Chapter 7

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

Variable
Costing

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 Overview of Absorption and
Variable Costing
No! You must consider these costs too!
Cost Per month Per day
Car payment $ 300.00 $ 10.00
Insurance 60.00 2.00

Absorption
Costing

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 Overview of Absorption and
Variable Costing
You are wrong. I have the car
payment and the
insurance payment even if
I do not make the trip.

Variable
Costing

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

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 Overview of Absorption and
Variable Costing
Absorption Variable
Costing Costing
Direct Materials
Product
Product Direct Labor
Costs
Costs Variable Manufacturing Overhead

Fixed Manufacturing Overhead

Period
Period Variable Selling and Administrative Expenses
Costs
Costs Fixed Selling and Administrative Expenses

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 Note: Manufacturing Cost
Flows
Balance Sheet Income
Costs Inventories Statement
Material Purchases Raw Materials Expenses

Direct Labor
Work in
Variable Process
Manufacturing
Overhead
Cost of
Fixed Finished
Goods
Manufacturing Goods
Overhead Sold

Selling and Selling and

Administrative Period Costs Administrative
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 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. . .

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 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. . .

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 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 ...

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 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
 

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 Note: Manufacturing Cost
Flows

Absorption Costing Balance Sheet

150 Fixed
manufacturing
100 overhead in
inventories
50
Variable
0 costing
Inventory Retained
Earnings

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 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 ...

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 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 ...

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 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.

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 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.

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 Overview of Absorption and
Variable Costing
Let’s put some numbers to the
issue and see if it will
sharpen our understanding.

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 Unit Cost Computations

Harvey Co. produces a single product with

the following information available:

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 Unit Cost Computations

Unit product cost is determined as follows:

Selling and administrative expenses are

always treated as period expenses and
deducted from revenue.
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 Income Comparison of
Absorption and Variable Costing
Harvey Co. had no beginning inventory, produced
25,000 units and sold 20,000 units this year.
Absorption Costing
Sales (20,000 × $30) $ 600,000
Less cost of goods sold:
Beginning inventory $ -
Add COGM (25,000 × $16) 400,000
Goods available for sale 400,000
Ending inventory (5,000 × $16) 80,000 320,000
Gross margin 280,000
Less selling & admin. exp.
Variable
Fixed
Net operating income

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 Income Comparison of
Absorption and Variable Costing
Harvey Co. had no beginning inventory, produced
25,000 units and sold 20,000 units this year.
Absorption Costing
Sales (20,000 × $30) $ 600,000
Less cost of goods sold:
Beginning inventory $ -
Add COGM (25,000 × $16) 400,000
Goods available for sale 400,000
Ending inventory (5,000 × $16) 80,000 320,000
Gross margin 280,000
Less selling & admin. exp.
Variable (20,000 × $3) $ 60,000
Fixed 100,000 160,000
Net operating income $ 120,000

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 Income Comparison of
Absorption and Variable Costing
Now let’s look at variable costing by Harvey Co.
Variable
Variable Costing
costs
Sales (20,000 × $30) $ 600,000
Less variable expenses: only.
Beginning inventory $ - All fixed
Add COGM (25,000 × $10) 250,000 manufacturing
Goods available for sale 250,000
overhead is
Less ending inventory (5,000 × $10) 50,000
Variable cost of goods sold 200,000 expensed.
Variable selling & administrative
expenses (20,000 × $3) 60,000 260,000
Contribution margin 340,000
Less fixed expenses:
Manufacturing overhead $ 150,000
Selling & administrative expenses 100,000 250,000
Net operating income $ 90,000
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 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.
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 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.
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 Income Comparison of
Absorption and Variable Costing
Let’s compare the methods.

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 Reconciliation
We can reconcile the difference between
absorption and variable income as follows:

Variable costing net operating income $ 90,000

Add: Fixed mfg. overhead costs
deferred in inventory
(5,000 units × $6 per unit) 30,000
Absorption costing net opearting income $ 120,000

Fixed mfg. overhead $150,000

= = $6.00 per unit
Units produced 25,000 units
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 Extending the Example
Let’s look at the
second year
of operations
for Harvey
Company.

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 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.

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 Harvey Co. Year 2

Unit product cost is determined as follows:

No change in Harvey’s
cost structure.
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 Harvey Co. Year 2

Now let’s look at Harvey’s income statement

assuming absorption costing is used.

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 Harvey Co. Year 2
Absorption Costing
Sales (30,000 × $30) $ 900,000
Less cost of goods sold:
Beg. inventory (5,000 × $16) $ 80,000
Add COGM (25,000 × $16) 400,000
Goods available for sale 480,000
Less ending inventory - 480,000
Gross margin 420,000
Less selling & admin. exp.
Variable (30,000 × $3) $ 90,000
Fixed 100,000 190,000
Net operating income $ 230,000

These are the 25,000 units

produced in the current period.
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 Harvey Co. Year 2

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

assuming is used.

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 Harvey Co. Year 2
Variable
costs
only.

All fixed
manufacturing
overhead is
expensed.

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 Reconciliation
We can reconcile the difference between
absorption and variable income as follows:

Variable costing net operating income $ 260,000

Deduct: Fixed manufacturing overhead
costs released from inventory
(5,000 units × $6 per unit) 30,000
Absorption costing net operating income $ 230,000

Fixed mfg. overhead $150,000

= = $6.00 per unit
Units produced 25,000 units

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 Summary

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 Summary

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 Advantages of the
Contribution Approach
Consistent with
CVP analysis.
Management finds it Net operating income
easy to understand. is closer to
net cash flow.
Consistent with standard
costs and flexible budgeting.
Advantages
Easier to estimate profitability
of products and segments.
Impact of fixed
costs on profits Profit is not affected by
emphasized. changes in inventories.
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 Variable versus
Absorption Costing
All manufacturing Fixed costs are
costs must be assigned
not really the costs
to products to properly
match revenues and of any particular
costs. product.

Absorption Variable
Costing Costing
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 Variable versus
Absorption Costing
Depreciation,
taxes, insurance and These are capacity
salaries are just as costs and will be
essential to products incurred even if nothing
as variable costs. is produced.

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

Variable Absorption
Costing Costing

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 Note on the
Absorption Costing
Effects ofsoldVolume
Cost of goods decreases because production
exceeds sales, leaving a portion of fixed
manufacturing costs in inventory.
Variable cost $10
Fixed manufacturing overhead $100,000
Units sold 10,000

Fixed Total Average

Units Total Variable Manufacturing Manufacturing Manufacturing Cost of
Produced Cost Overhead Cost Cost Goods Sold
10,000 $100,000 $100,000 $200,000 $ 20.00 $ 200,000
12,000 $120,000 $100,000 $220,000 $ 18.33 $ 183,333
14,000 $140,000 $100,000 $240,000 $ 17.14 $ 171,429
16,000 $160,000 $100,000 $260,000 $ 16.25 $ 162,500
18,000 $180,000 $100,000 $280,000 $ 15.56 $ 155,556
20,000 $200,000 $100,000 $300,000 $ 15.00 $ 150,000
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 Note on the Costing
Absorption
Cost of goods sold decreases because production
Effects
exceedsof Volume
sales, leaving a portion of fixed
manufacturing costs in inventory.
COGS for 10,000 units

$200,000
COGS

$150,000

$100,000
00

00

00

00

00

00

00
,0

,0

,0

,0

,0

,0

,0
10

14

18

22

26

30

34
Number of units produced

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 Impact of JIT Inventory
Methods

In a JIT inventory system . . .

Production
tends to equal
sales . . .

So, the difference between variable and

absorption income tends to disappear.

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 End of Chapter 7

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