produced 25,000 units = = $6 per unit Comparing the Two Methods We can reconcile the difference betweenabsorption and variable income as follows:

9. Extended Comparisons of Income Data Harvey Company – Year Two

10. 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.

11. Unit product cost. Absorption Costing Fixed manufacturing overhead released from inventory is 5,000 units × $6 = $30,000.

12. Variablemanufacturing costs only. All fixedmanufacturingoverhead isexpensed. Variable Costing

13. Fixed mfg. overhead $150,000 Units produced 25,000 units = = $6 per unit Comparing the Two Methods We can reconcile the difference betweenabsorption and variable income as follows:

14. Comparing the Two Methods

15. Summary of Key Insights

16. Absorption Costing vs Variable Costing • Absorption costing (also called full costing) – CGS includes DM, DL, VOH, and FOH for those units sold (CGS absorbs all manufacturing costs) • Absorption costing I/S (Required by GAAP, IRS for external reporting Sales Revenue - CGS (DM + DL+FOH+VOH) Gross Margin - Mktg & Admin Exp(including variable and fixed) Net income

17. Variable Costing • Variable costing (also called direct costing) – CGS includes DM, DL, and VOH for those units sold (CGS includes only variable manufacturing costs) • Variable costing I/S Sales revenue - VC CGS (DM, DL, VOH) - VC Mktg & Admin Contribution Margin - FC Mfg (FOH) - FC Mktg & Admin Net income or operating profit

18. Advantages and disadvantages of AC vs VC: Impact on the Manager Opponents of absorption costing argue thatshifting fixed manufacturing overhead costsbetween periods can lead to faulty decisions. These opponents argue that variable costing incomestatements are easier to understand because net operatingincome is only affected by changes in unit sales. Thisproduces net operating income figures that areconsistent with managers’ expectations.

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

20. Since top executivesare typically evaluated based on earnings reported to shareholdersin external reports, they may feel that decisions should be based on absorption costing data. Benefits of Absorption Costing: External Reporting and Income Taxes To conform toGAAP requirements,absorption costing must be used forexternal financial reports in the United States. Under the TaxReform Act of 1986,absorption costing must beused when filling out income tax returns.

21. Consistent with CVP analysis. Management findsit more useful. Net operating income is closer tonet cash flow. Consistent with standardcosts and flexible budgeting. Easier to estimate profitabilityof products and segments. Impact of fixed costs on profits emphasized. Profit is not affected bychanges in inventories. Advantages of Variable Costingand the Contribution Approach Advantages

22. Fixed manufacturingcosts must be assignedto products to properlymatch revenues andcosts. Fixed manufacturing costs are capacity costsand will be incurredeven if nothing isproduced. VariableCosting AbsorptionCosting Variable versus Absorption Costing

23. Impact of Lean Production When companies use Lean Production . . . Productiontends to equalsales . . . So, the difference between variable and absorption income tends to disappear.

24. 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.

25. Example: Profit under variable costing vs Absorption costing DM=$3/unit, DL = $5/unit, VOH = $2/unit, FOH = $50 /year, Variable mktg = $2/unit, Fixed mktg =$10/year, Selling price = $20/unit 20A20B20C Units produced 10 10 10 Units sold 10 9 11 Under variable costing: 20A(P=S) 20B(P>S) 20C(P<S) Sales $200 $180 $220 -VC 120 108 _____ CM 80 72 ______ -FC 60 60 ______ NI 20 12 ______ Under absorption costing: Sales $200 $180 $220 -CGS 150 135 ______ GM 50 45 ______ -Mktg 30 28 ______ NI 20 17 ______ Summary: 20A20B20C When P=S P>S P<S Then NIAC= NIVC NIAC> NIVC NIAC< NIVC The difference of NI between VC and AC is due to FOH ;Under VC: All FOH is expensed regardless of sales Under AC: Allocate FOH between units sold (CGS) and units on hand (INV)

26. End of Chapter 6