Chapter 19 Variable Costing and Performance Reporting

Variable Costing versus Absorption Costing Up until now, we have included DM, DL and OH in product costs. This is referred to as full ______________. Here we introduce ______________ which leaves fixed overhead out of the product cost.  They are treated as a period cost instead.

What?..... While full absorption costing is _________ for financial accounting purposes, variable costing may offer additional insights into performance. Example please…

Difference Between Absorption Costing and Variable Costing: Computing Unit Cost What are the variable and fixed overhead costs per unit at 60,000 units produced? VOH/unit = $180,000/60,000 units = $3/unit FOH/unit = $10/unit

What if? Assume IceAge receives a special order for 1,000 pairs of skates at an offer price of $22 per pair from a foreign skating school. This special order will not affect IceAge’s regular sales and its plant has excess capacity to fill the order. Drawing on absorption costing information, we observe that cost is $25 per unit and that the special order price is $22 per unit. These data would suggest that management would reject the order as it would lose $3,000, computed as 1,000 units at $3 loss per pair ($22-$25).

Difference Between Absorption Costing and Variable Costing: Computing Unit Cost

Analysis of Income Reporting for Both Absorption and Variable Costing

Analysis of Income Reporting for Absorption Costing: Units Produced Equal Units Sold

Notice that the net income is $580,000

Analysis of Income Reporting for Variable Costing: Units Produced Equal Units Sold

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.

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

Income for 2006 is $320,000

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

Under variable costing, the net income is only $120,000

Why is there such a difference? 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.

What if units sold exceeds units produced? Income should be more under variable costing? Why?  Fixed overhead associated with beginning inventory reduced income in 2006 under variable costing, so income should be higher now.

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

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

Production Planning What happens to unit costs under absorption costing as more units are produced?  Unit costs go _____ as fixed costs are spread over more units.  So, if unit costs go down, net income will go _____. What incentives would management have to increase production? Or to decrease production with full absorption costing?  Incentive is to increase production if bonus is based on income.

Sales Prices In the long run, price must exceed all costs both variable and fixed, so absorption costing may be better for setting prices in the long run. However, in the short run, fixed costs _________ and if extra capacity exists, we may elect to sell products at an amount only covering variable costs.

Setting Prices Let’s go back to IceAge to see how we can use our knowledge of variable costing in a special order decision.

Setting Prices So, as long as short run price for special order exceeds variable costs of producing more units, we should do it.

Controlling Costs using Variable Costing When companies wish to reduce costs, they are interested to see how well managers curtail costs that are under their control.  To hold someone responsible for something they cannot control is not equitable. Lower level managers typically have control over only variable costs in their area. Fixed costs are the result of decisions made by others.  Contribution margin reporting may be the answer.

So, which do we use? It depends…  We must use _________ costing for financial reporting and tax purposes.  Where helpful, we may consider using _________ for internal reporting purposes. It will depend on the decisions we are trying to make.

On to the homework!