Financial and Managerial Accounting Wild, Shaw, and Chiappetta Fifth Edition Wild, Shaw, and Chiappetta Fifth Edition Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 19 Variable Costing and Performance Reporting

Conceptual Learning Objectives C1: Describe how absorption costing can result in overproduction. C2: Explain the role of variable costing in pricing special orders. 19-3

A1: Compute and interpret break-even volume in units. Analytical Learning Objectives 19-4

P1: Compute unit cost under both absorption and variable costing. P2: Prepare and analyze an income statement using absorption costing and using variable costing. P3: Prepare a contribution margin report. P4: Convert income under variable costing to the absorption cost basis. Procedural Learning Objectives 19-5

Absorption costing (also called full costing), assumes that products absorb all costs incurred to produce them. While widely used for financial reporting (GAAP), this costing method can result in misleading product cost information for managers’ business decisions. Absorption costing (also called full costing), assumes that products absorb all costs incurred to produce them. While widely used for financial reporting (GAAP), this costing method can result in misleading product cost information for managers’ business decisions. Absorption Costing & Variable Costing C1 19-6

Absorption Costing & Variable Costing Under variable costing, only costs that change in total with changes in production level are included in product costs. C2 19-7

Distinguishing between Absorption Costing and Variable Costing: Absorption Costing Absorption Costing Direct Materials Direct Labor Variable Overhead Fixed Overhead Product Cost P1 19-8

Distinguishing between Absorption Costing and Variable Costing: Variable Costing Variable Costing Direct Materials Direct Labor Variable Overhead Fixed Overhead Product CostPeriod Cost P1 19-9

Difference between Absorption Costing and Variable Costing: Computing Unit Cost P

Difference between Absorption Costing and Variable Costing: Computing Unit Cost P $180,000/ 60,000 units = $3/unit $600,000/ 60,000 units = $10/unit Variable OH cost per unit: Fixed OH cost per unit:

Analysis of Income Reporting for Both Absorption and Variable Costing P

Analysis of Income Reporting for Absorption Costing: Units Produced Equal Units Sold P2 Notice that the net income is $580,

Analysis of Income Reporting for Variable Costing: Units Produced Equal Units Sold P We can see that the income under variable costing is also $580,000. This is because the number of units produced are equal to the number of units sold.

Contribution Margin Report P3 Contribution margin is the excess of sales over total variable expenses Contribution margin contributes to covering fixed costs and earning income 19-15

Contribution Margin Report P3 The contribution margin ratio is Contribution Margin Sales

Analysis of Income Reporting for Both Absorption and Variable Costing: Units Produced Equal Units Sold P

Analysis of Income Reporting for Variable Costing: Units Produced Exceed Units Sold P

Analysis of Income Reporting for Absorption Costing: Units Produced Exceed Units Sold P2 Income for 2012 is $320,

Analysis of Income Reporting for Variable Costing: Units Produced Exceed Units Sold P2 Under variable costing, the net income is only $120,

Analysis of Income Reporting for Variable Costing: Units Produced Exceed Units Sold P2 Under absorption costing,$200,000 of fixed overhead is allocated to the 20,000 units in ending inventory and is not expensed until future periods. Variable costing expenses the entire $600,000 of fixed overhead

Analysis of Income Reporting for Both Absorption and Variable Costing: Units Produced Exceed Units Sold P

Analysis of Income Reporting for Absorption Costing: Units Produced Are Less Than Units Sold P2 Income is now $840,

Analysis of Income Reporting for Variable Costing: Units Produced Are Less Than Units Sold P2 Income under variable costing is $1,040,

Analysis of Income Reporting for Both Absorption and Variable Costing: Units Produced Are Less Than Units Sold P

Summarizing Income Reporting P

Converting Reports under Variable Costing to Absorption Costing P

Planning Production C1 Producing too much inventory Excess inventory Higher storage and financing costs Greater risk of obsolescence Producing too little inventory Lost sales Customer dissatisfaction 19-28

Planning Production: Income under Absorption Costing for Different Production Levels C1 Why is income under absorption costing affected by the production level when that for variable costing is not? The answer lies in the different treatment of fixed overhead costs within the two methods

Planning Production C When 60,000 units are produced: Fixed overhead per unit is: $600,000/ 60,000 units = $10/unit When 100,000 units are produced: Fixed overhead per unit is: $600,000/ 100,000 units = $6/unit

Planning Production: Income under Absorption Costing for Different Production Levels C1 Exhibit The 41% income increase is computed as: $820,000-$580,000 = 0.41 Note: Income under absorption costing is 41% greater if management produces 40,000 more units than necessary and builds up ending inventory. $580,000

Planning Production: Income under Variable Costing for Different Production Levels C1 Exhibit

Setting Prices Over the Long Run: Price must be high enough to cover all costs, including variable costs and fixed costs, and still provide an acceptable return to owners C

Setting Prices Over the Short Run: Fixed production costs such as the cost to maintain plant capacity do not change with changes in production levels. With excess capacity, increases in production level would increase variable production costs, but not fixed costs. While managers try to maintain the long-run price on existing orders, which covers all production costs, managers should accept special orders provided the special order price exceeds variable cost. C

Setting Prices (Special Orders Illustration) C Should the company accept a special order for 1,000 pairs of skates at an offer price of $22 per pair?

Limitations of Reports Using Variable Costing P4 For income tax purposes, absorption costing is the only acceptable basis for filings with the Internal Revenue Service (IRS) under the Tax Reform Act of Absorption costing is the only acceptable basis for external reporting under both U.S. GAAP and IFRS

Calculating Breakeven We can use the data in the following contribution margin format for IceAge to help us determine break-even point. A

Calculating Breakeven Contribution margin per unit = Sales price per unit – Variable cost per unit Break-even volume in units = Total fixed costs Contribution margin per unit A

Calculating Breakeven A1 IceAge’s Break-Even Volume in Units Total fixed costs CM per unit = $800,000 $23 per unit =34,783 units (rounded) IceAge’s Contribution Margin per Unit = Sales price per unit – Variable cost per unit = $40 - $17 = $23

End of Chapter