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CHAPTER 7 VARIABLE COSTING:

A DECISION-MAKING PROCESS

Study Objectives

Explain the difference between absorption costing and variable costing.

Discuss the effect that changes in production level and sales level have on net income measured under absorption costing versus variable costing.

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Study Objectives: Continued

Discuss the relative merits of absorption costing versus variable costing for management decision making.

Explain the term sales mix and its effect on break-even sales.

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ABSORPTION COSTING VERSUS VARIABLE COSTING

Study Objective 1

Full or Absorption Costing Assigns all variable and fixed manufacturing costs to the

product

Required for external reporting

Variable Costing Assigns only variable manufacturing costs to the product Direct material, direct labor, variable manufacturing

overhead

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ABSORPTION COSTING VERSUS VARIABLE COSTING

COMPARISON

Primary Difference

Under variable costing, fixed manufacturing overhead is an expense in the current period.

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ABSORPTION COSTING VERSUS VARIABLE COSTINGCOMPARISON - Continued

Variable costing does not defer fixed manufacturing overhead to the future - i.e., they are not inventoried

Net income under absorption costing compared to net income under variable costing: Higher when units produced exceed units sold

Lower when units produced are less than units sold

Equal when units produced and sold are the same:

• There is no ending inventory so fixed costs are not deferred into the future

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ABSORPTION COSTING VERSUS VARIABLE COSTING

Example – Premium Products

Manufactures Fix-it, a sealant for car windows

Relevant data for the first month of production:

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ABSORPTION COSTING VERSUS VARIABLE COSTING

Example - Continued

Per unit manufacturing cost under each approach:

Manufacturing costs are $4 ($13 - $9) higher for absorption costing because fixed manufacturing costs are product costs.

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ABSORPTION COSTING VERSUS VARIABLE COSTING

Absorption Costing Income Statement

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ABSORPTION COSTING VERSUS VARIABLE COSTING

Variable Costing Income Statement

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ABSORPTION vs VARIABLE COSTING Extended Example – Overbay Inc – Basic Data

Study Objective 2

Manufacturing cost per airplane drone $300,000 : $240,000 variable and $60,000 fixed

Selling and administrative costs $130,000: $50,000 variable and $80,000 fixed

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ABSORPTION vs VARIABLE COSTING Extended Example – Overbay Inc – Continued

Net Income under Absorption Costing: $870,000

Absorption Costing Income Statement - 2005

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ABSORPTION vs VARIABLE COSTING Extended Example – Overbay Inc – Continued

Variable Costing Income Statement

Follows CVP format

Manufacturing costs include only the variable manufacturing costs - $240,000 in 2005

Expense all fixed manufacturing cost - $600,000 in 2005

Reports same net income in 2005 as the Absorption Costing Income Statement

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ABSORPTION vs VARIABLE COSTING Extended Example – Overbay Inc – Continued

Net Income under Variable Costing: $870,000

Variable Costing Income Statement - 2005

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ABSORPTION vs VARIABLE COSTING Extended Example – Overbay Inc – Continued

10 drones produced; 8 drones sold; 2 drones in ending inventory

Each unit in ending inventory includes $60,000 of fixed manufacturing overhead

$120,000 ($60,000 X 2) of fixed manufacturing costs are deferred until a future period

Absorption Costing - 2006

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ABSORPTION vs VARIABLE COSTING Extended Example – Overbay Inc – Continued

Absorption Costing Income Statement - 2006

Net Income under Absorption Costing: $680,000

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ABSORPTION vs VARIABLE COSTING Extended Example – Overbay Inc – Continued

Variable Costing Income Statement - 2006

Net Income under Variable Costing: $560,000

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ABSORPTION vs VARIABLE COSTING Extended Example – Overbay Inc – Continued

2006 Conclusions

When units produced (10) exceeds units sold (8), net income under absorption costing ($680,000)

is higher than net income under variable costing ($560,000).

Why?

Cost of ending inventory is higher under absorption costing than under variable costing.

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ABSORPTION vs VARIABLE COSTING Extended Example – Overbay Inc – Continued

10 drones produced; 12 drones sold - 10 from current year production and 2 from inventory

Fixed manufacturing overhead of $ 720,000 expensed $120,000 from 2006 and included in beginning inventory

$600,000 incurred in 2007

When units produced (10) are less than units sold (12), net income under absorption costing is less than net income under variable costing by the amount of fixed manufacturing costs included in beginning inventory.

Absorption Costing - 2007

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ABSORPTION vs VARIABLE COSTING Extended Example – Overbay Inc – Continued

Absorption Costing Income Statement - 2007

Net Income under Absorption Costing: $1,060,000

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ABSORPTION vs VARIABLE COSTING Extended Example – Overbay Inc – Continued

Variable Costing Income Statement - 2007

Net Income under Variable Costing: $1,180,000

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ABSORPTION vs VARIABLE COSTING Extended Example – Overbay Inc – Continued

Comparison of Net Income under the Two Approaches

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ABSORPTION vs VARIABLE COSTING Summary of Income Effects

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DECISION-MAKING CONCERNS

Generally Accepted Accounting Principles (GAAP) Must be followed for external reporting

Requires absorption costing for inventory

Does not differentiate between fixed and variable costs

Poor business decisions may result

Thus, variable costing used for internal decision making

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DECISION-MAKING CONCERNS

Example - Basic Data for Lighting Division

Decision: Produce 20,000 or 30,000 units?

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DECISION-MAKING CONCERNS

Example – Continued

At 20,000 units, net income is $85,000.

At 30,000 units, net income is $105,000 with 10,000 unit ending inventory.

Difference in income due to $20,000 fixed costs assigned to ending inventory.

Comparative Absorption Costing Income Statements

Based on these statements, should production be increased?

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DECISION-MAKING CONCERNS

Example – Continued

At both levels, net income is $85,000.

Fixed costs treated as a period expense.

10,000 units of ending inventory include only variable costs.

Comparative Variable Costing Income Statements

Based on these statements, should production be increased?

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ADVANTAGES OF VARIABLE

COSTINGStudy Objective 3

Consistent with CVP and incremental analysis

Net income unaffected by changes in production levels

Net income closely tied to changes in sales levels – not production levels

Easier to identify fixed and variable costs and their effect on company

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SALES MIXStudy Objective 4

Companies often sell more than one product

Critical decision:what mix of products to sell

Relative percentage in which each product is sold when more than one product is sold

Important because different products have substantially different contribution margins

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SALES MIXBreak-Even Sales In Units

Steps for a mix of two or more products:

Compute the weighted-average unit contribution margin of all the products:

Product 1 Unit Contribution Margin X Percentage of Sales

+ Product 2 Unit Contribution Margin X Percentage of Sales

= Weighted Average Unit Contribution Margin

Compute the break-even point in units:

Fixed Costs ÷Weighted Average = Break-even Unit Contribution Point

Margin in Units

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SALES MIXBreak-Even Sales In Units

Example – Vargo Video Basic Data

Sells both DVD players and TVs

Fixed costs of $200,000

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SALES MIX - Break-Even Sales In Units Example – Vargo Video Continued

Determine weighted-average unit contribution margin for the sales mix of 75 percent DVDs and 25 percent TVs:

Determine the break-even point in units:

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SALES MIX - Break-Even Sales In Units Example – Vargo Video (Continued)

Verify the number of DVDs and TVs to be sold to break even with a sales mix of 75 % DVDs and 25 % TVs and with fixed costs of $200,000:

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SALES MIXBreak-Even Sales In Units

At any level of units sold,

net income will be greater

if more high contribution margin units

are sold

than low contribution margin units.

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SALES MIXBreak-Even Sales In Dollars

Steps for a mix of many products in two or more product lines or divisions:

Compute the weighted-average unit contribution margin ratio of all product lines or divisions:

Division 1 Contribution Margin Ratio X Percentage of Sales

+ Division 2 Contribution Margin Ratio X Percentage of Sales

= Weighted Average Contribution Margin Ratio

Compute the break-even point in dollars:

Fixed Costs ÷Weighted Average = Break-even Contribution Point Margin Ratio in Dollars

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SALES MIXBreak-Even Sales In Dollars

Example – Kale Garden Supply Co. Basic Data

Total fixed costs $300,000

Two Product Divisions:

Indoor Plants: Sales Mix Ratio 20% Contribution Margin Ratio 40%

Outdoor Plants: Sales Mix Ratio 80% Contribution Margin Ratio 30%

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SALES MIX - Break-Even Sales In Dollars Example – Kale Garden Supply (Continued)

Determine weighted-average contribution margin ratio for all divisions:

Determine the break-even point in dollars:

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SALES MIX - Break-Even Sales In Dollars Example – Kale Garden Supply (Continued)

Using Kale’s sales mix of 20 percent and 80 percent, break-even sales from each division:

Indoor Plant Division:$187,500 (.20 X $937,500)

Outdoor Plant Division:$750,000(.80 X $937,500)

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SALES MIX - Break-Even Sales In Dollars Example – Kale Garden Supply (Continued)

Break-even point affected by a shift in sales from one division to another

Shift sales to the Indoor Plant Division: Division’s higher contribution margin ratio increases

weighted average contribution margin ratio

Results in a lower break-even point in sales dollars

Shift sales to the Outdoor Plant Division: Opposite effect occurs due to Division’s lower

contribution margin ratio

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SALES MIX

Understanding and managing

sales mix is

critical to company success