John Wiley & Sons, Inc. © 2005 Prepared by Dan R. Ward Suzanne P. Ward University of Louisiana at Lafayette Managerial Accounting Weygandt Kieso Kimmel CHAPTER 7 VARIABLE COSTING: 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.

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.  Understand how operating leverage affects profitability.

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

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

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

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

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.

ABSORPTION COSTING VERSUS VARIABLE COSTING Absorption Costing Income Statement

ABSORPTION COSTING VERSUS VARIABLE COSTING Variable Costing Income Statement

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

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

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

ABSORPTION vs VARIABLE COSTING Extended Example – Overbay Inc – Continued  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 Absorption Costing

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

ABSORPTION vs VARIABLE COSTING Extended Example – Overbay Inc – Continued Variable Costing Income Statement 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.

ABSORPTION vs VARIABLE COSTING Extended Example – Overbay Inc – Continued  10 drones produced; 12 drones sold - 10 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. Absorption Costing

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

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

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

ABSORPTION vs VARIABLE COSTING Summary of Income Effects

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

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

DECISION-MAKING CONCERNS Example – Continued  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. Comparative Absorption Costing Income Statements Based on these statements, should production be increased?

DECISION-MAKING CONCERNS Example – Continued  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. Comparative Variable Costing Income Statements Based on these statements, should production be increased?

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

SERVICE COMPANY PERSPECTIVE  Distinction between fixed and variable costs very relevant  Shipping companies rely heavily on variable costing for pricing decisions  When operating below full capacity, absorption costing results in a high charge per shipment  Resulting in price too high compared to competitors  Creates further decline in operations

Let’s Review Fixed manufacturing overhead costs are recognized as: a.Period costs under absorption costing b.Product costs under absorption costs c.Product costs under variable costing d.Part of ending inventory costs under both absorption and variable costing

Let’s Review Fixed manufacturing overhead costs are recognized as: a.Period costs under absorption costing b.Product costs under absorption costs c.Product costs under variable costing d.Part of ending inventory costs under both absorption and variable costing

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

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

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

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:

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:

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.

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 Ratioin Dollars

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 20% Contribution Margin Ratio 40% Outdoor Plants: Sales Mix Ratio 80% Contribution Margin Ratio 30%

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:

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)

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

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

COST STRUCTURE AND OPERATING LEVERAGE Study Objective 5 Cost Structure  Relative proportion of fixed versus variable costs for a company  Can have a significant impact on profits

COST STRUCTURE AND OPERATING LEVERAGE Operating Leverage  Extent to which a company’s net income reacts to a given change in sales  Higher fixed cost structure increases sensitivity to changes in sales; thus, higher operating leverage  Profits increase rapidly when sales increase and plunge drastically when sales decrease  When used carefully, can add to company profitability

COST STRUCTURE AND OPERATING LEVERAGE Example – Makers of Croquet Mallets  Old English Mallet Company - Labor-intensive manufacturing approach  New Wave Mallet Company - Completely automated system  Same sales and same net income  Managed differently due to different cost structures

COST STRUCTURE AND OPERATING LEVERAGE Effect on Contribution Margin Ratio Example – Makers of Croquet Mallets (Continued)  Higher cost structure for New Wave  More sensitive to changes in sales  Higher operating leverage  Net income increases 60¢ for each additional sales dollar  Net income decreases 60¢ for each lost sales dollar

COST STRUCTURE AND OPERATING LEVERAGE Degree of Operating Leverage  Measures earnings volatility Example – Makers of Croquet Mallets (Continued)  Higher operating leverage for New Wave  Net income changes 4 times (6 ÷ 1.5) as much as Old English with an equal change in sales  Exposed to greater earnings volatility risk

COST STRUCTURE AND OPERATING LEVERAGE Effect on Break-Even Point Example – Makers of Croquet Mallets (Continued)  Higher break-even point for New Wave  Needs $150,000 more in sales than Old English to break even  Riskier than Old English  Cannot survive for very long unless it breaks even

COST STRUCTURE AND OPERATING LEVERAGE Effect on Margin of Safety Ratio Example – Makers of Croquet Mallets (Continued) Old English could sustain a 67 percent decline in sales before operating at a loss New Wave could only have a 17 percent decline in sales prior to being in “the red” Thus, New Wave is riskier than Old English

Summary of Study Objectives  Explain the difference between absorption costing and variable costing  Absorption costing: Fixed manufacturing costs are product costs  Variable costing: Fixed manufacturing costs are period costs

Summary of Study Objectives  Explain the effect that changes in production level have on net income measured under absorption costing versus variable costing  If production volume exceeds sales volume, net income under absorption costing will be higher by the amount of fixed manufacturing costs in ending inventory  If production volume is less than sales volume, net income under absorption costing will be less by the amount of fixed manufacturing costs in the units sold but not manufactured during the period

Summary of Study Objectives  Discuss the relative merits of absorption costing versus variable costing for management decision making.  Variable costing is consistent with CVP analysis and incremental analysis  Net income under variable costing is unaffected by changes in production levels  Variable costing allows easier identification of fixed costs and the evaluation of their impact on profitability  Explain the term sales mix and its effect on break-even sales.  Sales mix is the relative proportion in which each product is sold  In a multi-product company, break-even sales in dollars is calculated using the weighted-average contribution margin ratio

Summary of Study Objectives  Understand how operating leverage affects profitability.  The degree to which a company’s net income reacts to a change in sales  Determined by a company’s relative use of fixed versus variable costs  Companies with high fixed costs relative to variable costs have high operating leverage and vice versa  High operating leverage results in a sharp increase (decrease) in net income with an increase (decrease) in sales  The degree of operating leverage can be measured by dividing contribution margin by net income

Let’s Review Sales mix is: a.Important to sales managers but not to accountants b.Easier to analyze on absorption costing income statements c.A measure of the relative percentage of a company’s variable costs to its fixed costs d.A measure of the relative percentage in which a company’s products are sold

Let’s Review Sales mix is: a.Important to sales managers but not to accountants b.Easier to analyze on absorption costing income statements c.A measure of the relative percentage of a company’s variable costs to its fixed costs d.A measure of the relative percentage in which a company’s products are sold

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