Chapter 21 Variable Costing

Learning Objectives Distinguish between variable costing and absorption costing Compute operating income using variable costing and absorption costing

Learning Objectives Use variable costing to make management decisions for a manufacturing business Use variable costing to make management decisions for a service business

Learning Objective 1 Distinguish between variable costing and absorption costing

How Does Variable Costing Differ from Absorption Costing? Managerial accounting provides managers with information that is useful for internal decision making. The cost of producing products is estimated using one of two methods: Absorption costing: Incudes all product costs. Variable costing: Considers only variable manufacturing costs. The purpose of managerial accounting is to provide managers with information that is useful for decision making—for planning and controlling decisions. In this chapter, two methods of determining the cost of producing products are discussed. Absorption costing is the product costing method that assigns direct materials, direct labor, variable manufacturing overhead, and fixed manufacturing overhead to products. It is required by GAAP for external reporting. On the other hand, variable costing is the product costing method that assigns only variable manufacturing costs to products: direct materials, direct labor, and variable manufacturing overhead. It is used for internal reporting.

How Does Variable Costing Differ from Absorption Costing? Exhibit 21-1 summarizes the differences between absorption costing and variable costing. Key differences between the two methods are highlighted in green. Absorption costing is used for external reports, and variable costing is used for internal reports. Generally Accepted Accounting Principles require the use of absorption costing. Absorption costing uses a traditional income statement, whereas variable costing uses a contribution margin income statement.

Comparison of Unit Product Costs Exhibit 21-2 summarizes Smart Touch Learning’s price and cost information, based on its 2018 income statement first illustrated in Chapter 16. To determine the unit cost using absorption costing, add the cost per tablet for the variable manufacturing costs: direct materials of $150, direct labor of $75, variable manufacturing overhead of $20, and the fixed manufacturing per unit of $55 ($110,000 fixed manufacturing overhead / 2,000 units). To determine the unit product cost using variable costing, simply add the cost per tablet for the variable manufacturing costs: direct materials of $150, direct labor of $75, and variable manufacturing overhead of $20.

Comparison of Unit Product Costs The unit product costs under both absorption and variable costing are summarized in Exhibit 21-3. Notice that the variable costing per unit product costs only includes variable product costs, whereas absorption costing includes all product costs. Notice that the selling and administrative costs, both fixed and variable, are not included in the unit product cost calculations. Both costing methods consider selling and administrative costs to be period costs. Variable costing also considers fixed manufacturing overhead to be a period cost.

Learning Objective 2 Compute operating income using variable costing and absorption costing

How Does Operating Income Differ Between Variable Costing and Absorption Costing? Variable costing and absorption costing will result in different operating income when: Units produced are more than units sold and Units produced are less than units sold The operating income result is the same under both methods when units produced equal units sold. Now that you know how to calculate unit product costs using variable costing and absorption costing, let’s see the effects the two methods have on calculating operating income. There are three different scenarios to consider: (1) units produced equal units sold, (2) units produced are more than units sold, and (3) units produced are less than units sold.

How Does Operating Income Differ Between Variable Costing and Absorption Costing? Income statements for absorption costing and variable costing: Absorption Costing Variable Costing Sales Less: Cost of Goods Sold Direct Materials Direct Labor Variable Manufacturing Overhead Fixed Manufacturing Overhead Less: Variable Costs Variable Selling & Admin. Expenses Gross Profit Contribution Margin Less: Selling and Admin. Expenses Fixed Selling & Admin. Expenses Less: Fixed Costs Operating Income This exhibit shows the income statements for absorption costing and variable costing in more detail. We see the main categories again. For absorption costing, we have Sales less Cost of Goods Sold equals Gross Profit. Gross Profit less Selling and Administrative Expenses equals Operating Income. For variable costing, we have Sales less Variable Costs equals Contribution Margin. Contribution Margin less Fixed Costs equals Operating Income. Thus, it is clear that the two approaches use different formats for the income statement. It is evident that the two approaches classify costs differently. Under absorption costing, product costs are reported in Cost of Goods Sold, whereas under variable costing, product costs are reported in Variable Costs. Variable costing emphasizes cost behavior when classifying costs, whereas absorption costing emphasizes functional areas. Differences in the treatment of specific costs are highlighted in red. Under absorption costing, Fixed Manufacturing Overhead is included on a per unit basis in the products that are sold during each accounting period. Under variable costing, Fixed Manufacturing Overhead is immediately expensed in total each accounting period. As a result, the amount of fixed manufacturing overhead that is expensed under the two approaches is different. Another difference is the placement of Variable Selling and Administrative Expenses. Under absorption costing, Variable Selling and Administrative Expenses are reported under Selling and Administrative Expenses. Under variable costing, variable selling and administrative expenses are reported under Variable Cost.

Production Equals Sales Assume the following: There is no beginning Finished Goods Inventory. Number of units produced is 2,000, and units sold is also 2,000. There is no ending Finished Goods Inventory because all units were sold. Operating income is the same under both methods. Assume there is no beginning Finished Goods Inventory. If the number of units produced equals the number of units sold, then there is no ending Finished Goods Inventory. When this situation occurs, the operating income under absorption costing equals the operating income under variable costing.

Production Equals Sales Exhibit 21-4 shows that there is no difference in operating income between the two costing methods. The reason is that all fixed costs are expensed. In other words, because the ending Finished Goods Inventory balance is zero, and there are no production costs assigned to the inventory accounts, all costs incurred have been recorded as expenses and deducted from revenues on the income statement.

Production Exceeds Sales Assume the following: There is no beginning Finished Goods Inventory. Produced 2,500 tablet computers. Sold 2,000 tablet computers. 500 units are included in ending Finished Goods Inventory. Operating income under absorption costing is greater than under variable costing. Assume that there is no beginning balance in Finished Goods Inventory. If the number of units produced exceeds the number of units sold, then there is an ending balance in Finished Goods Inventory. In this case, operating income under absorption costing exceeds operating income under variable costing. This is because the operating income is more under absorption costing since some of the fixed manufacturing costs are part of the ending inventory and not yet expensed.

Production Exceeds Sales Assume that Smart Touch Learning produced 2,500 tablet computers during the year and sold 2,000 units. The ending balance in Finished Goods Inventory is 500 units (Beginning balance 0 + Units produced 2,500 – Units sold 2,000). The increase in production decreased the total unit product cost from $300 (Exhibit 21-3) to $289 under absorption costing because the total fixed costs are distributed among a greater number of units.

Production Exceeds Sales Exhibit 21-6 shows that operating income is greater under absorption costing than under variable costing. The reason is that with absorption costing, some manufacturing fixed costs are still in ending Finished Goods Inventory on the balance sheet and have not been expensed. The difference between the operating incomes for the two methods is $22,000 ($181,000 – $159,000). This is the same difference in ending Finished Goods Inventory ($144,500 – 122,500).

Production Exceeds Sales Exhibit 21-7 illustrates the assignment of production costs in absorption costing and variable costing. In absorption costing, the costs assigned to ending Finished Goods Inventory are greater, and the costs expenses are less than the assignment in variable costing when units produced exceed units sold. This is because, in contrast to absorption costing, in variable costing, all fixed manufacturing costs are expensed in the period incurred.

Production Is Less Than Sales Assume the following: There are 500 units in beginning Finished Goods Inventory. Produced 1,500 tablet computers. Sold 2,000 tablet computers. Zero units in ending Finished Goods Inventory. Operating income under absorption costing is less than under variable costing. When the number of units produced is less than the number of units sold, operating income under absorption costing is less than operating income under variable costing. This is the opposite of the situation seen previously.

Production Is Less Than Sales The fixed manufacturing overhead costs per unit is recalculated because the number of units produced is 1,500 instead of 2,000, as shown in a previous example.

Production Is Less Than Sales Exhibit 21-9 shows the income statements for Smart Touch Learning for Year 3, using absorption costing and variable costing. When more units are sold than produced, operating income is less under absorption costing.

Production Is Less Than Sales Exhibit 21-10 illustrates the assignment of production costs in absorption costing and variable costing.

Production Is Less Than Sales Exhibit 21-11 summarizes the income statements for the three years. In the three years illustrated for Smart Touch Learning, the only difference was the number of tablet computers produced. In each year, the number of tablets sold, the sales price per unit, the variable costs per unit, and the total fixed costs were the same. In Exhibit 21-11, operating income under absorption costing was greater than operating income under variable costing in Year 2, when production exceeded sales. Notice that the three-year total of operating income is the same under both costing methods.

Learning Objective 3 Use variable costing to make management decisions for a manufacturing business

How Can Variable Costing Be Used for Decision Making in a Manufacturing Company? For decision making, some cases should use variable costing, while other cases should use absorption costing. Manager decisions include: Setting sales prices Controlling costs Planning production With the unit product cost information calculated under absorption costing and variable costing, managers can use the information to make decisions. In come cases, variable costing is more appropriate for decision making, but in other cases, absorption costing is more appropriate. In the long run, the sales price charged to customers must cover the full cost of the product. The full cost includes every part of the life cycle of the product: research and development, design, production, distribution, customer service, and disposal. Any fixed manufacturing costs must be included, so absorption costing is more appropriate when determining the product costs for long-term planning. However, in the short run, variable costing should be used in some cases. Short-term pricing decisions are discussed in more detail in a later chapter. In the long run, all costs are controllable. The production supervisor should focus on the costs that are controllable at the production level—that is, the variable manufacturing costs: direct materials, direct labor, and variable manufacturing overhead. Production planning decisions are similar to sales price decisions: Short-term decisions should be made using variable costing, and long-term decisions should be made using absorption costing. In the short run, production is limited by capacity, so variable costing is appropriate.

Analyzing Profitability Managers analyze profitability for products and segments. Managers must determine which products to sell. Managers assess the success or failure of the businesses segments. Managers analyze the contribution margin per unit and make decisions about the sales mix of its products. Managers make decisions about products and business segments using variable costing.

Products Assume that Smart Touch Learning sells two tablet computer models: standard and premium. The premium model has several superior features and costs more to manufacture than the standard model, but it also sells at a higher price. The cost data for the both models is provided in Exhibit 21-12.

Business Segments Many companies divide their business into segments. A business segment is an identifiable part of a company for which financial information is available. Businesses can be segmented by geography, customer types, products, or salespersons. Exhibit 21-13 shows the contribution margin income statements for two territories. In addition, Exhibit 21-13 shows that even though both sales representatives sold the same number of tablets, Salinas had higher revenues, whereas Carey had a higher contribution margin and contribution margin ratio.

Profitability Analysis Exhibit 21-14 shows the contribution margin by product for each territory. Salinas’s sales mix was 68% standard units and 32% premium units. Carey’s sales mix was 92% standard units and 8% premium units. Because the standard model has a higher contribution margin ratio than the premium model, Carey was able to contribute more to the company’s profits.

Analyzing Contribution Margin Exhibit 21-15 shows the income statements in contribution margin format for two accounting periods for Smart Touch Learning.

Analyzing Contribution Margin Exhibit 21-16 shows the contribution margin income statement divided into various components: total, units, amount per unit, and percent of sales. The change in contribution margin was the result of changes in both components: units and amount per unit. In other words, there was a volume effect and a price/cost effect. Further investigation revealed that direct materials cost increased by $60 per tablet, causing variable manufacturing costs to increase from $270 to $330 per tablet. The change in sales price by $50 per unit did not offset the increase in cost per unit.

Summary Exhibit 21-17 summarizes the situation in which managers must make decisions and the costing system that is more appropriate for each situation.

Learning Objective 4 Use variable costing to make management decisions for a service business

How Can Variable Costing Be Used for Decision Making in a Service Company? Service companies provide services, rather than products, to their customers. No inventory or Cost of goods sold Variable costing can be used by services since they have both fixed and variable costs. Service companies provide services to customers and therefore do not have inventory or cost of goods sold. However, they have fixed and variable costs associated with providing services. Because service companies have both fixed and variable costs, variable costing can also be used in service companies.

Operating Income The income statement for a service company, JR’s Towing Services, is shown in Exhibit 21-18.

Profitability Analysis JR’s Towing Services has analyzed its data and determined that it can separate the data into two business segments: city and county. The income statement by business segment is shown in Exhibit 21-19. Notice that the fixed costs are listed only in the Total column. These costs are considered common costs, not segment costs. By separating revenues and variable costs by business segment, we can see that the city jobs are much more profitable, with a 60% contribution margin ratio compared to 40% for county jobs. In addition, by separating costs by behavior, fixed and variable, the company can calculate the contribution margin ratio by dividing the contribution margin by revenues.

Contribution Margin Analysis Exhibit 21-20 shows the expanded statements with units and amounts per unit. The difference between the contribution margin for city and county is due to the higher variable costs per unit associated with county jobs. The county jobs require longer trips and incur more gas and drivers’ wages.