Variable Costing: A Tool for Management

1. Variable Costing: A Tool for Management

2. Absorption Costing • Treats all manufacturing costs as product costs, and non-manufacturing costs as period costs • Unit costs consist of direct material and direct labor and both variable and fixed manufacturing overhead. • Fixed manufacturing overhead is allocated to each unit of production • GAAP

3. Variable Costing • Only those costs of manufacturing that vary with output (variable costs) are treated as product costs • This would include direct material, direct labor and variable manufacturing overhead • Fixed manufacturing overhead is expensed during the current period • Variable costing is used for internal planning and control only; it’s not GAAP!

4. The only cost of driving my caron a 200 mile trip today is$12 for gasoline. VariableCosting Overview of Absorption and Variable(Marginal) Costing

5. AbsorptionCosting Overview of Absorption and Variable Costing No! You must consider these costs too!

6. You are wrong. I have the carpayment and theinsurance payment even ifI do not make the trip. VariableCosting Overview of Absorption and Variable (Marginal) Costing

7. Overview of Absorption and Variable Costing Who’s right? How should we treat the carpayment and the insurance?

8. Marginal Costing • Provides a useful tool for evaluating marginal business propositions

9. 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

10. Raw Materials Work in Process Absorption costing Cost of GoodsSold FinishedGoods Variable costing Fixed Mfr’g OH Selling andAdministrative Note: Manufacturing Cost Flows Balance SheetCosts Inventories Income StatementExpenses Material Purchases Direct Labor VariableManufacturing Overhead FixedManufacturing Overhead Selling andAdministrative Period Costs

11. 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. . .

12. 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. . .

13. 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 ...

14. Assets = Liabilities + Owners’ Equity   Quick Check  Which method will produce the highest retained earnings? (Hint: Remember the balance sheet equation.) a. Absorption costing, because some fixed costs stay in inventory until the product is sold b. Variable costing c. There would be no difference in retained earnings under the two methods. d. It depends ...

15. Overview of Absorption and Variable Costing Let’s put some numbers to theissue and see if it willsharpen our understanding.

16. Unit Cost Computations Harvey Co. produces a single product with the following information available:

17. Unit Cost Computations Unit product cost is determined as follows: Selling and administrative expenses arealways treated as period expenses and deducted from revenue.

18. Income Comparison of Absorption and Variable Costing Harvey Co. had no beginning inventory, produced25,000 units and sold 20,000 units this year.

19. Income Comparison of Absorption and Variable Costing Harvey Co. had no beginning inventory, produced 25,000 units and sold 20,000 units this year.

20. Variablecostsonly. All fixedmanufacturingoverhead isexpensed. Income Comparison of Absorption and Variable Costing Now let’s look at variable costing by Harvey Co.

21. 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.

22. 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.

23. Income Comparison of Absorption and Variable Costing Let’s compare the methods.

24. 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:

25. Let’s look at the second year of operations for Harvey Company. Extending the Example

26. 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.

27. Harvey Co. Year 2 Unit product cost is determined as follows: No change in Harvey’s cost structure.

28. These are the 25,000 units produced in the current period. Harvey Co. Year 2

29. Variablecostsonly. All fixedmanufacturingoverhead isexpensed. Harvey Co. Year 2

30. 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:

31. Summary

32. Comparative Income EffectsExhibit 7-4 • Production = Sales No change in inventory; income the same for both absorption and variable costing • Production > Sales Inventories increase; Absorption Income higher than Variable Cost income due to more fixed cost retained in inventory • Production < Sales Inventories decrease; Absorption Income lower than Variable Cost income as more fixed costs are released from inventory

33. Consistent with CVP analysis. Management finds it easy to understand. Can be used for marginal Cost analysis. Easier to estimate profitabilityof products and segments. Impact of fixed costs on profits emphasized. Profit is not affected bychanges in inventories. Advantages of the Variable Cost Approach Advantages

34. All manufacturingcosts must be assignedto products to properlymatch revenues andcosts. Fixed costs arenot really the costsof any particularproduct. VariableCosting AbsorptionCosting Variable versusAbsorption Costing

35. 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

36. They are the numbers that appear on our external reports. VariableCosting AbsorptionCosting Variable versus Absorption costing Absorption costing product costs are misleading for decision making.

37. End of Chapter