1. Variable Costing: A Tool for Management

2. Learning Objectives
Explain how variable costing differs from absorption costing
Compute the unit product cost under each method
Prepare income statements using variable and absorption costing, and reconcile the two income figures
Describe how fixed overhead costs are deferred in, and released from, inventory under absorption costing
Explain the advantages and limitations of variable and absorption costing
Prepare a segmented income statement and use it.
Compute companywide and segment break-even points.
Prepare income statements using super-variable costing and reconcile this approach with variable costing.

3. Variable Vs. Absorption Costing
Variable Costing
Absorption 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

4. Quick Test
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. . .

5. Quick Test
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. . .

6. Variable Vs. Absorption Costing Example
Mickey produces a product with a selling price of $100/unit. The following information is available for the first year.

7. Unit Cost Calculations
Selling and administrative expenses are always treated as period costs.

8. Income Statement – Absorption Costing
Fixed manufacturing overhead is allocated
Full mfg. costs

9. Income Statement – Variable Costing
Variable mfg. costs only
All fixed manufacturing overhead is expensed

10. Variable Vs. Absorption Costing Example
In its second year of operation, Mickey accumulated the following information:

11. Unit Cost Calculations
Selling and administrative expenses are always treated as period costs.

12. Income Statement – Absorption Costing
Fixed manufacturing overhead is allocated
Full mfg. costs

13. Income Statement – Variable Costing
Variable mfg. costs only
All fixed manufacturing overhead is expensed

14. Notes
If production > sales (inventory level increases), income (absorption) > income (variable).
Fixed overhead is partially deferred in inventory under absorption costing.
If production < sales (inventory level decreases), income (absorption) < income (variable).
Deferred fixed overhead is released to income statement under absorption costing.
If production = sales (inventory level is the same), Income (absorption) = Income (variable).

15. Reconciliation
In general, the difference in income between absorption and variable costing is the change in inventory value under absorption minus the change in inventory value under variable costing.
However, if unit cost does not change (or if there is no beginning inventory), then:
Income (absorption) - Income (variable) = Fixed overhead per unit * Change in inventory level
where, change in inventory level = production - sales, or EI - BI, in units.

16. Reconciliation
We can reconcile the difference between absorption and variable income as follows:

17. Reconciliation
Alternatively, we can reconcile the differences between absorption and variable income as follows:

18. Arguments For Variable Costing
Should we allocate Fixed overhead to units of output?
Is fixed overhead a product cost (an asset) or a period cost (an expense)?
Variable costing approach blends well (ties in) with CVP analysis, budgeting, segment reporting, etc.
Income under absorption costing may be manipulated by changing the production level.
In 1970s and 1980s, variable costing was used for internal use, but the trend is reversing because fixed overhead is becoming a major part of product cost.

19. Impact of JIT Inventory System
In a JIT inventory system . . .
production tends to equal sales . . .
So, the difference between variable and
absorption income tends to disappear.

20. Segment – Definition and Overview
A segment is any part of an entity for which it is useful to collect revenue, cost, or profit data.
A segment can be
A Customer
A Sales Territory
A Service Center
Dental office

21. Segment Reporting
Segment reporting refers to reports (income statements) that focus on various segments of an entity.
The objective of segment reporting is to provide information on the profitability of segments.
An entity can be segmented based on:
a single criterion at a time (e.g., product lines, products, sales territories)
multiple criteria, or
a combination.

22. Segmenting an Entity – Example
Regal Company
Product Lines
Products
Sales
Territories

23. Segment Income Statement
Segment income statement follows the contribution approach.
The fixed costs are, however, further divided into traceable and common.
Traceable (Direct) costs of a segment are costs that are directly related to that segment or can be reasonably allocated to it.
Common (Indirect) costs are costs that are not directly related to any segment and cannot be reasonably allocated to segments.

24. Identifying Traceable Fixed Costs
Traceable costs would disappear over time if the segment itself disappeared.
No computer
division means . . .
No computer
division manager

25. Identifying Common Fixed Costs
Common costs would not disappear if the segment were eliminated.
No computer
division but . . .
We still have a
company president.

26. Segment Income Statement
Company Television Appliance Computer
Sales $600, $300, $100, $200,000
Variable CGS (215,000) ( 90,000) (75,000) (50,000)
Other V.C (100,000) ( 60,000) (10,000) (30,000)
Contribution margin , , , ,000
Traceable F.C (180,000) ( 90,000) (10,000) ( 80,000)
Segment margin , , , ,000
Common F.C ( 25,000)
Net Income ,000

27. Segment Income Statement
Each segment is charged only for its traceable costs. Common costs of the organization are not charged/allocated to segments.
Traceable costs can become common if the company is divided into smaller segments.
Contribution margin data is useful as a short-term planning tool since it:
reveals the effect of a change in sales volume on income
facilitates decisions on temporary uses of capacity, special orders, and product promotion

28. Segment Income Statement
Segment margin represents the amount that the segment contributes toward the recovery of the common F.C. and then earning a profit.
Segment margin is the best gauge of the long-run profitability of a segment. It is useful for:
long-run capacity changes and pricing decisions
evaluating segments’ performance (i.e., decisions to retain or eliminate segments)
evaluating segment managers’ performance (some would argue that committed FC should be excluded)

29. Quick Test

30. Quick Test
How much of the common fixed cost of $200,000 can be avoided by eliminating the bar?
a. None of it.
b. Some of it.
c. All of it.

31. Quick Test
How much of the common fixed cost of $200,000 can be avoided by eliminating the bar?
a. None of it.
b. Some of it.
c. All of it.

32. Hindrances of Proper Cost Assignment
Omission of some costs in the assignment process
All costs, manufacturing or not, should be assigned.
Use of inappropriate methods for cost allocation
Traceable costs should not be allocated.
Costs that are not easily traceable should not be allocated on an arbitrary basis.
Allocation base should be appropriate.
Assignment of common costs of the organization
Common cost of the organization arise because of overall operating activities and should not be assigned.

33. Companywide and Segment Break-Even Points
Companywide break-even point is computed by dividing the sum of the company’s traceable fixed expenses and common fixed expenses by the company’s overall contribution margin ratio.
A segment’s break-even point is computed by dividing its traceable fixed expenses by its contribution margin ratio.

34. Variable vs. Super-Variable Costing
Super-variable costing classifies all direct labor and manufacturing overhead costs as fixed period costs and only direct materials as a variable product cost.
Super- Variable Costing
Variable Costing
Product Costs
Period Costs
Direct Materials
Direct Labor
Fixed Manufacturing Overhead
Fixed Selling and Administrative Expenses
Product Cost
Period Costs