Chapter7VariableCosting:

AToolforManagementLearningObjective1Explainhowvariablecostingdiffersfromabsorptioncostingandcomputeunitproductcostsundereachmethod.OverviewofAbsorption

andVariableCostingDirectMaterialsDirectLaborVariableManufacturingOverheadFixedManufacturingOverheadVariableSellingandAdministrativeExpensesFixedSellingandAdministrativeExpensesVariable

CostingAbsorption

CostingProduct

CostsPeriod

CostsProduct

CostsPeriod

CostsQuickCheck

Whichmethodwillproducethehighestvaluesforworkinprocessandfinishedgoodsinventories?a.Absorptioncosting.b.Variablecosting.c.Theyproducethesamevaluesforthese

inventories.d.Itdepends...HarveyCompanyproducesasingleproduct

withthefollowinginformationavailable:UnitCostComputationsUnitproductcostisdeterminedasfollows:Underabsorptioncosting,sellingandadministrativeexpensesare

alwaystreatedas

periodexpenses

anddeductedfromrevenueasincurred.UnitCostComputationsLearningObjective2Prepareincomestatementsusingbothvariableandabsorptioncosting.IncomeComparisonof

AbsorptionandVariableCosting

Let’sassumethefollowingadditionalinformationforHarveyCompany.20,000unitsweresoldduringtheyearatapriceof$30each.Therewerenounitsinbeginninginventory.

Now,let’scomputenetoperating

incomeusingbothabsorption

andvariablecosting.AbsorptionCostingVariable

manufacturing

costsonly.Allfixed

manufacturing

overheadis

expensed.VariableCostingLearningObjective3Reconcilevariablecostingandabsorptioncostingnetoperatingincomesandexplainwhythetwoamountsdiffer.ComparingtheTwoMethodsFixedmfg.Overhead$150,000Unitsproduced25,000units==$6.00perunitWecanreconcilethedifferencebetween

absorptionandvariableincomeasfollows:ComparingtheTwoMethodsExtendedComparisonsofIncomeDataHarveyCompanyYearTwoUnitCostComputationsSincetherewasnochangeinthevariablecosts

perunit,totalfixedcosts,orthenumberof

unitsproduced,theunitcostsremainunchanged.AbsorptionCostingThesearethe25,000unitsproducedinthecurrentperiod.VariableCostingAllfixed

manufacturing

overheadis

expensed.Variable

manufacturing

costsonly.Wecanreconcilethedifferencebetween

absorptionandvariableincomeasfollows:Fixedmfg.Overhead$150,000Unitsproduced25,000units==$6.00perunitComparingtheTwoMethodsComparingtheTwoMethodsSummaryofKeyInsightsEffectofChangesinProduction

onNetOperatingIncomeLet’srevisetheHarveyCompanyexample.Inthepreviousexample,

25,000unitswereproducedeachyear,

butsalesincreasedfrom20,000unitsinyear

oneto30,000unitsinyeartwo.Inthisrevisedexample,

productionwilldiffereachyearwhile

saleswillremainconstant.EffectofChangesinProduction

HarveyCompanyYearOneUnitproductcostisdeterminedasfollows:UnitCostComputationsforYearOneSincethenumberofunitsproducedincreased

inthisexample,whilethefixedmanufacturingoverhead

remainedthesame,theabsorptionunitcostisless.AbsorptionCosting:YearOneVariableCosting:YearOneVariable

manufacturing

costsonly.Allfixed

manufacturing

overheadis

expensed.EffectofChangesinProduction

HarveyCompanyYearTwoUnitproductcostisdeterminedasfollows:UnitCostComputationsforYearTwoSincethenumberofunitsproduceddecreasedinthe

secondyear,whilethefixedmanufacturingoverhead

remainedthesame,theabsorptionunitcostisnowhigher.AbsorptionCosting:YearTwoThesearethe20,000unitsproducedinthecurrent

periodatthehigherunitcostof$17.50each.VariableCosting:YearTwoAllfixed

manufacturing

overheadis

expensed.Variable

manufacturing

costsonly.Netoperatingincomeisnotaffectedbychangesin

productionusingvariablecosting.Netoperatingincomeisaffectedbychangesinproduction

usingabsorptioncostingeventhoughthenumberofunits

soldisthesameeachyear.ConclusionsComparingtheTwoMethodsLearningObjective4Understandtheadvantagesanddisadvantagesofbothvariableandabsorptioncosting.ImpactontheManagerOpponentsofabsorptioncostingarguethat

shiftingfixedmanufacturingoverheadcosts

betweenperiodscanleadtofaultydecisions.Theseopponentsarguethatvariablecostingincome

statementsareeasiertounderstandbecausenetoperating

incomeisonlyaffectedbychangesinunitsales.This

producesnetoperatingincomefiguresthatare

moreconsistentwithmanagers’expectations.CVPAnalysis,DecisionMaking

andAbsorptioncosting

AbsorptioncostingdoesnotsupportCVPanalysisbecauseitessentiallytreatsfixedmanufacturingoverheadasavariablecostbyassigningaperunitamountofthefixedoverheadtoeachunitofproduction.Treatingfixedmanufacturingoverheadasa

variablecostcan:Leadtofaultypricingdecisionsandkeep-or-drop

decisions.Producepositivenetoperatingincomeeven

whenthenumberofunitssoldislessthanthe

breakevenpoint.ExternalReportingToconformto

GAAPrequirements,

absorptioncostingmustbeusedfor

externalfinancialreports.Sincetopexecutives

areusuallyevaluatedbasedon

externalreportstoshareholders,

theymayfeelthatdecisions

shouldbebasedon

absorptioncostingdata.AdvantagesofVariableCosting

andtheContributionApproachAdvantagesManagementfinds

itmoreuseful.ConsistentwithCVPanalysis.Netoperatingincomeiscloserto

netcashflow.Profitisnotaffectedby

changesininventories.Consistentwithstandard

costsandflexiblebudgeting.Impactoffixedcostsonprofitsemphasized.Easiertoestimateprofitability

ofproductsandsegments.AdvantagesofVariableCosting

andtheContributionApproachThedatarequiredforCVPanalysiscanbetakendirectlyfromacontributionformatincomestatement.Profitsmoveinthesamedirectionassales,assumingotherthingsremainthesame.Managersoftenassumethatunitproductcostsarevariable.Undervariablecosting,thisassumptionistrue.Fixedcostsappearexplicitlyonacontributionformatincomestatement;thustheimpactoffixedcostsonprofitsisemphasized.Variablecostingdatamakeiteasiertoestimatetheprofitabili