Variable Costing: A Tool for Management. M. En C. Eduardo Bustos Farías

Variable Costing: A Tool for Management M. En C. Eduardo Bustos Farías 1

Absorption Costing A system of accounting for costs in which both fixed and variable production costs are considered product costs. Fixed Costs Variable Costs Product 2

Variable Costing A system of cost accounting that only assigns the variable cost of production to products. Fixed Costs Variable Costs Product 3

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 4

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 5

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 6

Overview of Absorption and Variable Costing Who s right? How should we treat the car payment and the insurance? 7

Overview of Absorption and Variable Costing Absorption Costing Product Costs Period Costs Direct Materials Direct Labor Variable Manufacturing Overhead Fixed Manufacturing Overhead Variable Selling and Administrative Expenses Fixed Selling and Administrative Expenses Variable Costing Product Costs Period Costs 8

Inventory-Costing Methods The difference between variable costing and absorption costing is based on the treatment of fixed manufacturing overhead. 9

Note: Manufacturing Cost Flows Costs Material Purchases Balance Sheet Inventories Raw Materials Income Statement Expenses Direct Labor Variable Manufacturing Overhead Fixed Manufacturing Overhead Absorption costing Work in Process Finished Goods Variable costing Cost of Goods Sold Selling and Administrative Period Costs Selling and Administrative 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 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... 13

Note: Manufacturing Cost Flows Absorption Costing Balance Sheet 150 100 50 0 Inventory Retained Earnings Fixed manufacturing overhead in inventories Variable costing 15

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... 16

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. 18

Overview of Absorption and Variable Costing Let s put some numbers to the issue and see if it will sharpen our understanding. 20

Unit Cost Computations Harvey 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: Manufacturing overhead $ 150,000 Selling & administrative expenses $ 100,000 21

Unit Cost Computations Unit product cost is determined as follows: Absorption Costing Variable 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. 22

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 23

Income Comparison of Absorption and Variable Costing Now let s look at variable costing by Harvey Co. Variable costs Variable Costing Sales (20,000 $30) $ 600,000 Less variable expenses: only. 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) 60,000 260,000 Contribution margin 340,000 Less fixed expenses: All fixed manufacturing overhead is expensed. Manufacturing overhead $ 150,000 Selling & administrative expenses 100,000 250,000 Net operating income $ 90,000 25

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. 26

Income Comparison of Absorption and Variable Costing Let s compare the methods. Cost of Goods Sold Ending Inventory Period Expense Total Absorption costing Variable mfg. costs $ 200,000 $ 50,000 $ - $ 250,000 Fixed mfg. costs 120,000 30,000-150,000 $ 320,000 $ 80,000 $ - $ 400,000 Variable costing Variable mfg. costs $ 200,000 $ 50,000 $ - $ 250,000 Fixed mfg. costs - - 150,000 150,000 $ 200,000 $ 50,000 $ 150,000 $ 400,000 28

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 29

Extending the Example Let s look at the second year of operations for Harvey Company. 30

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 25,000 Variable costs per unit: Direct materials, direct labor variable mfg. overhead $ 10 Selling & administrative expenses $ 3 Fixed costs per year: Manufacturing overhead $ 150,000 Selling & administrative expenses $ 100,000 31

Harvey Co. Year 2 Unit product cost is determined as follows: Absorption Costing Variable 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 No change in Harvey s cost structure. 32

Harvey Co. Year 2 Now let s look at Harvey s income statement assuming absorption costing is used. 33

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. 34

Harvey Co. Year 2 Next, we ll look at Harvey s income statement assuming is used. 35

Harvey Co. Year 2 Variable costs only. 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 Less 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: All fixed manufacturing overhead is expensed. Manufacturing overhead $ 150,000 Selling & administrative expenses 100,000 250,000 Net operating income $ 260,000 36

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 37

Summary Income Comparison Costing Method 1st Period 2nd Period Total Absorption $ 120,000 $ 230,000 $ 350,000 Variable 90,000 260,000 350,000 38

Summary Relation between Effect Relation between production on variable and and sales iniventory absorption income Inventory Absorption Production > Sales increases > Variable Inventory Absorption Production < Sales decreases < Variable Absorption Production = Sales No change = Variable 39

Summary Comparison of Absorption (AC) and Variable Costing (VC) Production versus Sales Total Inventory Effect Period Expense Effect Profit Effect Fixed mfg. Fixed mfg. Produced > Sold Increase costs expensed < costs expensed AC > VC AC VC Fixed mfg. Fixed mfg. Produced < Sold Decrease costs expensed > costs expensed AC < VC AC VC Fixed mfg. Fixed mfg. Produced = Sold No change costs expensed = costs expensed AC = VC AC VC 40

Advantages of the Contribution Approach Management finds it easy to understand. Advantages Impact of fixed costs on profits emphasized. Consistent with CVP analysis. Net operating income is closer to net cash flow. Consistent with standard costs and flexible budgeting. Easier to estimate profitability of products and segments. Profit is not affected by changes in inventories. 41

Variable versus Absorption Costing All manufacturing costs must be assigned to products to properly match revenues and costs. Fixed costs are not really the costs of any particular product. Absorption Costing Variable Costing 42

Variable versus Absorption Costing Depreciation, taxes, insurance and salaries are just as essential to products as variable costs. These are capacity costs and will be incurred even if nothing is produced. Absorption Costing Variable Costing 43

Variable versus Absorption Costing Absorption costing product costs are misleading for decision making. They are the numbers that appear on our external reports. Variable Costing Absorption Costing 44

Note on the Absorption Costing Cost of goods sold decreases because production exceeds sales, leaving a portion of fixed manufacturing costs in inventory. Effects of Volume 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 45

Note on the Absorption Costing Cost of goods sold decreases because production exceeds sales, leaving a portion of fixed manufacturing costs in inventory. Effects of Volume COGS for 10,000 units $200,000 COGS $150,000 $100,000 10,000 14,000 18,000 22,000 26,000 30,000 34,000 Number of units produced 46

Prepare income statements under absorption costing and variable costing. 47

Comparing Income Statements The following data pertain to Davenport Fixtures: Year 1 Year 2 Total Beginning inventory -0-2,000-0- Produced 10,000 11,500 21,500 Sold 8,000 13,000 21,000 Ending inventory 2,000 500 500 48

Comparing Income Statements The following information is on a per unit basis: Sales price: $71.00 Variable manufacturing costs: Direct materials: $ 4.00 Direct manufacturing labor: $21.00 Indirect manufacturing costs: $24.00 Fixed manufacturing costs: $ 4.50 49

Comparing Income Statements (Absorption Costing) Total fixed production costs are $54,000 at a normal capacity of 12,000 units. Fixed nonmanufacturing costs are $30,000 per year. Variable nonmanufacturing costs are $2.00 per unit sold. 50

Comparing Income Statements (Absorption Costing) Revenues $568,000 Cost of goods sold 428,000 Volume variance (U) 9,000 Gross margin $131,000 Nonmanufacturing costs 46,000 Operating income $ 85,000 51

Comparing Income Statements (Absorption Costing) Revenues for Year 1 are $568,000. What is the cost of goods sold? 8,000 $49 = $392,000 What is the manufacturing contribution margin? $568,000 $392,000 = $176,000 Net contribution margin = $160,000 52

Comparing Income Statements (Variable Costing) Revenues $568,000 Cost of goods sold 392,000 Variable nonmanufacturing costs 16,000 Contribution margin $160,000 Fixed manufacturing costs 54,000 Fixed nonmanufacturing costs 30,000 Operating income $ 76,000 53

Explain differences in operating income under absorption costing and variable costing. 54

Operating Income (Absorption Costing) What are revenues for Year 2? 13,000 $71 = $923,000 What is the cost of goods sold? 13,000 $53.50 = $695,500 Is there a volume variance? (12,000 11,500) $4.50 = $2,250 underallocated fixed manufacturing costs 55

Operating Income (Absorption Costing) What is the gross margin? $923,000 ($695,500 + $2,250) = $225,250 What are the nonmanufacturing costs? 13,000 units sold $2.00 = $26,000 variable costs + $30,000 fixed costs = $56,000 56

Operating Income (Absorption Costing) What is the operating income before taxes? $225,250 $56,000 = $169,250 What is the operating income for the two years combined? $85,000 + $169,250 = $254,250 57

Income Statements (Absorption Costing) Year 1 Year 2 Combined Revenues $568,000 $923,000 $1,491,000 Cost of goods sold 428,000 695,500 1,123,500 Volume variance (U) 9,000 2,250 11,250 Gross margin $131,000 $225,250 $ 356,250 Nonmfg. costs 46,000 56,000 102,000 Operating income $ 85,000 $169,250 $ 254,250 58

Operating Income (Variable Costing) Revenues for Year 2 are $923,000. What is the cost of goods sold? 13,000 $49 = $637,000 What is the manufacturing contribution margin? $923,000 $637,000 = $286,000 59

Operating Income (Variable Costing) What is the net contribution margin? $286,000 $26,000 variable nonmanufacturing costs = $260,000 net contribution margin What is the operating income before taxes? $260,000 $54,000 fixed manufacturing costs $30,000 fixed nonmanufacturing costs = $176,000 60

Income Statements (Variable Costing) Year 1 Year 2 Combined Revenues $568,000 $923,000 $1,491,000 Cost of goods sold 392,000 637,000 1,029,000 Mfg. contr. margin $176,000 $286,000 $ 462,000 Variable nonmfg. 16,000 26,000 42,000 Net contr. margin $160,000 $260,000 $ 420,000 61

Income Statements (Variable Costing) Year 1 Year 2 Combined Net contr. margin $160,000 $260,000 $420,000 Fixed mfg. costs 54,000 54,000 108,000 Fixed nonmfg. costs 30,000 30,000 60,000 Operating income $ 76,000 $176,000 $252,000 62

Comparison of Variable and Absorption Costing Variable costing operating income Year 1: $76,000 Absorption costing operating income Year 1: $85,000 Absorption costing operating income is $9,000 higher. Why? 63

Comparison of Variable and Absorption Costing Production exceeds sales in Year 1. The 2,000 units in ending inventory are valued as follows: Absorption costing: 2,000 $53.50 = $107,000 Variable costing: 2,000 $49.00 = $ 98,000 Difference: $ 9,000 64

Comparison of Variable and Absorption Costing Variable costing operating income Year 2: $176,000 Absorption costing operating income Year 2: $169,250 Variable costing operating income is $6,750 higher. Why? 65

Comparison of Variable and Absorption Costing Sales exceeded units produced in Year 2. 13,000 11,500 = 1,500 decrease in inventory Absorption costing: 1,500 $53.50 = $80,250 Variable costing: 1,500 $49.00 = $73,500 Higher cost of goods sold under absorption costing: $ 6,750 66

Comparison of Variable and Absorption Costing Variable costing combined net income: $252,000 Absorption costing combined net income: $254,250 Absorption costing is higher by $2,250 500 units in inventory $4.50 = $2,250 67

Comparison of Variable and Absorption Costing Absorption costing operating income Fixed manufacturing costs in ending inventory under absorption costing EQUALS Variable costing operating income Fixed manufacturing costs in beginning inventory under absorption costing 68

Understand how absorption costing can provide undesirable incentives for managers to build up finished goods inventory. 69

Inventory Buildup Assume that Davenport Fixtures produced 4,400 units in Year 1 and sold 4,100. What is the production volume variance? (12,000 4,400) $4.50 = $34,200 U What is the net operating income or loss for the period? 70

Inventory Buildup Revenues (4,100 $71) $291,100 Cost of goods sold (4,100 $53.50) 219,350 Volume variance 34,200 Gross margin $ 37,550 Nonmanufacturing costs 38,200 Net loss $ 650 71

Inventory Buildup How many units are in ending inventory? 4,400 4,100 = 300 How much cost is in ending inventory? 300 $53.50 = $16,050 72

Inventory Buildup Suppose that management decides to produce 9,000 units next year. Sales remain the same (4,100 units). What is the volume variance? (12,000 9,000) $4.50 = $13,500 U What is the operating income or loss? 73

Inventory Buildup Revenues (4,100 $71) $291,100 Cost of goods sold (4,100 $53.50) 219,350 Volume variance 13,500 Gross margin $ 58,250 Nonmanufacturing costs 38,200 Net income $ 20,050 74

Inventory Buildup How many units are in ending inventory? 300 + 9,000 4,100 = 5,200 How much cost is in ending inventory? 5,200 $53.50 = $278,200 75

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. 76