Variable Costing: A Tool for Management Chapter 7

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Overview of Absorption and Variable Costing The only cost of driving my car on a 200 mile trip today is $12 for gasoline. Variable Costing

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Overview of Absorption and Variable Costing No! You must consider these costs too! Absorption Costing

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Overview of Absorption and Variable Costing You are wrong. I have the car payment and the insurance payment even if I do not make the trip. Variable Costing

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Overview of Absorption and Variable Costing Who’s right? How should we treat the car payment and the insurance?

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Overview of Absorption and Variable Costing Direct Materials Direct Labor Variable Manufacturing Overhead Fixed Manufacturing Overhead Variable Selling and Administrative Expenses Fixed Selling and Administrative Expenses Variable Costing Absorption Costing Product Costs Period Costs Product Costs Period Costs

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Variable costing Balance Sheet Costs Inventories Note: Manufacturing Cost Flows Income Statement Expenses Cost of Goods Sold Selling and Administrative Period Costs Work in Process Finished Goods Raw Materials Variable Manufacturing Overhead Material Purchases Direct Labor Selling and Administrative Fixed Manufacturing Overhead Absorption costing

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin 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... 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...

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin 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... 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... Quick Check

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Quick Check Which method will produce the highest retained earnings? (Hint: Remember the balance sheet equation.) a. Absorption costing b. Variable costing c. There would be no difference in retained earnings under the two methods. d. It depends... Which method will produce the highest retained earnings? (Hint: Remember the balance sheet equation.) a. Absorption costing b. Variable costing c. There would be no difference in retained earnings under the two methods. d. It depends...

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Which method will produce the highest retained earnings? (Hint: Remember the balance sheet equation.) a. Absorption costing b. Variable costing c. There would be no difference in retained earnings under the two methods. d. It depends... Which method will produce the highest retained earnings? (Hint: Remember the balance sheet equation.) a. Absorption costing b. Variable costing c. There would be no difference in retained earnings under the two methods. d. It depends... Quick Check Assets = Liabilities + Owners’ Equity   Assets = Liabilities + Owners’ Equity  

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Note: Manufacturing Cost Flows

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Quick Check Which method will produce the highest cumulative net operating income? a. Absorption costing b. Variable costing c. There would be no difference in cumulative net operating income under the two methods. d. It depends... Which method will produce the highest cumulative net operating income? a. Absorption costing b. Variable costing c. There would be no difference in cumulative net operating income under the two methods. d. It depends...

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Which method will produce the highest cumulative net operating income? a. Absorption costing b. Variable costing c. There would be no difference in cumulative net operating income under the two methods. d. It depends... Which method will produce the highest cumulative net operating income? a. Absorption costing b. Variable costing c. There would be no difference in cumulative net operating income under the two methods. d. It depends... Quick Check

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Quick Check If the Internal Revenue Service lets you use either absorption or variable costing, which method should you choose to minimize your taxes? (Assume that once you have decided which method to use, you cannot later change.) a. Absorption costing. b. Variable costing. c. The two methods would have the same effect on taxes. If the Internal Revenue Service lets you use either absorption or variable costing, which method should you choose to minimize your taxes? (Assume that once you have decided which method to use, you cannot later change.) a. Absorption costing. b. Variable costing. c. The two methods would have the same effect on taxes.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin If the Internal Revenue Service lets you use either absorption or variable costing, which method should you choose to minimize your taxes? (Assume that once you have decided which method to use, you cannot later change.) a. Absorption costing. b. Variable costing. c. The two methods would have the same effect on taxes. If the Internal Revenue Service lets you use either absorption or variable costing, which method should you choose to minimize your taxes? (Assume that once you have decided which method to use, you cannot later change.) a. Absorption costing. b. Variable costing. c. The two methods would have the same effect on taxes. Quick Check

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Let’s put some numbers to the issue and see if it will sharpen our understanding. Overview of Absorption and Variable Costing

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Harvey Co. produces a single product with the following information available: Unit Cost Computations

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Unit product cost is determined as follows: Selling and administrative expenses are always treated as period expenses and deducted from revenue. Unit Cost Computations

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Harvey Co. had no beginning inventory, produced 25,000 units and sold 20,000 units this year. Income Comparison of Absorption and Variable Costing

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Harvey Co. had no beginning inventory, produced 25,000 units and sold 20,000 units this year. Income Comparison of Absorption and Variable Costing

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Now let’s look at variable costing by Harvey Co. Variable costs only. All fixed manufacturing overhead is expensed. Income Comparison of Absorption and Variable Costing

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Quick Check The net operating income under absorption costing was $120,000 and under variable costing it was $90,000 because of higher expenses. Where is the missing $30,000 under absorption costing? a. It has disappeared into an accounting black hole. b. It is in ending inventories. c. It represents taxes that have been saved. d. The $30,000 wasn’t a real cost, so nothing is really missing. The net operating income under absorption costing was $120,000 and under variable costing it was $90,000 because of higher expenses. Where is the missing $30,000 under absorption costing? a. It has disappeared into an accounting black hole. b. It is in ending inventories. c. It represents taxes that have been saved. d. The $30,000 wasn’t a real cost, so nothing is really missing.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The net operating income under absorption costing was $120,000 and under variable costing it was $90,000 because of higher expenses. Where is the missing $30,000 under absorption costing? a. It has disappeared into an accounting black hole. b. It is in ending inventories. c. It represents taxes that have been saved. d. The $30,000 wasn’t a real cost, so nothing is really missing. The net operating income under absorption costing was $120,000 and under variable costing it was $90,000 because of higher expenses. Where is the missing $30,000 under absorption costing? a. It has disappeared into an accounting black hole. b. It is in ending inventories. c. It represents taxes that have been saved. d. The $30,000 wasn’t a real cost, so nothing is really missing. Quick Check

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Let’s compare the methods. Income Comparison of Absorption and Variable Costing

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Reconciliation Fixed mfg. overhead $150,000 Units produced 25,000 units = = $6.00 per unit We can reconcile the difference between absorption and variable income as follows:

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Extending the Example Let’s look at the second year of operations for Harvey Company.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Harvey Co. Year 2 In its second year of operations, Harvey Co. started with an inventory of 5,000 units, produced 25,000 units and sold 30,000 units.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Harvey Co. Year 2 Unit product cost is determined as follows: No change in Harvey’s cost structure.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Harvey Co. Year 2 Now let’s look at Harvey’s income statement assuming absorption costing is used.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Harvey Co. Year 2 These are the 25,000 units produced in the current period.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Harvey Co. Year 2 Next, we’ll look at Harvey’s income statement assuming is used.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Harvey Co. Year 2 Variable costs only. All fixed manufacturing overhead is expensed.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Reconciliation We can reconcile the difference between absorption and variable income as follows: Fixed mfg. overhead $150,000 Units produced 25,000 units = = $6.00 per unit

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Summary

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Summary

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Advantages of the Contribution Approach Advantages Management finds it easy to understand. Consistent with CVP analysis. Net operating income is closer to net cash flow. Profit is not affected by changes in inventories. Consistent with standard costs and flexible budgeting. Impact of fixed costs on profits emphasized. Easier to estimate profitability of products and segments.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Fixed costs are not really the costs of any particular product. Variable Costing Variable versus Absorption Costing Absorption Costing All manufacturing costs must be assigned to products to properly match revenues and costs.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Absorption Costing These are capacity costs and will be incurred even if nothing is produced. Variable versus Absorption Costing Variable Costing Depreciation, taxes, insurance and salaries are just as essential to products as variable costs.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Variable Costing Absorption costing product costs are misleading for decision making. They are the numbers that appear on our external reports. Absorption Costing Variable versus Absorption Costing

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Note on the Effects of Volume Absorption Costing Cost of goods sold decreases because production exceeds sales, leaving a portion of fixed manufacturing costs in inventory.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Note on the Effects of Volume Absorption Costing Cost of goods sold decreases because production exceeds sales, leaving a portion of fixed manufacturing costs in inventory.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Impact of JIT Inventory Methods In a JIT inventory system... Production tends to equal sales... So, the difference between variable and absorption income tends to disappear.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin End of Chapter 7