Variable Costing: A Tool for Management 3/17/04 Chapter 7 Variable Costing: A Tool for Management 3/17/04

Absorption Costing Treats all manufacturing costs as product costs, and non-manufacturing costs as period costs Unit costs consist of direct material and direct labor and both variable and fixed manufacturing overhead. Fixed manufacturing overhead is allocated to each unit of production GAAP

Variable Costing Only those costs of manufacturing that vary with output (variable costs) are treated as product costs This would include direct material, direct labor and variable manufacturing overhead Fixed manufacturing overhead is expensed during the current period Variable costing is used for internal planning and control only; it’s not GAAP!

Overview of Absorption and Variable(Marginal) Costing The only cost of driving my car on a 200 mile trip today is $12 for gasoline. Variable Costing

Overview of Absorption and Variable Costing No! You must consider these costs too! Absorption Costing

Overview of Absorption and Variable (Marginal) Costing You are wrong. I have the car payment and the insurance payment even if I do not make the trip. Variable Costing

Overview of Absorption and Variable Costing Who’s right? How should we treat the car payment and the insurance?

Marginal Costing Provides a useful tool for evaluating marginal business propositions Example, WTT exhibit Marginal costs versus fixed costs

Overview of Absorption and Variable Costing Absorption Costing Variable Costing Product Costs Period Costs Direct Materials Direct Labor Variable Manufacturing Overhead Fixed Manufacturing Overhead Variable Selling and Administrative Expenses Fixed Selling and Administrative Expenses Product Costs Period Costs

Note: Manufacturing Cost Flows Balance Sheet Costs Inventories Income Statement Expenses Material Purchases Work in Process Finished Goods Raw Materials Direct Labor Variable Manufacturing Overhead Absorption costing Cost of Goods Sold Fixed Mfr’g OH Selling and Administrative Fixed Manufacturing Overhead Variable costing Selling and Administrative Period Costs

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. . .

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. . .

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 ...

Quick Check  Assets = Liabilities + Owners’ Equity   Which method will produce the highest retained earnings? (Hint: Remember the balance sheet equation.) a. Absorption costing, because some fixed costs stay in inventory until the product is sold b. Variable costing c. There would be no difference in retained earnings under the two methods. d. It depends ... Assets = Liabilities + Owners’ Equity  

Overview of Absorption and Variable Costing Let’s put some numbers to the issue and see if it will sharpen our understanding.

Unit Cost Computations Harvey Co. produces a single product with the following information available:

Unit Cost Computations Unit product cost is determined as follows: Selling and administrative expenses are always treated as period expenses and deducted from revenue.

Income Comparison of Absorption and Variable Costing Harvey Co. had no beginning inventory, produced 25,000 units and sold 20,000 units this year.

Income Comparison of Absorption and Variable Costing Harvey Co. had no beginning inventory, produced 25,000 units and sold 20,000 units this year.

Income Comparison of Absorption and Variable Costing Now let’s look at variable costing by Harvey Co. Variable costs only. All fixed manufacturing overhead is expensed.

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.

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.

Income Comparison of Absorption and Variable Costing Let’s compare the methods.

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

Extending the Example Let’s look at the second year of operations for Harvey Company.

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.

Unit product cost is determined as follows: Harvey Co. Year 2 Unit product cost is determined as follows: No change in Harvey’s cost structure.

produced in the current period. Harvey Co. Year 2 These are the 25,000 units produced in the current period.

All fixed manufacturing overhead is expensed. Harvey Co. Year 2 Variable costs only. All fixed manufacturing overhead is expensed.

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

Summary

Comparative Income Effects Exhibit 7-4 Production = Sales No change in inventory; income the same for both absorption and variable costing Production > Sales Inventories increase; Absorption Income higher than Variable Cost income due to more fixed cost retained in inventory Production < Sales Inventories decrease; Absorption Income lower than Variable Cost income as more fixed costs are released from inventory

Advantages of the Variable Cost Approach Consistent with CVP analysis. Management finds it easy to understand. Can be used for marginal Cost analysis. Advantages Easier to estimate profitability of products and segments. Profit is not affected by changes in inventories. Impact of fixed costs on profits emphasized.

Variable versus Absorption Costing All manufacturing costs must be assigned to products to properly match revenues and costs. Fixed costs are not really the costs of any particular product. Variable Costing Absorption Costing

Variable versus Absorption Costing Depreciation, taxes, insurance and salaries are just as essential to products as variable costs. These are capacity costs and will be incurred even if nothing is produced. Absorption Costing Variable Costing

Variable versus Absorption costing They are the numbers that appear on our external reports. Absorption costing product costs are misleading for decision making. Absorption Costing Variable Costing

End of Chapter 7