1. A DECISION-MAKING PROCESS
CHAPTER 7
VARIABLE COSTING:
A DECISION-MAKING PROCESS
Study Objectives
Explain the difference between absorption costing and variable costing.
Discuss the effect that changes in production level and sales level have on net income measured under absorption costing versus variable costing.

2. Study Objectives: Continued
Discuss the relative merits of absorption costing versus variable costing for management decision making.
Explain the term sales mix and its effect on break-even sales.

3. ABSORPTION COSTING VERSUS VARIABLE COSTING Study Objective 1
Full or Absorption Costing
Assigns all variable and fixed manufacturing costs to the product
Required for external reporting
Variable Costing
Assigns only variable manufacturing costs to the product
Direct material, direct labor, variable manufacturing overhead

4. ABSORPTION COSTING VERSUS VARIABLE COSTING COMPARISON
Primary Difference
Under variable costing, fixed manufacturing overhead is an expense in the current period.

5. ABSORPTION COSTING VERSUS VARIABLE COSTING COMPARISON - Continued
Variable costing does not defer fixed manufacturing overhead to the future - i.e., they are not inventoried
Net income under absorption costing compared to net income under variable costing:
Higher when units produced exceed units sold
Lower when units produced are less than units sold
Equal when units produced and sold are the same:
There is no ending inventory so fixed costs are not deferred into the future

6. ABSORPTION COSTING VERSUS VARIABLE COSTING
Example – Premium Products
Manufactures Fix-it, a sealant for car windows
Relevant data for the first month of production:

7. ABSORPTION COSTING VERSUS VARIABLE COSTING
Example - Continued
Per unit manufacturing cost under each approach:
Manufacturing costs are $4 ($13 - $9) higher for absorption costing because fixed manufacturing costs are product costs.

8. ABSORPTION COSTING VERSUS VARIABLE COSTING Absorption Costing Income Statement

9. ABSORPTION COSTING VERSUS VARIABLE COSTING Variable Costing Income Statement

10. ABSORPTION vs VARIABLE COSTING Extended Example – Overbay Inc – Basic Data Study Objective 2
Manufacturing cost per airplane drone $300,000 :
$240,000 variable and $60,000 fixed
Selling and administrative costs $130,000:
$50,000 variable and $80,000 fixed

11. ABSORPTION vs VARIABLE COSTING Extended Example – Overbay Inc – Continued
Absorption Costing Income Statement
Net Income under Absorption Costing: $870,000

12. Variable Costing Income Statement
ABSORPTION vs VARIABLE COSTING Extended Example – Overbay Inc – Continued
Variable Costing Income Statement
Follows CVP format
Manufacturing costs include only the variable manufacturing costs - $240,000 in 2005
Expense all fixed manufacturing cost - $600,000 in 2005
Reports same net income in 2005 as the Absorption Costing Income Statement

13. ABSORPTION vs VARIABLE COSTING Extended Example – Overbay Inc – Continued
Variable Costing Income Statement
Net Income under Variable Costing: $870,000

14. ABSORPTION vs VARIABLE COSTING Extended Example – Overbay Inc – Continued
Absorption Costing
10 drones produced; 8 drones sold; 2 drones in ending inventory
Each unit in ending inventory includes $60,000 of fixed manufacturing overhead
$120,000 ($60,000 X 2) of fixed manufacturing costs are deferred until a future period

15. ABSORPTION vs VARIABLE COSTING Extended Example – Overbay Inc – Continued
Absorption Costing Income Statement
Net Income under Absorption Costing: $680,000

16. ABSORPTION vs VARIABLE COSTING Extended Example – Overbay Inc – Continued
Variable Costing Income Statement
Net Income under Variable Costing: $560,000

17. is higher than net income under variable costing ($560,000).
ABSORPTION vs VARIABLE COSTING Extended Example – Overbay Inc – Continued
2006 Conclusions
When units produced (10) exceeds units sold (8), net income under absorption costing ($680,000)
is higher than net income
under variable costing ($560,000).
Why?
Cost of ending inventory is higher under absorption costing than under variable costing.

18. ABSORPTION vs VARIABLE COSTING Extended Example – Overbay Inc – Continued
Absorption Costing
10 drones produced; 12 drones sold from current year production and 2 from inventory
Fixed manufacturing overhead of $ 720,000 expensed
$120,000 from 2006 and included in beginning inventory
$600,000 incurred in 2007
When units produced (10) are less than units sold (12), net income under absorption costing is less than net income under variable costing by the amount of fixed manufacturing costs included in beginning inventory.

19. ABSORPTION vs VARIABLE COSTING Extended Example – Overbay Inc – Continued
Absorption Costing Income Statement
Net Income under Absorption Costing: $1,060,000

20. ABSORPTION vs VARIABLE COSTING Extended Example – Overbay Inc – Continued
Variable Costing Income Statement
Net Income under Variable Costing: $1,180,000

21. Comparison of Net Income under the Two Approaches
ABSORPTION vs VARIABLE COSTING Extended Example – Overbay Inc – Continued
Comparison of Net Income under the Two Approaches

22. ABSORPTION vs VARIABLE COSTING Summary of Income Effects

23. DECISION-MAKING CONCERNS
Generally Accepted Accounting Principles (GAAP)
Must be followed for external reporting
Requires absorption costing for inventory
Does not differentiate between fixed and variable costs
Poor business decisions may result
Thus, variable costing used for internal decision making

24. DECISION-MAKING CONCERNS
Example - Basic Data for Lighting Division
Decision: Produce 20,000 or 30,000 units?

25. DECISION-MAKING CONCERNS Example – Continued
Comparative Absorption Costing Income Statements
At 20,000 units, net income is $85,000.
At 30,000 units, net income is $105,000 with 10,000 unit ending inventory.
Difference in income due to $20,000 fixed costs assigned to ending inventory.
Based on these statements, should production be increased?

26. DECISION-MAKING CONCERNS Example – Continued
Comparative Variable Costing Income Statements
At both levels, net income is $85,000.
Fixed costs treated as a period expense.
10,000 units of ending inventory include only variable costs.
Based on these statements, should production be increased?

27. ADVANTAGES OF VARIABLE COSTING Study Objective 3
Consistent with CVP and incremental analysis
Net income unaffected by changes in production levels
Net income closely tied to changes in sales levels – not production levels
Easier to identify fixed and variable costs and their effect on company

28. SALES MIX Study Objective 4
Companies often sell more than one product
Critical decision:
what mix of products to sell
Relative percentage in which each product is sold when more than one product is sold
Important because different products have substantially different contribution margins

29. SALES MIX Break-Even Sales In Units
Steps for a mix of two or more products:
Compute the weighted-average unit contribution margin of all the products:
Product 1 Unit Contribution Margin X Percentage of Sales
+ Product 2 Unit Contribution Margin X Percentage of Sales
= Weighted Average Unit Contribution Margin
Compute the break-even point in units:
Fixed Costs ÷ Weighted Average = Break-even
Unit Contribution Point
Margin in Units

30. SALES MIX Break-Even Sales In Units
Example – Vargo Video Basic Data
Sells both DVD players and TVs
Fixed costs of $200,000

31. SALES MIX - Break-Even Sales In Units Example – Vargo Video Continued
Determine weighted-average unit contribution margin for the sales mix of 75 percent DVDs and 25 percent TVs:
Determine the break-even point in units:

32. SALES MIX - Break-Even Sales In Units Example – Vargo Video (Continued)
Verify the number of DVDs and TVs to be sold to break even with a sales mix of 75 % DVDs and 25 % TVs and with fixed costs of $200,000:

33. SALES MIX Break-Even Sales In Units
At any level of units sold,
net income will be greater
if more high contribution margin units
are sold
than low contribution margin units.

34. SALES MIX Break-Even Sales In Dollars
Steps for a mix of many products in two or more product lines or divisions:
Compute the weighted-average unit contribution margin ratio of all product lines or divisions:
Division 1 Contribution Margin Ratio X Percentage of Sales
+ Division 2 Contribution Margin Ratio X Percentage of Sales
= Weighted Average Contribution Margin Ratio
Compute the break-even point in dollars:
Fixed Costs ÷ Weighted Average = Break-even
Contribution Point
Margin Ratio in Dollars

35. SALES MIX Break-Even Sales In Dollars
Example – Kale Garden Supply Co. Basic Data
Total fixed costs $300,000
Two Product Divisions:
Indoor Plants:
Sales Mix Ratio %
Contribution Margin Ratio %
Outdoor Plants:
Sales Mix Ratio %
Contribution Margin Ratio 30%

36. SALES MIX - Break-Even Sales In Dollars Example – Kale Garden Supply (Continued)
Determine weighted-average contribution margin ratio for all divisions:
Determine the break-even point in dollars:

37. SALES MIX - Break-Even Sales In Dollars Example – Kale Garden Supply (Continued)
Using Kale’s sales mix of 20 percent and 80 percent, break-even sales from each division:
Indoor Plant Division:
$187,500
(.20 X $937,500)
Outdoor Plant Division:
$750,000
(.80 X $937,500)

38. SALES MIX - Break-Even Sales In Dollars Example – Kale Garden Supply (Continued)
Break-even point affected by a shift in sales from one division to another
Shift sales to the Indoor Plant Division:
Division’s higher contribution margin ratio increases weighted average contribution margin ratio
Results in a lower break-even point in sales dollars
Shift sales to the Outdoor Plant Division:
Opposite effect occurs due to Division’s lower contribution margin ratio

39. Understanding and managing critical to company success
SALES MIX
Understanding and managing
sales mix is
critical to company success