Now that you have learned about the differences between absorption costing and variable costing and how they can affect operating income, let’s consider some situations where managers must make decisions. In some cases, variable costing is more appropriate for deci- sion making, but in other cases, absorption costing is more appropriate.
Learning Objective 3 Use variable costing to make
management decisions for a manufacturing business
In the chapter opener, we introduced CF Industries Holdings, Inc., one of the largest manufacturers and distributors of nitrogen fertilizer and other nitrogen products in the world. CF Industries has six nitrogen fertilizer manufacturing facilities that distribute fertilizer products throughout the United States and Canada.
The company is the largest nitrogen fertilizer producer in North America selling 13,276,000 tons in 2014. The market for nitrogen fertilizer is highly seasonal with the strongest demand for fertil- izer products during the spring planting season. This leads to the company building inventory levels during low demand periods to ensure there is enough product available during peak seasons.
Would CF Industries Holdings, Inc. use absorption or variable costing on the income statement included in the company’s annual report?
CF Industries Holdings, Inc. would use absorption costing on the income statement included in the company’s annual report because this method is required by Generally Accepted Account- ing Principles.
How does an absorption costing income statement differ from a variable costing income statement?
When a company uses absorption costing, the cost of direct mate- rials, direct labor, variable manufacturing overhead, and fixed manufacturing overhead are treated as product costs and included first in the asset account, inventory, on the balance sheet. It is only when the inventory is sold that the costs are expensed as cost
of goods sold on the income statement. An absorption income statement follows a traditional format calculating first gross profit as net sales revenue less cost of goods sold, and then operating income as gross profit less selling and administrative costs.
Alternatively, a variable costing income statement includes only variable manufacturing costs (direct labor, direct materials, and variable manufacturing overhead) when determining product costs. The fixed manufacturing overhead cost is treated as a period cost, not a product cost. A variable costing income statement fol- lows the contribution margin format calculating first contribution margin as net sales revenue less variable costs, and then operating income as contribution margin less fixed costs.
If CF Industries Holdings, Inc. prepared a variable costing income statement instead of an absorption costing income statement would the operating income be the same?
Most likely the operating income would not be the same when using the two different methods. The only time operating income is the same under both the absorption and variable costing income statement is when units produced are equal to units sold. When units produced are different than units sold, the operating income will be different. For example, if units produced are more than units sold, the operating income is greater under absorption costing than variable costing because some fixed manufacturing costs are still in inventory and have not yet been expensed. Alternatively, if units produced are less than units sold, the operating income is less under absorption costing than variable costing.
TYING IT ALL TOGETHER
Try It!
2. Hayden Company has 50 units in Finished Goods Inventory at the beginning of the accounting period. During the accounting period, Hayden produced 150 units and sold 200 units for $150 each. All units incurred $80 in variable manufacturing costs and $20 in fixed manufacturing costs. Hayden also incurred $7,500 in Selling and Administrative Costs, all fixed. Calculate the operating income for the year using absorption costing and variable costing.
Check your answer online in MyAccountingLab or at http://www.pearsonhighered.com/Horngren.
For more practice, see Short Exercises S21-4 through S21-9. MyAccountingLab
Setting Sales Prices
In the long run, the sales price charged to customers must cover the full cost of the product.
The full cost includes every part of the life cycle of the product: research and development, design, production, distribution, customer service, and disposal. Any fixed manufacturing costs must be included, so absorption costing is more appropriate when determining the product costs for long-term planning.
In the short run, however, variable costing should be used in some cases. For exam- ple, if a company has excess capacity and has a one-time opportunity to accept a customer order at a discounted sales price, the order should be accepted if the sales price exceeds the variable costs. In this situation, fixed costs are not relevant because they would be incurred whether or not the order is accepted. If the fixed costs are not relevant, they should not be considered when making the decision—and variable costing is an appropri- ate costing method to use. Short-term pricing decisions are covered in more detail in a later chapter.
Controlling Costs
We sometimes think that some costs are not controllable. For example, if the company signs a five-year lease for the manufacturing facility, the rent expense is fixed and will remain fixed for five years. However, in the long run, all costs are controllable. After five years, the company can renegotiate the lease, rent another building, or buy a building. Even though the cost of occupying the manufacturing facility is controllable, it is a decision made by upper management. The production supervisor does not control this cost. Most fixed man- ufacturing costs are controlled by upper management. Therefore, managers should focus on and be accountable for the costs they can control. At the production supervisor’s level, the controllable costs are the variable manufacturing costs: direct materials, direct labor, and variable manufacturing overhead.
Planning Production
Production planning decisions are similar to sales price decisions: Short-term decisions should be made using variable costing, and long-term decisions should be made using absorption costing.
In the short run, production is limited by capacity. Therefore, production supervisors should produce the products with the highest contribution margin per unit, as long as there is demand for the products. Producing and selling the products with the highest contribution margin per unit generates the highest operating income. So, in the short term, variable costing is appropriate. However, in the long run, capacity can be expanded. Because expansion would affect both fixed and variable costs, absorption costing is more appropriate. Production plan- ning decisions are covered in more detail in a later chapter.
Analyzing Profitability
We looked at profitability analysis in our study of cost-volume-profit analysis when we calculated sales needed to break even and earn a target profit. Let’s expand that analysis to include decisions about products and business segments. In this type of analysis, it is helpful to use variable costing.
company, and the sales representatives have been encouraged to promote the new model.
As an incentive, their sales commission is greater for the premium model. Price and cost information for the two models are shown in Exhibit 21-10.
Exhibit21-10 | Standard and Premium Tablets
Standard Premium
Units Sold 2,000 units 500 units
Sales Price per Unit
Variable Manufacturing Cost per Unit (Including direct materials, direct labor, and variable manufacturing overhead)
245
$ 500
360
$ 600
25 Sales Commissions per Unit:
Standard: 5% of sales price
Premium: 10% of sales price 60
Business Segments
Many companies divide their business into segments. A business segment is an identifi- able part of the company for which financial information is available. Businesses can be segmented by geography (domestic and international), customer types (commercial and residential), products (motorcycles and all-terrain vehicles), or salespersons (Jane’s sales territory and John’s sales territory).
Let’s assume that Smart Touch Learning has two business segments based on the sales territories of two sales representatives—Avila Salinas and John Carey—who are assigned specific geographic regions. During the last accounting period, both sales repre- sentatives sold 1,250 tablets each. Exhibit 21-11 shows the contribution margin income statements for both territories and determines the contribution margin ratio. As a reminder, the contribution margin ratio is the ratio of contribution margin to net sales revenue and can be calculated as follows:
Business Segment An identifiable part of the company
for which financial information is available.
Contribution Margin Ratio The ratio of contribution margin to net sales revenue. Contribution margin / Net sales revenue.
Contribution margin = Net sales revenue - Variable costs Contribution margin ratio = Contribution margin / Net sales revenue
Exhibit21-11 | Smart Touch Learning Contribution Margin Income Statements by Sales Territories
Units Sold
Salinas Carey Total
Net sales Revenue $ 665,000 1,250 units
$ 635,000 1,250 units
$ 1,300,000 2,500 units
Variable Costs:
Manufacturing 352,250 317,750 670,000
Sales Commissions 34,750 80,000
Contribution Margin
45,250
$ 267,500 $ 282,500 $ 550,000 Contribution Margin Ratio 40.23% 44.49% 42.31%
Profitability Analysis
Exhibit 21-11 shows that even though both sales representatives sold the same number of tablets, Salinas had higher revenues, whereas Carey had a higher contribution margin and contribution margin ratio. Let’s look at each sales territory in more detail by examining how the sales mix affected the results. Exhibit 21-12 shows the contribution margin by products for each territory.
The more detailed statements in Exhibit 21-12 show how the sales mix of each territory affected the total contribution margin. Salinas’s sales mix was 68% standard units and 32% premium units. Carey’s sales mix was 92% standard units and 8% pre- mium units. Because the standard model has a higher contribution margin ratio than the premium model, 46% compared with 30%, Carey was able to contribute more to the company’s profits.
Exhibit21-12 | Contribution Margin by Product
SALINAS Standard Premium Total
Units Sold
Sales Mix 850 units
68% 400 units
32% 1,250 units 100%
Net Sales Revenue (850 units × $500 per unit) $ 425,000
(400 units × $600 per unit) $ 240,000 $ 665,000 Variable Costs:
Manufacturing (850 units × $245 per unit) 208,250
(400 units × $360 per unit) 144,000 352,250 Sales Commissions (5% of Sales Revenue) 21,250
(10% of Sales Revenue) 24,000 45,250
Contribution Margin $ 195,500 $ 72,000 $ 267,500
Contribution Margin Ratio 46.00% 30.00% 40.23%
CAREY Standard Premium Total
Units Sold
Sales Mix 1,150 units
92% 100 units
8% 1,250 units 100%
Net Sales Revenue (1,150 units × $500 per unit) $ 575,000
(100 units × $600 per unit) $ 60,000 $ 635,000 Variable Costs:
Manufacturing (1,150 units × $245 per unit) 281,750
(100 units × $360 per unit) 36,000 317,750 Sales Commissions (5% of Sales Revenue) 28,750
(10% of Sales Revenue) 6,000 34,750
Contribution Margin $ 264,500 $ 18,000 $ 282,500
Contribution Margin Ratio 46.00% 30.00% 44.49%
The management of Smart Touch Learning should analyze the statements and make recommendations to the sales representatives. Questions to consider include:
• Should the sales representatives continue to focus on the premium model if it has a lower
Analyzing Contribution Margin
In the previous section on profitability analysis, we analyzed the effects of sales mix on profitability. In this section, we look at the effects of changes in sales volume, sales price per unit, and variable cost per unit using a new scenario for Smart Touch Learning. This is another situation in which it is helpful to use variable costing. To do this, we will use Exhibit 21-13, which shows the income statements in contribution margin format for two accounting periods for Smart Touch Learning.
Exhibit21-13 | Contribution Margin Analysis—Smart Touch Learning
Units Sold
Period 1 Period 2 Difference
Net Sales Revenue $ 250,000
500 units
$ 220,000 400 units
Variable Costs:
Manufacturing 135,000 132,000 (3,000)
Sales Commissions 17,600 (2,400)
$ (24,600)
$ (30,000)
Contribution Margin
20,000
$ 95,000 $ 70,400
Contribution Margin Ratio 38% 32%
Exhibit21-14 | Expanded Contribution Margin Analysis—Smart Touch Learning
Period 1 Total Units Amount
per Unit Percent of Sales
Total Units Amount
per Unit Percent of Sales
Net Sales Revenue $ 250,000 500 units $ 500 100%
Variable Costs:
Manufacturing 135,000 500 units 270 54%
Sales Commissions 500 units 40 8%
Contribution Margin
20,000
$ 95,000 500 units $ 190 38%
Contribution Margin Ratio
Period 2
Net Sales Revenue $ 220,000 400 units $ 550 100%
Variable Costs:
400 units
Manufacturing 132,000 330 60%
Sales Commissions 400 units 44 8%
Contribution Margin
17,600
$ 70,400 400 units $ 176 32%
Contribution Margin Ratio 32% 32%
38% 38%
At first glance, it appears that it was the decrease in the number of units sold (from 500 units in Period 1 to 400 units in Period 2) that caused a decrease in contribution margin.
However, that does not explain why the contribution margin ratio decreased from 38% to 32%. Remember, a change in sales volume does not affect the contribution margin per unit.
So why did the contribution margin ratio decrease? Let’s take the total amounts and expand them into their two components—units and amount per unit—by dividing the totals by the number of units. Exhibit 21-14 shows the expanded statements.
We can now see that the change in contribution margin was the result of changes in both components—units and amount per unit. In other words, there was a volume effect and a price/cost effect. Further investigation revealed that direct materials cost increased by
$60 per tablet causing variable manufacturing costs to increase from $270 to $330 per tablet.
Therefore, management increased the sales price by $50 per tablet (from $500 to $550).
This did not totally offset the increase in direct materials cost, but management felt the market would not bear a greater price increase. In fact, raising the sales price to $550 caused a decrease of 100 units sold, from 500 units to 400 units, which was a 20% decrease in sales (100 units / 500 units = 20%). The sales commission remained the same at 8% of sales.
The contribution margin ratio decreased from 38% to 32%.
The contribution margin analysis shown here is a type of variance analysis, which will be illustrated in greater detail in a later chapter.
Summary
Exhibit 21-15 summarizes the situations in which managers must make decisions and the costing system that is more appropriate for each situation.
Exhibit21-15 | Decision-Making Summary
Setting Sales Prices
Controlling Costs
Planning Production
Analyzing Profitability Analyzing Contribution Margin
Absorption
Variable Long run
Short run
The sales price must cover the full cost in the long run, including fixed costs.
Fixed costs are not relevant in the short run because they usually do not change.
Absorption Upper management
Lower management
Long run
Short run
Sales mix
Volume, price, variable costs
All costs, including fixed costs, are controllable by upper management in the long run.
Variable Lower management usually does not have control over most fixed costs.
Absorption
Variable
Variable
Variable
With capacity limits in the short run, products with the highest contribution margin per unit should be produced.
To increase profits,
businesses should emphasize the products with the highest contribution margin per unit.
Fixed costs do not affect contribution margin.
Expansion to avoid capacity limits includes both fixed and variable costs.
Appropriate Costing Method
Decision Reason