Chapter 8

Variable Costing

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 Absorption and Variable Costing
Absorption Variable
Costing Costing

Direct materials
Direct labor Product costs
Product costs Variable mfg. overhead

Fixed mfg. overhead

Period costs
Period costs Selling & Admin. exp.

8-2
 Absorption and Variable Costing
Absorption Variable
Costing Costing

Direct materials
Direct labor Product costs
Product costs Variable mfg. overhead

Fixed mfg. overhead

Period costs
Period costs Selling & Admin. exp.

The difference between absorption and variable

costing is the treatment of fixed manufacturing overhead.
8-3
Absorption and Variable Costing
Mellon Co. produces a single product with the following
information available:

Number of units produced annually 25,000

Variable costs per unit:
Direct materials, direct labor
and variable mfg. overhead $ 10
Selling & administrative
expenses $ 3
Fixed costs per year:
Mfg. overhead $ 150,000
Selling & administrative
expenses $ 100,000

8-4
Absorption and Variable Costing
Unit product cost is determined as follows:

Absorption Variable
Costing Costing
Direct materials, direct labor, and
variable mfg. overhead $ 10 $ 10
Fixed mfg. overhead
($150,000 ÷ 25,000 units) 6 -
Unit product cost $ 16 $ 10

Selling and administrative expenses are

always treated as period expenses and
deducted from revenue.
8-5
Absorption Costing
Income Statements
Mellon Co. had no beginning inventory, produced 25,000 units, and sold
20,000 units this year at $30 each.

Absorption Costing
Sales (20,000 × $30) $ 600,000
Less cost of goods sold:
Beginning inventory
Add COGM
Goods available for sale
Ending inventory
Gross margin
Less selling & admin. exp.
Variable
Fixed
Net income

8-6
Absorption Costing
Income Statements
Mellon Co. had no beginning inventory, produced 25,000 units, and sold
20,000 units this year at $30 each.
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 income

8-7
Absorption Costing
Income Statements
Mellon Co. had no beginning inventory, produced 25,000 units, and sold
20,000 units this year at $30 each.

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 income $ 120,000

8-8
Variable Costing
Income Statements
Now let’s look at variable costing by Mellon Co.
Variable Costing
Sales (20,000 × $30) $ 600,000
Less variable expenses:
Beginning inventory $ -
Add COGM
Goods available for sale
Ending inventory
Variable cost of goods sold
Variable selling & administrative
expenses
Contribution margin
Less fixed expenses:
Manufacturing overhead
Selling & administrative expenses
Net income

8-9
Variable Costing
Income Statements
Now let’s look at variable costing by Mellon Co.
We exclude the
fixed manufacturing
Variable Costing
Sales (20,000 × $30) $ 600,000
Less variable expenses:
overhead.
Beginning inventory $ -
Add COGM (25,000 × $10) 250,000
Goods available for sale $ 250,000
Ending inventory (5,000 × $10) 50,000
Variable cost of goods sold $ 200,000
Variable selling & administrative
expenses
Contribution margin
Less fixed expenses:
Manufacturing overhead
Selling & administrative expenses
Net income

8-10
Variable Costing
Income Statements
Now let’s look at variable costing by Mellon Co.
Variable Costing
Sales (20,000 × $30) $ 600,000
Less variable expenses:
Beginning inventory $ -
Add COGM (25,000 × $10) 250,000
Goods available for sale $ 250,000
Ending inventory (5,000 × $10) 50,000
Variable cost of goods sold $ 200,000
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 income $ 90,000

8-11
Reconciling Income Under Absorption and
Variable Costing
We can reconcile the difference between absorption and
variable net income as follows:

Variable costing net income $ 90,000

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

Fixed mfg. overhead $150,000

= = $6.00 per unit
Units produced 25,000
8-12
Cost-Volume-Profit Analysis
 CVP includes all fixed costs to compute breakeven.
 Variable costing and CVP are consistent as both treat fixed costs as a
lump sum.
 Absorption costing defers fixed costs into inventory.
 Absorption costing is inconsistent with CVP because absorption costing
treats fixed costs on a per unit basis.

8-13
Mellon Co. Year 2
In its second year of operations, Mellon Co. started with an inventory of
5,000 units, produced 25,000 units, and sold 30,000 units at $30 each.

Number of units produced annually 25,000

Variable costs per unit:
Direct materials, direct labor
and variable mfg. overhead $ 10
Selling & administrative
expenses $ 3
Fixed costs per year:
Mfg. overhead $ 150,000
Selling & administrative
expenses $ 100,000

8-14
Mellon Co. Year 2
Unit product cost is determined as follows:

Absorption Variable
Costing Costing
Direct materials, direct labor,
and variable mfg. overhead $ 10 $ 10
Fixed mfg. overhead
($150,000 ÷ 25,000 units) 6 -
Unit product cost $ 16 $ 10

There has been no

change in Mellon’s
cost structure.
8-15
Mellon Co. Year 2
Units in ending inventory from the previous period.
Absorption Costing
Sales (30,000 × $30) $ 900,000
Less cost of goods sold:
Beg. inventory (5,000 x $16) $ 80,000
Add COGM (25,000 × $16) 400,000
Goods available for sale $ 480,000
Ending inventory - 480,000
Gross margin $ 420,000
Less selling & admin. exp.
Variable (30,000 × $3) $ 90,000
Fixed 100,000 190,000
Net income $ 230,000

8-16
Mellon Co. Year 2

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

25,000 units produced in the current period.

8-17
Mellon Co. Year 2
Variable Costing
Sales (30,000 × $30) $ 900,000
Less variable expenses:
Beg. inventory (5,000 × $10) $ 50,000
Add COGM (25,000 × $10) 250,000
Goods available for sale $ 300,000
Ending inventory -
Variable cost of goods sold $ 300,000
Variable selling & administrative
expenses (30,000 × $3) 90,000 390,000
Contribution margin $ 510,000
Less fixed expenses:
Manufacturing overhead $ 150,000
Selling & administrative expenses 100,000 250,000
Net income $ 260,000

Excludes fixed manufacturing overhead.

8-18
Summary
Income Comparison

Costing Method 1st Period 2nd Period Total

Absorption $ 120,000 $ 230,000 $ 350,000
Variable 90,000 260,000 350,000

In the first period, production (25,000 units)

was greater than sales (20,000).

In the second period, production (25,000 units)

was less than sales (30,000).
8-19
Summary
Income Comparison

Costing Method 1st Period 2nd Period Total

Absorption $ 120,000 $ 230,000 $ 350,000
Variable 90,000 260,000 350,000

For the two-year period, total absorption

income and total variable income are the same.

8-20
Evaluation of Variable Costing

Management finds it Consistent with

easy to understand. CVP analysis.

Emphasizes contribution in
Advantages short-run pricing decisions.

Impact of fixed Profit for period not

costs on profits affected by changes
emphasized. in fixed mfg. overhead.
8-21
Evaluation of Absorption Costing
Fixed manufacturing overhead is
treated the same as the other product
costs, direct material and direct labor.

Consistent with long-run

Advantages pricing decisions that must
cover full cost.

External reporting
and income tax law
require absorption costing.
8-22