Cost Behavior: Analysis and Use

Cost Behavior: Analysis and Use
5-1 Chapter 5 Cost Behavior: Analysis and Use Chapter 5: Cost Behavior: Analysis and Use. Managers who understand how costs behave are better able to predict costs and make decisions under various circumstances. This chapter explores the meaning of fixed, variable, and mixed costs (the relative proportions of which define an organization’s cost structure). It also introduces a new income statement format called the contribution approach. McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

5-2 5-2 Learning Objective 1 Understand how fixed and variable costs behave and how to use them to predict costs. Learning objective number 1 is to understand how fixed and variable costs behave and how to use them to predict costs.

Types of Cost Behavior Patterns
5-3 5-3 Types of Cost Behavior Patterns Recall the summary of our cost behavior discussion from Chapter 1. A variable cost is a cost whose total dollar amount varies in direct proportion to changes in the activity level.

A measure of what causes the incurrence of a variable cost.
5-4 5-4 The Activity Base Units produced Miles driven Machine hours Labor hours A measure of what causes the incurrence of a variable cost. An activity base (also called a cost driver) is a measure of what causes the incurrence of variable costs. As the level of the activity base increases, the variable cost increases proportionally. Units produced (or sold) is not the only activity base within companies. A cost can be considered variable if it varies with activity bases such as miles driven, machine hours, or labor hours.

True Variable Cost Example
5-5 5-5 True Variable Cost Example A variable cost is a cost whose total dollar amount varies in direct proportion to changes in the activity level. Your total long distance telephone bill is based on how many minutes you talk. Total Long Distance Telephone Bill As an example of an activity base, consider your total long distance telephone bill. The activity base is the number of minutes that you talk. Minutes Talked

5-6 5-6 Types of Cost Behavior Patterns Recall the summary of our cost behavior discussion from Chapter 1. Variable costs remain constant if expressed on a per unit basis.

Variable Cost Per Unit Example
5-7 5-7 Variable Cost Per Unit Example A variable cost remains constant if expressed on a per unit basis. The per minute cost of long distance calls is constant, for example, 10¢ per minute. Per Minute Telephone Charge Referring to the telephone example, the cost per minute talked is constant (e.g., 10 cents per minute) Minutes Talked

Extent of Variable Costs
5-8 5-8 Extent of Variable Costs The proportion of variable costs differs across organizations. For example . . . A public utility with large investments in equipment will tend to have fewer variable costs. A manufacturing company will often have many variable costs. The proportion of variable costs differs across organizations. For example: A public utility like Florida Power and Light, with large investments in equipment, will tend to have fewer variable costs. A manufacturing company like Black and Decker will often have many variable costs associated with the manufacture and distribution of its products to customers. A merchandising company like Wal-Mart will usually have a high proportion of variable costs such as the cost of merchandise purchased for resale. Some service companies, such as restaurants, have a high proportion of variable costs due to their raw material costs. Other service companies, such as an architectural firm, have a high proportion of fixed costs in the form of highly trained salaried employees. A merchandising company usually will have a high proportion of variable costs like cost of sales. A service company will normally have a high proportion of variable costs.

Examples of Variable Costs
5-9 5-9 Examples of Variable Costs Merchandising companies – cost of goods sold. Manufacturing companies – direct materials, direct labor, and variable overhead. Merchandising and manufacturing companies – commissions, shipping costs, and clerical costs such as invoicing. Service companies – supplies, travel, and clerical. Common examples of variable costs are: 1. Merchandising companies  cost of goods sold. Manufacturing companies  direct materials, direct labor, and variable overhead. Merchandising and manufacturing companies  commissions, shipping costs, and clerical costs such as invoicing. Service companies  supplies, travel, and clerical.

5-10 5-10 True Variable Cost Direct materials is a true or proportionately variable cost because the amount used during a period will vary in direct proportion to the level of production activity. A true variable cost is an amount used during the period that varies in direct proportion to the activity level. The long distance phone bill was one example of a true variable cost. Direct material is another example of a cost that behaves in a true variable pattern. Direct materials purchased but not used can be stored and carried forward to the next period as inventory. Cost Volume

5-11 5-11 Step-Variable Costs A resource that is obtainable only in large chunks (such as maintenance workers) and whose costs increase or decrease only in response to fairly wide changes in activity. Volume Cost A step variable cost is a resource that is obtainable only in large chunks and whose costs change only in response to fairly wide changes in activity. For example, maintenance workers are often considered to be a variable cost, but this labor cost does not behave as a true variable cost.

5-12 5-12 Step-Variable Costs Small changes in the level of production are not likely to have any effect on the number of maintenance workers employed. Volume Cost Small changes in the level of production are not likely to have any effect on the number of maintenance workers employed.

5-13 5-13 Step-Variable Costs Only fairly wide changes in the activity level will cause a change in the number of maintenance workers employed. Volume Cost Only fairly wide changes in the activity level will cause a change in the number of maintenance workers employed. Maintenance workers are obtainable only in large chunks of a whole person who is capable of working approximately 2,000 hours a year.

The Linearity Assumption and the Relevant Range
5-14 5-14 The Linearity Assumption and the Relevant Range Relevant Range A straight line closely approximates a curvilinear variable cost line within the relevant range. Economist’s Curvilinear Cost Function Total Cost Part I Economists correctly point out that many costs that accountants classify as variable costs actually behave in a curvilinear fashion. Part II Nonetheless, within a narrow band of activity known as the relevant range, a curvilinear cost can be satisfactorily approximated by a straight line. Part III The relevant range is the range of activity within which the assumptions made about cost behavior are valid. Accountant’s Straight-Line Approximation (constant unit variable cost) Activity

5-15 5-15 Types of Cost Behavior Patterns Let’s turn our attention to fixed cost behavior. A fixed cost is a cost whose total dollar amount remains constant as the activity level changes.

Total Fixed Cost Example
5-16 5-16 Total Fixed Cost Example A fixed cost is a cost whose total dollar amount remains constant as the activity level changes. Your monthly basic telephone bill is probably fixed and does not change when you make more local calls. Monthly Basic Telephone Bill For example, your monthly basic telephone bill is probably fixed and does not change when you make more local calls. Number of Local Calls

5-17 5-17 Types of Cost Behavior Patterns Recall the summary of our cost behavior discussion from Chapter 1. Average fixed costs per unit decrease as the activity level increases.

Fixed Cost Per Unit Example
5-18 5-18 Fixed Cost Per Unit Example Average fixed costs per unit decrease as the activity level increases. The fixed cost per local call decreases as more local calls are made. Monthly Basic Telephone Bill per Local Call For example, the fixed cost per local call decreases as more local calls are made. Number of Local Calls

Types of Fixed Costs Committed Discretionary Examples Examples
5-19 5-19 Types of Fixed Costs Committed Long-term, cannot be significantly reduced in the short-term. Discretionary May be altered in the short-term by current managerial decisions Examples Depreciation on Buildings and Equipment and Real Estate Taxes Examples Advertising and Research and Development Part I Committed costs are long-term in nature (i.e., greater than one year). These costs cannot be significantly reduced even for short periods of time without seriously impairing the long-run goals of the organization. Examples of committed-fixed costs include depreciation on buildings and equipment and real estate taxes. Part II Discretionary costs usually arise from annual decisions by management to spend in certain fixed cost areas. These costs can be cut for short periods of time with minimal damage to the long-term goals of the organization. Examples of discretionary fixed costs include advertising and research and development. A cost may be discretionary or committed depending on management’s strategy. For example, some construction companies may layoff workers during months with minimal customer demand. However, other construction companies may opt to retain their workers all year.

The Trend Toward Fixed Costs
5-20 5-20 The Trend Toward Fixed Costs The trend in many industries is toward greater fixed costs relative to variable costs. As machines take over many mundane tasks previously performed by humans, “knowledge workers” are demanded for their minds rather than their muscles. Knowledge workers tend to be salaried, highly-trained, and difficult to replace. The cost to compensate these valued employees is relatively fixed rather than variable. Part I The trend in many industries is toward greater fixed costs relative to variable costs. For example: H&R Block employees used to fill out tax returns for customers by hand. Now, computer software is used to complete tax returns. Safeway and Kroger employees used to key-in prices by hand on cash registers. Now, barcode readers enter price and other product information automatically. Part II As machines take over many mundane tasks previously performed by humans, “knowledge workers” are demanded for their minds rather than their muscles. Knowledge workers tend to be salaried, highly-trained, and difficult to replace; consequently, the cost of compensating these valued employees is relatively fixed rather than variable.

Is Labor a Variable or a Fixed Cost?
5-21 5-21 Is Labor a Variable or a Fixed Cost? The behavior of wage and salary costs can differ across countries, depending on labor regulations, labor contracts, and custom. In France, Germany, China, and Japan, management has little flexibility in adjusting the size of the labor force. Labor costs are more fixed in nature. The behavior of wage and salary costs can differ across countries, depending on labor regulations, labor contracts, and custom. For example: In France, Germany, China, and Japan management has little flexibility in adjusting the size of the labor force; hence, labor costs are more fixed in nature. Within countries managers can view labor costs differently depending on their strategy. Nonetheless, most companies in the United States continue to view direct labor as a variable cost. Most companies in the United States continue to view direct labor as a variable cost.

Fixed Costs and Relevant Range
5-22 5-22 Fixed Costs and Relevant Range 90 Total cost doesn’t change for a wide range of activity, and then jumps to a new higher cost for the next higher range of activity. Relevant Range 60 Rent Cost in Thousands of Dollars The relevant range of activity for a fixed cost is the range of activity over which the graph of the cost is flat. 30 , , , Rented Area (Square Feet)

5-23 5-23 Fixed Costs and Relevant Range The relevant range of activity for a fixed cost is the range of activity over which the graph of the cost is flat. Example: Office space is available at a rental rate of $30,000 per year in increments of 1,000 square feet. As the business grows, more space is rented, increasing the total cost. For example, assume office space is available at a rental rate of $30,000 per year in increments of 1,000 square feet. Fixed costs would increase in a step fashion at a rate of $30,000 for each additional 1,000 square feet.

5-24 5-24 Fixed Costs and Relevant Range Step-variable costs can be adjusted more quickly and . . . The width of the activity steps is much wider for the fixed cost. How does this type of fixed cost differ from a step-variable cost? While this step-function pattern appears similar to the idea of step-variable costs, there are two important differences between step-variable costs and fixed costs: Step-variable costs can often be adjusted quickly as conditions change, whereas fixed costs cannot be changed easily. The width of the steps for fixed costs is wider than the width of the steps for step-variable costs. For example, a step-variable cost such as maintenance workers may have steps with a width of 40 hours a week. However, fixed costs may have steps that have a width of thousands or tens of thousands of hours of activity.

Which of the following statements about cost behavior are true?
5-25 5-25 Quick Check  Which of the following statements about cost behavior are true? Fixed costs per unit vary with the level of activity. Variable costs per unit are constant within the relevant range. Total fixed costs are constant within the relevant range. Total variable costs are constant within the relevant range. Take a minute to answer this question before we move on. There can be more than one correct answer. Be careful and take your time.

Which of the following statements about cost behavior are true?
5-26 5-26 Quick Check  Which of the following statements about cost behavior are true? Fixed costs per unit vary with the level of activity. Variable costs per unit are constant within the relevant range. Total fixed costs are constant within the relevant range. Total variable costs are constant within the relevant range. Number 4 is not correct because total variable costs increase as activity increases, within the relevant range and decrease as activity decreases, within the relevant range.

Fixed Monthly Utility Charge
5-27 5-27 Mixed Costs A mixed cost has both fixed and variable components. Consider your utility costs. X Y Total mixed cost Total Utility Cost A mixed cost contains both variable and fixed cost elements. For example, utility bills often contain fixed and variable cost components. The fixed portion of the utility bill is constant regardless of kilowatt hours consumed. This cost represents the minimum cost that is incurred to have the service ready and available for use. The variable portion of the bill varies in direct proportion to the consumption of kilowatt hours. Variable Cost per KW Fixed Monthly Utility Charge Activity (Kilowatt Hours)

Fixed Monthly Utility Charge
5-28 5-28 Mixed Costs X Y Total mixed cost Total Utility Cost An equation can be used to express the relationship between mixed costs and the level of the activity. This equation can be used to calculate what the total mixed cost would be for any level of activity. The equation is Y = a + bX Y = The total mixed cost. a = The total fixed cost (the vertical intercept of the line). b = The variable cost per unit of activity (the slope of the line). X = The level of activity. Variable Cost per KW Fixed Monthly Utility Charge Activity (Kilowatt Hours)

Mixed Costs Example Y = a + bX Y = $40 + ($0.03 × 2,000) Y = $100
5-29 5-29 Mixed Costs Example If your fixed monthly utility charge is $40, your variable cost is $0.03 per kilowatt hour, and your monthly activity level is 2,000 kilowatt hours, the amount of your utility bill is: Y = a + bX Y = $40 + ($0.03 × 2,000) Y = $100 For example, if your fixed monthly utility charge is $40, your variable cost is 3 cents per kilowatt hour, and your monthly activity level was 2,000 kilowatt hours, this equation can be used to calculate your total utility cost of $100.

Analysis of Mixed Costs
5-30 5-30 Analysis of Mixed Costs Account analysis Each account is classified as either variable or fixed based on the analyst’s knowledge of how the account behaves. Engineering Approach Cost estimates are based on an evaluation of production methods, and material, labor and overhead requirements. In account analysis, each account under consideration is classified as variable or fixed based on the analyst’s prior knowledge about how costs behave. This approach is limited in value in the sense that it glosses over the fact that some accounts may have both fixed and variable components. The engineering approach classifies costs based on an industrial engineer’s evaluation of production methods, material specifications, labor requirements, equipment usage, power consumption, and so on. This approach is particularly useful when no past experience is available concerning activity and costs.

Use a scattergraph plot to diagnose cost behavior.
5-31 5-31 Learning Objective 2 Use a scattergraph plot to diagnose cost behavior. Learning objective number 2 is to use a scattergraph plot to diagnose cost behavior.

The Scattergraph Method
5-32 5-32 The Scattergraph Method Plot the data points on a graph (total cost vs. activity). * Maintenance Cost 1,000’s of Dollars 10 20 Patient-days in 1,000’s X Y The scattergraph plot is also called the quick-and-dirty method. The first step when using this method to analyze a mixed cost is to plot the data on a scattergraph. The cost, which is known as the dependent variable, is plotted on the Y axis. The activity, which is known as the independent variable, is plotted on the X axis. The second step is to examine the dots on the scattergraph to see if they are linear, such that a straight line can be drawn that approximates the relation between cost and activity. If the dots are not linear, do not analyze the data any further. Instead, search for another independent variable that bears a stronger linear relationship with the dependent variable.

5-33 5-33 The Scattergraph Method Draw a line through the data points with about an equal number of points above and below the line. * Maintenance Cost 1,000’s of Dollars 10 20 Patient-days in 1,000’s X Y The third step is to draw a straight line where, roughly speaking, an equal number of points reside above and below the line. Make sure that the straight line goes through at least one data point on the scattergraph.

5-34 5-34 The Scattergraph Method Use one data point to estimate the total level of activity and the total cost. * Maintenance Cost 1,000’s of Dollars 10 20 Patient-days in 1,000’s X Y Total maintenance cost = $11,000 Patient days = 800 Intercept = Fixed cost: $10,000 Part I The fourth step is to identify the Y intercept. This intercept represents the estimated fixed cost portion of the mixed cost ($10,000 in this example). Part II The fifth step is to estimate the variable cost per unit of the activity by first selecting one point on the scattergraph that intersects the straight line and then determining the total cost and the total activity level at the chosen point.

5-35 5-35 The Scattergraph Method Make a quick estimate of variable cost per unit and determine the cost equation. Variable cost per unit = $1, = $1.25 per patient-day Step 5 (continued) Part I Subtract the fixed costs from the total costs to arrive at the total variable costs for the chosen activity level. Part II Divide the total variable costs by the activity level at the chosen point. This is the variable cost per unit of activity. Part III Construct an equation that can be used to estimate total costs at any activity level. Y = $10,000 + $1.25X Number of patient days Total maintenance cost

Analyze a mixed cost using the high-low method.
5-36 5-36 Learning Objective 3 Analyze a mixed cost using the high-low method. Learning objective number 3 is to analyze a mixed cost using the high-low method.

5-37 5-37 The High-Low Method Assume the following hours of maintenance work and the total maintenance costs for six months. This method can be used to analyze mixed costs if a scattergraph plot reveals a linear relationship between the X and Y variables. For illustrative purposes, assume the information as shown.

5-38 5-38 The High-Low Method The variable cost per hour of maintenance is equal to the change in cost divided by the change in hours. Part I The first step is to choose the data points pertaining to the highest and lowest activity levels (high = 800 units; low = 500 units). Notice, this method relies on two data points to estimate the fixed and variable portions of a mixed cost, as opposed to one data point with the scattergraph method. The second step is to determine the total costs associated with the two chosen points (high = $9,800; low = $7,400). Part II The third step is to calculate the change in cost between the two data points ($2,400) and divide it by the change in activity level between the two data points (300 units). The quotient represents an estimate of variable cost per unit of activity ($8.00 per unit). = $8.00/hour $2, hours

5-39 5-39 The High-Low Method Total Fixed Cost = Total Cost – Total Variable Cost The fourth step is to take the total cost at either activity level (in this case, $9,800) and deduct the variable cost component ($6,400). The residual represents the estimate of total fixed costs ($3,400). The variable cost component ($6,400) is determined by multiplying the level of activity (800 units) by the estimated variable cost per unit of the activity ($8.00 per unit). Total Fixed Cost = $9,800 – ($8/hour × 800 hours) Total Fixed Cost = $9,800 – $6,400 Total Fixed Cost = $3,400

The Cost Equation for Maintenance
5-40 5-40 The High-Low Method The fifth step is to construct an equation that can be used to estimate the total cost at any activity level (Y = $3,400 + $8.00X). Y = $3,400 + $8.00X The Cost Equation for Maintenance

5-41 5-41 Quick Check  Sales salaries and commissions are $10,000 when 80,000 units are sold, and $14,000 when 120,000 units are sold. Using the high-low method, what is the variable portion of sales salaries and commission? a. $0.08 per unit b. $0.10 per unit c. $0.12 per unit d. $0.125 per unit Now, let’s apply what we have just discussed to determine the variable portion of sales salaries and commissions for this company.

5-42 5-42 Quick Check  Sales salaries and commissions are $10,000 when 80,000 units are sold, and $14,000 when 120,000 units are sold. Using the high-low method, what is the variable portion of sales salaries and commission? a. $0.08 per unit b. $0.10 per unit c. $0.12 per unit d. $0.125 per unit $4,000 ÷ 40,000 units = $0.10 per unit The correct answer is 10 cents per unit.

5-43 5-43 Quick Check  Sales salaries and commissions are $10,000 when 80,000 units are sold, and $14,000 when 120,000 units are sold. Using the high-low method, what is the fixed portion of sales salaries and commissions? a. $ 2,000 b. $ 4,000 c. $10,000 d. $12,000 Using the same data, calculate the total fixed cost portion of sales salaries and commissions.

5-44 5-44 Quick Check  Sales salaries and commissions are $10,000 when 80,000 units are sold, and $14,000 when 120,000 units are sold. Using the high-low method, what is the fixed portion of sales salaries and commissions? a. $ 2,000 b. $ 4,000 c. $10,000 d. $12,000 The calculation for the answer is a bit more complex, but we see that total fixed cost equals $2,000.

Least-Squares Regression Method
5-45 5-45 Least-Squares Regression Method A method used to analyze mixed costs if a scattergraph plot reveals an approximately linear relationship between the X and Y variables. This method uses all of the data points to estimate the fixed and variable cost components of a mixed cost. The least-squares regression method can be used to analyze mixed costs if a scattergraph plot reveals an approximately linear relationship between the X and Y variables. This method uses all of the data points to estimate the fixed and variable cost components of a mixed cost. Because it uses all of the data points, least-squares regression is superior to the scattergraph plot method that relies on only one data point and the high-low method that uses only two data points to estimate the fixed and variable cost components of a mixed cost. The basic goal of this method is to fit a straight line to the data that minimizes the sum of the squared errors. The regression errors are the vertical deviations from the data points to the regression line. The goal of this method is to fit a straight line to the data that minimizes the sum of the squared errors.

Least-Squares Regression Method
5-46 5-46 Least-Squares Regression Method Software can be used to fit a regression line through the data points. The cost analysis objective is the same: Y = a + bX The formulas that are used for least-squares regression are complex. Fortunately, computers can perform the calculations quickly. The observed values of the X and Y variables are entered into the computer and the software does the rest. The output from the regression analysis can be used to create an equation that enables you to estimate total costs at any activity level. The output from the regression analysis can be used to create an equation that enables you to estimate total costs at any activity level.

Comparing Results From the Three Methods
5-47 5-47 Comparing Results From the Three Methods The three methods just discussed provide slightly different estimates of the fixed and variable cost components of the mixed cost. This is to be expected because each method uses different amounts of the data points to provide estimates. Least-squares regression provides the most accurate estimate because it uses all of the data points. The three methods just discussed provide slightly different estimates of the fixed and variable cost components of the mixed cost. This is to be expected because each method uses differing amounts of the data points to provide estimates. Least-squares regression provides the most accurate estimates because it uses all of the data points.

Prepare an income statement using the contribution format.
5-48 5-48 Learning Objective 4 Prepare an income statement using the contribution format. Learning objective number 4 is to prepare an income statement using the contribution format.

The Contribution Format Income Statement
5-49 5-49 The Contribution Format Income Statement Let’s put our knowledge of cost behavior to work by preparing a contribution format income statement. The contribution approach provides an income statement format geared directly to cost behavior, which has been the focus of discussion in this chapter.

The Contribution Format
5-50 5-50 The Contribution Format The contribution margin format emphasizes cost behavior, by separating costs into fixed and variable categories. Contribution margin covers fixed costs and provides for income. This approach separates costs into fixed and variable categories. Sales minus variable costs equals contribution margin. The contribution margin minus fixed costs equals net operating income.

Uses of the Contribution Format
5-51 5-51 Uses of the Contribution Format The contribution income statement format is used as an internal planning and decision making tool. We will use this approach for: Cost-volume-profit analysis (chapter 6). Budgeting (chapter 7). Special decisions such as pricing and make-or-buy analysis (chapter 11). This approach is used as an internal planning and decision making tool. For example, this approach is useful for: 1. Cost-volume-profit analysis (chapter 6). 2. Budgeting (chapter 7). 3. Special decisions such as pricing and make-or-buy analysis (chapter 11).

The Contribution Format
5-52 5-52 The Contribution Format The contribution approach differs from the traditional approach illustrated in chapter 1. The traditional approach organizes costs in a functional format. Costs relating to production, administration, and sales are grouped together without regard to their cost behavior. The traditional approach is used primarily for external reporting purposes. Used primarily for external reporting. Used primarily by management.

5-53 Appendix 5A Variable Costing Appendix 5A: Variable Costing

5-54 5-54 Learning Objective 5 Explain how variable costing differs from absorption costing and compute unit product costs under each method. Learning objective number 5 is to explain how variable costing differs from absorption costing and compute unit product costs under each method.

Overview of Absorption and Variable Costing
5-55 5-55 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 Absorption costing treats all manufacturing costs as product costs, regardless of whether they are variable or fixed. The cost of a unit of product consists of direct materials, direct labor, and both variable and fixed overhead. Variable and fixed selling and administrative expenses are treated as period costs and are deducted from revenue as incurred. Variable costing treats only those costs of production that vary with output as product costs. The cost of a unit of product consists of direct materials, direct labor, and variable overhead. Fixed manufacturing overhead, and both variable and fixed selling and administrative expenses are treated as period costs and deducted from revenue as incurred.

5-56 5-56 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. To answer this question correctly, recall which method includes more manufacturing costs in the unit product cost.

5-57 5-57 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. Unit product costs are in both work in process and finished goods inventories. Absorption costing results in the highest inventory values because it treats fixed manufacturing overhead as a product cost. Using variable costing, fixed manufacturing overhead is expensed as incurred and never becomes a part of the product cost.

Unit Cost Computations
5-58 5-58 Unit Cost Computations Harvey Company produces a single product with the following information available: Assume Harvey Company produces a single product with available information as shown.

5-59 5-59 Unit Cost Computations Unit product cost is determined as follows: The unit product costs under absorption and variable costing would be $16 and $10, respectively. Under absorption costing, all production costs, variable and fixed, are included when determining unit product cost. Under variable costing, only the variable production costs are included in product costs. Selling and administrative expenses are always treated as period expenses and deducted from revenue as incurred.

Prepare income statements using both variable and absorption costing.
5-60 5-60 Learning Objective 6 Prepare income statements using both variable and absorption costing. Learning objective number 6 is to prepare income statements using both variable and absorption costing.

Income Comparison of Absorption and Variable Costing
5-61 5-61 Income Comparison of Absorption and Variable Costing Let’s assume the following additional information for Harvey Company. 20,000 units were sold during the year at a price of $30 each. There is no beginning inventory. The Harvey Company example continued (additional assumptions): 20,000 units were sold during the year. The selling price per unit is $30. There is no beginning inventory. Now, let’s compute net operating income using both absorption and variable costing.

5-62 5-62 Absorption Costing An income statement prepared using absorption costing shows that: The unit product cost is $16. The fixed manufacturing overhead cost deferred in inventory is $30,000 (5,000 units × $6 per unit). The net operating income is $120,000.

Variable Costing Variable manufacturing costs only.
5-63 5-63 Variable Costing Variable manufacturing costs only. All fixed manufacturing overhead is expensed. An income statement prepared using variable costing shows that: The unit product cost is $10. All $150,000 of fixed manufacturing cost is expensed in the current period. The net operating income is $90,000.

Extended Comparison of Income Data
5-64 5-64 Extended Comparison of Income Data Here is information about the operation of Harvey Company for the second year. Let’s continue the Harvey Company example with these additional assumptions/facts: 30,000 units were sold in year 2. The selling price per unit, variable costs per unit, total fixed costs, and number of units produced remain unchanged. 5,000 units are in beginning inventory.

5-65 5-65 Unit Cost Computations Since the variable costs per unit, total fixed costs, and the number of units produced remained unchanged, the unit cost computations also remain unchanged. Since there was no change in the variable costs per unit, total fixed costs, or the number of units produced, the unit costs remain unchanged.

produced in the current period.
5-66 5-66 Absorption Costing These are the 25,000 units produced in the current period. An income statement prepared using absorption costing for the second year shows that: The unit product cost is $16. The fixed manufacturing overhead cost released from inventory is $30,000. The net operating income is $230,000.

Variable Costing All fixed manufacturing overhead is expensed.
5-67 5-67 Variable Costing Variable manufacturing costs only. All fixed manufacturing overhead is expensed. An income statement prepared using absorption costing for the second year shows that: The unit product cost is $10. All $150,000 of fixed manufacturing overhead cost is expensed in the current period. The net operating income is $260,000.

5-68 5-68 Learning Objective 7 Reconcile variable costing and absorption costing net operating incomes and explain why the two amounts differ. Learning objective number 7 is to reconcile variable costing and absorption costing net operating incomes and explain why the two amounts differ.

Comparing Absorption and Variable Costing: Year 1
5-69 5-69 Comparing Absorption and Variable Costing: Year 1 Let’s compare the methods. Under absorption costing, $120,000 of fixed manufacturing overhead is included in cost of goods sold and $30,000 is deferred in ending inventory as an asset on the balance sheet. Under variable costing, the entire $150,000 of fixed manufacturing overhead is treated as a period expense. The variable costing ending inventory is $30,000 less than absorption costing, thus explaining the difference in net operating income between the two methods.

5-70 5-70 Comparing Absorption and Variable Costing: Year 1 We can reconcile the difference between absorption and variable net operating income as follows: The difference in net operating income between the two methods ($30,000) can also be reconciled by multiplying the number of units in ending inventory (5,000 units) by the fixed manufacturing overhead per unit ($6) that is deferred in ending inventory under absorption costing. Fixed mfg. overhead $150,000 Units produced ,000 units = = $6.00 per unit

5-71 5-71 Comparing Absorption and Variable Costing: Year 2 We can reconcile the difference between absorption and variable net operating income as follows: The difference in net operating income between the two methods ($30,000) can be reconciled by multiplying the number of units in beginning inventory (5,000 units) by the fixed manufacturing overhead per unit ($6) that is released from beginning inventory under absorption costing. Fixed mfg. overhead $150,000 Units produced ,000 units = = $6.00 per unit

Comparing Absorption and Variable Costing: Years 1 and 2
5-72 5-72 Comparing Absorption and Variable Costing: Years 1 and 2 Across the two year time frame, both methods reported the same total net operating income ($350,000). This is because over an extended period of time sales cannot exceed production, nor can production much exceed sales. The shorter the time period, the more the net operating income figures will tend to differ.

Summary of Key Insights
5-73 5-73 Summary of Key Insights We can summarize what we have observed over the two-year period for Harvey as follows: When units produced exceed unit sales, as in year 1 for Harvey, absorption costing net operating income is greater than variable costing net operating income. When units produced are less than unit sales, as in year 2 for Harvey, absorption costing net operating income is less than variable costing net operating income. When units produced equal unit sales, the two methods report the same net operating income. NOI = net operating income

5-74 5-74 End of Chapter 5 End of Chapter 5.

Cost Behavior: Analysis and Use

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