1 Variable Costing for Management Analysis 20

2 Describe and illustrate income reporting under variable costing and absorption costing. Objective

3 Absorption Costing Under absorption costing, all manufacturing costs are included in finished goods and remain there as an asset until the goods are sold. 20-1

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5 Absorption costing is necessary in determining historical costs for financial reporting to external users and for tax reporting. 20-1

6 Variable costing (also called direct costing) may be more useful to management in making decisions. In variable costing, the cost of goods manufactured is composed only of variable manufacturing costs. Variable Costing 20-1

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8 Variable Costing Absorption Costing Cost of Goods Manufactured DirectMaterialsDirectLaborVariable Factory OH Fixed Period Expense Costs of Goods Manufactured Comparison

99 Variable Costing Income Statement Compared to Absorption Costing Income Statement Assume that Belling Co. manufactured 15,000 units at the following costs: 20-1

Variable Costing Income Statement

Absorption Costing Income Statement

12 The absorption costing income statement does not distinguish between variable and fixed costs. All manufacturing costs are included in the cost of good sold. Deducting cost of goods sold from sales yields gross profit. Deducting selling and administrative expenses then yields income from operations. 20-1

13 Income from Operations When Units Manufactured Equal Units Sold In Exhibits 1 and 2 (Slides 10 and 11), 15,000 units were manufactured and sold. Both the variable and the absorption costing income statements reported the same income from operations of $100,000. Thus, when the number of units manufactured equals the number of units sold, income from operations will be the same under both methods

14 Income from Operations When Units Manufactured Exceed Units Sold Assume that in the preceding example only 12,000 units of the 15,000 units manufactured were sold. Examine Exhibit 3 (Slides 15 and 16) and you will see that income from operations using variable costing is $40,000 while absorption costing provides an income of $70,

Units Manufactured Exceed Units Sold (Continued)

Units Manufactured Exceed Units Sold (Concluded)

17 Operating Income: Absorption costing$70,000 Variable costing 40,000 Difference$30,000 Why is absorption costing income higher when units manufactured exceed units sold?

18 Analysis: 18 Operating Income: Absorption costing$70,000 Variable costing 40,000 Difference$30,000 Units manufactured15,000 Units sold 12,000 Ending inventory units3,000 Fixed cost per unitx $10 Difference$30,

19 Income from Operations When Units Manufactured Are Less than Units Sold Assume that 5,000 units of inventory were on hand at the beginning of a period, 10,000 units were manufactured during the period and 15,000 units were sold at $50 per unit. 20-1

20 Exhibit 4 (Slides 21 and 22) shows the two income statements prepared from the spreadsheet displayed below

Units Manufactured Are Less than Units Sold (Continued)

Units Manufactured Are Less than Units Sold 4 (Concluded)

23 Operating Income: Variable costing$100,000 Absorption costing 50,000 Difference$ 50,000 Why is variable costing income higher when units manufactured are less than units sold?

24 Operating Income: Variable costing$100,000 Absorption costing 50,000 Difference$ 50, Analysis: Units sold15,000 Units manufactured 10,000 Beginning inventory units5,000 Fixed cost per unit x $10 Difference$50,

25 IF Units Sold < Units produced THEN Variable Costing < Absorption CostingIncome Comparing Income from Operations Under the Two Concepts

26 IF Units Sold > Units produced THEN Variable Costing > Absorption CostingIncome

27 Describe and illustrate income analysis under variable costing and absorption costing. Objective

28 Frand Manufacturing Company has no beginning inventory and sales are estimated to be 20,000 units at $75 per unit, regardless of production levels. What will income from operations be if Frand manufactures 20,000 units? 25,000? 20-2

29 Proposal 1: 20,000 Units to be Manufactured and Sold

30 Proposal 2: 25,000 Units to be Manufactured; 20,000 Units to be Sold 20-2

Absorption Costing Income Statements for Two Production Levels $35V 20F $55

Absorption Costing Income Statements for Two Production Levels $35V 16F $51

The $80,000 increase in income from operations would be caused by allocating the fixed manufacturing costs of $400,000 over a greater number of units of production.

34 Now, assume that Frand Manufacturing uses variable costing and has sales of 20,000 units. Exhibit 6 (Slide 35) illustrates that net income remains a constant $200,000 at the three levels of production. 20-2

Variable Costing Income Statements for Two Production Levels

36 Describe and illustrate management’s use of variable costing and absorption costing for controlling costs, pricing products, planning production, analyzing contribution margins, and analyzing market segments. Objective

Accounting Reports and Management Decisions

38 Controllable and Noncontrollable Costs For a specific level of management, controllable costs are costs that can be influenced by management at that level, and noncontrollable costs are costs that another level of management controls. 20-3

39 Pricing Products Many factors enter into determining the selling price of a product. The cost of making the product is clearly significant. In the short run, pricing decisions should be based upon making the best use of existing manufacturing facilities. 20-3

40 In the long run, plant capacity can be increased or decreased. If a business is to continue operating, the selling prices of its products must cover all costs and provide a reasonable income. 20-3

41 Analyzing Contribution Margins Managers can plan and control operations by evaluating the differences between planned and actual contribution margin (Objective 5). 20-3

42 Analyzing Market Segments A market segment is a portion of a business that can be analyzed using sales, costs, and expenses to determine its profitability. 20-3

43 Use variable costing for analyzing market segments including product, territories, and salespersons segments. Objective

44 Camelot Fragrance Company manufactures and sells the Gwenevere perfume for women and the Lancelot cologne line for men. The inventories are negligible. Analyzing Market Segments 20-4

Camelot Fragrance Company

46 Sales Territory Profitability Analysis To illustrate the analysis of profit differences by sales territory, Exhibit 8 (Slide 47) shows the variable costing income statements by sales territories for Camelot Fragrance Company. 20-4

Contribution Margin by Sales Territory Report

48 The contribution margin ratio is 43% ($34,400/$80,000) for the Northern Territory, and 50.5% ($40,400/$80,000) for the Southern Territory. 20-4

49 Sales mix, sometimes referred to as product mix, is defined as the relative distribution of sales among the various products sold. Sales Mix 20-4

50 Product Profitability Analysis Some products are more profitable than others due to differences with respect to pricing, manufacturing costs, advertising support, or salesperson support. Exhibit 9 (Slide 51) shows the contribution margin by product for Camelot Fragrance Company. 20-4

Contribution Margin by Product Line Report

52 Salesperson Profitability Analysis Sales managers may wish to evaluate the performance of salespersons. This may be done with a report that shows contribution margin by salesperson. Such a report is shown in Exhibit 10 (Slide 53) for the Northern Territory salespersons. 20-4

Contribution Margin by Salesperson Report 53

54 Use variable costing for analyzing and explaining changes in contribution margin as a result of quantity and price factors. Objective

55 Contribution Margin Analysis A difference between the planned and actual contribution margin can be caused by: (1) an increase or decrease in the amount of sales or (2) an increase or decrease in the amount of variable costs. 20-5

56 Quantity Factor and Price Factor The quantity factor is the effect of a difference between the actual quantity sold and the planned quantity sold. Unit price factor or unit cost factor is the effect of a difference in unit sales price or unit cost on the number of units sold. 20-5

57 Describe and illustrate the use of variable costing for service firms. Objective

58 Contribution Margin Analysis Unlike a manufacturing firm, a service firm does not make a product for sale. As a result, service firms do not have inventory and thus do not allocate fixed costs to inventory using absorption costing concepts. 20-6

59 Service firms can, however, report and analyze contribution margin as the difference between revenues and variable costs. 20-6