6.1: Introduction to Variable Costing Analysis

Operating income on the income statement is one of the most important results that a manufacturing company reports on its financial statements. External parties such as investors, creditors, and governmental agencies look to this amount to evaluate a company’s performance and how it affects them. Managers and others within a company use operating income as a measure for evaluating and improving operational performance.

We have been preparing income statements for manufacturers using this basic structure.

Absorption Costing Income Statement

Sales	$750,000
Cost of goods sold	525,000
Gross profit	$225,000
Selling and administrative expenses	125,000
Operating income	$100,000

This format is referred to as an absorption costing income statement. Expenses are separated into two accounts: Cost of Goods Sold, which are product costs of the manufactured goods themselves, and Selling and Administrative Expenses, which are general operating costs.

Each of these two expense accounts includes both variable and fixed costs. Cost of Goods Sold is made up of the three costs of manufacturing: direct materials and direct labor, which are variable, and factory overhead, which may be both variable and fixed. Likewise, Selling and Administrative Expenses may include both variable and fixed costs.

Absorption costing is required under generally accepted accounting principles (GAAP) for external reporting. All manufacturing costs, whether fixed or variable, must be treated as product costs and included in an inventory amount on the balance sheet until the product is sold. When the product is sold, its cost is then expensed off as cost of goods sold on the income statement. Under absorption costing, fixed factory overhead is allocated to the finished goods inventory account and is expensed to cost of goods sold when the product is sold.

For managers within a company, it is also useful to prepare an income statement in a different format that separates out the expenses that truly vary directly with revenues. Variable costs are typically more controllable than fixed costs, so it is useful to isolate them so they can be analyzed by management. A variable costing income statement only includes variable manufacturing costs in the finished goods inventory and cost of goods sold amounts on the financial statements. Under variable costing, fixed factory overhead is NOT allocated to the finished goods inventory and is NOT expensed to cost of goods sold when the product is sold. Instead, total fixed factory overhead is treated as a period cost that is deducted from gross profit. On a variable costing income statement, all variable expenses are deducted from revenue to determine the contribution margin, from which all fixed expenses are subtracted to arrive at operating income for the period.

The following is a sample variable costing income statement.

Variable Costing Income Statement

Sales		$750,000
Variable cost of goods sold		375,000
Manufacturing margin		$375,000
Variable selling and administrative expenses		75,000
Contribution margin		$300,000
Fixed costs:
\(\ \quad \quad\)Fixed manufacturing costs	$150,000
\(\ \quad \quad\)Fixed selling and administrative expenses	50,000
\(\ \quad \quad\quad \quad\)Total fixed costs		200,000
Operating income		$100,000

As is shown on the variable costing income statement, total sales is matched with the total direct costs of generating those sales. The difference between sales and total variable costs is the contribution margin, which is the amount available to pay all fixed costs.

Under both methods, direct costs (materials and labor) and variable factory overhead costs are applied to the cost of the product. The difference between the two costing methods is how the fixed factory overhead costs are treated. Under variable costing, fixed factory overhead costs are expensed in the period in which they are incurred, regardless of whether the product is sold yet. Under absorption costing, fixed factory overhead costs are expensed only when the product is sold.

To recap, the variable costing income statement is different from the absorption costing income statement in several ways. (1) Only variable production costs are included in cost of goods sold. (2) Manufacturing margin replaces gross profit. (3) Variable selling and administrative expenses are grouped with variable production costs as part of the calculation of contribution margin. (4) Contribution margin is listed after deducting all variable costs from sales. (5) Fixed production costs are shown below the contribution margin on the income statement with fixed operating costs.

Contribution margin (variable costing) is often higher than gross profit (absorption costing because many production costs, and most selling and administrative expenses, are fixed. Since variable costing tends to reduce cost of goods sold than it increases general operating expenses, the net result is a higher contribution margin.

The following data will be used for three pairs of income statements that follow in sample problems. The only difference in the three scenarios is the number of units produced.

Number of units sold	15,000
Selling price per unit	$50
Number of units produced	15,000 for Example A 20,000 for Example B 10,000 for Example C
Variable manufacturing cost per unit	$25
Fixed manufacturing costs	$150,000
Variable selling and administrative cost per unit	$5
Fixed selling and administrative costs	$50,000