Prepared by Debby Bloom-Hill CMA, CFM

CHAPTER 5 Variable Costing

Full (Absorption) Costing Required by GAAP for external reporting purposes. Inventory costs include: Direct materials used. Generally variable. Direct labor incurred. Manufacturing overhead. Includes both fixed and variable costs.

Variable Costing Inventory costs includes: Direct materials used. Direct labor incurred. Variable manufacturing overhead. Fixed manufacturing overhead treated as a period cost . Helpful for internal decision making. Not allowed for GAAP reporting.

Difference Between Full and Variable Costing The only difference between full and variable costing is their treatment of fixed manufacturing overhead. Under full costing, fixed manufacturing overhead is included in inventory. These costs enter into the determination of expense only when the inventory is sold. Under variable costing, fixed manufacturing overhead becomes a period expense.

Variable Costing Income Statement Classifies all expenses in terms of their cost behavior, either fixed or variable. With variable and fixed expenses separated, the contribution margin can be presented. Contribution margin is revenues minus total variable expenses. The contribution margin allows users to make reasonable estimates of how much profit will change with changes in sales.

Variable Costing Income Statement Sales are $100,000 and contribution margin is $65,000. Calculate the contribution margin ratio: Calculate the change in contribution margin if sales change by $10,000. $10,000 * 0.65 = $6,500

Variable Costing Income Statement Example

Full Costing Income Statement Example

Variable Costing vs. Full Costing Income Statement The full costing income statement cannot be used to estimate the increase in profit due to an increase in sales. The reason is that cost of goods sold includes both fixed and variable costs. The fixed costs will not increase when sales increase. Under full costing we do not know how much of cost of goods sold is fixed or variable.

Example - Clausen Tube Selling price $2,000. Variable costs (per unit): Materials = $600/unit Labor = $225/unit Variable mfg. overhead = $75/unit Variable selling expense = $40/unit Fixed mfg. overhead = $1,200,000. Production = 5,000 units.

Clausen Tube Full Cost per Unit Full cost per unit for 5,000 units is calculated as follows: Total Material Costs $600 per unit Total labor costs $225 per unit Total variable OH $75 per unit Fixed Overhead $1,200,000/5,000 units $240 per unit Full Cost per Unit = $1,140 per unit

Clausen Tube Variable Cost per Unit Variable cost per unit for 5,000 units is calculated as follows: Total Material Costs $600 per unit Total labor costs $225 per unit Total variable OH $75 per unit Variable Cost per Unit = $900 per unit

Clausen Tube – Income Statements Production equals sales (5,000 units)

Quantity Produced Equals Quantity Sold When the quantity produced equals the quantity sold, there is no difference between net income calculated using full cost versus variable costing. Since all units produced are sold, no fixed cost ends up in ending inventory. The only difference is that variable costing calculates the contribution margin.

Clausen Tube – Income Statements Production (6,000 units) is greater than sales (4,800 units)

Quantity Produced is Greater Than Quantity Sold When the quantity produced is greater than the quantity sold income will be greater under full costing as opposed to variable costing. Under full costing, inventory cost includes some of the fixed manufacturing overhead. Under variable costing, all fixed manufacturing overhead is expensed as a period cost.

Clausen Tube – Income Statements Production (6,000 units) is less than sales (7,200 units)

Quantity Produced is Less Than Quantity Sold When the quantity produced is less than the quantity sold, income will be greater under variable costing as opposed to full costing. Beginning inventory under fixed costing includes fixed manufacturing overhead. When the beginning inventory is charged to cost of goods sold the charge will be higher under full costing.

Impact of Method Selection on Income Statement Units produced = units sold: No difference in net income. Units produced greater than units sold: Full costing yields higher net income. Units produced less than units sold: Variable costing yields higher net income.

Impact of JIT on Income Companies using JIT typically have low levels of inventory. Units produced are approximately equal to units sold. Difference in income between full costing and variable costing is likely to be very small.

Benefits of Variable Costing for Internal Reporting Variable costing facilitates cost-volume-profit (CVP) analysis. Separates fixed and variable costs. Allows managers to accurately estimate the impact of changes in volume on cost and profit. Cannot be answered using full costing.

Benefits of Variable Costing for Internal Reporting Variable costing limits management of earnings via production volume. Managers are often compensated based on income in their division. Full costing produces higher income when production is greater than sales. Managers have an incentive to manage earnings under full costing.

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