1. 11th Edition Chapter 7

2. Variable Costing: A Tool for Management
Chapter Seven
Two general approaches are used for valuing inventories and cost of goods sold. One approach, called absorption costing, is generally used for external reporting. The other approach, called variable costing, is preferred by some managers for internal decision making and must be used when an income statement is prepared in the contribution format. This chapter shows how these two methods differ from each other.

3. 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
Absorption costing (also called full costing) charges products with all manufacturing costs, regardless of whether the costs are fixed or variable. The cost of a unit of product consists of all four types of manufacturing costs — direct material, direct labor, variable manufacturing overhead, and fixed manufacturing overhead. Since no distinction is made between variable and fixed costs, absorption costing is not well suited for cost-volume-profit analysis.
Variable costing (also called direct costing) charges products with only the variable manufacturing costs. The cost of a unit of product consists of the three variable manufacturing costs — direct material, direct labor, and variable manufacturing overhead. Variable costing is consistent with the contribution format income statement and it supports cost-volume-profit analysis because of its emphasis on separating variable and fixed costs.
The only difference in the two approaches is the treatment of fixed manufacturing overhead. With absorption costing, fixed manufacturing overhead is a product cost. With variable costing, fixed manufacturing overhead is a period cost. Note that selling and administrative costs are treated as period costs with both absorption costing and variable costing.
Think about the impact of each method on inventory values, and then answer the following question.

4. 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. . .
To answer this question correctly, recall which method includes more manufacturing costs in the unit product cost.

5. 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. . .
Unit product costs are in both work in process and finished goods inventories. Absorption costing results in the highest inventory values because it treats fixed manufacturing overhead as a product cost. Using variable costing, fixed manufacturing overhead is expensed as incurred and never becomes a part of the product cost.

6. Unit Cost Computations
Harvey Company produces a single product with the following information available:
Harvey Company makes twenty-five thousand units of a single product. Variable manufacturing costs total ten dollars per unit. Variable selling and administrative expenses are three dollars per unit. Fixed manufacturing overhead for the year is one hundred fifty thousand dollars and fixed selling and administrative expenses for the year are one hundred thousand dollars.

7. Unit Cost Computations
Unit product cost is determined as follows:
With variable costing, only the ten dollars per unit variable manufacturing costs (direct material, direct labor, and variable manufacturing overhead) are product costs. With absorption costing, we include fixed manufacturing overhead in product costs. To compute the per unit amount of fixed manufacturing overhead, we divide one hundred fifty thousand dollars of fixed manufacturing overhead by the twenty-five thousand units manufactured.
Selling and administrative expenses are always treated as period expenses and deducted from revenue as incurred.
Selling and administrative expenses are always treated as period expenses and deducted from revenue as incurred.

8. Income Comparison of Absorption and Variable Costing
Let’s assume the following additional information for Harvey Company.
20,000 units were sold during the year at a price of $30 each.
There were no units in beginning inventory.
Now, let’s compute net operating income using both absorption and variable costing.
We need some additional information to allow us to prepare income statements for Harvey Company:
Twenty thousand units were sold during the year.
There were no units in beginning inventory.
Now let’s prepare income statements for Harvey Company. We will start with an absorption income statement.

9. Absorption Costing
Harvey had no beginning inventory and sold only twenty thousand of the twenty-five thousand units produced, leaving five thousand units in ending inventory. The sales price is thirty dollars per unit, so sales revenue for the twenty thousand units sold is six hundred thousand dollars. The computation of cost of goods sold on your screen starts with beginning inventory, adds cost of goods manufactured and subtracts ending inventory. We could also compute cost of goods sold directly by multiplying twenty thousand units sold times the sixteen dollar unit cost. We subtract cost of goods sold from sales to get the two hundred eighty thousand dollar gross margin.
We subtract selling and administrative expenses from gross margin to get absorption cost net operating income of one hundred twenty thousand dollars. The sixty thousand dollar variable selling and administrative expense is computed by multiplying twenty thousand units sold times three dollars per unit. The one hundred thousand dollar fixed administrative expense was given earlier.

10. Variable Costing Variable manufacturing costs only.
All fixed manufacturing overhead is expensed.
Now let’s examine a variable cost income statement. Notice that this is a contribution format statement. First, we subtract all variable expenses from sales to get contribution margin. The first variable expense is variable cost of goods sold, which is computed using only the ten dollar per unit variable manufacturing cost. The next variable expense is the variable selling and administrative expense. It is computed as before, twenty thousand units sold at three dollars per unit.
After computing contribution margin, we subtract fixed expenses to get the ninety thousand dollar variable cost net operating income. Note that all of the one hundred fifty thousand dollars of fixed manufacturing overhead is expensed as a lump sum.

11. Income Comparison of Absorption and Variable Costing
Let’s compare the methods.
The only difference between the two methods is the treatment of fixed manufacturing overhead. Absorption costing treats fixed manufacturing overhead as a product cost using an overhead rate of six dollars per unit. As a result, thirty thousand dollars of fixed manufacturing overhead is left in inventory as a part of the cost of the five thousand unsold units.
Income computed using variable costing expenses all one hundred fifty thousand dollars of the fixed manufacturing overhead as a period expense. None of the fixed manufacturing overhead remains in inventory with variable costing. The variable costing inventory of fifty thousand dollars is computed by multiplying the ten dollar per unit variable product cost times the five thousand unsold units.

12. Reconciliation
We can reconcile the difference between absorption and variable income as follows:
The difference between absorption cost net operating income and variable cost net operating income results from the thirty thousand dollars of fixed manufacturing overhead remaining in inventory as a part of cost of the five thousand unsold units using absorption costing. Using variable costing, this thirty thousand dollars is expensed in the period resulting in a net operating income that is thirty thousand dollars less than absorption cost net operating income.
The thirty thousand dollars can be computed by multiplying the five thousand unsold units times the six dollar fixed manufacturing overhead cost per unit.
We can reconcile the difference between the two methods by adding the thirty thousand dollars to the ninety thousand dollar variable cost income to get the one hundred twenty thousand dollar absorption cost net operating income.
Fixed mfg. Overhead $150,000
Units produced ,000 units
= = $6.00 per unit

13. Extended Comparison of Income Data Harvey Company Year Two
In the second year, Harvey Company again makes twenty-five thousand units of the same product, but sells thirty thousand units. Five thousand units are in beginning inventory, left from last year. The sales price is the same as last year, thirty dollars per unit.
Variable manufacturing costs total ten dollars per unit. Variable selling and administrative expenses are three dollars per unit. Fixed manufacturing overhead for the year is one hundred fifty thousand dollars and fixed selling and administrative expenses for the year are one hundred thousand.

14. Unit Cost Computations
With variable costing, only the ten dollars per unit variable manufacturing costs (direct material, direct labor, and variable manufacturing overhead) are product costs. With absorption costing, we include fixed manufacturing overhead in product costs. To compute the per unit amount of fixed manufacturing overhead, we divide one hundred fifty thousand dollars of fixed manufacturing overhead by the twenty-five thousand units manufactured.
Since there was no change in the per unit variable costs, total fixed costs, or the number of units produced, the unit costs remain unchanged.
Since there was no change in the variable costs per unit, total fixed costs, or the number of units produced, the unit costs remain unchanged.

15. produced in the current period.
Absorption Costing
These are the 25,000 units
produced in the current period.
Harvey sold thirty thousand units in the second year, twenty-five thousand units produced in the second year plus five thousand units from beginning inventory. The sales price is again thirty dollars per unit, so sales revenue for the thirty thousand units sold is nine hundred thousand dollars. The computation of cost of goods sold on your screen starts with beginning inventory, adds cost of goods manufactured and subtracts ending inventory. We could also compute cost of goods sold directly by multiplying thirty thousand units sold times the sixteen dollar unit cost. We subtract cost of goods sold from sales to get the four hundred twenty thousand dollar gross margin.
We subtract selling and administrative expenses from gross margin to get absorption cost net operating income of two hundred thirty thousand dollars. The ninety thousand dollar variable selling and administrative expense is computed by multiplying thirty thousand units sold times three dollars per unit. The one hundred thousand dollar fixed administrative expense was given.

16. Variable Costing All fixed manufacturing overhead is expensed.
Variable manufacturing costs only.
All fixed manufacturing overhead is expensed.
Now let’s examine a variable cost income statement for the second year. Again, notice that this is a contribution format statement. First, we subtract all variable expenses from sales to get contribution margin. The first variable expense is variable cost of goods sold, which is computed using only the ten dollar per unit variable manufacturing cost. The next variable expense is the variable selling and administrative expense. It is computed as before, thirty thousand units sold at three dollars per unit.
After computing contribution margin, we subtract fixed expenses to get the two hundred sixty thousand dollar variable cost net operating income. Note that all of the one hundred fifty thousand dollars of fixed manufacturing overhead is expensed as a lump sum.

17. Reconciliation
We can reconcile the difference between absorption and variable income as follows:
The difference between absorption cost net operating income and variable cost net operating income results from the thirty thousand dollars of fixed manufacturing overhead released from beginning inventory using absorption costing. Using variable costing, this thirty thousand dollars was expensed in the first year, never becoming a part of the inventory value.
The thirty thousand dollars can be computed by multiplying the five thousand units from inventory times the six dollar fixed manufacturing overhead cost per unit.
We can reconcile the difference between the two methods by subtracting the thirty thousand dollars from the two hundred sixty thousand dollar variable cost income to get the two hundred thirty thousand dollar absorption cost net operating income.
Fixed mfg. Overhead $150,000
Units produced ,000 units
= = $6.00 per unit

18. Income Comparison
For the two-year time period, both methods report the same total income, three hundred fifty thousand dollars, because for the two-year period total sales of fifty thousand units equals total production of fifty thousand units.
Although sales and production may differ in any given year, over an extended period of time sales cannot exceed production, nor can production greatly exceed sales. The shorter the time period, the more the net operating income figures will tend to differ.

19. Summary
On your screen is a nice summary of what we have observed from the Harvey Company’s two years:
For year one, Harvey’s production exceeded sales. Fixed manufacturing overhead was deferred into inventory with absorption costing, so absorption costing net operating income was greater than variable costing net operating income.
For year two, Harvey’s production was less than sales. Fixed manufacturing overhead was released from inventory with absorption costing, so absorption costing net operating income was less than variable costing net operating income.
For the two years combined, production equaled sales so absorption costing net operating income equaled variable costing net operating income.

20. Effect of Changes in Production on Net Operating Income
Let’s revise the Harvey Company example.
In the previous example, 25,000 units were produced each year, but sales increased from 20,000 units in year one to 30,000 units in year two.
In the previous example, twenty-five thousand units were produced each year, but sales increased from twenty thousand units in year one to thirty thousand units in year two.
Let’s revisit Harvey Company, but this time we will hold sales constant and allow production to change.
In this revised example, production will differ each year while sales will remain constant.

21. Effect of Changes in Production Harvey Company Year One
In the first year, Harvey Company makes thirty thousand units of the same product, but sells twenty-five thousand units. Five thousand units are left in ending inventory. The sales price is thirty dollars per unit.
Variable manufacturing costs total ten dollars per unit. Variable selling and administrative expenses are three dollars per unit. Fixed manufacturing overhead for the year is one hundred fifty thousand dollars and fixed selling and administrative expenses for the year are one hundred thousand dollars.

22. Unit Cost Computations for Year One
Unit product cost is determined as follows:
Since the number of units produced increased in this example, while the fixed manufacturing overhead remained the same, the absorption unit cost is less.
With variable costing, only the ten dollars per unit variable manufacturing costs (direct material, direct labor, and variable manufacturing overhead) are product costs. With absorption costing, we include fixed manufacturing overhead in product costs. To compute the per unit amount of fixed manufacturing overhead, we divide one hundred fifty thousand dollars of fixed manufacturing overhead by the thirty thousand units manufactured.
Note that the fixed manufacturing overhead cost per unit is now fifteen dollars per unit, a decline from sixteen dollars per unit in the previous example. Since the number of units produced increased to thirty thousand in this example, and the fixed manufacturing overhead remained the same, the absorption unit cost is less.

23. Absorption Costing: Year One
Harvey had no beginning inventory and sold only twenty-five thousand of the thirty thousand units produced, leaving five thousand units in ending inventory. The sales price is thirty dollars per unit, so sales revenue for the twenty-five thousand units sold is seven hundred fifty thousand dollars. The computation of cost of goods sold on your screen starts with beginning inventory, adds cost of goods manufactured and subtracts ending inventory. We could also compute cost of goods sold directly by multiplying twenty-five thousand units sold times the sixteen dollar unit cost. We subtract cost of goods sold from sales to get the three hundred seventy five thousand dollar gross margin.
We subtract selling and administrative expenses from gross margin to get absorption cost net operating income of two hundred thousand dollars. The seventy-five thousand dollar variable selling and administrative expense is computed by multiplying twenty-five thousand units sold times three dollars per unit. The one hundred thousand dollar fixed administrative expense was given.

24. Variable Costing: Year One
Variable manufacturing costs only.
All fixed manufacturing overhead is expensed.
Now let’s examine a variable cost income statement prepared in the contribution format. First, we subtract all variable expenses from sales to get contribution margin. The first variable expense is variable cost of goods sold, which is computed using only the ten dollar per unit variable manufacturing cost. The next variable expense is the variable selling and administrative expense. It is computed as before, twenty-five thousand units sold at three dollars per unit.
After computing contribution margin, we subtract fixed expenses to get the one hundred seventy-five thousand dollar variable cost net operating income. Note that all of the one hundred fifty thousand dollars of the fixed manufacturing overhead is expensed as a lump sum.

25. Effect of Changes in Production Harvey Company Year Two
In the second year, Harvey Company again sells twenty-five thousand units, but makes only twenty thousand units. Five thousand units are in beginning inventory, left from last year. The sales price is the same as last year, thirty dollars per unit.
Variable manufacturing costs total ten dollars per unit. Variable selling and administrative expenses are three dollars per unit. Fixed manufacturing overhead for the year is one hundred fifty thousand dollars and fixed selling and administrative expenses for the year are one hundred thousand dollars.

26. Unit Cost Computations for Year Two
Unit product cost is determined as follows:
Since the number of units produced decreased in the second year, while the fixed manufacturing overhead remained the same, the absorption unit cost is now higher.
With variable costing, only the ten dollar per unit variable manufacturing costs (direct material, direct labor, and variable manufacturing overhead) are product costs. With absorption costing, we include fixed manufacturing overhead in product costs. To compute the per unit amount of fixed manufacturing overhead, we divide one hundred fifty thousand dollars of fixed manufacturing overhead by the twenty thousand units manufactured.
Note that the fixed manufacturing overhead cost per unit is now seventeen dollars and fifty cents per unit, an increase from fifteen dollars per unit in the first year. Since the number of units produced decreased from thirty thousand in the first year to twenty thousand in the second year, while the fixed manufacturing overhead remained the same, the absorption unit cost is higher.

27. Absorption Costing: Year Two
These are the 20,000 units produced in the current period at the higher unit cost of $17.50 each.
Harvey again sold twenty-five thousand units in the second year, twenty thousand units produced in the second year plus five thousand units from beginning inventory. The sales price is again thirty dollars per unit, so sales revenue for the twenty-five thousand units sold is seven hundred fifty thousand dollars, the same as for the first year. The computation of cost of goods sold on your screen starts with beginning inventory, adds cost of goods manufactured and subtracts ending inventory. We subtract cost of goods sold from sales to get the three hundred twenty-five thousand dollar gross margin.
We subtract selling and administrative expenses from gross margin to get absorption cost net operating income of one hundred fifty thousand dollars. The seventy-five thousand dollar variable selling and administrative expense is computed by multiplying twenty-five thousand units sold times three dollars per unit. The one hundred thousand dollar fixed administrative expense was given.

28. Variable Costing: Year Two
Variable manufacturing costs only.
All fixed manufacturing overhead is expensed.
Now let’s examine a variable cost income statement for the second year. Again, notice that this is a contribution format statement. First, we subtract all variable expenses from sales to get contribution margin. The first variable expense is variable cost of goods sold, which is computed using only the ten dollar per unit variable manufacturing cost. The next variable expense is the variable selling and administrative expense. It is computed as before, twenty-five thousand units sold at three dollars per unit.
After computing contribution margin, we subtract fixed expenses to get the one hundred seventy-five thousand dollar variable cost net operating income. Note that all of the one hundred fifty thousand dollars of fixed manufacturing overhead is expensed as a lump sum.

29. Income Comparison Conclusions
 Net operating income is not affected by changes in production using variable costing.
 Net operating income is affected by changes in production using absorption costing even though the number of units sold is the same each year.
Conclusions
For the two-year time period, both methods report the same total income, three hundred fifty thousand dollars, because for the two-year period, total sales of fifty thousand units equals total production of fifty thousand units.
Although sales and production may differ in any given year, over an extended period of time sales cannot exceed production, nor can production greatly exceed sales. The shorter the time period, the more the net operating income figures will tend to differ.
Unit sales are the same for both years, twenty-five thousand units. Note that variable cost net operating income is the same for each year, which is what we would expect since units sales are the same for both years. Variable cost net operating income is not affected by changes in production.
However, absorption costing net operating income differs each year because it is affected by the change in production from year one to year two.

30. Impact on the Manager
Opponents of absorption costing argue that shifting fixed manufacturing overhead costs between periods can lead to misinterpretations and faulty decisions.
Those who favor variable costing argue that the income statements are easier to understand because net operating income is only affected by changes in unit sales. The resulting income amounts are more consistent with managers’ expectations.
Opponents of absorption costing argue that shifting fixed manufacturing overhead costs between periods can be confusing and lead to misinterpretations and even to faulty decisions.
Those opponents of absorption costing argue variable costing income statements are easier to understand because net operating income is only affected by changes in unit sales. The resulting net operating income amounts are more consistent with managers’ expectations.

31. CVP Analysis, Decision Making and Absorption costing
Absorption costing does not support CVP analysis because it essentially treats fixed manufacturing overhead as a variable cost by assigning a per unit amount of the fixed overhead to each unit of production.
Treating fixed manufacturing overhead as a variable cost can:
Lead to faulty pricing decisions and keep/drop decisions.
Produce positive net operating income even when the number of units sold is less than the breakeven point.
Absorption costing does not support CVP analysis because it essentially treats fixed manufacturing overhead as a variable cost by assigning a per unit amount of the fixed overhead to each unit of production.
Treating fixed manufacturing overhead as a variable cost can:
Lead to faulty pricing decisions and keep/drop decisions.
Produce positive net operating income even when the number of units sold is less than the breakeven point.

32. External Reporting and Income Taxes
To conform to GAAP requirements, absorption costing must be used for external financial reports in the United States.
Under the Tax Reform Act of 1986, absorption costing must be used when filing income tax returns.
Since top executives are usually evaluated based on external reports to shareholders, they may feel that decisions should be based on absorption cost income.
To conform to GAAP requirements, absorption costing must be used for external financial reports in the United States. Since top executives are usually evaluated based on earnings reported to shareholders in external reports, they may feel that decisions should be based on absorption cost income. Under the Tax Reform Act of 1986, absorption costing must be used when filing income tax returns.

33. Advantages of Variable Costing and the Contribution Approach
Consistent with
CVP analysis.
Management finds it more useful.
Net operating income
is closer to net cash flow.
Consistent with standard costs and flexible budgeting.
Advantages
The advantages of variable costing and the contribution approach include:
The data required for cost-volume-profit analysis can be taken directly from a contribution format income statement.
Profits move in the same direction as sales assuming other things remain the same.
Managers often assume that unit product costs are variable. Under variable costing, this assumption is true.
The impact of fixed costs on profits is emphasized because fixed costs appear explicitly on the contribution format income statement.
Variable costing data make it easier to estimate the profitability of products, customers, and other business segments.
Variable costing ties in with cost control methods such as standard costs and flexible budgeting.
Variable costing net operating income is closer to net cash flow than absorption costing net operating income.
Easier to estimate profitability of products and segments.
Profit is not affected by changes in inventories.
Impact of fixed
costs on profits
emphasized.

34. Variable versus Absorption Costing
Fixed manufacturing costs must be assigned to products to properly match revenues and costs.
Fixed manufacturing costs are capacity costs and will be incurred even if nothing is produced.
Advocates of absorption costing argue that it better matches costs with revenues. They contend that fixed manufacturing costs are just as essential to manufacturing products as are the variable costs.
Advocates of variable costing view fixed manufacturing costs as capacity costs. They argue that fixed manufacturing costs should not be considered product costs because they would be incurred even if no units were produced.
Absorption Costing
Variable Costing

35. Variable Costing and the Theory of Constraints (TOC)
Companies involved in TOC use a form of variable costing, but treating direct labor as a fixed cost for three reasons:
Many companies have a commitment to guarantee workers a minimum number of paid hours.
TOC emphasizes the role of direct labor in continuous improvement. Fluctuating levels of direct labor can devastate morale and defeat the role of employees in continuous improvement efforts.
Direct labor is usually not the constraint.
Companies involved in Theory of Constraint (TOC) applications use a form of variable costing, but they treat direct labor as a fixed cost for three reasons:
Although direct labor is paid an hourly wage, many companies have a commitment — sometimes enforced by labor contracts or by the law — to guarantee workers a minimum number of paid hours.
TOC emphasizes the role of direct labor in continuous improvement Fluctuating levels of direct labor can devastate morale and defeat the role of employees in continuous improvement efforts.
Direct labor is usually not the constraint.

36. Impact of JIT Inventory Methods
In a JIT inventory system . . .
Production tends to equal sales . . .
When companies use Just–in–Time inventory methods, the goal is to eliminate finished goods inventory and to reduce work in process inventory to very low levels. The reduction in inventory levels causes absorption costing net operating income to essentially move in the same direction as sales. The result is that the difference between absorption costing and variable costing tend to disappear.
So, the difference between variable and
absorption income tends to disappear.

37. End of Chapter 7
Variable costing and absorption costing are two different approaches for valuing inventories and cost of goods sold. Absorption costing is generally used for external reporting. Variable costing is preferred by some managers for internal decision making and cost-volume-profit analysis.
The shifting of fixed manufacturing overhead between reporting periods using absorption costing can cause net operating income to fluctuate with production decisions, leading to possible confusion and unwise decisions.