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6.7: Using Variable Costing to Make Decisions

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    1755
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    Skills to Develop

    • Understand how managers use variable costing to make decisions.

    In Chapter 2, we discussed how to report manufacturing costs and nonmanufacturing costs following U.S. Generally Accepted Accounting Principles (U.S. GAAP). Under U.S. GAAP, all nonmanufacturing costs (selling and administrative costs) are treated as period costs because they are expensed on the income statement in the period in which they are incurred. All costs associated with production are treated as product costs, including direct materials, direct labor, and fixed and variable manufacturing overhead. These costs are attached to inventory as an asset on the balance sheet until the goods are sold, at which point the costs are transferred to cost of goods sold on the income statement as an expense. This method of accounting is called absorption costing17 because all manufacturing overhead costs (fixed and variable) are absorbed into inventory until the goods are sold. (The term full costing is also used to describe absorption costing.)

    Question: Although absorption costing is used for external reporting, managers often prefer to use an alternative costing approach for internal reporting purposes called variable costing. What is variable costing, and how does it compare to absorption costing?

    Answer:

    Variable costing18 requires that all variable production costs be included in inventory, and all fixed production costs (fixed manufacturing overhead) be reported as period costs. Thus all fixed production costs are expensed as incurred.

    The only difference between absorption costing and variable costing is in the treatment of fixed manufacturing overhead. Using absorption costing, fixed manufacturing overhead is reported as a product cost. Using variable costing, fixed manufacturing overhead is reported as a period cost. Figure 6.8 summarizes the similarities and differences between absorption costing and variable costing.

    Figure 6.8.png

    Impact of Absorption Costing and Variable Costing on Profit

    Question: If a company uses just-in-time inventory, and therefore has no beginning or ending inventory, profit will be exactly the same regardless of the costing approach used. However, most companies have units of product in inventory at the end of the reporting period. How does the use of absorption costing affect the value of ending inventory?

    Answer:

    Since absorption costing includes fixed manufacturing overhead as a product cost, all products that remain in ending inventory (i.e., are unsold at the end of the period) include a portion of fixed manufacturing overhead costs as an asset on the balance sheet. Since variable costing treats fixed manufacturing overhead costs as period costs, all fixed manufacturing overhead costs are expensed on the income statement when incurred. Thus if the quantity of units produced exceeds the quantity of units sold, absorption costing will result in higher profit.

    We illustrate this concept with an example.

    The following information is for Bullard Company, a producer of clock radios:

    Figure 6.7.1.png

    Assume Bullard has no finished goods inventory at the beginning of month 1. We will look at absorption costing versus variable costing for three different scenarios:

    • Month 1 scenario: 10,000 units produced equals 10,000 units sold
    • Month 2 scenario: 10,000 units produced is greater than 9,000 units sold
    • Month 3 scenario: 10,000 units produced is less than 11,000 units sold

    Month 1: Number of Units Produced Equals Number of Units Sold

    Question: During month 1, Bullard Company sells all 10,000 units produced during the month. How does operating profit compare using absorption costing and variable costing when the number of units produced equals the number of units sold?

    Answer:

    Figure 6.9 presents the results for each costing method. Notice that the absorption costing income statement is called a traditional income statement, and the variable costing income statement is called a contribution margin income statement.

    As you review Figure 6.9, notice that when the number of units produced equals the number sold, profit totaling $90,000 is identical for both costing methods. With absorption costing, fixed manufacturing overhead costs are fully expensed because all units produced are sold (there is no ending inventory). With variable costing, fixed manufacturing overhead costs are treated as period costs and therefore are always expensed in the period incurred. Because all other costs are treated the same regardless of the costing method used, profit is identical when the number of units produced and sold is the same.

    Figure 6.9.png

    Figure 6.9 - Number of Units Produced Equals Number of Units Sold

    a $250,000 = $25 × 10,000 units sold.

    b $110,000 = ($4 per unit fixed production cost × 10,000 units sold) + ($7 per unit variable production cost × 10,000 units sold).

    c $70,000 = $7 per unit variable production cost × 10,000 units sold.

    d $50,000 = $20,000 fixed selling and admin. cost + ($3 per unit variable selling and admin. cost × 10,000 units sold).

    e $30,000 = $3 per unit variable selling and admin. cost × 10,000 units sold.

    f Variable costing treats fixed manufacturing overhead as a period cost. Thus all fixed manufacturing overhead costs are expensed in the period incurred regardless of the level of sales.

    g Given.

    Month 2: Number of Units Produced Is Greater Than Number of Units Sold

    Question: During month 2, Bullard Company produces 10,000 units but sells only 9,000 units. How does operating profit compare using absorption costing and variable costing when the number of units produced is greater than the number of units sold?

    Answer:

    Figure 6.10 presents the results for each costing method. Notice that absorption costing results in higher profit. When absorption costing is used, a portion of fixed manufacturing overhead costs remains in ending inventory as an asset on the balance sheet until the goods are sold. However, variable costing requires that all fixed manufacturing overhead costs be expensed as incurred regardless of the level of sales. Thus when more units are produced than are sold, variable costing results in higher costs and lower profit.

    The difference in profit between the two methods of $4,000 (= $79,000 − $75,000) is attributed to the $4 per unit fixed manufacturing overhead cost assigned to the 1,000 units in ending inventory using absorption costing ($4,000 = $4 × 1,000 units).

    Figure 6.10.png

    Figure 6.10 - Number of Units Produced Is Greater Than Number of Units Sold

    a $225,000 = $25 × 9,000 units sold.

    b $99,000 = ($4 per unit fixed production cost × 9,000 units sold) + ($7 per unit variable production cost × 9,000 units sold).

    c $63,000 = $7 per unit variable production cost × 9,000 units sold.

    d $47,000 = $20,000 fixed selling and admin. cost + ($3 per unit variable selling and admin. cost × 9,000 units sold). 

    e $27,000 = $3 per unit variable selling and admin. cost × 9,000 units sold.

    f Variable costing always treats fixed manufacturing overhead as a period cost. Thus all fixed manufacturing overhead costs are expensed in the period incurred regardless of the level of sales.

    g Given.

    Month 3: Number of Units Produced Is Less Than Number of Units Sold

    Question: During month 3, Bullard Company produces 10,000 units but sells 11,000 units (1,000 units were left over from month 2 and therefore were in inventory at the beginning of month 3). How does operating profit compare using absorption costing and variable costing when the number of units produced is less than the number of units sold?

    Answer:

    Figure 6.11 presents the results for each costing method. Using variable costing, the $40,000 in fixed manufacturing overhead costs continues to be expensed when incurred. However, using absorption costing, the entire $40,000 is expensed because all 10,000 units produced were sold; an additional $4,000 related to the 1,000 units produced last month and pulled from inventory this month is also expensed. Thus when fewer units are produced than are sold, absorption costing results in higher costs and lower profit.

    The difference in profit between the two methods of $4,000 (= $105,000 − $101,000) is attributed to the $4 per unit fixed manufacturing overhead cost assigned to the 1,000 units in inventory on the balance sheet at the end of month 2 and recorded as cost of goods sold during month 3 using absorption costing ($4,000 = $4 × 1,000 units).

    Figure 6.11.png

    Figure 6.11 - Number of Units Produced Is Less Than Number of Units Sold

    a $275,000 = $25 × 11,000 units sold.

    b $121,000 = ($4 per unit fixed production cost × 11,000 units sold) + ($7 per unit variable production cost × 11,000 units sold).

    c $77,000 = $7 per unit variable production cost × 11,000 units sold.

    d $53,000 = $20,000 fixed selling and admin. cost + ($3 per unit variable selling and admin. cost × 11,000 units sold).

    e $33,000 = $3 per unit variable selling and admin. cost × 11,000 units sold.

    f Variable costing always treats fixed manufacturing overhead as a period cost. Thus all fixed manufacturing overhead costs are expensed in the period incurred regardless of the level of sales.

    g Given.

    Advantages of Using Variable Costing

    Question: Why do organizations use variable costing?

    Answer:

    Variable costing provides managers with the information necessary to prepare a contribution margin income statement, which leads to more effective cost-volume-profit (CVP) analysis. By separating variable and fixed costs, managers are able to determine contribution margin ratios, break-even points, and target profit points, and to perform sensitivity analysis. Conversely, absorption costing meets the requirements of U.S. GAAP, but is not as useful for internal decision-making purposes.

    Another advantage of using variable costing internally is that it prevents managers from increasing production solely for the purpose of inflating profit. For example, assume the manager at Bullard Company will receive a bonus for reaching a certain profit target but expects to be $15,000 short of the target. The company uses absorption costing, and the manager realizes increasing production (and therefore increasing inventory levels) will increase profit. The manager decides to produce 20,000 units in month 4, even though only 10,000 units will be sold. Half of the $40,000 in fixed production cost ($20,000) will be included in inventory at the end of the period, thereby lowering expenses on the income statement and increasing profit by $20,000. At some point, this will catch up to the manager because the company will have excess or obsolete inventory in future months. However, in the short run, the manager will increase profit by increasing production. This strategy does not work with variable costing because all fixed manufacturing overhead costs are expensed as incurred, regardless of the level of sales.

    KEY TAKEAWAY

    As shown in Figure 6.8, the only difference between absorption costing and variable costing is in the treatment of fixed manufacturing overhead costs. Absorption costing treats fixed manufacturing overhead as a product cost (included in inventory on the balance sheet until sold), while variable costing treats fixed manufacturing overhead as a period cost (expensed on the income statement as incurred).

    When comparing absorption costing with variable costing, the following three rules apply: (1) When units produced equals units sold, profit is the same for both costing approaches. (2) When units produced is greater than units sold, absorption costing yields the highest profit. (3) When units produced is less than units sold, variable costing yields the highest profit.

    REVIEW PROBLEM 6.8

    Winter Sports, Inc., produces snowboards. The company has no finished goods inventory at the beginning of year 1. The following information pertains to Winter Sports, Inc.,:

    Figure 6.7.2.png

    1. All 100,000 units produced during year 1 are sold during year 1.
      1. Prepare a traditional income statement assuming the company uses absorption costing.
      2. Prepare a contribution margin income statement assuming the company uses variable costing.
    2. Although 100,000 units are produced during year 2, only 80,000 are sold during the year. The remaining 20,000 units are in finished goods inventory at the end of year 2.
      1. Prepare a traditional income statement assuming the company uses absorption costing.
      2. Prepare a contribution margin income statement assuming the company uses variable costing.
    Answer:
    1.  
      1. Traditional income statement (absorption costing), year 1:
        Figure 6.7.3.png
        1. $20,000,000 = $200 × 100,000 units sold.
        2. $13,500,000 = ($5 per unit fixed production cost × 100,000 units sold) + ($130 per unit variable production cost × 100,000 units sold).
        3. $1,800,000 = $800,000 fixed selling and admin. cost + ($10 per unit variable selling and admin. cost × 100,000 units sold).
      2. Contribution margin income statement (variable costing), year 1:
        Figure 6.7.4.png
        1. $20,000,000 = $200 × 100,000 units sold.
        2. $13,000,000 = $130 per unit variable production cost × 100,000 units sold.
        3. $1,000,000 = $10 per unit variable selling and admin. cost × 100,000 units sold.
        4. Variable costing treats fixed manufacturing overhead as a period cost. Thus all fixed manufacturing overhead costs are expensed in the period incurred regardless of the level of sales.
        5. Given.
    2.  
      1. Traditional income statement (absorption costing), year 2:
        Figure 6.7.5.png
        1. $16,000,000 = $200 × 80,000 units sold.
        2. $10,800,000 = ($5 per unit fixed production cost × 80,000 units sold) + ($130 per unit variable production cost × 80,000 units sold).
      2. Contribution margin income statement (variable costing), year 2:
        Figure 6.7.6.png
        1. $16,000,000 = $200 × 80,000 units sold.
        2. $10,400,000 = $130 per unit variable production cost × 80,000 units sold.
        3. $800,000 = $10 per unit variable selling and admin. cost × 80,000 units sold.
        4. Variable costing treats fixed manufacturing overhead as a period cost. Thus all fixed manufacturing overhead costs are expensed in the period incurred regardless of the level of sales.
        5. Given.

    Definitions

    1. A costing method that includes all manufacturing costs (fixed and variable) in inventory until the goods are sold.
    2. A costing method that includes all variable manufacturing costs in inventory until the goods are sold (just like absorption costing) but reports all fixed manufacturing costs as an expense on the income statement when incurred.