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VARIABLE COSTING
Key Terms and Concepts to Know
Variable vs. Absorption Costing
- Absorption Costing is required by GAAP for external reporting purposes. This is the costing method used for the traditional income statement.
- Absorption costing classifies costs based on their function: product or period costs.
- Variable Costing is often used for internal decision-making. This is the costing method used for the contribution format income statement.
- Variable costing classifies costs based on their behavior when the activity level changes: variable or fixed costs.
- The difference between the two methods is how they account for fixed manufacturing overhead. Product Costs:
- Product costs are the manufacturing costs incurred to produce the products to be sold.
- Product costs under absorption costing include both manufacturing costs.
- Product costs under variable costing include only variable manufacturing costs.
- Absorption costing accounts for fixed manufacturing overhead as a product cost.
- Variable costing accounts for fixed manufacturing overhead as a period cost. Period Costs:
- Period costs are the non-manufacturing costs incurred to operate the company.
- Period costs are accounted for as expenses in the period incurred.
- Absorption costing accounts for both variable and fixed non-manufacturing costs, i.e., selling and administrative costs as period costs.
- Variable costing accounts for both variable and fixed non-manufacturing costs, i.e., selling and administrative costs, and fixed manufacturing overhead as period costs.
Key Topics to Know
Product vs. Period Costs and Variable vs. Fixed Costs
- Absorption costing accounts for fixed manufacturing overhead as a product cost.
- Variable costing accounts for fixed manufacturing overhead as a period cost.
- The traditional and contribution format income statements are presented below along with the separation of traditional expense categories into their variable and fixed components. Traditional Income Statement Contribution Income Statement Sales Sales Cost of Goods Sold Variable Expenses: Production (COGS) Selling Administrative Gross Margin Contribution Margin Operating Expenses: Fixed Expenses: Selling Production (COGS) Administrative Selling Administrative Operating Income Operating Income Stays the same Variable cost Fixed cost
- Under Variable Costing: o Only those costs of production that vary with output are product costs. This is consistent with the contribution format income statement and cost- volume-profit analysis because of the emphasis on separating variable and fixed costs. o The cost of a unit of product consists of direct materials, direct labor, and variable overhead.
- Under Absorption Costing: o All costs of production are 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.
Solution # a) Absorption Variable Sales $600,000 Sales $600, Cost of Goods Sold Variable Expenses: 320, Production 200, Manufacturing Margin 400, Selling & Administrative 80, Gross Margin 280,000 Contribution Margin 320, Operating Expenses: Fixed Expenses: Production 150, Selling & Administrative 160, Selling & Administrative 80, Operating Income $120,000 Operating Income $90, b) Operating income – absorption costing $120, Less: fixed overhead deferred in ending inventory 30, Operating income – variable costing $90, c) Units produced and not sold 25,000 – 20,000 = 5, Fixed overhead cost per unit $16 - $10 = $6. Fixed overhead deferred in ending inventory $30, Units in ending inventory (25,000 – 20,000) 5, Variable cost per unit $10. Value of ending inventory $50,
Example # H Company produces a single product. Available information for year 2 is: a) 25,000 units were produced and 30,000 units were sold during the year. b) The selling price per unit, variable costs per unit, total fixed costs and selling and administrative expenses remained unchanged from the prior year. c) 5,000 units are in beginning inventory from year 1 d) The net operating income is $230,000 under absorption costing. Required: a) Prepare income statements using variable and absorption costing. b) Reconcile variable costing and absorption costing net operating incomes and explain why the two amounts differ. c) Determine the amount of fixed overhead released from ending inventory. d) Determine the total operating income for the 2 years under both methods. Solution #
Absorption Income Statement Variable Income statement Sales $900,000 Sales $900, Cost of Goods Sold Variable Expenses: 48 0, Production 300, Manufacturing Margin 600, Selling & Administrative 80, Gross Margin 42 0,000 Contribution Margin 520, Operating Expenses: Fixed Expenses: Production 150, Selling & Administrative 160, Selling & Administrative 80, Operating Income $2 6 0,000 Operating Income $290,
Operating income – absorption costing $260, plus: fixed overhead released from ending inventory 30, Operating income – variable costing $290,
Relationship Between Inventory levels and Operating Income
- Absorption costing income is influenced by changes in unit sales and units of production. Simply producing more units even if those units are not sold can increase net operating income.
- Absorption costing assigns per unit fixed manufacturing overhead costs to production. This can potentially produce positive net operating income even when the number of units sold is less than the breakeven point.
- Variable costing income is only affected by changes in unit sales. The number of units produced does not affect it. As a general rule, when sales go up net operating income goes up and vice versa.
- When units produced equals units sold, the two methods report the same net operating income.
- When units produced are greater than units sold, i.e., units in inventory increase, absorption income is greater than variable costing income because absorption costing defers a portion of fixed manufacturing costs in finished goods inventory.
- When units produced are less than units sold, units in inventory decrease, absorption costing income is less than variable costing income because absorption costing the previously deferred fixed manufacturing costs in finished goods inventory are now included in the cost of goods sold for the units sold from inventory.
- In summary: Inventory Level Net Income Units produced = units sold No change Absorption = Variable Units produced > units sold Increases Absorption > Variable Units produced = units sold Decreases Absorption < Variable
Contribution Margin Analysis
- Explains the difference between expected and actual contribution margin.
- Differences are due to two factors: quantity and unit price/cost
- Quantity factor is due to a difference in the number of units sold x the planned unit price/cost
- Unit price/cost factor due to a difference in the unit sales price or variable unit cost x actual units sold
- Both the Quantity factor and the Unit Price/cost factor are further divided into
- The factors are summarized in the following chart.: Planned Quantity Factor Unit Price/Cost factor Actual Sales = Planned units sold x Planned unit sales price (Actual sold- planned sold) x Planned unit sales price Actual units sold x (Actual unit price - planned unit price) Sales = Actual units sold x Actual unit price Variable cost = Planned units sold x Planned unit cost (Planned sold- actual sold) x Planned unit cost Actual units sold x (Planned unit cost - actual unit cost) Variable cost = Actual units sold x Actual unit cost Contribution margin = Planned units sold x Planned unit CM (Actual sold- planned sold) x Planned unit CM Actual units sold x (Planned unit CM - actual CM unit CM) Contribution margin = Actual units sold x Actual unit CM
- Note the following consistencies in the chart: o The components that repeat across columns have been underlined. o The quantity factor calculations are always based on the planned $ per unit o The Unit price/cost factor calculations are always based on the actual units sold
Practice Problem # C Company reports the following first year production cost information. Units produced 53,000 units Units sold 50,000 units Sales price $150.00 per unit Direct labor $8.00 per unit Direct materials $4.00 per unit Variable overhead $2,173, Fixed overhead $3,339, Operating expenses $1,000, Required: a) Determine the net income using variable costing. b) Determine the net income using absorption costing. c) Reconcile the two net incomes. Practice Problem # S Company began operations on April 1 of the current year. During this time, the company produced 750,000 units and sold 720,000 units at a sales price of $9 per unit. Cost information for this period is shown below. Production costs: Direct labor $.30 per unit Direct materials $1.80 per unit Variable overhead $495, Fixed overhead $450,00 0 Non-production costs: Variable selling expense $18, Fixed administrative expenses $53, Required: a) Determine the net income using variable costing. b) Determine the net income using absorption costing. c) Reconcile the two net incomes.
Practice Problem # L Company reports the following first year production cost information. Units produced 62, Units sold 59, Direct labor $41 per unit Direct materials $15 per unit Variable overhead $9,300, Fixed overhead $4,340, Required: a) Compute production cost per unit under variable costing. b) Compute production cost per unit under absorption costing. c) Determine the cost of ending inventory using variable costing. d) Determine the cost of ending inventory using absorption costing.
- The absorption costing income statement classifies costs based on cost behavior rather than function. True False
- When units produced equal units sold, reported income is identical under absorption costing and variable costing. True False
- When units produced exceed the units sold, income under absorption costing is higher than income under variable costing. True False
- When units produced are less than units sold, income under absorption costing is higher than income under variable costing. True False
- To convert variable costing income to absorption costing income, management will need to change the way fixed overhead costs are treated. True False
- Variable costing is the only acceptable basis for both external reporting and tax reporting. True False
- The quantity factor measures the effect of a difference between actual and planned selling price on contribution margin. True False
- Fixed costs are not considered in contribution margin analysis. True False
- The unit price factor is computed only for sales. True False
- The quantity factor and unit sales factor must always be positive. True False
Multiple Choice Questions
1. Which of the following statements is true regarding absorption costing?
a) It is not the traditional costing approach. b) It is not permitted to be used for financial reporting. c) It assigns all manufacturing costs to products. d) It assigns only variable manufacturing costs to products.
2. Which of the following statements is true regarding variable costing?
a) It is a traditional costing approach. b) Only manufacturing costs that change in total with changes in production level are included in product costs. c) It is not used for managerial reporting. d) It treats overhead in the same manner as absorption costing.
3. Which of the following statements is true?
a) Variable costing treats fixed overhead as a period cost. b) Absorption costing treats fixed overhead as a period cost. c) Absorption costing treats fixed overhead as an expense in the period it is incurred. d) Variable costing excludes all overhead from product costs.
4. Under absorption costing, a company had the following unit costs when 8,
units were produced. Direct labor $8. Direct materials 9. Variable overhead 6. Fixed overhead 7. Total unit cost $31. Compute the total production cost per unit under variable costing if 30, units had been produced. a) $31. b) $27. c) $26. d) $24.
The next 5 questions refer to the following information: Advanced Company reports the following information for the current year. There was no beginning inventory this year. Units produced 25, Units sold 15, Direct materials $9.00/unit Direct labor $11.00/unit Variable overhead $75, Fixed overhead $137,
8. Compute^ the^ cost per unit of finished goods under variable costing.
a) $20. b) $25. c) $21. d) $23.
9. Compute^ the^ cost per unit of finished goods under absorption costing.
a) $20. b) $34. c) $25. d) $28.
10. Compute^ the^ cost of finished goods in inventory under absorption costing.
a) $285, b) $712, c) $427, d) $230,
11. Compute^ the^ cost of finished goods in inventory under variable costing.
a) $285, b) $712, c) $427, d) $230,
12. If^ the product is sold for $50 per unit and^ fixed^ operating expenses are
$200,000, compute the net income under absorption costing. a) $55, b) $67, c) $80, d) $122,
13. If^ the product is sold for $50 per unit and^ fixed^ operating expenses are
$200,000, compute the net income under variable costing. a) $55, b) $67, c) $80, d) $122,
Absorption Variable Sales $7,500,000 Sales $7,500, Cost of goods sold $8 + $4 + $104 = $ 5,800,000 Variable costs $8 + $4 + $41 = $
Gross margin 1,700,000 Contribution margin 4,850, Operating expenses 1,000,000 Fixed cost 3,339,000 + 1,000,
Net income 700,000 511, Proof: 3,000 units produced and not sold x ($104 - $41) = $189, Net income: absorption $700,000 – variable 189,000 = $189, Variable Rate Total rate Overhead cost $2,173,000 $5,512, Units produced 53,000 53, Rate = $41.00 = $104. Practice Problem # Absorption Variable Sales $6,480,000 Sales $6,480, Cost of goods sold $1.80 + $.30 + $1.26 = $3. 2,419,200 Variable production $1.80 + $.30 + $.66 = $2.
Variable selling 18, Gross margin 4,060,800 Contribution margin 4,478, Operating expenses 53,000 + 18, 71,000 Fixed cost 450,000 + 53,
Net income $3,989,800 $3,971, Proof: 30,000 units produced and not sold x ($3.36 - $2.76) = $18, Net income: absorption $3,989,800 – variable 3,971,800 = $18, Variable Rate Total rate Overhead cost $495,000 $945, Units produced 750,000 750, Rate =$.66 = $1.2 6
= $150 per unit
- Practice Problem #
- Variable overhead $9,300,
- Fixed overhead $4,340,
- Direct materials $15 $ Variable Costing Absorption Costing
- Direct Labor
- Variable overhead
- Fixed overhead
- Total Cost per Unit $206 $
- Units produced 62,
- Units sold 59,
- Units in inventory 3,000 3,
- Total Cost per Unit $206 $
- Value of ending inventory $618,000 $828,
