Lesson 4

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 Variable Costing: A
Tool for Management
Decision Making

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 Product Cost VS Period Cost

Any business incurs two major types of costs:

product and period costs.
Product Costs
Product costs are expenses that a business
incurs in acquiring raw materials and
manufacturing a product.
For example: Material Costs, Labour Costs,
Factory overhead costs (e.g., salaries of
employees working in a factory are product
costs)
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 Product Cost VS Period Cost (Cont.)

Period Costs
All other expenses a business incurs that are
not used for making products rather they are
period related are period costs.
For example:
Selling expenses, Advertising expenses
Depreciation expense, General and
administrative expenses Executive and
administrative salaries and benefits, Office rent,
Interest expense.
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 Unit Product Costs

Unit Product Cost

Cost of Direct materials xxx

Cost of Direct labor xxx
Cost of factory overhead xxx
= Unit product cost xxx

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 Unit Product Costs (cont.)

Factory overhead costs can be either

Fixed factory overhead costs
e.g., Factory manager salaries
Factory Building Expenses
Variable factory overhead costs
e.g., Production supplies (maintenance
materials, janitorial/cleaning supplies,
Machine lubricants)
Equipment utilities
Materials handling wages
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 Absorption Costing VS Variable Costing
(cont.)
Variable and absorption costing are two
different costing methods.

Almost all successful companies in the world

use both the methods. Variable costing and
absorption costing cannot be substituted for one
another because both the systems have their
own benefits and limitations.

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 Absorption Costing VS Variable Costing
(cont.)
These costing approaches are known by
various names.

For example,
Variable costing is also known as direct
costing or marginal costing

Absorption costing is also known as full

costing or traditional costing.

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 Absorption Costing VS Variable Costing
(cont.)
The information provided by variable costing
method is mostly used by internal management
for decision making purposes.

Absorption costing provides information that is

used by internal management as well as by
external parties like creditors, government
agencies and auditors etc.

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 Absorption Costing VS Variable Costing
(cont.)
Absorption Costing
A costing method that includes all
manufacturing costs e.g., direct material,
direct labor, and both variable and fixed
manufacturing overhead – in unit product
costs.

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 Absorption Costing VS Variable Costing
(cont.)

Variable Costing
A costing method that includes only variable
manufacturing costs e.g., direct materials, direct
labor, and only variable manufacturing overhead
– in unit product cost.

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 Overview of Absorption
and Variable Costing

Absorption Variable
Costing Costing
Direct Materials
Product
Product Direct Labor
Costs
Costs Variable Manufacturing Overhead

Fixed Manufacturing Overhead

Period
Period Variable Selling and Administrative Expenses
Costs
Costs Fixed Selling and Administrative Expenses

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 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. . .

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 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. . .

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 Unit Cost Computations

Harvey Company produces a single product

with the following information available:

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 Unit Cost Computations

Unit product cost is determined as follows:

Selling and administrative expenses are

always treated as period expenses and
deducted from revenue as incurred.
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 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.
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 Absorption Costing

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 Variable Costing

Variable
manufacturing
Variable Costing
costs only.
Sales (20,000 × $30) $ 600,000
Less variable expenses:
Beginning inventory $ -
All fixed
Add COGM (25,000 × $10) 250,000
manufacturing
Goods available for sale 250,000
overhead is
Less ending inventory (5,000 × $10) 50,000
expensed.
Variable cost of goods sold 200,000
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

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 Income Comparison of
Absorption and Variable Costing

Let’s compare the methods.

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 Reconciliation

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
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 Extended Comparison of Income Data
Harvey Company Year Two

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 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.
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 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.
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 Variable Costing
Variable
manufacturing
costs only.

All fixed
manufacturing
overhead is
expensed.

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 Reconciliation

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
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 Income Comparison

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 Summary

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 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.
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 Effect of Changes in Production
Harvey Company Year One

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 Unit Cost Computations for Year One

Unit product cost is determined as follows:

Since the number of units produced increased

in this example, while the fixed manufacturing overhead
remained the same, the absorption unit cost is less.
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 Absorption Costing: Year One

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 Variable Costing: Year One

Variable
manufacturing
Variable Costing
costs only.
Sales (25,000 × $30) $ 750,000
Less variable expenses:
Beginning inventory $ -
All fixed
Add COGM (30,000 × $10) 300,000
manufacturing
Goods available for sale 300,000
overhead is
Less ending inventory (5,000 × $10) 50,000
expensed.
Variable cost of goods sold 250,000
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

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 Effect of Changes in Production
Harvey Company Year Two

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 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.
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 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.
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 Variable Costing: Year Two
Variable
manufacturing
costs only.

All fixed
manufacturing
overhead is
expensed.

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 Income Comparison

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.
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 Impact on the Manager

Opponents of absorption costing argue that shifting

fixed manufacturing overhead costs between periods
can lead to misinterpretations and faulty decisions.

Those who favor variable costing argue that the income

statements are easier to understand because net operating
income is only affected by changes in unit sales. The
resulting income amounts are more consistent with
managers’ expectations.

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 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/drop
decisions.
• Produce positive net operating income even
when the number of units sold is less than the
breakeven point.
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 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.
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 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.
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 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
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 Variable Costing and the
Theory of Constraints (TOC)

Companies involved in TOC use a form of

variable costing, but treating direct labor as a
fixed cost for three reasons:
 Many companies have a commitment to guarantee
workers a minimum number of paid hours.
 TOC emphasizes the role of direct labor in
continuous improvement. Fluctuating levels of
direct labor can devastate morale and defeat
the role of employees in continuous improvement
efforts.
 Direct labor is usually not the constraint.

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 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.
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 End of Lesson 5

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