Variable Costing
Activity Based Costing
ACCO 20113 Strategic Cost Management
Week 3
James Robert D. Aguila, CPA, CMA
ACCO 20113 Strategic Cost Management
House Rules
• Inform me if I am speaking too fast or unclear.
• Take an active part in class discussions by
asking questions.
• Professional demeanor is expected from
everyone.
• Avoid using mobile phones/gadgets during class
hours. Mobile phones/gadgets must be switched
off or turned to silent mode.
ACCO 20113 Strategic Cost Management
Variable Costing
• Absorption costing vs. variable costing
• Contribution margin income statement
• Reconciliation of absorption income vs. variable costing income
ACCO 20113 Strategic Cost Management
Overview of Absorption
and Variable Costing
Absorption Variable
Costing Costing
Direct Materials
Product
Product Direct Labor
Costs
Costs Variable Manufacturing Overhead
Fixed Manufacturing Overhead
Period
Period Variable Selling and Administrative Expenses
Costs
Costs Fixed Selling and Administrative Expenses
ACCO 20113 Strategic Cost Management
Quick Check ü
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. . .
ACCO 20113 Strategic Cost Management
Quick Check ü
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. . .
ACCO 20113 Strategic Cost Management
Unit Cost Computations
Harvey Company produces a single product
with the following information available:
ACCO 20113 Strategic Cost Management
Unit Cost Computations
Unit product cost is determined as follows:
Selling and administrative expenses are
always treated as period expenses and
deducted from revenue as incurred.
ACCO 20113 Strategic Cost Management
Income Comparison of
Absorption and Variable Costing
Let’s assume the following additional
information for Harvey Company.
w 20,000 units were sold during the year at a price of
$30 each.
w There were no units in beginning inventory.
Now, let’s compute net operating
income using both absorption
and variable costing.
ACCO 20113 Strategic Cost Management
Absorption Costing
ACCO 20113 Strategic Cost Management
Variable Costing
Variable
manufacturing
Variable Costing
costs only.
Sales (20,000 × $30) $ 600,000
Less variable expenses:
Beginning inventory $ -
All fixed
Add COGM (25,000 × $10) 250,000
Goods available for sale 250,000
manufacturing
Less ending inventory (5,000 × $10) 50,000
overhead is
Variable cost of goods sold 200,000 expensed.
Variable selling & administrative
expenses (20,000 × $3) 60,000 260,000
Contribution margin 340,000
Less fixed expenses:
Manufacturing overhead $ 150,000
Selling & administrative expenses 100,000 250,000
Net operating income $ 90,000
ACCO 20113 Strategic Cost Management
Income Comparison of
Absorption and Variable Costing
Let’s compare the methods.
ACCO 20113 Strategic Cost Management
Reconciliation
We can reconcile the difference between
absorption and variable income as follows:
Variable costing net operating income $ 90,000
Add: Fixed mfg. overhead costs
deferred in inventory
(5,000 units × $6 per unit) 30,000
Absorption costing net operating income $ 120,000
Fixed mfg. Overhead $150,000
= = $6.00 per unit
Units produced 25,000 units
ACCO 20113 Strategic Cost Management
Extended Comparison of Income Data
Harvey Company Year Two
ACCO 20113 Strategic Cost Management
Unit Cost Computations
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.
ACCO 20113 Strategic Cost Management
Absorption costing vs. variable
costing income statements
Income statement under Income statement under
absorption costing variable costing
ACCO 20113 Strategic Cost Management
Absorption costing vs. variable
costing income statements
Income statement under Income statement under
absorption costing variable costing
ACCO 20113 Strategic Cost Management
Absorption costing vs. variable
costing income statements
Income statement under Income statement under
absorption costing variable costing
by function
ACCO 20113 Strategic Cost Management
Absorption costing vs. variable
costing income statements
Income statement under Income statement under
absorption costing variable costing
by function
ACCO 20113 Strategic Cost Management
Absorption costing vs. variable
costing income statements
Income statement under Income statement under
absorption costing variable costing
by function by behavior
ACCO 20113 Strategic Cost Management
Variable versus Absorption Costing
Fixed manufacturing
costs must be assigned Fixed manufacturing
to products to properly costs are capacity costs
match revenues and and will be incurred
costs. even if nothing is
produced.
Absorption Variable
Costing Costing
ACCO 20113 Strategic Cost Management
Absorption Costing
Absorption Costing
Sales (30,000 × $30) $ 900,000
Less cost of goods sold:
Beg. inventory (5,000 × $16) $ 80,000
Add COGM (25,000 × $16) 400,000
Goods available for sale 480,000
Less ending inventory - 480,000
Gross margin 420,000
Less selling & admin. exp.
Variable (30,000 × $3) $ 90,000
Fixed 100,000 190,000
Net operating income $ 230,000
These are the 25,000 units
produced in the current period.
ACCO 20113 Strategic Cost Management
Variable Costing
Variable
manufacturing
costs only.
All fixed
manufacturing
overhead is
expensed.
ACCO 20113 Strategic Cost Management
Reconciliation
We can reconcile the difference between
absorption and variable income as follows:
Variable costing net operating income $ 260,000
Deduct: Fixed manufacturing overhead
costs released from inventory
(5,000 units × $6 per unit) 30,000
Absorption costing net operating income $ 230,000
Fixed mfg. Overhead $150,000
= = $6.00 per unit
Units produced 25,000 units
ACCO 20113 Strategic Cost Management
Income Comparison
ACCO 20113 Strategic Cost Management
Summary
ACCO 20113 Strategic Cost Management
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 this revised example,
production will differ each year while
sales will remain constant.
ACCO 20113 Strategic Cost Management
Effect of Changes in Production
Harvey Company Year One
ACCO 20113 Strategic Cost Management
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.
ACCO 20113 Strategic Cost Management
Absorption Costing: Year One
ACCO 20113 Strategic Cost Management
Variable Costing: Year One
Variable
manufacturing
Variable Costing
costs only.
Sales (25,000 × $30) $ 750,000
Less variable expenses:
Beginning inventory $ -
All fixed
Add COGM (30,000 × $10) 300,000
Goods available for sale 300,000
manufacturing
Less ending inventory (5,000 × $10) 50,000
overhead is
Variable cost of goods sold 250,000 expensed.
Variable selling & administrative
expenses (25,000 × $3) 75,000 325,000
Contribution margin 425,000
Less fixed expenses:
Manufacturing overhead $ 150,000
Selling & administrative expenses 100,000 250,000
Net operating income $ 175,000
ACCO 20113 Strategic Cost Management
Effect of Changes in Production
Harvey Company Year Two
ACCO 20113 Strategic Cost Management
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.
ACCO 20113 Strategic Cost Management
Absorption Costing: Year Two
Absorption Costing
Sales (25,000 × $30) $ 750,000
Less cost of goods sold:
Beg. inventory (5,000 × $15) $ 75,000
Add COGM (20,000 × $17.50) 350,000
Goods available for sale 425,000
Less ending inventory - 425,000
Gross margin 325,000
Less selling & admin. exp.
Variable (25,000 × $3) $ 75,000
Fixed 100,000 175,000
Net operating income $ 150,000
These are the 20,000 units produced in the current
period at the higher unit cost of $17.50 each.
ACCO 20113 Strategic Cost Management
Variable Costing: Year Two
Variable
manufacturing
costs only.
All fixed
manufacturing
overhead is
expensed.
ACCO 20113 Strategic Cost Management
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.
ACCO 20113 Strategic Cost Management
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.
ACCO 20113 Strategic Cost Management
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.
ACCO 20113 Strategic Cost Management
Advantages of Variable Costing
and the Contribution Approach
Consistent with
CVP analysis.
Management finds Net operating income
it more useful. is closer to
net cash flow.
Consistent with standard
costs and flexible budgeting.
Advantages
Easier to estimate profitability
of products and segments.
Impact of fixed
costs on profits Profit is not affected by
emphasized. changes in inventories.
ACCO 20113 Strategic Cost Management
Impact of JIT Inventory Methods
In a JIT inventory system . . .
Production
tends to equal
sales . . .
So, the difference between variable and
absorption income tends to disappear.
ACCO 20113 Strategic Cost Management
Exercise
ACCO 20113 Strategic Cost Management
Activity Based Costing and
Activity Based Management
• How costs are being treated under ABC
• Designing an ABC system
• ABC vs. Traditional costing systems
• Process Improvement
ACCO 20113 Strategic Cost Management
Activity Based Costing (ABC)
ABC is a
ABC is designed to good supplement
provide managers with to our traditional
cost information for cost system
I agree!
strategic and other
decisions that
potentially affect
capacity and therefore
affect fixed as well as
variable costs.
ACCO 20113 Strategic Cost Management
How Costs are Treated Under
Activity–Based Costing
“Best practice” ABC differs from traditional costing in five ways.
Manufacturing Nonmanufacturing
costs costs
Traditional ABC
product costing product costing
ABC assigns both types of costs to products.
ACCO 20113 Strategic Cost Management
How Costs are Treated Under
Activity–Based Costing
“Best practice” ABC differs from traditional costing in five ways.
Manufacturing Nonmanufacturing
costs costs
Some
All
Traditional ABC
product costing product costing
ABC does not assign all manufacturing costs to products.
ACCO 20113 Strategic Cost Management
How Costs are Treated Under
Activity–Based Costing
“Best practice” ABC differs from traditional costing in five ways.
Level of complexity
Activity–Based
Costing
Departmental
Overhead
Rates
Plantwide
Overhead
Rate
Number of cost pools
ABC uses more cost pools.
ACCO 20113 Strategic Cost Management
How Costs are Treated Under
Activity–Based Costing
“Best practice” ABC differs from traditional costing in five ways.
Volume
Allocation Bases
measures
plus other
Number of
Bases usually
rely solely on bases.
volume
measures.
Traditional Costing ABC
ABC uses more allocation bases.
ACCO 20113 Strategic Cost Management
How Costs are Treated Under
Activity–Based Costing
“Best practice” ABC differs from traditional costing in five ways.
The most commonly used allocation base
in traditional costing is direct labor hours.
Direct labor hours work
well when overhead
increases as direct
labor hours increase.
ABC uses more allocation bases.
ACCO 20113 Strategic Cost Management
How Costs are Treated Under
Activity–Based Costing
“Best practice” ABC differs from traditional costing in five ways.
The most commonly used allocation base
in traditional costing is direct labor hours.
Problems:
In many processes, overhead is increasing
while direct labor is decreasing.
Variety and complexity of products is increasing.
ABC uses more allocation bases.
ACCO 20113 Strategic Cost Management
How Costs are Treated Under
Activity–Based Costing
“Best practice” ABC differs from traditional costing in five ways.
ABC uses
volume as well as
other allocation bases not
All overhead related to the volume
costs are not related of production.
to volume measures like
direct labor
hours.
ABC uses more allocation bases.
ACCO 20113 Strategic Cost Management
How Costs are Treated Under
Activity–Based Costing
“Best practice” ABC differs from traditional costing in five ways.
Traditional Costing ABC
The predetermined Products are charged
overhead rate is based for the costs of
on budgeted activity. capacity they use – not
This results in applying for the costs of
all overhead costs capacity they don’t
including unused, or use. Unused capacity
idle capacity costs to costs are treated as
products. period expenses.
ABC bases level of activity on capacity.
ACCO 20113 Strategic Cost Management
Characteristics of Successful
ABC Implementations
Strong top
management support
Link to evaluations
and rewards
Cross-functional
involvement
ACCO 20113 Strategic Cost Management
Designing an ABC System
Cost Objects
(e.g., products Activities
and customers)
Consumption
of Resources
Cost
ACCO 20113 Strategic Cost Management
Designing an ABC System
Steps for Implementing ABC
Identify and define activities and activity cost
pools.
Trace costs to activities and cost objects.
Assign costs to activity cost pools.
Calculate activity rates.
Assign costs to cost objects.
Prepare management reports.
ACCO 20113 Strategic Cost Management
Identify and Define Activities
and Activity Cost Pools
Unit-Level Batch-Level
Activity Activity
Manufacturing
companies typically combine
their activities into five
classifications.
Product-Level Customer-Level
Activity Organization- Activity
sustaining
Activity
ACCO 20113 Strategic Cost Management
Identify and Define Activities
and Activity Cost Pools
Activities
should only be
combined within a level
if they are highly
correlated.
When combining
activities, they should be
grouped together only at
the appropriate
level.
ACCO 20113 Strategic Cost Management
Identify and Define Activities
and Activity Cost Pools
An Activity Cost $$
Pool is a “bucket” in $
$ $
which costs are $
accumulated that
relate to a single
activity measure in
the ABC system.
ACCO 20113 Strategic Cost Management
Identify and Define Activities
and Activity Cost Pools
Two types of activity measures:
Transaction Duration
driver driver
Simple count A measure
of the number of of the amount
times an activity of time needed
occurs. for an activity.
ACCO 20113 Strategic Cost Management
Identify and Define Activities
and Activity Cost Pools
At Classic Brass, the ABC team, selected the following
activity cost pools and activity measures:
ACCO 20113 Strategic Cost Management
Identify and Define Activities
and Activity Cost Pools
• Customer Orders - assigned all costs of resources
that are consumed by taking and processing
customer orders.
• Product Designs - assigned all costs of resources
consumed by designing products.
• Order Size - assigned all costs of resources
consumed as a consequence of the number of units
produced.
• Customer Relations – assigned all costs associated
with maintaining relations with customers.
• Other – assigned all overhead costs that are not
associated with the other cost pools.
ACCO 20113 Strategic Cost Management
When Possible, Directly Trace Overhead
Costs to Activities and Cost Objects
ACCO 20113 Strategic Cost Management
Assign Costs to Activity Cost Pools
At Classic Brass the following distribution of resource
consumption across activity cost pools is determined.
**Not included because they are directly traced to customer orders.
ACCO 20113 Strategic Cost Management
Assign Costs to Activity Cost Pools
Indirect factory wages $500,000
Percent consumed by customer orders 25%
$125,000
ACCO 20113 Strategic Cost Management
Assign Costs to Activity Cost Pools
Factory equipment depreciation $300,000
Percent consumed by customer orders 20%
$ 60,000
ACCO 20113 Strategic Cost Management
Assign Costs to Activity Cost Pools
ACCO 20113 Strategic Cost Management
Calculate Activity Rates
The ABC team determines that Classic Brass will
have these total activities for each activity cost
pool . . .
w 1,000 customer orders,
w 200 new designs,
w 20,000 machine-hours,
w 100 customer relations activities.
Now the team can compute the individual
activity rates by dividing the total cost for
each activity by the total activity levels.
ACCO 20113 Strategic Cost Management
Calculate Activity Rates
ACCO 20113 Strategic Cost Management
Activity-Based Costing at Classic Brass
Direct Direct Shipping
Overhead Costs
Materials Labor Costs
Traced Traced Traced
Cost Objects:
Products, Customer Orders, Customers
ACCO 20113 Strategic Cost Management
Activity-Based Costing at Classic Brass
Direct Direct Shipping
Overhead Costs
Materials Labor Costs
First-Stage Allocation
Order Customer Product Customer
Other
Size Orders Design Relations
Cost Objects:
Products, Customer Orders, Customers
ACCO 20113 Strategic Cost Management
Activity-Based Costing at Classic Brass
Direct Direct Shipping
Overhead Costs
Materials Labor Costs
First-Stage Allocation
Order Customer Product Customer
Other
Size Orders Design Relations
Second-Stage Allocations
$/MH $/Order $/Design $/Customer
Cost Objects:
Unallocated
Products, Customer Orders, Customers
ACCO 20113 Strategic Cost Management
Assigning Costs to Cost Objects
Let’s take a look at how our system works
for just one customer – Windward Yachts.
Standard Stanchions (no design required)
1. 400 units ordered with 2 separate orders.
2. Each stanchion required 0.5 machine-hours.
3. Selling price is $34 each.
4. Direct materials total $2,110.
5. Direct labor totals $1,850.
6. Shipping costs total $180.
Custom Compass Housing (requires new design)
1. One order during the year.
2. Each housing required 4 machine-hours.
3. Selling price is $650 each.
4. Direct materials total $13.
5. Direct labor totals $50.
6. Shipping costs total $25.
ACCO 20113 Strategic Cost Management
Assigning Costs to Cost Objects
The customer-level
cost is assigned to
customers directly;
it is not assigned to
products.
ACCO 20113 Strategic Cost Management
Prepare Management Reports
Standard Stanchions
Sales $ 13,600
Cost:
Direct materials $ 2,110
Direct labor 1,850
Shipping costs 180
Customer orders 630
Product design -
Order size 3,800 8,570
Product margin $ 5,030
Custom Compass Housing
Sales $ 650
Cost:
Direct materials $ 13
Direct labor 50
Shipping costs 25
Customer orders 315
Product design 1,285
Order size 76 1,764
Product margin $ (1,114)
ACCO 20113 Strategic Cost Management
Prepare Management Reports
Customer Profitability Analysis
ACCO 20113 Strategic Cost Management
Product Margins
Traditional Cost Accounting System
400 units x 0.5 MH/unit x $50/MH = $10,000
Predetermined manufacturing $1,000,000
= = $50/MH
overhead rate 20,000 MH
ACCO 20113 Strategic Cost Management
Differences Between ABC and
Traditional Product Costs
Product margins are different for four reasons:
Traditional costing assigns design costs to both products
based on machine hours. ABC assigns product design
costs to a product only if product design work is required.
Traditional costing assigns customer order costs, a batch-
level cost, using a unit-level allocation base, machine hours.
ABC assigns these batch-level costs using a batch-level
activity measure.
Traditional costing assigns only manufacturing costs to
products. ABC also assigns nonmanufacturing costs to
products.
Traditional costing assigns all manufacturing costs to
products. The ABC system does not assign organization-
sustaining manufacturing costs to the products.
ACCO 20113 Strategic Cost Management
Differences Between ABC and
Traditional Product Costs
When batch-level and
product-level costs are present,
ABC will usually shift costs from high
volume products, produced in large batches,
to low volume products produced in small batches.
This cost shifting will usually have its
greatest impact on the per
unit cost of the low
volume products.
ACCO 20113 Strategic Cost Management
Targeting Process Improvement
Activity-based management is
used in conjunction with ABC to
identify areas that would benefit
from process improvements.
While the theory of constraints
approach is a powerful tool for
targeting improvement efforts, activity
rates can also provide valuable clues
on where to focus improvement
efforts.
ACCO 20113 Strategic Cost Management
Activity-Based Costing and External Reporting
Most companies do not use ABC
for external reporting because . . .
1. External reports are less detailed than internal
reports.
2. It may be difficult to make changes to the company’s
accounting system.
3. ABC does not conform to GAAP.
4. Auditors may be suspect of the subjective allocation
process based on interviews with employees.
ACCO 20113 Strategic Cost Management
ABC Limitations
Substantial resources Resistance to
required to implement unfamiliar numbers
and maintain. and reports.
Desire to fully Potential
allocate all costs misinterpretation of
to products. unfamiliar numbers.
Does not conform to
GAAP. Two costing
systems may be needed.
ACCO 20113 Strategic Cost Management
Exercise
ACCO 20113 Strategic Cost Management
Questions?
ACCO 20113 Strategic Cost Management
