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managerial account (7)

Chapter 7

Variable Costing: A Tool for Management Solutions to Questions

7-1The basic difference between absorption and variable costing is due to the handling of fixed manufacturing overhead. Under absorption costing, fixed manufacturing overhead is treated as a product cost and hence is an asset until products are sold. Under variable costing, fixed manufacturing overhead is treated as a period cost and is charged in full against the current period’s income.

7-2Selling and administrative expenses are treated as period costs under both variable cost-ing and absorption costing.

7-3Under absorption costing, fixed manu-facturing overhead costs are included in product costs, along with direct materials, direct labor, and variable manufacturing overhead. If some of the units are not sold by the end of the period, then they are carried into the next period as inventory. The fixed manufacturing overhead cost attached to the units in ending inventory follow the units into the next period as part of their inventory cost. When the units carried over as inventory are finally sold, the fixed manufac-turing overhead cost that has been carried over with the units is included as part of that period’s cost of goods sold.

7-4Absorption costing advocates believe

that absorption costing does a better job of matching costs with revenues than variable cost-ing. They argue that all manufacturing costs must be assigned to products to properly match the costs of producing units of product with the revenues from the units when they are sold. They believe that no distinction should be made between variable and fixed manufacturing costs for the purposes of matching costs and revenues. 7-5Advocates of variable costing argue that fixed manufacturing costs are not really the cost of any particular unit of product. If a unit is made or not, the total fixed manufacturing costs will be exactly the same. Therefore, how can one say that these costs are part of the costs of the products? These costs are incurred to have the capacity to make products during a particu-lar period and should be charged against that period as period costs according to the matching principle.

7-6If production and sales are equal, net operating income should be the same under ab-sorption and variable costing. When production equals sales, inventories do not increase or de-crease and therefore under absorption costing fixed manufacturing overhead cost cannot be deferred in inventory or released from inventory.

7-7If production exceeds sales, absorption costing will usually show higher net operating income than variable costing. When production exceeds sales, inventories increase and there-fore under absorption costing part of the fixed manufacturing overhead cost of the current pe-riod will be deferred in inventory to the next pe-riod. In contrast, all of the fixed manufacturing overhead cost of the current period will be charged immediately against income as a period cost under variable costing.

7-8If fixed manufacturing overhead cost is released from inventory, then inventory levels must have decreased and therefore production must have been less than sales.

7-9Inventory decreased. The decrease re-sulted in fixed manufacturing overhead cost be-ing released from inventory and charged against income as part of cost of goods sold. This added fixed manufacturing overhead cost resulted in a loss even though the company operated at its breakeven.

7-10Under absorption costing it is possible to increase net operating income simply by increas-ing the level of production without any increase in sales. If production exceeds sales, units of product are added to inventory. These units car-ry a portion of the current period’s fixed man u-facturing overhead costs into the inventory ac-count, thereby reducing the current period’s r e-ported expenses and causing net operating in-come to increase.

7-11Generally speaking, variable costing cannot be used externally for financial reporting purposes nor can it be used for tax purposes. It can, however, be used in internal reports.

7-12Differences in reported net operating income between absorption and variable costing arise because of changing levels of inventory. Under JIT, goods are produced strictly to cus-tomers’ orders. With production geared to sales, inventories are largely (or entirely) eliminated. If inventories are completely eliminated, they can-not change from one period to another and ab-sorption costing and variable costing will report the same net operating income.

(Note: All currency values are in thousands of rupiah.)

1. Under absorption costing, all manufacturing costs (variable and fixed)

are included in product costs.

Direct materials .............................................................. R p100

Direct labor (320)

Variable manufacturing overhead (40)

Fixed manufacturing overhead (Rp60,000 ÷

Unit product cost ............................................................ R p700

2. Under variable costing, only the variable manufacturing costs are in-

cluded in product costs.

Direct materials .............................................................. R p100

Direct labor (320)

Variable manufacturing overhead (40)

Unit product cost ............................................................ R p460

Note that selling and administrative expenses are not treated as product costs under either absorption or variable costing; that is, they are not included in the costs that are inventoried. These expenses are always treated as period costs and are charged against the current period’s

revenue.

(Note: All currency values are in thousands of rupiah.)

1. 25 units × Rp240 per unit fixed manufacturing overhead per unit =

Rp6,000

2. The variable costing income statement appears below:

Sales .............................................................. Rp191,250 Less variable expenses:

Variable cost of goods sold:

Beginning inventory ................................... Rp 0

Add variable manufacturing costs

(250 units × Rp460 per unit) .................... 115,000

Goods available for sale .............................. 115,000

Less ending inventory

(25 units × Rp460 per unit) ..................... 11,500

Variable cost of goods sold* .......................... 103,500

Variable selling and administrative expenses

(225 units × Rp20 per unit) ........................ 4,500 108,000 Contribution margin ......................................... 83,250 Less fixed expenses:

Fixed manufacturing overhead ....................... 60,000

Fixed selling and administrative expenses ....... 20,000 80,000 Net operating income ...................................... Rp 3,250 * The variable cost of goods sold could be computed more simply as:

225 units sold × Rp460 per unit = Rp103,500.

The difference in net operating income between variable and absorption costing can be explained by the deferral of fixed manufacturing over-head cost in inventory that has taken place under the absorption costing approach. Note from part (1) that Rp6,000 of fixed manufacturing over-head cost has been deferred in inventory to the next period. Thus, net operating income under the absorption costing approach is Rp6,000 higher than it is under variable costing.

1. Year 1 Year 2 Year 3

Beginning inventories

(units) ............................... 200 170 180

Ending inventories (units) ..... 170 180 220

Change in inventories

(units) ............................... (30) 10 40

Variable costing net operat-

ing income ........................ $1,080,400 $1,032,400 $996,400

Add: Fixed manufacturing

overhead cost deferred in

inventory under absorp-

tion costing (10 units ×

$560 per unit; 40 units ×

$560 per unit) ................... 5,600 22,400

Deduct: Fixed manufactur-

ing overhead cost re-

leased from inventory un-

der absorption costing (30

units × $560 per unit) ........ (16,800)

Absorption costing net op-

erating income ................... $1,063,600 $1,038,000 $1,018,800

2. Since absorption costing net operating income was greater than variable

costing net operating income in Year 4, inventories must have increased during the year and hence fixed manufacturing overhead was deferred in inventories. The amount of the deferral is just the difference between the two net operating incomes or $28,000 = $1,012,400 – $984,400.

1. a. By assumption, the unit selling price, unit variable costs, and total

fixed costs are constant from year to year. Consequently, variable

costing net operating income will vary with sales. If sales increase,

variable costing net operating income will increase. If sales decrease, variable costing net operating income will decrease. If sales are con-stant, variable costing net operating income will be constant. Since

variable costing net operating income was $510,600 each year, unit

sales must have been the same in each year.

The same is not true of absorption costing net operating income.

Sales and absorption costing net operating income do not necessarily move in the same direction since changes in inventories also affect

absorption costing net operating income.

b. When variable costing net operating income exceeds absorption cost-

ing net operating income, sales exceed production. Inventories shrink and fixed manufacturing overhead costs are released from invento-

ries. In contrast, when variable costing net operating income is less

than absorption costing net operating income, production exceeds

sales. Inventories grow and fixed manufacturing overhead costs are deferred in inventories. The year-by-year effects are shown below.

2. a. As discussed in part (1 a) above, unit sales and variable costing net

operating income move in the same direction when unit selling prices and the cost structure are constant. Since variable costing net operat-ing income varied from year to year, unit sales must have also varied from year to year. This is true even though the absorption costing net operating income was the same for all four years. How can that be?

By manipulating production (and inventories) it may be possible for

some time to keep absorption costing net operating income rock

steady or on an upward path even though unit sales fluctuate from

year to year. However, if this is done in the face of falling sales, even-tually inventories will grow to be so large that they cannot be ignored.

b. As stated in part (1 b) above, when variable costing net operating in-

come exceeds absorption costing net operating income, sales exceed production. Inventories shrink and fixed manufacturing overhead

costs are released from inventories. In contrast, when variable cost-

ing net operating income is less than absorption costing net operating income, production exceeds sales. Inventories grow and fixed manu-

facturing overhead costs are deferred in inventories. The year-by-

year effects are shown below.

3. Variable costing appears to provide a much better picture of economic

reality than absorption costing in the examples above. In the first case, absorption costing net operating income fluctuates wildly even though unit sales are the same each year and there are no changes in unit sell-ing prices, unit variable costs, or total fixed costs. In the second case, absorption costing net operating income is rock steady from year to year even though unit sales fluctuate significantly. Absorption costing is much more subject to manipulation than variable costing. Simply by changing production levels (and thereby deferring or releasing costs from invento-ry) absorption costing net operating income can be manipulated upward or downward.

Note: This exercise is based on the following data:

Common data:

Annual fixed manufacturing costs ....... $1,436,400

Contribution margin per unit .............. $130

Annual fixed SGA costs ...................... $653,000

Part 1:

Year 1 Year 2 Year 3 Year 4 Beginning inventory ... 500 1,500 3,500 2,500

Production ................ 21,000 22,000 19,000 18,000

Sales ........................ 20,000 20,000 20,000 20,000

Ending ...................... 1,500 3,500 2,500 500

Variable costing net

operating income .. $510,600 $510,600 $510,600 $510,600 Fixed manufacturing

overhead in begin-

ning inventory* ..... $35,910 $102,600 $228,518 $189,000 Fixed manufacturing

overhead in ending

inventory .............. $102,600 $228,518 $189,000 $39,900 Absorption costing net

operating income .. $577,290 $636,518 $471,082 $361,500

Part 2:

Year 1 Year 2 Year 3 Year 4 Beginning inventory ... 6,000 2,000 1,775 5,463

Production ................ 18,000 20,775 22,688 20,936

Sales ........................ 22,000 21,000 19,000 20,000

Ending ...................... 2,000 1,775 5,463 6,399

Variable costing net

operating income .. $770,600 $640,600 $380,600 $510,600 Fixed manufacturing

overhead in begin-

ning inventory* ..... $326,455 $159,600 $122,745 $345,890 Fixed manufacturing

overhead in ending

inventory .............. $159,600 $122,745 $345,890 $439,035 Absorption costing net

operating income .. $603,745 $603,745 $603,745 $603,745

* Fixed manufacturing overhead in beginning inventory is assumed in both parts 1 and 2 for Year 1. A FIFO inventory flow assumption is used.

1. a. The unit product cost under absorption costing would be:

Direct materials................................................................ $ 6

Direct labor (9)

Variable manufacturing overhead (3)

Total variable costs (18)

Fixed manufacturing overhead ($300,000 ÷ 25,000 units) .. 12

Unit product cost ............................................................. $30

b. The absorption costing income statement:

Sales (20,000 units × $50 per unit) ................ $1,000,000 Less cost of goods sold:

Beginning inventory .................................... $ 0

Add cost of goods manufactured

(25,000 units × $30 per unit) ................... 750,000

Goods available for sale .............................. 750,000

Less ending inventory

(5,000 units × $30 per unit) ..................... 150,000 600,000 Gross margin ................................................ 400,000 Less selling and administrative expenses

[(20,000 units × $4 per unit) + $190,000] ... 270,000 Net operating income .................................... $ 130,000

2. a. The unit product cost under variable costing would be:

Direct materials............................ $ 6

Direct labor (9)

Variable manufacturing overhead .. 3

Unit product cost ......................... $18

b. The variable costing income statement:

Sales (20,000 units × $50 per unit) .............. $1,000,000 Less variable expenses:

Variable cost of goods sold:

Beginning inventory ............................... $ 0

Add variable manufacturing costs

(25,000 units × $18 per unit) ............... 450,000

Goods available for sale .......................... 450,000

Less ending inventory

(5,000 units × $18 per unit) ................ 90,000

Variable cost of goods sold ........................ 360,000 *

Variable selling expense

(20,000 units × $4 per unit) ................... 80,000 440,000 Contribution margin .................................... 560,000 Less fixed expenses:

Fixed manufacturing overhead .................. 300,000

Fixed selling and administrative expense .... 190,000 490,000 Net operating income .................................. $ 70,000 *The variable cost of goods sold could be computed more simply as:

20,000 units × $18 per unit = $360,000.

1. Sales (35,000 units × $25 per unit) ................. $875,000

Less variable expenses:

Variable cost of goods sold

(35,000 units × $12 per unit*) ................... $420,000

Variable selling and administrative expenses

(35,000 units × $2 per unit) ...................... 70,000 490,000 Contribution margin ........................................ 385,000 Less fixed expenses:

Fixed manufacturing overhead ...................... 160,000

Fixed selling and administrative expenses ...... 210,000 370,000 Net operating income ..................................... $ 15,000 * Direct materials ............................... $ 5

Direct labor (6)

Variable manufacturing overhead (1)

Total variable manufacturing cost ...... $12

2. The difference in net operating income can be explained by the $20,000

in fixed manufacturing overhead deferred in inventory under the absorp-tion costing method:

Variable costing net operating income ........................ $15,000

Add: Fixed manufacturing overhead cost deferred in

inventory under absorption costing: 5,000 units ×

$4 per unit in fixed manufacturing cost .................... 20,000

Absorption costing net operating income .................... $35,000

1. The company is using variable costing. The computations are:

Variable Costing Absorption Costing

Direct materials .............................. $ 9 $ 9

Direct labor .................................... 10 10

Variable manufacturing overhead .... 5 5

Fixed manufacturing overhead

($150,000 ÷ 25,000 units) ........... — 6

Unit product cost ............................ $24 $30

Total cost, 3,000 units .................... $72,000 $90,000

2. a. No, $72,000 is not the correct figure to use, since variable costing is

not generally accepted for external reporting purposes or for tax pur-poses.

b. The Finished Goods inventory account should be stated at $90,000,

which represents the absorption cost of the 3,000 unsold units. Thus, the account should be increased by $18,000 for external reporting

purposes. This $18,000 consists of the amount of fixed manufactur-

ing overhead cost that is allocated to the 3,000 unsold units under

absorption costing:

3,000 units × $6 per unit fixed manufacturing overhead cost =

$18,000

1. Under variable costing, only the variable manufacturing costs are in-

cluded in product costs.

Direct materials............................. $ 50

Direct labor (80)

Variable manufacturing overhead (20)

Unit product cost .......................... $150

Note that selling and administrative expenses are not treated as product costs; that is, they are not included in the costs that are inventoried.

These expenses are always treated as period costs and are charged

against the current period’s revenue.

2. The variable costing income statement appears below:

Sales ............................................................. $3,990,000 Less variable expenses:

Variable cost of goods sold:

Beginning inventory .................................. $ 0

Add variable manufacturing costs

(20,000 units × $150 per unit) ................ 3,000,000

Goods available for sale ............................. 3,000,000

Less ending inventory

(1,000 units × $150 per unit) .................. 150,000

Variable cost of goods sold* ......................... 2,850,000

Variable selling and administrative expenses

(19,000 units × $10 per unit) .................... 190,000 3,040,000 Contribution margin ........................................ 950,000 Less fixed expenses:

Fixed manufacturing overhead ...................... 700,000

Fixed selling and administrative expenses ...... 285,000 985,000 Net operating loss .......................................... $ (35,000) * The variable cost of goods sold could be computed more simply as:

19,000 units sold × $150 per unit = $2,850,000.

3. The break-even point in units sold can be computed using the contribu-

tion margin per unit as follows:

Selling price per unit ................ $210

Variable cost per unit (160)

Contribution margin per unit .... $ 50

Fixed expen ses

B reak-even u n it sales =

U n it con tribu tion m argin

$985,000

== 19,700 u n its

$50 per u n it

1. Under absorption costing, all manufacturing costs (variable and fixed)

are included in product costs.

Direct materials ................................................................ $ 50

Direct labor (80)

Variable manufacturing overhead (20)

Fixed manufacturing overhead ($700,000 ÷ 20,000 units) .. 35

Unit product cost .............................................................. $185

2. The absorption costing income statement appears below:

Sales (19,000 units × $210 per unit) ................ $3,990,000 Cost of goods sold:

Beginning inventory ...................................... $ 0

Add cost of goods manufactured

(20,000 units × $185 per unit) .................... 3,700,000

Goods available for sale ................................ 3,700,000

Less ending inventory

(1,000 units × $185 per unit) ..................... 185,000 3,515,000 Gross margin .................................................. 475,000 Less selling and administrative expenses:

Variable selling and administrative expenses

(19,000 units × $10 per unit) ..................... 190,000

Fixed selling and administrative expenses ....... 285,000 475,000 Net operating income ...................................... $ 0 Note: The company apparently has exactly zero net operating income even though its sales are below the break-even point computed in Exer-cise 7-8. This occurs because $35,000 of fixed manufacturing overhead has been deferred in inventory and does not appear on the income

statement prepared using absorption costing.

1. a. The unit product cost under absorption costing is:

Direct materials ................................................................. $20

Direct labor (8)

Variable manufacturing overhead (2)

Fixed manufacturing overhead ($100,000 ÷ 10,000 units) (10)

Unit product cost ............................................................... $40

b. The absorption costing income statement is:

Sales (8,000 units × $75 per unit).................... $600,000

Less cost of goods sold:

Beginning inventory ...................................... $ 0

Add cost of goods manufactured

(10,000 units × $40 per unit) ..................... 400,000

Goods available for sale ................................ 400,000

Less ending inventory

(2,000 units × $40 per unit) ....................... 80,000 320,000 Gross margin .................................................. 280,000

Less selling and administrative expenses

[(8,000 units × $6 per unit) + $200,000] ....... 248,000

Net operating income ...................................... $ 32,000 2. a. The unit product cost under absorption costing is:

Direct materials ............................. $20

Direct labor (8)

Variable manufacturing overhead (2)

Unit product cost ........................... $30

b. The variable costing income statement is:

Sales (8,000 units × $75 per unit) .................... $600,000 Less variable expenses:

Variable cost of goods sold:

Beginning inventory .................................... $ 0

Add variable manufacturing costs

(10,000 units × $30 per unit).................... 300,000

Goods available for sale............................... 300,000

Less ending inventory

(2,000 units × $30 per unit) ..................... 60,000

Variable cost of goods sold ............................. 240,000

Variable selling expenses

(8,000 units × $6 per unit) .......................... 48,000 288,000 Contribution margin ......................................... 312,000 Less fixed expenses:

Fixed manufacturing overhead ....................... 100,000

Fixed selling and administrative expenses ....... 200,000 300,000 Net operating income ....................................... $ 12,000 3. The difference in the ending inventory relates to a difference in the han-

dling of fixed manufacturing overhead costs. Under variable costing, these costs have been expensed in full as period costs. Under absorp-tion costing, these costs have been added to units of product at the rate of $10 per unit ($100,000 ÷ 10,000 units produced = $10 per unit).

Thus, under absorption costing a portion of the $100,000 fixed manu-facturing overhead cost for the month has been added to the inventory account rather than expensed on the income statement:

Added to the ending inventory

(2,000 units × $10 per unit) ........................................ $ 20,000 Expensed as part of cost of goods sold

(8,000 units × $10 per unit) ........................................ 80,000 Total fixed manufacturing overhead cost for the month ... $100,000

Since $20,000 of fixed manufacturing overhead cost has been deferred in inventory under absorption costing, the net operating income reported un-der that costing method is $20,000 higher than the net operating income under variable costing, as shown in parts (1) and (2) above.

1. The unit product cost under the variable costing method is computed as

follows:

Direct materials ............................. $ 4

Direct labor (7)

Variable manufacturing overhead (1)

Unit product cost ........................... $12

With this figure, the variable costing income statements can be pre-

pared:

Year 1 Year 2 Sales ............................................................ $1,000,000 $1,250,000 Less variable expenses:

Variable cost of goods sold

(@ $12 per unit) ...................................... 480,000 600,000 Variable selling and administrative ex-

penses (@ $2 per unit) ............................. 80,000 100,000 Total variable expenses .................................. 560,000 700,000 Contribution margin ....................................... 440,000 550,000 Less fixed expenses:

Fixed manufacturing overhead ..................... 270,000 270,000 Fixed selling and administrative expenses ..... 130,000 130,000 Total fixed expenses ...................................... 400,000 400,000 Net operating income .................................... $ 40,000 $ 150,000 2. The reconciliation of absorption and variable costing follows:

Year 1 Year 2 Variable costing net operating income ........... $40,000 $150,000 Add: Fixed manufacturing overhead de-

ferred in inventory under absorption cost-

ing (5,000 units × $6 per unit) ................... 30,000

Deduct: Fixed manufacturing overhead re-

leased from inventory under absorption

costing (5,000 units × $6 per unit) ............. (30,000) Absorption costing net operating income ....... $70,000 $120,000