Variable Costing: A Tool for Management

1. Variable Costing:A Tool for Management

2. Beware of the Average Costs • Is the average cost a variable or fixed cost? • Recall that total costs include • fixed costs that do not change with volume • variable costs that do change with volume AC = TC / q = (VC + FC) / q = v + FC / q • Decisions based on average costs may be erroneous.

3. Example: Vortex Inc. • Vortec has contracted with customers to sell 100,000 units $5.00 per unit. • Its total cost with this contract is estimated to be $450,000, i.e., $4.50 per unit • Vortec has a new business opportunity to sell additional 2,000 units at $4 per unit. • In that case, the estimated average cost is $4.47 for the total 102,000 units. • The additional sales do not affect the current administrative expenses $27,500.

4. Example: Vortex Inc. • You are the owner of this company. • You are concerned about the price of the additional sales $4.00, which is lower than the average unit cost $4.47. • What will you do for this additional sales opportunity? • Provide an analysis guiding your decision of whether or not to sell the additional 2,000 units?

5. Example: Vortex Inc. Current Special Order • Units produced and sold 100,000102,000 Total Revenue and Costs: Sales ($5.00 regular, $ 500,000 $4.00 special) $508,000 Cost of sales ($4.50, $4.47) 450,000 455.940 Administrative expenses - 27,500 - 27,500 Net profit before taxes $ 22,500$ 24,560

6. Example: Vortex Inc. Alternatively, • Incremental revenue (2,000 units x $4.00) $8,000 • Incremental cost of 2,000 units • Total cost @ 102,000 units (102,000 x $4.47) 455,940 • Total cost @ 100,000 units (100,000 x $4.50) 450,0005,940 • Incremental profit of 2,000 units $2,060

7. Example: Vortex Inc. • Is the average cost of $4.47 useful information? • How much is the average cost per unit to produce the additional 2,000 units? • The incremental cost per unit of the 2000 units $(455,940 – 450,000) / 2000 = $5940 / 2000 = $2.97 < 4.47

8. Learning Objective 1 Explain how variable costing differs from absorption costing and compute unit product costs under each method.

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 Absorptionand Variable Costing AbsorptionCosting VariableCosting

10. 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. . .

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

13. Unit Cost Computations Unit product cost is determined as follows: Under absorption and variable costing, selling and administrative expenses arealways treated asperiod expensesand deducted from revenue as incurred.

14. Learning Objective 2 Prepare income statements using both variable and absorption costing.

15. 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 price of $30 each. • There were no units in beginning inventory. Now, let’s compute net operatingincome using both absorptionand variable costing.

16. Absorption Costing

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

18. Learning Objective 3 Reconcile variable costing and absorption costing net operating incomes and explain why the two amounts differ.

19. Comparing the Two Methods

20. Comparing the Two Methods We can reconcile the difference betweenabsorption and variable income as follows:

21. Extended Comparisons of Income Data Harvey Company Year Two

22. Unit Cost Computations Since there was no change in the variable costsper unit, total fixed costs, or the number ofunits produced, the unit costs remain unchanged.

23. These are 25,000 units produced in the current period. Absorption Costing

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

25. Fixed mfg. Overhead $150,000 Units produced 25,000 units = = $6.00 per unit Comparing the Two Methods We can reconcile the difference betweenabsorption and variable income as follows:

26. Summary of Key Insights

27. Effect of Changes in Productionon Net Operating Income Let’s revise the Harvey Company example. In the previous example,25,000 units were produced each year,but sales increased from 20,000 units in yearone to 30,000 units in year two. In this revised example,production will differ each year whilesales will remain constant.

28. Effect of Changes in ProductionHarvey Company Year One

29. Since the number of units produced increasedin this example, while the fixed manufacturing overheadremained the same, the absorption unit cost is less. Unit Cost Computations for Year One Unit product cost is determined as follows:

30. Absorption Costing: Year One

31. Variablemanufacturing costs only. All fixedmanufacturingoverhead isexpensed. Variable Costing: Year One

32. Effect of Changes in ProductionHarvey Company Year Two

33. Since the number of units produced decreased in thesecond year, while the fixed manufacturing overheadremained the same, the absorption unit cost is now higher. Unit Cost Computations for Year Two Unit product cost is determined as follows:

34. These are the 20,000 units produced in the currentperiod at the higher unit cost of $17.50 each. Absorption Costing: Year Two

35. Variablemanufacturing costs only. All fixedmanufacturingoverhead isexpensed. Variable Costing: Year Two

36. Conclusions  Net operating income is not affected by changes in production using variable costing.  Net operating income is affected by changes in production using absorption costing even though the number of units sold is the same each year. Comparing the Two Methods

37. Learning Objective 4 Understand the advantages and disadvantages of both variable and absorption costing.

38. 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

39. 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 aremore consistent with managers’ expectations.

40. CVP Analysis, Decision Makingand Absorption costing Absorption costing does not support CVP analysis because it essentially treats fixed manufacturing overhead as if it isa variable cost by assigning a per unit amount of the fixed overhead to each unit of production. • Treating fixed manufacturing overhead as a variable cost can: • Lead to erroneous decisions. • Example: Vortec Inc. • Produce a positive net operating income even when the number of units sold is less than the breakeven point.

41. 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

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