Variable Costing:

A Tool for Management

Chapter Seven
7-2

Learning Objective 1

Explain how variable

costing differs from
absorption costing and
compute unit product
costs under each method.
 7-3
Overview of Absorption
and Variable Costing

Absorption Variable
Costing Costing

Direct Materials
Product
Direct Labor
Product Costs
Costs Variable Manufacturing Overhead

Fixed Manufacturing Overhead

Period
Variable Selling and Administrative Expenses
Period Costs
Costs Fixed Selling and Administrative Expenses
7-4

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. . .
7-5

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. . .
7-6

Unit Cost Computations

Harvey Company produces a single product

with the following information available:
7-7

Unit Cost Computations

Unit product cost is determined as follows:

7-8

Learning Objective 2

Prepare income
statements using both
variable and absorption
costing.
7-9
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.
7-10

Absorption Costing
7-11

Variable Costing

Variable
manufacturing
Variable Costing
costs only.
Sales (20,000 × $30) $ 600,000
Less variable expenses:
Beginning inventory $ -
Add COGM (25,000 × $10) 250,000
All fixed
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
 7-12

• Exercise 7-1, 7-2, 7-5, 7-8, 7-9

7-13

Learning Objective 3

Reconcile variable costing

and absorption costing net
operating incomes and
explain why the two
amounts differ.
7-14

Comparing the Two Methods

7-15

Comparing the Two Methods

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
7-16
Extended Comparisons of Income Data Harvey Company
Year Two
7-17

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.
7-18

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.
7-19

Variable Costing
Variable
manufacturing
costs only.

All fixed
manufacturing
overhead is
expensed.
7-20

Comparing the Two Methods

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
7-21

Comparing the Two Methods

7-22

Summary of Key Insights

7-23
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.
7-24
Effect of Changes in Production
Harvey Company Year One
7-25

Unit Cost Computations for Year One

Unit product cost is determined as follows:

Since
Since the
the number
number of of units
units produced
produced increased
increased
in
in this
this example,
example, while
while the
the fixed
fixed manufacturing
manufacturing overhead
overhead
remained
remained the
the same,
same, thethe absorption
absorption unit
unit cost
cost is
is less.
less.
7-26

Absorption Costing: Year One

7-27

Variable Costing: Year One

Variable
manufacturing
Variable Costing
costs only.
Sales (25,000 × $30) $ 750,000
Less variable expenses:
Beginning inventory $ -
Add COGM (30,000 × $10) 300,000
All fixed
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
7-28
Effect of Changes in Production
Harvey Company Year Two
7-29

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.
7-30

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.
7-31

Variable Costing: Year Two

Variable
manufacturing
costs only.

All fixed
manufacturing
overhead is
expensed.
7-32

Comparing the Two Methods

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.
 7-33

• Exercise 7-3, 7-7, 7-10

• Problems 7-11, 7-12
7-34

Learning Objective 4

Understand the
advantages and
disadvantages of both
variable and absorption
costing.
7-35

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
more consistent with managers’ expectations.
7-36
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-or-drop
decisions.
• Produce positive net operating income even
when the number of units sold is less than the
breakeven point.
7-37

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
Since top executives tax returns.
are usually evaluated based on
external reports to shareholders,
they may feel that decisions
should be based on
absorption cost income.
7-38
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.
7-39

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
7-40
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.
7-41

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.
 7-42

• Exercise 7-4, 7-6

• Problems: 7-13, 7-14, 7-15, 7-16, 7-17, 7-18
7-43

End of Chapter 7