1. Variable Costing: A Tool for Management 3/17/04
Chapter 7
Variable Costing: A Tool for Management 3/17/04

2. Absorption Costing
Treats all manufacturing costs as product costs, and non-manufacturing costs as period costs
Unit costs consist of direct material and direct labor and both variable and fixed manufacturing overhead.
Fixed manufacturing overhead is allocated to each unit of production
GAAP

3. Variable Costing
Only those costs of manufacturing that vary with output (variable costs) are treated as product costs
This would include direct material, direct labor and variable manufacturing overhead
Fixed manufacturing overhead is expensed during the current period
Variable costing is used for internal planning and control only; it’s not GAAP!

4. Overview of Absorption and Variable(Marginal) Costing
The only cost of driving my car on a 200 mile trip today is $12 for gasoline.
Variable Costing

5. Overview of Absorption and Variable Costing
No! You must consider these costs too!
Absorption Costing

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

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

8. Marginal Costing
Provides a useful tool for evaluating marginal business propositions
Example, WTT exhibit
Marginal costs versus fixed costs

9. Overview of Absorption and Variable Costing
Absorption Costing
Variable 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
Product Costs
Period Costs

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

11. 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. . .

12. 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. . .

13. 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 ...

14. Quick Check  Assets = Liabilities + Owners’ Equity  
Which method will produce the highest retained earnings? (Hint: Remember the balance sheet equation.)
a. Absorption costing, because some fixed costs stay in inventory until the product is sold
b. Variable costing
c. There would be no difference in retained earnings under the two methods.
d. It depends ...
Assets = Liabilities + Owners’ Equity
 

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

16. Unit Cost Computations
Harvey Co. produces a single product with the following information available:

17. Unit Cost Computations
Unit product cost is determined as follows:
Selling and administrative expenses are always treated as period expenses and deducted from revenue.

18. Income Comparison of Absorption and Variable Costing
Harvey Co. had no beginning inventory, produced 25,000 units and sold 20,000 units this year.

19. Income Comparison of Absorption and Variable Costing
Harvey Co. had no beginning inventory, produced 25,000 units and sold 20,000 units this year.

20. Income Comparison of Absorption and Variable Costing
Now let’s look at variable costing by Harvey Co.
Variable costs only.
All fixed manufacturing overhead is expensed.

21. 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.

22. 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.

23. Income Comparison of Absorption and Variable Costing
Let’s compare the methods.

24. Reconciliation
We can reconcile the difference between absorption and variable income as follows:
Fixed mfg. overhead $150,000
Units produced ,000 units
= = $6.00 per unit

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

26. 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.

27. Unit product cost is determined as follows:
Harvey Co. Year 2
Unit product cost is determined as follows:
No change in Harvey’s
cost structure.

28. produced in the current period.
Harvey Co. Year 2
These are the 25,000 units
produced in the current period.

29. All fixed manufacturing overhead is expensed.
Harvey Co. Year 2
Variable costs only.
All fixed manufacturing overhead is expensed.

30. Reconciliation
We can reconcile the difference between absorption and variable income as follows:
Fixed mfg. overhead $150,000
Units produced ,000 units
= = $6.00 per unit

31. Summary

32. Comparative Income Effects Exhibit 7-4
Production = Sales
No change in inventory; income the same for both absorption and variable costing
Production > Sales
Inventories increase; Absorption Income higher than Variable Cost income due to more fixed cost retained in inventory
Production < Sales
Inventories decrease; Absorption Income lower than Variable Cost income as more fixed costs are released from inventory

33. Advantages of the Variable Cost Approach
Consistent with
CVP analysis.
Management finds it
easy to understand.
Can be used for marginal
Cost analysis.
Advantages
Easier to estimate profitability of products and segments.
Profit is not affected by changes in inventories.
Impact of fixed
costs on profits
emphasized.

34. 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.
Variable Costing
Absorption Costing

35. 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

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

37. End of Chapter 7