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Chap007 Variable Costing

Variable Costing: A
Tool for Management
and Variable
Two general approaches are used for
valuing inventories and cost of goods sold.
Costing
Overview of
One approach, called absorption costing,
is generally used for external reporting. The
other approach, called variable costing, is

Absorption
preferred by some managers for internal
decision making and must be used when an
income statement is prepared in the
contribution format.

and Variable
Overview of Costing
Absorption Overview of
and Variable Absorption
Costing and Variable
Overview of Costing
Absorption Overview of
and Variable Absorption
Costing and Variable
Overview of Costing
Overview of Absorption and Variable

Absorption Costing

and Variable
Costing
Overview of Absorption Costing (Full Costing)

Absorption  Includes all manufacturing costs

(fixed + variable) in the product cost.
 Costs include direct materials,
direct labor, variable overhead,
and fixed overhead.
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 Not ideal for analyzing cost behavior

because it does not separate fixed
and variable costs.
Variable Costing (Direct Costing)
 Includes only variable
manufacturing costs in the product
cost.
Unit product cost is determined as
 Costs include direct materials, follows:
direct labor, and variable
overhead (fixed overhead is not
included).
 Variable costing is consistent with
the contribution format income
statement and helps with cost-
volume-profit (CVP) analysis by Selling and administrative expenses are
clearly separating variable and fixed always treated as period expenses and
costs. deducted from revenue as incurred.

Income
Key Difference:
 The only difference in the two
approaches is the treatment of fixed


manufacturing overhead.
Absorption costing treats fixed
Comparison
of
overhead as a product cost
(included in inventory).
 Variable costing treats fixed
overhead as a period
(expensed immediately).
cost
Absorption
and Variable
 Selling & administrative costs are
period costs in both methods.
Quick Check ✔
Which method will produce the highest
values for work in process and finished
Costing
goods inventories?
a. Absorption costing. Income
b. Variable costing.
c. They produce the same values for these
Comparison
of
inventories.
d. It depends. . .

Absorption
Absorption costing results in the highest
inventory values because it treats fixed
manufacturing overhead as a product cost.

and Variable
Using variable costing, fixed manufacturing
overhead is expensed as incurred and
never becomes a part of the product cost.
Unit Cost Computations
Harvey Company produces a single
Costing
Income Comparison of Absorption and
product with the following information
available: Variable Costing

1st Year Let’s assume the following additional

information for Harvey Company.
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 20,000 units were sold during the

year at a price of $30 each.
 There were no units in beginning
inventory.

Extended
Comparison
of Income
Data Harvey
Company
Year Two
Extended Comparison of Income Data

Income
Harvey Company.
2nd Year

Comparison
of
Absorption
and Variable
Costing Unit Cost Computations

Since there was no change in the variable

costs per unit, total fixed costs, or the
Reconciliation
number of units produced, the unit costs
We can reconcile the difference between remain unchanged.
absorption and variable income as
Absorption Costing
follows:
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Operating
Income
Effect of
These are the 25,000 units produced in the
current period.

Variable Costing
Changes in
Production
on Net
Operating
Reconciliation
Income
Effect of
Changes in
Income Comparison
Production
on Net
Summary
Operating
Income
Effect of Changes in Production of Net
operating Income
Revised example of Harvey Company
In the previous example,
25,000 units were produced each year,
but sales increased from 20,000 units in

Effect of year
one to 30,000 units in year two.

Changes in
In this revised example,
production will differ each year while
sales will remain constant.

Production 1st Year

on Net
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Effect of
Changes in
Production
Harvey
Company
Absorption Costing: Year One
Year Two
Effect of
Changes in
Production
Variable Costing: Year One
Harvey
Company
Year Two

Effect of
Changes in Year 2:

Production
Harvey
Company
Year Two
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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.
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 Comparison 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.
Net operating income is not affected by Under the Tax Reform Act of 1986,
changes in production using variable absorption costing must be used when filing
costing. income tax returns.
Net operating income is affected by
changes in production using absorption
costing even though the number of units
sold is the same each year.
Advantages
of Variable
CVP
Costing
Analysis,
and the
Decision
Contribution
Making
Approach
and
Advantages
Absorption
of Variable
costing
CVP Analysis, Decision Making and
Absorption Costing
Costing
Absorption costing does not support CVP
analysis because it essentially treats fixed and the
manufacturing overhead as a variable cost
by assigning a per unit amount of the fixed
overhead to each unit of production.
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Contribution Constraints
Approach
Advantages of Variable Costing and the
(TOC)
Contribution Approach
Variable
Costing and
the
Theory of
Variable versus Absorption Costing
Constraints
(TOC)
Variable
Costing and
Variable the
Costing and Theory of
the Constraints
Theory of (TOC)
Constraints
(TOC)
Variable Variable Costing and the Theory of

Costing and Constraints (TOC)

the
Theory of
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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.
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.