Variable Costing: A Tool for Management

Chapter 7 Variable Costing: A Tool for Management

Absorption Costing • Treats all cost of production as product cost, whether fixed or variable. • Therefore cost of a unit of product include-DM, DL and both variable and fixed O/H. • Also referred as the Full Cost Method.

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

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

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

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

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

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  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 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 ...

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 ...

Note: Manufacturing Cost Flows

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

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

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

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

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

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.

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

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:

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

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

Harvey Co. Year 2 Now let’s look at Harvey’s income statement assuming absorption costingis used.

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

Harvey Co. Year 2 Next, we’ll look at Harvey’s income statement assuming is used. Variable costing

Variablecostsonly. All fixedmanufacturingoverhead isexpensed. Harvey Co. Year 2

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:

Summary

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

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

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

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 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 In a JIT inventory system . . . Productiontends to equalsales . . . So, the difference between variable and absorption income tends to disappear.

End of Chapter 7

Variable Costing: A Tool for Management