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Chapter 7. Variable Costing: A Tool for Management. The only cost of driving my car on a 200 mile trip today is $12 for gasoline. Variable Costing. Overview of Absorption and Variable Costing. Absorption Costing. Overview of Absorption and Variable Costing.

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overview of absorption and variable costing5
Overview of Absorption and Variable Costing

Who’s right?

How should we treat the carpayment and the insurance?

overview of absorption and variable costing6

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

note manufacturing cost flows

Raw Materials

Work in Process

Absorption costing

Cost of GoodsSold

FinishedGoods

Variable costing

Selling andAdministrative

Note: Manufacturing Cost Flows

Balance SheetCosts Inventories

Income StatementExpenses

Material Purchases

Direct Labor

VariableManufacturing Overhead

FixedManufacturing Overhead

Selling andAdministrative

Period Costs

quick check
Quick Check 

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 check9
Quick Check 

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 check10
Quick Check 

Which method will produce the highest retained earnings? (Hint: Remember the balance sheet equation.)

a. Absorption costing

b. Variable costing

c. There would be no difference in retained earnings under the two methods.

d. It depends ...

quick check11

Assets = Liabilities + Owners’ Equity

 

Quick Check 

Which method will produce the highest retained earnings? (Hint: Remember the balance sheet equation.)

a. Absorption costing

b. Variable costing

c. There would be no difference in retained earnings under the two methods.

d. It depends ...

quick check13
Quick Check 

Which method will produce the highest cumulative net operating income?

a. Absorption costing

b. Variable costing

c. There would be no difference in cumulative net operating income under the two methods.

d. It depends ...

quick check14
Quick Check 

Which method will produce the highest cumulative net operating income?

a. Absorption costing

b. Variable costing

c. There would be no difference in cumulative net operating income under the two methods.

d. It depends ...

quick check15
Quick Check 

If the Internal Revenue Service lets you use either absorption or variable costing, which method should you choose to minimize your taxes? (Assume that once you have decided which method to use, you cannot later change.)

a. Absorption costing.

b. Variable costing.

c. The two methods would have the same effect on taxes.

quick check16
Quick Check 

If the Internal Revenue Service lets you use either absorption or variable costing, which method should you choose to minimize your taxes? (Assume that once you have decided which method to use, you cannot later change.)

a. Absorption costing.

b. Variable costing.

c. The two methods would have the same effect on taxes.

overview of absorption and variable costing17
Overview of Absorption and Variable Costing

Let’s put some numbers to theissue and see if it willsharpen our understanding.

unit cost computations
Unit Cost Computations

Harvey Co. produces a single product with the following information available:

unit cost computations19
Unit Cost Computations

Unit product cost is determined as follows:

Selling and administrative expenses arealways treated as period expenses and deducted from revenue.

income comparison of absorption and variable costing
Income Comparison of Absorption and Variable Costing

Harvey Co. had no beginning inventory, produced25,000 units and sold 20,000 units this year.

income comparison of absorption and variable costing21
Income Comparison of Absorption and Variable Costing

Harvey Co. had no beginning inventory, produced 25,000 units and sold 20,000 units this year.

income comparison of absorption and variable costing22

Variablecostsonly.

All fixedmanufacturingoverhead isexpensed.

Income Comparison of Absorption and Variable Costing

Now let’s look at variable costing by Harvey Co.

quick check23
Quick Check 

The net operating income under absorption costing was $120,000 and under variable costing it was $90,000 because of higher expenses. Where is the missing $30,000 under absorption costing?

a. It has disappeared into an accounting black hole.

b. It is in ending inventories.

c. It represents taxes that have been saved.

d. The $30,000 wasn’t a real cost, so nothing is really missing.

quick check24
Quick Check 

The net operating income under absorption costing was $120,000 and under variable costing it was $90,000 because of higher expenses. Where is the missing $30,000 under absorption costing?

a. It has disappeared into an accounting black hole.

b. It is in ending inventories.

c. It represents taxes that have been saved.

d. The $30,000 wasn’t a real cost, so nothing is really missing.

reconciliation

Fixed mfg. overhead $150,000

Units produced 25,000 units

= = $6.00 per unit

Reconciliation

We can reconcile the difference betweenabsorption and variable income as follows:

extending the example

Let’s look at the

second year

of operations

for Harvey

Company.

Extending the Example
harvey co year 2
Harvey Co. Year 2

In its second year of operations, Harvey Co. started with an inventory of 5,000 units, produced 25,000 units and sold 30,000 units.

harvey co year 229
Harvey Co. Year 2

Unit product cost is determined as follows:

No change in Harvey’s

cost structure.

harvey co year 230
Harvey Co. Year 2

Now let’s look at Harvey’s income statement

assuming absorption costingis used.

harvey co year 231

These are the 25,000 units

produced in the current period.

Harvey Co. Year 2
harvey co year 232
Harvey Co. Year 2

Next, we’ll look at Harvey’s income statement

assuming is used.

Variable costing

harvey co year 233

Variablecostsonly.

All fixedmanufacturingoverhead isexpensed.

Harvey Co. Year 2
reconciliation34

Fixed mfg. overhead $150,000

Units produced 25,000 units

= = $6.00 per unit

Reconciliation

We can reconcile the difference betweenabsorption and variable income as follows:

advantages of the contribution approach

Consistent with

CVP analysis.

Management finds it

easy to understand.

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 the Contribution Approach

Advantages

variable versus absorption costing

All manufacturingcosts must be assignedto products to properlymatch revenues andcosts.

Fixed costs arenot really the costsof any particularproduct.

VariableCosting

AbsorptionCosting

Variable versusAbsorption Costing
variable versus absorption costing39

These are capacitycosts and will beincurred even if nothingis produced.

Depreciation,taxes, insurance andsalaries are just asessential to productsas variable costs.

VariableCosting

AbsorptionCosting

Variable versusAbsorption Costing
variable versus absorption costing40

They are the numbers that appear on our external reports.

VariableCosting

AbsorptionCosting

Variable versusAbsorption Costing

Absorption

costing product costs

are misleading for

decision making.

note on the effects of volume
Note on theEffects of Volume

Absorption CostingCost of goods sold decreases because production exceeds sales, leaving a portion of fixedmanufacturing costs in inventory.

note on the effects of volume42
Note on theEffects of Volume

Absorption CostingCost of goods sold decreases because production exceeds sales, leaving a portion of fixedmanufacturing costs in inventory.

impact of jit inventory methods
Impact of JIT Inventory Methods

In a JIT inventory system . . .

Productiontends to equalsales . . .

So, the difference between variable and

absorption income tends to disappear.