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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
Car payment
Insurance

Per month

Per day

$ 300.00

$ 10.00

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
Whos right?
How should we treat the car
payment and the insurance?

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Overview of Absorption and


Variable Costing
Absorption
Costing

Variable
Costing
Direct Materials

Product
Costs

Product
Costs

Direct Labor
Variable Manufacturing Overhead
Fixed Manufacturing Overhead

Period
Costs

Variable Selling and Administrative Expenses

Period
Costs

Fixed Selling and Administrative Expenses

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Note: Manufacturing Cost


Flows
Balance Sheet
Inventories

Costs
Material Purchases

Raw Materials

Direct Labor
Variable
Manufacturing
Overhead

s
b
A

Fixed
Manufacturing
Overhead

Selling and
Administrative
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o
c
on
i
t
orp

Income
Statement
Expenses

Work in
g Process
n
i
st
Finished
Goods

Variable
cos

ting

Period Costs

Cost of
Goods
Sold
Selling and
Administrative

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Quick Check
Which
Which method
method will
will produce
produce the
the highest
highest values
values
for
for work
work in
in process
process and
and finished
finished goods
goods
inventories?
inventories?
a.
a. Absorption
Absorption costing.
costing.
b.
b.
c.
c.

Variable
Variable costing.
costing.
They
They produce
produce the
the same
same values
values for
for these
these
inventories.
inventories.
d.
d. ItIt depends.
depends. .. ..

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Quick Check
Which
Which method
method will
will produce
produce the
the highest
highest values
values
for
for work
work in
in process
process and
and finished
finished goods
goods
inventories?
inventories?
a.
a. Absorption
Absorption costing.
costing.
b.
b.
c.
c.

Variable
Variable costing.
costing.
They
They produce
produce the
the same
same values
values for
for these
these
inventories.
inventories.
d.
d. ItIt depends.
depends. .. ..

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Quick Check
Which
Which method
method will
will produce
produce the
the highest
highest retained
retained
earnings?
earnings? (Hint:
(Hint: Remember
Remember the
the balance
balance sheet
sheet
equation.)
equation.)
a.
a. Absorption
Absorption costing
costing
b.
b.
c.
c.

Variable
Variable costing
costing
There
There would
would be
be no
no difference
difference in
in retained
retained
earnings
earnings under
under the
the two
two methods.
methods.
d.
d. ItIt depends
depends ...
...

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Quick Check
Which
Which method
method will
will produce
produce the
the highest
highest retained
retained
earnings?
earnings? (Hint:
(Hint: Remember
Remember the
the balance
balance sheet
sheet
equation.)
equation.)
a.
a. Absorption
Absorption costing
costing
b.
b.
c.
c.

Variable
Variable costing
costing
There
There would
would be
be no
no difference
difference in
in retained
retained
earnings
earnings under
under the
the two
two methods.
methods.
d.
Assets
d. ItIt depends
depends
...== Liabilities
Assets...
Liabilities ++ Owners
OwnersEquity
Equity

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Note: Manufacturing Cost


Flows
Absorption Costing Balance Sheet
Fixed
manufacturing
overhead in
inventories
Variable
costing

150
100
50
0
Inventory

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Retained
Earnings

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Quick Check
Which
Which method
method will
will produce
produce the
the highest
highest
cumulative
cumulative net
net operating
operating income?
income?
a.
a. Absorption
Absorption costing
costing
b.
b.
c.
c.

Variable
Variable costing
costing
There
There would
would be
be no
no difference
difference in
in
cumulative
cumulative net
net operating
operating income
income
under
under the
the two
two methods.
methods.
d.
d. ItIt depends
depends ...
...

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Quick Check
Which
Which method
method will
will produce
produce the
the highest
highest
cumulative
cumulative net
net operating
operating income?
income?
a.
a. Absorption
Absorption costing
costing
b.
b.
c.
c.

Variable
Variable costing
costing
There
There would
would be
be no
no difference
difference in
in
cumulative
cumulative net
net operating
operating income
income
under
under the
the two
two methods.
methods.
d.
d. ItIt depends
depends ...
...

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

Variable
Variable costing.
costing.
The
The two
two methods
methods would
would have
have the
the same
same
effect
effect on
on taxes.
taxes.

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

Variable
Variable costing.
costing.
The
The two
two methods
methods would
would have
have the
the same
same
effect
effect on
on taxes.
taxes.

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Overview of Absorption and


Variable Costing
Lets 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:
Number of units produced annually
Variable costs per unit:
Direct materials, direct labor,
and variable mfg. overhead
Selling & administrative expenses

$
$

Fixed costs per year:


Manufacturing overhead
Selling & administrative expenses

$ 150,000
$ 100,000

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25,000

10
3

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Unit Cost Computations


Unit product cost is determined as follows:
Direct materials, direct labor,
and variable mfg. overhead
Fixed mfg. overhead
($150,000 25,000 units)
Unit product cost

Absorption
Costing

Variable
Costing

10

10

6
16

10

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)
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
Gross margin
Less selling & admin. exp.
Variable
Fixed
Net operating income

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$ 600,000

320,000
280,000

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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)
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
Gross margin
Less selling & admin. exp.
Variable (20,000 $3)
$ 60,000
Fixed
100,000
Net operating income

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$ 600,000

320,000
280,000

160,000
$ 120,000

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Income Comparison of
Absorption and Variable Costing
Now lets look at variable costing by Harvey Co.
Variable
costs
only.

Variable Costing

Sales (20,000 $30)


Less variable expenses:
Beginning inventory
$
Add COGM (25,000 $10)
250,000
Goods available for sale
250,000
Less ending inventory (5,000 $10)
50,000
Variable cost of goods sold
200,000
Variable selling & administrative
expenses (20,000 $3)
60,000
Contribution margin
Less fixed expenses:
Manufacturing overhead
$ 150,000
Selling & administrative expenses 100,000
Net operating income
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$ 600,000

All fixed
manufacturing
overhead is
expensed.
260,000
340,000

250,000
$ 90,000

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Quick Check
The
The net
net operating
operating income
income under
under absorption
absorption
costing
costing was
was $120,000
$120,000 and
and under
under variable
variable
costing
costing itit was
was $90,000
$90,000 because
because of
of higher
higher
expenses.
expenses. Where
Where is
is the
the missing
missing $30,000
$30,000 under
under
absorption
absorption costing?
costing?
a.
a. ItIt has
has disappeared
disappeared into
into an
an accounting
accounting black
black
hole.
hole.
b.
b. ItIt is
is in
in ending
ending inventories.
inventories.
c.
c.
d.
d.

ItIt represents
represents taxes
taxes that
that have
have been
been saved.
saved.
The
The $30,000
$30,000 wasnt
wasnt aa real
real cost,
cost, so
so nothing
nothing
is
is really
really missing.
missing.

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Quick Check
The
The net
net operating
operating income
income under
under absorption
absorption
costing
costing was
was $120,000
$120,000 and
and under
under variable
variable
costing
costing itit was
was $90,000
$90,000 because
because of
of higher
higher
expenses.
expenses. Where
Where is
is the
the missing
missing $30,000
$30,000 under
under
absorption
absorption costing?
costing?
a.
a. ItIt has
has disappeared
disappeared into
into an
an accounting
accounting black
black
hole.
hole.
b.
b. ItIt is
is in
in ending
ending inventories.
inventories.
c.
c.
d.
d.

ItIt represents
represents taxes
taxes that
that have
have been
been saved.
saved.
The
The $30,000
$30,000 wasnt
wasnt aa real
real cost,
cost, so
so nothing
nothing
is
is really
really missing.
missing.

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Income Comparison of
Absorption and Variable Costing
Lets compare the methods.
Cost of
Goods
Sold

Ending
Inventory

Period
Expense

Absorption costing
Variable mfg. costs $ 200,000
Fixed mfg. costs
120,000
$ 320,000

$ 50,000
30,000
$ 80,000

Variable costing
Variable mfg. costs $ 200,000
Fixed mfg. costs
$ 200,000

$ 50,000
$ 50,000

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150,000
$ 150,000

Total
$ 250,000
150,000
$ 400,000

$ 250,000
150,000
$ 400,000

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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


Lets 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.
Number of units produced annually
Variable costs per unit:
Direct materials, direct labor
variable mfg. overhead
Selling & administrative
expenses
Fixed costs per year:
Manufacturing overhead
Selling & administrative
expenses
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25,000

10

$ 150,000
$ 100,000

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Harvey Co. Year 2


Unit product cost is determined as follows:

Direct materials, direct labor,


and variable mfg. overhead
Fixed mfg. overhead
($150,000 25,000 units)
Unit product cost

Absorption
Costing

Variable
Costing

10

10

6
16

10

No change in Harveys
cost structure.
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Harvey Co. Year 2


Now lets look at Harveys income statement
assuming absorption costing is used.

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Harvey Co. Year 2


Absorption Costing
Sales (30,000 $30)
Less cost of goods sold:
Beg. inventory (5,000 $16)
Add COGM (25,000 $16)
Goods available for sale
Less ending inventory
Gross margin
Less selling & admin. exp.
Variable (30,000 $3)
Fixed
Net operating income

$ 900,000
$ 80,000
400,000
480,000
-

$ 90,000
100,000

480,000
420,000

190,000
$ 230,000

These are the 25,000 units


produced in the current period.
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Harvey Co. Year 2


Next, well look at Harveys income statement
assuming
is used.

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Harvey Co. Year 2


Variable
costs
only.

Variable Costing

Sales (30,000 $30)


Less variable expenses:
Beg. inventory (5,000 $10)
$ 50,000
Add COGM (25,000 $10)
250,000
Goods available for sale
300,000
Less ending inventory
Variable cost of goods sold
300,000
Variable selling & administrative
expenses (30,000 $3)
90,000
Contribution margin
Less fixed expenses:
Manufacturing overhead
$ 150,000
Selling & administrative expenses
100,000
Net operating income
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$ 900,000

All fixed
manufacturing
overhead is
expensed.
390,000
510,000

250,000
$ 260,000

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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
Income Comparison
Costing Method
Absorption
Variable

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1st Period
$ 120,000
90,000

2nd Period
$ 230,000
260,000

Total
$ 350,000
350,000

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Summary
Relation between
production
and sales
Production > Sales

Effect
on
iniventory
Inventory
increases

Production < Sales

Inventory
decreases

Production = Sales

No change

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Relation between
variable and
absorption income
Absorption
>
Variable
Absorption
<
Variable
Absorption
=
Variable

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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.

Advantages

Impact of fixed
costs on profits
emphasized.
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Consistent with standard


costs and flexible budgeting.
Easier to estimate profitability
of products and segments.
Profit is not affected by
changes in inventories.

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Variable versus
Absorption Costing
All manufacturing
costs must be assigned
to products to properly
match revenues and
costs.

Absorption
Costing
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Fixed costs are


not really the costs
of any particular
product.

Variable
Costing

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Variable versus
Absorption Costing
Depreciation,
taxes, insurance and
salaries are just as
essential to products
as variable costs.

Absorption
Costing
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These are capacity


costs and will be
incurred even if nothing
is produced.

Variable
Costing

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Variable versus
Absorption Costing
Absorption
costing product costs
are misleading for
decision making.

Variable
Costing
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They are the


numbers that
appear on our
external
reports.

Absorption
Costing

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Note on the
Absorption Costing
Cost of goodsof
soldVolume
decreases because production
Effects
exceeds sales, leaving a portion of fixed
manufacturing costs in inventory.

Variable cost
Fixed manufacturing overhead
Units sold

Units Total Variable


Produced
Cost
10,000
$100,000
12,000
$120,000
14,000
$140,000
16,000
$160,000
18,000
$180,000
20,000
$200,000
McGraw-Hill/Irwin

$10
$100,000
10,000

Fixed
Total
Average
Manufacturing Manufacturing Manufacturing
Overhead
Cost
Cost
$100,000
$200,000 $
20.00
$100,000
$220,000 $
18.33
$100,000
$240,000 $
17.14
$100,000
$260,000 $
16.25
$100,000
$280,000 $
15.56
$100,000
$300,000 $
15.00

Cost of
Goods Sold
$ 200,000
$ 183,333
$ 171,429
$ 162,500
$ 155,556
$ 150,000

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Absorption
Costing
Note
on
the
Cost of goods sold decreases because production
exceedsof
sales,
leaving a portion of fixed
Effects
Volume
manufacturing costs in inventory.

COGS for 10,000 units

COGS

$200,000

$150,000

$100,000

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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