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Chapter 19 Variable Costing and Performance Reporting.

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Presentation on theme: "Chapter 19 Variable Costing and Performance Reporting."— Presentation transcript:

1 Chapter 19 Variable Costing and Performance Reporting

2 19-2 Conceptual Learning Objectives C1: Distinguish between absorption costing and variable costing. C2: Describe how absorption costing can result in over-production. C3: Explain the role of variable costing in pricing special orders.

3 19-3 A1: Analyze income reporting for both absorption and variable costing. A2: Compute and interpret breakeven volume in units. Analytical Learning Objectives

4 19-4 P1: Compute unit cost under both absorption and variable costing. P2: Prepare an income statement using absorption costing and using variable costing. P3: Prepare a contribution margin report. P4: Convert income under variable costing to the absorption cost basis. Procedural Learning Objectives

5 19-5 Absorption costing (also called full costing), assumes that products absorb all costs incurred to produce them. While widely used for financial reporting (GAAP), this costing method can result in misleading product cost information for business decisions. Absorption costing (also called full costing), assumes that products absorb all costs incurred to produce them. While widely used for financial reporting (GAAP), this costing method can result in misleading product cost information for business decisions. Absorption Costing & Variable Costing C1

6 Under absorption costing direct labor, direct materials and all overhead costs (both fixed and variable), are allocated to the product.

7 19-7 Distinguishing Between Absorption Costing and Variable Costing: Absorption Costing Absorption Costing Direct Materials Direct Labor Variable Overhead Fixed Overhead Product Cost C1

8 19-8 Absorption Costing & Variable Costing Under variable costing, only costs that change in total with changes in production level are included in product costs. C1

9 Under variable costing direct labor, direct materials, and variable overhead costs (not fixed overhead) are allocated to the product.

10 19-10 Distinguishing Between Absorption Costing and Variable Costing: Variable Costing Variable Costing Direct Materials Direct Labor Variable Overhead Fixed Overhead Product CostPeriod Cost C1

11 Computing Unit Cost 1. To compute the unit cost under absorption costing, add the direct labor per unit, the direct materials per unit, the variable overhead per unit and the fixed overhead per unit. 2. To compute the unit cost under variable costing, add the direct labor per unit, the direct materials per unit, and the variable overhead per unit.

12 19-12 Difference Between Absorption Costing and Variable Costing: Computing Unit Cost P1

13 19-13 Difference Between Absorption Costing and Variable Costing: Computing Unit Cost P1

14 Analysis of Income Reporting for Both Absorption and Variable Costing

15 Performance Reporting (Income) Implications A. Units Produced Equal Units Sold Reported income is identical under absorption costing and variable costing when units produced equals units sold.

16 19-16 Analysis of Income Reporting for Absorption Costing: Units Produced Equal Units Sold A1 P2 Notice that the net income is $580,000

17 19-17 Analysis of Income Reporting for Variable Costing: Units Produced Equal Units Sold A1 P2

18 19-18 Analysis of Income Reporting for Variable Costing: Units Produced Equal Units Sold A1 P2 We can see that the income under variable costing is also $580,000. This is because the number of units produced are equal to the number of units sold.

19 19-19 Analysis of Income Reporting for Both Absorption and Variable Costing: Units Produced Equal Units Sold A1

20 Performance Reporting (Income) Implications B. Units Produced Exceed Units Sold When production exceeds sales, fixed costs are allocated to ending inventory under absorption costing. This means that some of the fixed overhead costs incurred are not expensed until future periods when the ending inventory is sold. Consequently, income under absorption costing is higher than income under variable costing when units produced exceed units sold.

21 Analysis of Income Reporting for Absorption Costing: Units Produced Exceed Units Sold

22 Analysis of Income Reporting for Variable Costing: Units Produced Exceed Units Sold

23 19-23 Analysis of Income Reporting for Variable Costing: Units Produced Exceed Units Sold A1 P2 Under absorption costing,$200,000 of fixed overhead is allocated to the 20,000 units in ending inventory and is not expensed until future periods. Variable costing expenses the entire $600,000 of fixed overhead.

24 Analysis of Income Reporting for Both Absorption and Variable Costing: Units Produced Exceed Units Sold

25 Performance Reporting (Income) Implications C. Units Produced Are Less Than Units Sold When units produced are less than units sold, beginning inventory is sold. Under absorption costing beginning inventory includes fixed and variable overhead costs from the previous period, where under variable costing only variable overhead costs are included. Consequently, income is less under absorption costing than under variable costing.

26 Analysis of Income Reporting for Absorption Costing: Units Produced Are Less Than Units Sold Income is now $840,000

27 Analysis of Income Reporting for Variable Costing: Units Produced Are Less Than Units Sold Income under variable costing is $1,040,000

28 Analysis of Income Reporting for Both Absorption and Variable Costing: Units Produced Are Less Than Units Sold

29 Summarizing Income Reporting The differences in income reported under variable costing and absorption costing are due to timing. Income under the two costing methods will be different whenever the quantity produced and quantities sold are different. Specifically, income under absorption is higher when more units are produced than sold, and is lower when fewer units are produced than sold.

30 19-30 Income Reporting Summarized A1

31 Converting Reports Under Variable Costing to Absorption Costing Companies often use variable costing for internal reporting and business decisions, and use absorption costing for external reporting and tax reporting. To convert variable costing income to absorption costing income, add the fixed production cost in ending inventory and subtract the fixed production cost in beginning inventory.

32 Converting Reports Under Variable Costing to Absorption Costing

33 Planning Production Production levels should be based on reliable sales forecasts. However, many companies link manager bonuses to income computed under absorption costing (GAAP). Reported income under absorption costing increases with production. This could lead to overproduction and inventory build-up. The manager incentive problem can be avoided when income is measured using variable costing. Income under variable costing is not affected by production because all fixed costs are expensed during the period they were incurred.

34 Planning Production

35 Planning Production: Income Under ABSORPTION Costing for Different Production Levels Exhibit 19.10

36 Planning Production: Income Under VARIABLE Costing for Different Production Levels Exhibit 19.11

37 19-37 Planning Production: Income Under Absorption Costing for Different Production Levels C2 Why is income under absorption costing affected by the production level when that for variable costing is not? The answer lies in the different treatment of fixed overhead costs for the two method.

38 19-38 Planning Production C2 Producing too much inventory Excess inventory Higher storage and financing costs Greater risk of obsolescence Producing too little inventory Lost sales Customer dissatisfaction

39 Setting Prices Cost information from both absorption costing and variable costing can aid managers in pricing.

40 Setting Prices Over the Long Run: Price must be high enough to cover all costs, including variable costs and fixed costs, and still provide an acceptable return to owners. Absorption cost information is useful because it reflects the full costs that sales must exceed for the company to be profitable.

41 Setting Prices Over the Short Run: Fixed production costs such as the cost to maintain plant capacity do not change with changes in production levels. With excess capacity, increases in production level would increase variable production costs, but not fixed costs. While managers try to maintain the long-run price on existing orders, which covers all production costs, managers should accept special orders provided the special order price exceeds variable cost. If the incremental revenue from the special order exceeds incremental costs, accepting the special order increases company income.

42 Setting Prices IceAge Data: Production cost under VARIABLE Costing = $15/Unit Production cost under ABSORPTION Costing = $25/Unit Received a SPECIAL Order of 1,000 pairs of skates at an offer price of $22 per pair. This SPECIAL Order will not effect IceAge's -Regular sales, and -Its plant has excess capacity to fill the order. Should we ACCEPT or REJECT the order?

43 Setting Prices If offer is rejected, only VARIABLE Costs are saved. FIXED costs do not change in the short run regardless of accepting or rejecting the order.

44 19-44 Contribution Margin Report P3 Contribution margin is the excess of sales over total variable expenses Contribution margin contributes to covering fixed costs and earning income

45 19-45 Contribution Margin Report P3 The Contribution Margin Ratio is contribution margin divided by sales

46 19-46 Limitations of Reports Using Variable Costing P3 Absorption costing is almost exclusively used for external reporting (GAAP). For income tax purposes, absorption costing is the only acceptable basis for filings with the Internal Revenue Service (IRS) under the Tax Reform Act of Absorption costing is the only acceptable basis for both external reporting and tax reporting.

47 19-47 Calculating Break-Even We can use the data in the following contribution margin format for IceAge to help us determine break-even point. A2

48 19-48 Calculating Break-Even Break-Even Volume in Units = Total Fixed Costs Contribution Margin per Unit Where: Contribution margin per unit = Sales price per unit – Variable cost per unit A2

49 19-49 Calculating Break-Even A2 Precision Tech’s Break-Even Volume in Units Total fixed costs CM per unit = $800,000 $23 per unit = 34,783 units


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