1. Copyright © The McGraw-Hill Companies, Inc 2011 VARIABLE COSTING: A TOOL FOR MANAGEMENT Chapter 6

2. Copyright © The McGraw-Hill Companies, Inc 2011 6-2 Copyright © The McGraw-Hill Companies, Inc 2011 2 Overview of Absorption and Variable Costing Direct Materials Direct Labor Variable Manufacturing Overhead Fixed Manufacturing Overhead Variable Selling and Administrative Expenses Fixed Selling and Administrative Expenses Variable Costing Absorption Costing Product Costs Period Costs Product Costs Period Costs

3. Copyright © The McGraw-Hill Companies, Inc 2011 6-3 Harvey Company produces a single product with the following information available: Unit Cost Computations

4. Copyright © The McGraw-Hill Companies, Inc 2011 6-4 Unit product cost is determined as follows: Under absorption costing, all production costs, variable and fixed, are included when determining unit product cost. Under variable costing, only the variable production costs are included in product costs. Unit Cost Computations

5. Copyright © The McGraw-Hill Companies, Inc 2011 6-5 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 is no beginning inventory. Now, let’s compute net operating income using both absorption and variable costing.

6. Copyright © The McGraw-Hill Companies, Inc 2011 6-6 Copyright © The McGraw-Hill Companies, Inc 2011 6 Absorption Costing Fixed manufacturing overhead deferred in inventory is 5,000 units × $6 = $30,000.

7. Copyright © The McGraw-Hill Companies, Inc 2011 6-7 Copyright © The McGraw-Hill Companies, Inc 2011 7 Variable manufacturing costs only. All fixed manufacturing overhead is expensed. Variable Costing

8. Copyright © The McGraw-Hill Companies, Inc 2011 6-8 Fixed mfg. overhead $150,000 Units produced 25,000 units = = $6 per unit We can reconcile the difference between absorption and variable income as follows: Comparing the Two Methods

9. Copyright © The McGraw-Hill Companies, Inc 2011 6-9 Extended Comparisons of Income Data Harvey Company – Year Two

10. Copyright © The McGraw-Hill Companies, Inc 2011 6-10 Unit Cost Computations Since the variable costs per unit, total fixed costs, and the number of units produced remained unchanged, the unit cost computations also remain unchanged.

11. Copyright © The McGraw-Hill Companies, Inc 2011 6-11 Copyright © The McGraw-Hill Companies, Inc 2011 11 Absorption Costing Fixed manufacturing overhead released from inventory is 5,000 units × $6 = $30,000. Unit product cost.

12. Copyright © The McGraw-Hill Companies, Inc 2011 6-12 Copyright © The McGraw-Hill Companies, Inc 2011 12 Variable Costing All fixed manufacturing overhead is expensed. Variable manufacturing costs only.

13. Copyright © The McGraw-Hill Companies, Inc 2011 6-13 We can reconcile the difference between absorption and variable income as follows: Fixed mfg. overhead $150,000 Units produced 25,000 units = = $6 per unit Comparing the Two Methods

14. Copyright © The McGraw-Hill Companies, Inc 2011 6-14 Copyright © The McGraw-Hill Companies, Inc 2011 14 Comparing the Two Methods

15. Copyright © The McGraw-Hill Companies, Inc 2011 6-15 Copyright © The McGraw-Hill Companies, Inc 2011 15 Summary of Key Insights

16. Copyright © The McGraw-Hill Companies, Inc 2011 6-16 Absorption Costing vs Variable Costing Absorption costing (also called full costing) – CGS includes DM, DL, VOH, and FOH for those units sold (CGS absorbs all manufacturing costs) Absorption costing I/S (Required by GAAP, IRS for external reporting Sales Revenue - CGS (DM + DL+FOH+VOH) Gross Margin - Mktg & Admin Exp (including variable and fixed) Net income

17. Copyright © The McGraw-Hill Companies, Inc 2011 6-17 Variable Costing Variable costing (also called direct costing) – CGS includes DM, DL, and VOH for those units sold (CGS includes only variable manufacturing costs) Variable costing I/S Sales revenue - VC CGS (DM, DL, VOH) - VC Mktg & Admin Contribution Margin - FC Mfg (FOH) - FC Mktg & Admin Net income or operating profit

18. Copyright © The McGraw-Hill Companies, Inc 2011 6-18 Copyright © The McGraw-Hill Companies, Inc 2011 18 Advantages and disadvantages of AC vs VC: Impact on the Manager Opponents of absorption costing argue that shifting fixed manufacturing overhead costs between periods can lead to faulty decisions. These opponents argue that variable costing income statements are easier to understand because net operating income is only affected by changes in unit sales. This produces net operating income figures that are consistent with managers’ expectations.

19. Copyright © The McGraw-Hill Companies, Inc 2011 6-19 CVP Analysis, Decision Making and Absorption costing Absorption costing does not dovetail with CVP analysis, nor does it support decision making. It treats fixed manufacturing overhead as a variable cost. It assigns per unit fixed manufacturing overhead costs to production. Treating fixed manufacturing overhead as a variable cost can: Lead to faulty pricing decisions and faulty keep-or-drop decisions. Treating fixed manufacturing overhead as a variable cost can: Lead to faulty pricing decisions and faulty keep-or-drop decisions. Assigning per unit fixed manufacturing overhead costs to production can: Potentially produce positive net operating income even when the number of units sold is less than the breakeven point. Assigning per unit fixed manufacturing overhead costs to production can: Potentially produce positive net operating income even when the number of units sold is less than the breakeven point.

20. Copyright © The McGraw-Hill Companies, Inc 2011 6-20 Copyright © The McGraw-Hill Companies, Inc 2011 20 Benefits of Absorption Costing: 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 filling out income tax returns. Since top executives are typically evaluated based on earnings reported to shareholders in external reports, they may feel that decisions should be based on absorption costing data. Since top executives are typically evaluated based on earnings reported to shareholders in external reports, they may feel that decisions should be based on absorption costing data.

21. Copyright © The McGraw-Hill Companies, Inc 2011 6-21 Copyright © The McGraw-Hill Companies, Inc 2011 21 Advantages of Variable Costing and the Contribution Approach Advantages Management finds it more useful. Consistent with CVP analysis. Net operating income is closer to net cash flow. Profit is not affected by changes in inventories. Consistent with standard costs and flexible budgeting. Impact of fixed costs on profits emphasized. Easier to estimate profitability of products and segments.

22. Copyright © The McGraw-Hill Companies, Inc 2011 6-22 Copyright © The McGraw-Hill Companies, Inc 2011 22 Variable Costing Variable versus Absorption Costing 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.

23. Copyright © The McGraw-Hill Companies, Inc 2011 6-23 Copyright © The McGraw-Hill Companies, Inc 2011 23 Impact of Lean Production When companies use Lean Production... Production tends to equal sales... So, the difference between variable and absorption income tends to disappear.

24. Copyright © The McGraw-Hill Companies, Inc 2011 6-24 Variable Costing and the Theory of Constraints (TOC) Companies involved in TOC use a form of variable costing. However, one difference of the TOC approach is that it treats direct labor as a fixed cost for three reasons:  Many companies have a commitment to guarantee workers a minimum number of paid hours.  Direct labor is usually not the constraint.  TOC emphasizes the role direct laborers play in driving continuous improvement. Since layoffs often devastate morale, managers involved in TOC are extremely reluctant to lay off employees.

25. Copyright © The McGraw-Hill Companies, Inc 2011 6-25 Example: Profit under variable costing vs Absorption costing DM=$3/unit, DL = $5/unit, VOH = $2/unit, FOH = $50 /year, Variable mktg = $2/unit, Fixed mktg =$10/year, Selling price = $20/unit 20A20B20C Units produced 101010 Units sold 10 911 Under variable costing: 20A(P=S) 20B(P>S) 20C(P<S) Sales $200$180 $220 -VC 120 108 _____ CM 80 72 ______ -FC 60 60 ______ NI 20 12 ______ Under absorption costing: Sales $200$180 $220 -CGS 150 135 ______ GM 50 45 ______ -Mktg 30 28 ______ NI 20 17 ______ Summary: 20A 20B 20C When P=S P>S P<S ThenNI AC = NI VC NI AC > NI VC NI AC < NI VC The difference of NI between VC and AC is due to FOH ;Under VC: All FOH is expensed regardless of sales Under AC: Allocate FOH between units sold (CGS) and units on hand (INV)

26. Copyright © The McGraw-Hill Companies, Inc 2011 6-26 Copyright © The McGraw-Hill Companies, Inc 2011 26 End of Chapter 6