Overview managerial accounting chapter 07

Under absorption costing, if inventories increase then a portion of the fixed manufacturing overhead costs of the current period is deferred to future periods in the inventory account.

Chapter 7

Variable Costing—A Tool for Management

Learning Objectives

LO1 Explain how variable costing differs from absorption costing and compute unit product

costs under each method

LO2 Prepare income statements using both variable and absorption costing

LO3 Reconcile variable costing and absorption costing net operating incomes and explain

why the two amounts differ

LO4 Understand the advantages and disadvantages of both variable and absorption costing

New in this Edition

• Additional exercises have been created

Chapter Overview

A Overview of Variable and Absorption Costing. At least two methods can be used

in manufacturing companies to value units of product for accounting purposes—absorption costing and variable costing These methods differ only in how they treat fixed manufacturing overhead costs

1 Variable Costing Variable costing includes only variable production costs in product

costs Direct materials, direct labor and variable manufacturing overhead costs would ordinarily be included in product costs under variable costing Fixed manufacturing overhead is not treated as a product cost under this method Rather, fixed manufacturing overhead is treated as a period cost and is charged against income each period

2 Absorption Costing Absorption costing treats all production costs as product costs,

regardless of whether they are variable or fixed Under absorption costing, a portion of fixed manufacturing overhead is allocated to each unit of product

B Comparison of Absorption and Variable Costing. (Exercises 7-3, 7-5, 7-6, 7-8, and 7-9.) When comparing absorption costing and variable costing income statements, a number of points should be noted:

1 Deferral of fixed manufacturing costs under absorption costing Under absorption

costing, if inventories increase then a portion of the fixed manufacturing overhead costs

of the current period is deferred to future periods in the inventory account When the units are later taken out of inventory and sold, the deferred fixed costs flow through to the income statement as part of cost of goods sold

2 Differences in inventories under the two methods The ending inventory figures

under the variable costing and absorption costing methods are different Under variable costing, only the variable manufacturing costs are included in inventory Under absorption costing, both variable and fixed manufacturing costs are included in inventory

3 Suitability for CVP analysis An absorption costing income statement is not well suited

for providing data for CVP computations since it makes no distinction between fixed and variable costs In contrast, the variable costing method classifies costs by behavior and is very useful in setting-up CVP computations

C Extended Comparison of Income Data. (Exercises 7-2 and 7-6.) Exhibit 7-3 in the text presents a comparison of absorption costing and variable costing income statements over three years in which production is constant but sales vary Exhibit 7-6 in the text also presents comparative income statements over three years but holds annual sales constant and varies annual production From these Exhibits, several generalizations can be drawn (All of these generalizations assume the LIFO inventory flow assumption is being used The generalizations may not hold in some rare cases if a company uses an inventory flow assumption other than LIFO.)

1 Production equals sales (no change in inventories) When production equals sales,

inventories do not change If inventories do not change, then there is no change in the fixed manufacturing overhead costs in inventories under absorption costing Therefore, under both costing methods all of the current fixed manufacturing overhead will flow through to the income statement as an expense In the case of absorption costing it will

be part of cost of goods sold In the case of variable costing, it will be a period expense

2 Production exceeds sales (inventories increase) When production exceeds sales,

inventories grow If inventories grow, then some of the current fixed manufacturing overhead costs will be deferred in inventories under absorption costing Since all of the current fixed manufacturing overhead costs are expensed under variable costing, the net operating income reported under absorption costing will be greater than the net operating income reported under variable costing

3 Sales exceed production (inventories decrease) When sales exceed production,

inventories shrink If inventories decrease, then some of the fixed manufacturing overhead costs that had been deferred in inventories in previous periods will be released

to the income statement as part of cost of goods sold as well as all of the current fixed manufacturing overhead costs Since only the current fixed manufacturing overhead costs are expensed under variable costing, the net operating income reported under absorption costing will be less than the net operating income reported under variable costing

4 Long-term differences in income Over an extended period of time, the cumulative net

operating income figures reported under absorption costing and variable costing will be about the same; they will differ only by the amount of fixed manufacturing overhead cost in ending inventories under absorption costing Cumulative net operating income figures will be identical whenever ending inventories are reduced to zero

5 Changes in production volume Variable costing net operating income is not affected

by changes in production volume On the other hand, absorption costing net operating

income is affected by changes in production volume For any given level of sales, net

operating income under absorption costing will increase as the level of output increases and hence inventories increase

D The Matching Principle. Accountants and managers have been arguing for decades concerning the relative merits of absorption and variable costing In practice, absorption costing is used far more than variable costing even for internal reports The reasons for this are not entirely clear, although the perception that absorption costing is required for external reporting undoubtedly plays a key role The argument for using absorption costing in external reports seems to be based on the matching principle

1 Argument for absorption costing Advocates of absorption costing argue that all

manufacturing costs must be assigned to units of product so as to properly match costs with revenues They argue that fixed manufacturing overhead costs are essential to the production process and must be included when costing units of product, regardless of how the cost behaves

2 Argument for variable costing Advocates of variable costing argue that fixed

manufacturing overhead costs are incurred in order to have the capacity to produce Moreover, they will be incurred regardless of whether anything is actually produced Since these costs are not caused by any particular unit of product and are incurred to provide capacity for a particular period, the matching principle would dictate that fixed manufacturing overhead costs must be expensed in the current period

E Advantages of the Contribution Approach. (Exercises 7-4 and 7-7.) There are a number of advantages to using variable costing (and the contribution approach) in internal reports and analysis

1 More useful for CVP analysis Variable costing statements provide data that are

immediately useful for CVP analysis since they categorize costs on the basis of their behavior In contrast, it is often difficult to rework absorption costing data so that they can be used in CVP analysis and in decisions

2 Income is not affected by changes in production volume Under absorption costing,

reported net operating income is affected by changes in production since fixed costs are spread across more or fewer units This can distort income and may even result in income moving in an opposite direction from sales This does not occur under variable costing

3 Avoids misunderstandings concerning unit product costs Absorption costing unit

product costs can be easily misinterpreted as variable costs since they are stated on a per unit basis Such a misperception can lead to serious errors in making decisions Variable costing avoids this problem since unit costs include only variable costs

4 Fixed costs are more visible The impact of fixed costs on profits is emphasized

because the total amount of such costs for the period appears separately and is highlighted in the income statement rather than being buried in cost of goods sold and ending inventory

5 Understandability Managers should find it easier to understand variable costing

reports because data are organized by behavior and because variable costing is much closer to cash flow

6 Control is facilitated Variable costing ties in with cost control methods such as

flexible budgets

7 Incremental analysis is more straight-forward Variable cost corresponds closely

with the current out-of-pocket expenditure necessary to produce and sell products and services and can therefore be used more readily in incremental analysis than absorption costing data And since variable costing net operating income is closer to net cash flow than absorption costing net operating income, it is likely to be more useful to companies that have cash flow problems

However, variable costing is not generally accepted by auditors for external financial reports and is not permitted by the IRS in the United States and by tax authorities in many other countries for income tax calculations There is some question about whether variable costing

is actually prohibited in the United States by official pronouncements and some companies do use some form of variable costing in their external reports, but absorption costing must be considered the most generally accepted practice

F Impact of JIT Inventory Methods. When companies use JIT methods for controlling their operations, the distortions of income that can occur under absorption costing largely (or completely) disappear

1 The cause of distortions in net operating income Erratic movements in net operating

income under absorption costing and the differences in net operating income between absorption and variable costing can be traced to changing levels of inventory When inventory levels are constant or negligible, absorption costing and variable costing methods yield the essentially same net operating income

2 The JIT solution Under an ideally functioning JIT system, goods are produced strictly

to customers’ orders Finished goods inventories almost disappear and work in process inventories are kept to a minimum With little or no inventories, fixed manufacturing overhead costs cannot be shifted between periods under absorption costing As a result, both variable and absorption costing will show essentially the same net operating income figure, and the net operating income under absorption costing will move in the same direction as movements in sales

Assignment Materials

Assignment Topic

Level of Difficulty

Suggested Time

Exercise 7-1 Variable and absorption unit product costs Basic 15 min Exercise 7-2 Variable costing income statement; explanation of

difference in net operating income Basic 30 min Exercise 7-3 Reconciliation of absorption and variable costing net

operating incomes Basic 20 min Exercise 7-4 Evaluating absorption and variable costing as alternative

costing methods Medium 30 min Exercise 7-5 Variable and absorption costing unit product costs and

income statements Basic 30 min Exercise 7-6 Variable costing income statement; reconciliation Basic 20 min Exercise 7-7 Inferring costing method; unit product costs Basic 20 min Exercise 7-8 Variable costing unit product cost and income statement;

break-even Basic 30 min Exercise 7-9 Absorption costing unit product cost and income statement Basic 20 min Problem 7-10 Variable and absorption costing unit product costs and

income statements; explanation of difference in net operating income Basic 45 min Problem 7-11 Variable costing income statement; reconciliation Basic 30 min Problem 7-12 Absorption and variable costing; production constant, sales

fluctuate Medium 60 min Problem 7-13 Comprehensive problem with labor fixed Medium 45 min Problem 7-14 Preparation and reconciliation of variable costing statements Medium 45 min Problem 7-15 Variable costing statements; sales constant, production

varies; JIT impact Difficult 45 min Problem 7-16 Incentives created by absorption costing; ethics and the

manager Difficult 30 min Problem 7-17 Prepare and interpret statements; changes in both sales and

production; JIT impact Difficult 75 min Case 7-18 Absorption and variable costing; uneven production; break-

even analysis; JIT impact Difficult 90 min Case 7-19 Ethics and the manager; absorption costing income

statements Difficult 120 min Case 7-20 The case of the plummeting profits Difficult 90 min

Essential Problems: Problem 7-10 or Problem 7-13, Problem 7-11, Problem 7-14

Supplementary Problems: Problem 7-12, Problem 7-15, Problem 7-16, Problem 7-17, Case 7-18,

Case 7-19, Case 7-20

Linked problems and exercises:

Exercise 7-9 should be assigned after Exercise 7-8

Exercise 7-2 should be assigned after Exercise 7-1

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Chapter 7 Lecture Notes

Helpful Hint: Before beginning the lecture, show students the fifth segment from the first tape of the McGraw-Hill/Irwin Managerial/Cost Accounting video library This segment introduces students to many of the concepts discussed in chapter 7 The lecture notes reinforce the concepts introduced in the video

Chapter theme: Two general approaches are used for

valuing inventories and cost of goods sold One approach,

called absorption costing, is generally used for external reporting purposes The other approach, called variable

costing, is preferred by some managers for internal

decision making and must be used when an income

statement is prepared in the contribution format This

chapter shows how these two methods differ from each other

I Overview of absorption and variable costing

A Absorption costing (also called the full cost method)

treats all costs of production as product costs, regardless of whether they are variable or fixed Since

no distinction is made between variable and fixed costs, absorption costing is not well suited for CVP

computations

i The cost of a unit of product consists of

direct materials, direct labor, and both variable and fixed overhead

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ii Variable and fixed selling and administrative

expenses are treated as period costs and are

deducted from revenue as incurred

B Variable costing (also called direct costing or

marginal costing) treats only those costs of production

that vary with output as product costs This approach

dovetails with the contribution approach income

statement and supports CVP analysis because of its

emphasis on separating variable and fixed costs

i The cost of a unit of product consists of

direct materials, direct labor, and variable overhead

Helpful Hint: For simplicity, nearly all examples, exhibits, problems, and exercises in this chapter treat direct labor as a variable cost However, students should be reminded that labor is essentially a fixed cost

in some companies This is a growing phenomenon as pointed out in earlier chapters Under variable costing, direct labor would not be included in product costs when it is a fixed cost This point is reinforced in the discussion on theory of constraints at the end of the chapter

“In Business Insights”

To piggyback on the Helpful Hint above, there are many companies that treat direct labor as a fixed cost For example:

“Direct Labor – A Fixed Cost in China” (page 280)

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• The Shanghai Bund Steel Works (SBSW) of the

Peoples’ Republic of China is a large state-owned enterprise

• In such an enterprise, management has very little

freedom to adjust the work force – eliminating jobs would create political problems

• Therefore, for internal management purposes,

SBSW treats labor cost as part of fixed manufacturing overhead

ii Fixed manufacturing overhead, and both

variable and fixed selling and administrative

expenses are treated as period costs and

deducted from revenue as incurred

Helpful Hint: Emphasize that the only difference between variable and absorption costing is in how the two methods treat fixed manufacturing overhead costs Also, emphasize that under both methods, selling and administrative costs are period costs and are not product costs

Quick Check – absorption vs variable costing

C Unit cost computations

i Assume Harvey Company produces a single

product with available information as shown

ii The unit product costs under absorption and

variable costing would be $16 and $10,

respectively

1 Under absorption costing, all production

costs, variable and fixed, are included when

determining unit product cost

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2 Under variable costing, only the variable

production costs are included in product

ending inventory equals cost of goods sold Therefore, a higher ending inventory results in a lower expense (cost

of goods sold) deducted to arrive at net operating income

II Income comparison of absorption and variable costing

A The Harvey Company example continued:

i Additional assumptions:

1 20,000 units were sold during the year

2 The selling price per unit is $30

3 There is no beginning inventory

ii Absorption costing

1 The unit product cost is $16

2 The fixed manufacturing overhead cost

deferred in inventory is $30,000 (5,000

units × $6 per unit)

3 The net operating income is $120,000

Helpful Hint: Explain that under absorption costing, the recognition of fixed costs as an expense is really a timing issue When the items are sold, the fixed costs

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will be reflected on the income statement as part of cost

of goods sold

iii Variable costing

1 The unit product cost is $10

2 All $150,000 of fixed manufacturing cost is

expensed in the current period

3 The net operating income is $90,000

iv Comparing the two methods

1 Under absorption costing, $120,000 of fixed

manufacturing overhead is included in cost

of goods sold and $30,000 is deferred in

ending inventory as an asset on the balance sheet

2 Under variable costing, the entire $150,000

of fixed manufacturing overhead is treated

as a period expense

a The variable costing ending inventory

is $30,000 less than absorption

costing, thus explaining the difference

in net operating income between the two methods

3 The difference in net operating income

between the two methods ($30,000) can also

be reconciled by multiplying the number of

units in ending inventory (5,000 units) by

the fixed manufacturing overhead per unit

($6) that is deferred in ending inventory

under absorption costing

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III Extended comparisons of income data

A The Harvey Company example continued:

i Additional assumptions/facts:

1 30,000 units were sold in year 2

2 The selling price per unit, variable costs per unit, total fixed costs, and number of units

produced remain unchanged

3 5,000 units are in beginning inventory

ii Unit cost computations

1 Since the variable costs per unit, total fixed costs, and the number of units produced

remained unchanged, the unit cost

computations also remain unchanged

iii Absorption costing

1 The unit product cost is $16

2 The fixed manufacturing overhead cost

released from inventory is $30,000

3 The net operating income is $230,000

iv Variable costing

1 The unit product cost is $10

2 All $150,000 of fixed manufacturing overhead cost is expensed in the current

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v Comparing the two methods

1 The difference in net operating income

between the two methods ($30,000) can be

reconciled by multiplying the number of

units in beginning inventory (5,000 units)

by the fixed manufacturing overhead per

unit ($6) that is released from beginning

inventory under absorption costing

2 Across the two year time frame, both

methods reported the same total net

operating income ($350,000) This is

because over an extended period of time sales cannot exceed production, nor can production much exceed sales The shorter the time period, the more the net operating income figures will tend to differ

B Summary of key insights

i When production is greater than sales, as in

year 1 for Harvey, absorption income is

greater than variable costing income

ii When production is less than sales, as in

year 2 for Harvey, absorption costing

income is less than variable costing income

iii When production equals sales, the two

methods report the same net operating income

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“In Business Insights”

The relationship between production and sales can have a significant impact on the net operating income

of companies that use absorption costing For example:

“Chainsaw Al Dunlap’s Legacy at Sunbeam” (page 287)

• Al Dunlap was hired to turn around Sunbeam

Corp with his well-known cost-cutting and disregard for the welfare of existing employees

• Three years later, Dunlap left a legacy of

questionable accounting practices and excess inventories

• Dunlap’s successors complain that eliminating

those excess inventories has required the company to keep production levels well under capacity

• Since Sunbeam uses absorption costing,

liquidating these excess inventories has depressed the company’s profits

“The Perverse Effects of Absorption Costing at Nissan” (page 289)

• Nissan North America liked to run its factories at

capacity, regardless of how well cars were selling, because under absorption costing it would help the factories generate a profit

• As a consequence, Nissan dealers had to slash

prices and offer big rebates to sell their cars

• According to Fortune magazine, “Years of

discounting and distress sales seriously undercut the value of the Nissan brand While Toyota stood for quality, customers came to Nissan to get a better deal.”

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IV Effect of changes in production on net operating income

A The Harvey Co example revisited

i Overview of revised example:

1 In the previous Harvey Co example:

a Units of production was constant

b Sales in units fluctuated

2 In the forthcoming example:

a Units of production will fluctuate

b Sales in units will remain constant

Helpful Hint: To emphasize the key point of the forthcoming example, ask students how absorption costing net operating income can be increased or decreased without changing sales The answer is by altering production since increasing or decreasing ending inventories results in a net deferral or a net release of fixed manufacturing overhead costs

ii Harvey Co year 1 data:

1 30,000 units are produced

2 25,000 units are sold

3 There is no beginning inventory

4 The selling price per unit, variable costs per

unit, and total fixed costs remain

unchanged from the prior example

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iii Unit cost computations: year 1

1 The unit product costs under absorption and

variable costing would be $15 and $10,

respectively

iv Absorption costing: year 1

1 The unit product cost is $15

2 The fixed manufacturing overhead cost

deferred in inventory is $25,000

3 The net operating income is $200,000

v Variable costing: year 1

1 The unit product cost is $10

2 All $150,000 of fixed manufacturing overhead cost is expensed in the current

period

3 The net operating income is $175,000

vi Harvey Co year 2 data:

1 20,000 units are produced

2 25,000 units are sold

3 There are 5,000 units in beginning inventory

4 The selling price per unit, variable costs per

unit, and total fixed costs remain

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