Chapter 7

Variable CostingA Tool for Management

Learning Objectives
LO1. Explain how variable costing differs from absorption costing and compute unit product
costs under each method.
LO2. Prepare income statements using both variable and absorption costing.
LO3. Reconcile variable costing and absorption costing net operating incomes and explain
why the two amounts differ.
LO4. Understand the advantages and disadvantages of both variable and absorption costing.

New in this Edition

Additional exercises have been created.

Chapter Overview
A. Overview of Variable and Absorption Costing. At least two methods can be used
in manufacturing companies to value units of product for accounting purposesabsorption
costing and variable costing. These methods differ only in how they treat fixed manufacturing
overhead costs.

1. Variable Costing. Variable costing includes only variable production costs in product
costs. Direct materials, direct labor and variable manufacturing overhead costs would
ordinarily be included in product costs under variable costing. Fixed manufacturing
overhead is not treated as a product cost under this method. Rather, fixed manufacturing
overhead is treated as a period cost and is charged against income each period.

2. Absorption Costing. Absorption costing treats all production costs as product costs,
regardless of whether they are variable or fixed. Under absorption costing, a portion of
fixed manufacturing overhead is allocated to each unit of product.

B. Comparison of Absorption and Variable Costing. (Exercises 7-3, 7-5, 7-6, 7-8,
and 7-9.) When comparing absorption costing and variable costing income statements, a
number of points should be noted:

1. Deferral of fixed manufacturing costs under absorption costing. Under absorption

costing, if inventories increase then a portion of the fixed manufacturing overhead costs
of the current period is deferred to future periods in the inventory account. When the
units are later taken out of inventory and sold, the deferred fixed costs flow through to
the income statement as part of cost of goods sold.

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2. Differences in inventories under the two methods. The ending inventory figures
under the variable costing and absorption costing methods are different. Under variable
costing, only the variable manufacturing costs are included in inventory. Under
absorption costing, both variable and fixed manufacturing costs are included in
inventory.

3. Suitability for CVP analysis. An absorption costing income statement is not well suited
for providing data for CVP computations since it makes no distinction between fixed and
variable costs. In contrast, the variable costing method classifies costs by behavior and is
very useful in setting-up CVP computations.

C. Extended Comparison of Income Data. (Exercises 7-2 and 7-6.) Exhibit 7-3 in the
text presents a comparison of absorption costing and variable costing income statements over
three years in which production is constant but sales vary. Exhibit 7-6 in the text also presents
comparative income statements over three years but holds annual sales constant and varies
annual production. From these Exhibits, several generalizations can be drawn. (All of these
generalizations assume the LIFO inventory flow assumption is being used. The
generalizations may not hold in some rare cases if a company uses an inventory flow
assumption other than LIFO.)

1. Production equals sales (no change in inventories). When production equals sales,
inventories do not change. If inventories do not change, then there is no change in the
fixed manufacturing overhead costs in inventories under absorption costing. Therefore,
under both costing methods all of the current fixed manufacturing overhead will flow
through to the income statement as an expense. In the case of absorption costing it will
be part of cost of goods sold. In the case of variable costing, it will be a period expense.

2. Production exceeds sales (inventories increase). When production exceeds sales,

inventories grow. If inventories grow, then some of the current fixed manufacturing
overhead costs will be deferred in inventories under absorption costing. Since all of the
current fixed manufacturing overhead costs are expensed under variable costing, the net
operating income reported under absorption costing will be greater than the net
operating income reported under variable costing.

3. Sales exceed production (inventories decrease). When sales exceed production,

inventories shrink. If inventories decrease, then some of the fixed manufacturing
overhead costs that had been deferred in inventories in previous periods will be released
to the income statement as part of cost of goods sold as well as all of the current fixed
manufacturing overhead costs. Since only the current fixed manufacturing overhead
costs are expensed under variable costing, the net operating income reported under
absorption costing will be less than the net operating income reported under variable
costing.

4. Long-term differences in income. Over an extended period of time, the cumulative net
operating income figures reported under absorption costing and variable costing will be
about the same; they will differ only by the amount of fixed manufacturing overhead
cost in ending inventories under absorption costing. Cumulative net operating income
figures will be identical whenever ending inventories are reduced to zero.

5. Changes in production volume. Variable costing net operating income is not affected
by changes in production volume. On the other hand, absorption costing net operating

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 income is affected by changes in production volume. For any given level of sales, net
operating income under absorption costing will increase as the level of output increases
and hence inventories increase.

D. The Matching Principle. Accountants and managers have been arguing for decades
concerning the relative merits of absorption and variable costing. In practice, absorption
costing is used far more than variable costing even for internal reports. The reasons for this
are not entirely clear, although the perception that absorption costing is required for external
reporting undoubtedly plays a key role. The argument for using absorption costing in external
reports seems to be based on the matching principle.

1. Argument for absorption costing. Advocates of absorption costing argue that all
manufacturing costs must be assigned to units of product so as to properly match costs
with revenues. They argue that fixed manufacturing overhead costs are essential to the
production process and must be included when costing units of product, regardless of
how the cost behaves.

2. Argument for variable costing. Advocates of variable costing argue that fixed
manufacturing overhead costs are incurred in order to have the capacity to produce.
Moreover, they will be incurred regardless of whether anything is actually produced.
Since these costs are not caused by any particular unit of product and are incurred to
provide capacity for a particular period, the matching principle would dictate that fixed
manufacturing overhead costs must be expensed in the current period.

E. Advantages of the Contribution Approach. (Exercises 7-4 and 7-7.) There are a
number of advantages to using variable costing (and the contribution approach) in internal
reports and analysis.

1. More useful for CVP analysis. Variable costing statements provide data that are
immediately useful for CVP analysis since they categorize costs on the basis of their
behavior. In contrast, it is often difficult to rework absorption costing data so that they
can be used in CVP analysis and in decisions.

2. Income is not affected by changes in production volume. Under absorption costing,

reported net operating income is affected by changes in production since fixed costs are
spread across more or fewer units. This can distort income and may even result in
income moving in an opposite direction from sales. This does not occur under variable
costing.

3. Avoids misunderstandings concerning unit product costs. Absorption costing unit

product costs can be easily misinterpreted as variable costs since they are stated on a per
unit basis. Such a misperception can lead to serious errors in making decisions. Variable
costing avoids this problem since unit costs include only variable costs.

4. Fixed costs are more visible. The impact of fixed costs on profits is emphasized
because the total amount of such costs for the period appears separately and is
highlighted in the income statement rather than being buried in cost of goods sold and
ending inventory.

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5. Understandability. Managers should find it easier to understand variable costing
reports because data are organized by behavior and because variable costing is much
closer to cash flow.

6. Control is facilitated. Variable costing ties in with cost control methods such as
flexible budgets.

7. Incremental analysis is more straight-forward. Variable cost corresponds closely

with the current out-of-pocket expenditure necessary to produce and sell products and
services and can therefore be used more readily in incremental analysis than absorption
costing data. And since variable costing net operating income is closer to net cash flow
than absorption costing net operating income, it is likely to be more useful to companies
that have cash flow problems.

However, variable costing is not generally accepted by auditors for external financial reports
and is not permitted by the IRS in the United States and by tax authorities in many other
countries for income tax calculations. There is some question about whether variable costing
is actually prohibited in the United States by official pronouncements and some companies do
use some form of variable costing in their external reports, but absorption costing must be
considered the most generally accepted practice.

F. Impact of JIT Inventory Methods. When companies use JIT methods for
controlling their operations, the distortions of income that can occur under absorption costing
largely (or completely) disappear.

1. The cause of distortions in net operating income. Erratic movements in net operating
income under absorption costing and the differences in net operating income between
absorption and variable costing can be traced to changing levels of inventory. When
inventory levels are constant or negligible, absorption costing and variable costing
methods yield the essentially same net operating income.

2. The JIT solution. Under an ideally functioning JIT system, goods are produced strictly
to customers orders. Finished goods inventories almost disappear and work in process
inventories are kept to a minimum. With little or no inventories, fixed manufacturing
overhead costs cannot be shifted between periods under absorption costing. As a result,
both variable and absorption costing will show essentially the same net operating
income figure, and the net operating income under absorption costing will move in the
same direction as movements in sales.

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Assignment Materials
Level of Suggested
Assignment Topic Difficulty Time
Exercise 7-1 Variable and absorption unit product costs ............................... Basic 15 min.
Exercise 7-2 Variable costing income statement; explanation of
difference in net operating income....................................... Basic 30 min.
Exercise 7-3 Reconciliation of absorption and variable costing net
operating incomes ................................................................ Basic 20 min.
Exercise 7-4 Evaluating absorption and variable costing as alternative
costing methods.................................................................... Medium 30 min.
Exercise 7-5 Variable and absorption costing unit product costs and
income statements ................................................................ Basic 30 min.
Exercise 7-6 Variable costing income statement; reconciliation ................... Basic 20 min.
Exercise 7-7 Inferring costing method; unit product costs ............................ Basic 20 min.
Exercise 7-8 Variable costing unit product cost and income statement;
break-even ............................................................................ Basic 30 min.
Exercise 7-9 Absorption costing unit product cost and income statement..... Basic 20 min.
Problem 7-10 Variable and absorption costing unit product costs and
income statements; explanation of difference in net
operating income.................................................................. Basic 45 min.
Problem 7-11 Variable costing income statement; reconciliation ................... Basic 30 min.
Problem 7-12 Absorption and variable costing; production constant, sales
fluctuate................................................................................ Medium 60 min.
Problem 7-13 Comprehensive problem with labor fixed................................. Medium 45 min.
Problem 7-14 Preparation and reconciliation of variable costing statements .. Medium 45 min.
Problem 7-15 Variable costing statements; sales constant, production
varies; JIT impact................................................................. Difficult 45 min.
Problem 7-16 Incentives created by absorption costing; ethics and the
manager ................................................................................ Difficult 30 min.
Problem 7-17 Prepare and interpret statements; changes in both sales and
production; JIT impact ......................................................... Difficult 75 min.
Case 7-18 Absorption and variable costing; uneven production; break-
even analysis; JIT impact ..................................................... Difficult 90 min.
Case 7-19 Ethics and the manager; absorption costing income
statements............................................................................. Difficult 120 min.
Case 7-20 The case of the plummeting profits........................................... Difficult 90 min.

Essential Problems: Problem 7-10 or Problem 7-13, Problem 7-11, Problem 7-14
Supplementary Problems: Problem 7-12, Problem 7-15, Problem 7-16, Problem 7-17, Case 7-18,
Case 7-19, Case 7-20

Linked problems and exercises:

Exercise 7-9 should be assigned after Exercise 7-8
Exercise 7-2 should be assigned after Exercise 7-1

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 Chapter 7
Lecture Notes

Helpful Hint: Before beginning the lecture, show

students the fifth segment from the first tape of the
McGraw-Hill/Irwin Managerial/Cost Accounting video
library. This segment introduces students to many of
the concepts discussed in chapter 7. The lecture notes
reinforce the concepts introduced in the video.

Chapter theme: Two general approaches are used for

valuing inventories and cost of goods sold. One approach,
called absorption costing, is generally used for external
reporting purposes. The other approach, called variable
1 costing, is preferred by some managers for internal
decision making and must be used when an income
statement is prepared in the contribution format. This
chapter shows how these two methods differ from each
other.

I. Overview of absorption and variable costing

A. Absorption costing (also called the full cost method)

treats all costs of production as product costs,
regardless of whether they are variable or fixed. Since
no distinction is made between variable and fixed costs,
absorption costing is not well suited for CVP
2 computations.

i. The cost of a unit of product consists of

direct materials, direct labor, and both
variable and fixed overhead.

401
2

402
 ii. Variable and fixed selling and administrative
expenses are treated as period costs and are
deducted from revenue as incurred.

B. Variable costing (also called direct costing or

marginal costing) treats only those costs of production
that vary with output as product costs. This approach
dovetails with the contribution approach income
statement and supports CVP analysis because of its
emphasis on separating variable and fixed costs.

i. The cost of a unit of product consists of

direct materials, direct labor, and variable
overhead.

2 Helpful Hint: For simplicity, nearly all examples,

exhibits, problems, and exercises in this chapter treat
direct labor as a variable cost. However, students
should be reminded that labor is essentially a fixed cost
in some companies. This is a growing phenomenon as
pointed out in earlier chapters. Under variable costing,
direct labor would not be included in product costs
when it is a fixed cost. This point is reinforced in the
discussion on theory of constraints at the end of the
chapter.

In Business Insights
To piggyback on the Helpful Hint above, there are
many companies that treat direct labor as a fixed cost.
For example:

Direct Labor A Fixed Cost in China (page 280)

403
2 3 4

5 6

404
 The Shanghai Bund Steel Works (SBSW) of the
Peoples Republic of China is a large state-owned
enterprise.
In such an enterprise, management has very little
freedom to adjust the work force eliminating
jobs would create political problems.
Therefore, for internal management purposes,
2 SBSW treats labor cost as part of fixed
manufacturing overhead.

ii. Fixed manufacturing overhead, and both

variable and fixed selling and administrative
expenses are treated as period costs and
deducted from revenue as incurred.

Helpful Hint: Emphasize that the only difference between

variable and absorption costing is in how the two methods
treat fixed manufacturing overhead costs. Also, emphasize
that under both methods, selling and administrative costs
are period costs and are not product costs.

3-4 Quick Check absorption vs. variable costing

C. Unit cost computations

i. Assume Harvey Company produces a single

5 product with available information as shown.

ii. The unit product costs under absorption and

variable costing would be $16 and $10,
respectively.
6
1. Under absorption costing, all production
costs, variable and fixed, are included when
determining unit product cost.

405
6 7 8

406
 2. Under variable costing, only the variable
6 production costs are included in product
costs.

Helpful Hint: Before beginning the forthcoming income

comparisons, remind students of the relationship
between ending inventory and net operating income.
Higher ending inventory results in higher net operating
income since costs of goods available for sale less
ending inventory equals cost of goods sold. Therefore, a
higher ending inventory results in a lower expense (cost
of goods sold) deducted to arrive at net operating
income.

II. Income comparison of absorption and variable costing

A. The Harvey Company example continued:

i. Additional assumptions:

1. 20,000 units were sold during the year.

7
2. The selling price per unit is $30.
3. There is no beginning inventory.

ii. Absorption costing

1. The unit product cost is $16.

8 2. The fixed manufacturing overhead cost
deferred in inventory is $30,000 (5,000
units $6 per unit).
3. The net operating income is $120,000.

Helpful Hint: Explain that under absorption costing,

the recognition of fixed costs as an expense is really a
timing issue. When the items are sold, the fixed costs

407
9 10 11

408
 will be reflected on the income statement as part of cost
of goods sold.

iii. Variable costing.

1. The unit product cost is $10.

9 2. All $150,000 of fixed manufacturing cost is
expensed in the current period.
3. The net operating income is $90,000.

iv. Comparing the two methods.

1. Under absorption costing, $120,000 of fixed

manufacturing overhead is included in cost
of goods sold and $30,000 is deferred in
ending inventory as an asset on the balance
sheet.
10 2. Under variable costing, the entire $150,000
of fixed manufacturing overhead is treated
as a period expense.
a. The variable costing ending inventory
is $30,000 less than absorption
costing, thus explaining the difference
in net operating income between the
two methods.
3. The difference in net operating income
between the two methods ($30,000) can also
be reconciled by multiplying the number of
11 units in ending inventory (5,000 units) by
the fixed manufacturing overhead per unit
($6) that is deferred in ending inventory
under absorption costing.

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12 13 14

15

410
III. Extended comparisons of income data

A. The Harvey Company example continued:

i. Additional assumptions/facts:

12 1. 30,000 units were sold in year 2.

2. The selling price per unit, variable costs per
unit, total fixed costs, and number of units
produced remain unchanged.
3. 5,000 units are in beginning inventory.

ii. Unit cost computations

1. Since the variable costs per unit, total fixed

13 costs, and the number of units produced
remained unchanged, the unit cost
computations also remain unchanged.

iii. Absorption costing

1. The unit product cost is $16.

14 2. The fixed manufacturing overhead cost
released from inventory is $30,000.
3. The net operating income is $230,000.

iv. Variable costing

1. The unit product cost is $10.

2. All $150,000 of fixed manufacturing
15
overhead cost is expensed in the current
period.
3. The net operating income is $260,000.

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16 17 18

412
 v. Comparing the two methods

1. The difference in net operating income

between the two methods ($30,000) can be
reconciled by multiplying the number of
16 units in beginning inventory (5,000 units)
by the fixed manufacturing overhead per
unit ($6) that is released from beginning
inventory under absorption costing.
2. Across the two year time frame, both
methods reported the same total net
operating income ($350,000). This is
17 because over an extended period of time
sales cannot exceed production, nor can
production much exceed sales. The shorter
the time period, the more the net operating
income figures will tend to differ.

B. Summary of key insights

i. When production is greater than sales, as in

year 1 for Harvey, absorption income is
greater than variable costing income.

ii. When production is less than sales, as in

18 year 2 for Harvey, absorption costing
income is less than variable costing income.

iii. When production equals sales, the two

methods report the same net operating
income.

413
414
 In Business Insights
The relationship between production and sales can
have a significant impact on the net operating income
of companies that use absorption costing. For example:

Chainsaw Al Dunlaps Legacy at Sunbeam (page

287)
Al Dunlap was hired to turn around Sunbeam
Corp. with his well-known cost-cutting and
disregard for the welfare of existing employees.
Three years later, Dunlap left a legacy of
questionable accounting practices and excess
inventories.
Dunlaps successors complain that eliminating
those excess inventories has required the
company to keep production levels well under
capacity.
Since Sunbeam uses absorption costing,
liquidating these excess inventories has depressed
the companys profits.

The Perverse Effects of Absorption Costing at Nissan

(page 289)
Nissan North America liked to run its factories at
capacity, regardless of how well cars were
selling, because under absorption costing it
would help the factories generate a profit.
As a consequence, Nissan dealers had to slash
prices and offer big rebates to sell their cars.
According to Fortune magazine, Years of
discounting and distress sales seriously undercut
the value of the Nissan brand. While Toyota
stood for quality, customers came to Nissan to
get a better deal.

415
19 20

416
IV. Effect of changes in production on net operating income

A. The Harvey Co. example revisited

i. Overview of revised example:

1. In the previous Harvey Co. example:

a. Units of production was constant.
19 b. Sales in units fluctuated.
2. In the forthcoming example:
a. Units of production will fluctuate.
b. Sales in units will remain constant.

Helpful Hint: To emphasize the key point of the

forthcoming example, ask students how absorption
costing net operating income can be increased or
decreased without changing sales. The answer is by
altering production since increasing or decreasing
ending inventories results in a net deferral or a net
release of fixed manufacturing overhead costs.

ii. Harvey Co. year 1 data:

1. 30,000 units are produced.

2. 25,000 units are sold.
20
3. There is no beginning inventory.
4. The selling price per unit, variable costs per
unit, and total fixed costs remain
unchanged from the prior example.

417
21 22 23

24

418
 iii. Unit cost computations: year 1

21 1. The unit product costs under absorption and

variable costing would be $15 and $10,
respectively.

iv. Absorption costing: year 1

1. The unit product cost is $15.

22 2. The fixed manufacturing overhead cost
deferred in inventory is $25,000.
3. The net operating income is $200,000.

v. Variable costing: year 1

1. The unit product cost is $10.

23 2. All $150,000 of fixed manufacturing
overhead cost is expensed in the current
period.
3. The net operating income is $175,000.

vi. Harvey Co. year 2 data:

1. 20,000 units are produced.

2. 25,000 units are sold.
24 3. There are 5,000 units in beginning
inventory.
4. The selling price per unit, variable costs per
unit, and total fixed costs remain
unchanged.

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25 26 27

28

420
 vii. Unit cost computations: year 2

1. The unit product costs, for year 2

25 production, under absorption and variable
costing would be $17.50 and $10,
respectively.

viii. Absorption costing: year 2

1. The unit product cost for units in beginning

inventory is $15. The unit product cost for
26
goods manufactured in year 2 is $17.50.
2. The fixed manufacturing overhead cost
released from inventory is $25,000.
3. The net operating income is $150,000.

ix. Variable costing: year 2

1. The unit product cost is $10.

27 2. All $150,000 of fixed manufacturing cost is
expensed in the current period.
3. The net operating income is $175,000.

x. Comparing the two methods

1. The difference in net operating income

between the two methods ($25,000) can be
reconciled by multiplying the number of
units in beginning inventory (5,000 units)
28 by the fixed manufacturing overhead per
unit ($5) that is deferred in ending inventory
and then released from beginning inventory
in the next period under absorption costing.
2. Units sold, selling price, variable costs per
unit, and total fixed costs remained

421
28 29 30

422
 constant across years 1 and 2. Thus, the
contribution margin and variable costing
net operating income did not change.
3. Across the two year time frame, both
methods reported the same total net
28 operating income ($350,000). This is
because over an extended period of time
sales cannot exceed production, nor can
production much exceed sales. The shorter
the time period, the more the net operating
income figures will tend to differ.

V. Choosing a costing method

A. The impact on the manager

i. Opponents of absorption costing argue that

shifting fixed manufacturing overhead costs
55 between periods can lead to faulty decisions.

ii. These opponents argue that variable costing

29 income statements are easier to understand
because net operating income is only
affected by changes in unit sales. This
produces net operating income figures that are
consistent with managers expectations.

B. CVP analysis, decision making and absorption

costing

i. Absorption costing does not dovetail with

30 CVP analysis, nor does it support decision
making.

423
30 31

424
 1. It treats fixed manufacturing overhead as
a variable cost. This can lead to faulty
pricing decisions and keep/drop decisions.
2. It assigns per unit fixed manufacturing
30 overhead costs to production. This can
potentially produce positive net operating
income even when the number of units
sold is less than the breakeven point.

C. External reporting and income taxes

i. Practically speaking, absorption costing is

required for external reports in the United
States.

In Business Insights
Absorption costing is also prevalent around the world.
For example:

Absorption Costing Around the World (page 291)

After the fall of communism, accounting methods
were changed in Russia to bring them into better
31 alignment with methods used in the West. One
result was the adoption of absorption costing.

ii. Under the Tax Reform Act of 1986, a form of

absorption costing must be used when
filling out income tax forms.

iii. Since top executives are typically evaluated

based on earnings reported to shareholders in
external reports, they may feel that decisions
should be based on absorption costing data.

425
32 33

426
 D. Advantages of variable costing and the contribution
approach

i. The advantages include:

1. The data required for CVP analysis can be

taken directly from a contribution format
income statement.
2. Profits move in the same direction as sales
(assuming other things remain the same).
3. Managers often assume that unit product
costs are variable costs. Under variable
costing, this assumption holds true.
4. Fixed costs appear explicitly on a
32 contribution format income statement; thus,
the impact of fixed costs on profits is
emphasized.
5. Variable costing data make it easier to
estimate the profitability of products,
customers, and other business segments.
6. Variable costing ties in with cost control
methods such as standard costs and flexible
budgets.
7. Variable costing net operating income is
closer to net cash flow than absorption
costing net operating income.

ii. With all of these advantages, why is

absorption costing still so prevalent? One
reason (in addition to the external reporting
issue) relates to the matching principle:
33
1. Advocates of absorption costing argue that
it better matches costs with revenues.
They contend that fixed manufacturing costs

427
33 34 35

428
 are just as essential to manufacturing
products as are the variable costs.
2. Advocates of variable costing view fixed
33 manufacturing costs as capacity costs. They
argue that fixed manufacturing costs would
be incurred even if no units were produced.

E. Variable costing and the theory of constraints

i. Companies involved in TOC use a form of

variable costing. However, one difference of
the TOC approach is that it treats direct
labor as a fixed cost for three reasons:

1. Although direct laborers are paid an hourly

wage, many companies have a commitment
sometimes enforced by labor contracts or
34 by law to guarantee workers a minimum
number of paid hours.
2. Direct labor is not usually the constraint;
therefore, there is no reason to increase the
number of direct laborers.
3. TOC emphasizes the role direct laborers
play in driving continuous improvement.
Since layoffs often devastate morale,
managers involved in TOC are extremely
reluctant to lay off employees.

F. Impact of JIT inventory methods

i. When companies use JIT methods, the goal is

to eliminate finished goods inventories and
35 reduce work in process inventory to almost
nothing. This causes absorption costing net
operating income to essentially move in the

429
35

430
 same direction as sales. Therefore, the
35 difference between absorption costing and
variable costing income tends to disappear.

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 Chapter 7
Transparency Masters

432
TM 7-1

AGENDA: VARIABLE AND ABSORPTION COSTING

Variable costing and absorption costing are alternative methods of

determining unit product costs. They affect:
Inventory valuations.
Net operating income.

1. Key elements of variable and absorption costing.

2. Classification of costs under variable and absorption costing.
3. Unit product cost comparison.
4. Income statement comparison.
5. Extended examplefluctuating sales.
6. Comparative income effects.
7. Extended examplefluctuating production.
8. JIT and absorption costing.
9. Advantages of variable costing.

The McGraw-Hill Companies, Inc., 2006. All rights reserved.

TM 7-2

KEY ELEMENTS

ABSORPTION COSTING
Absorption costing was used in earlier chapters and is generally
considered to be required for external financial reports and is clearly
required for tax reporting.
Under absorption costing, product costs include all manufacturing costs:
Direct materials.
Direct labor.
Variable manufacturing overhead.
Fixed manufacturing overhead.
Under absorption costing, the following costs are treated as period
expenses and are excluded from product costs:
Variable selling and administrative costs.
Fixed selling and administrative costs.
VARIABLE COSTING
Variable costing is an alternative for internal management reports.
Under variable costing, product costs include only the variable
manufacturing costs:
Direct materials.
Direct labor (unless fixed).
Variable manufacturing overhead.
Under variable costing, the following costs are treated as period
expenses and are excluded from product costs:
Fixed manufacturing overhead.
Variable selling and administrative costs.
Fixed selling and administrative costs.

The McGraw-Hill Companies, Inc., 2006. All rights reserved.

TM 7-3

CLASSIFICATION OF COSTS UNDER

VARIABLE AND ABSORPTION COSTING

The McGraw-Hill Companies, Inc., 2006. All rights reserved.

TM 7-4

UNIT PRODUCT COST COMPARISON

Unit product costs differ between variable and absorption costing.

EXAMPLE: Harvey Company produces a single product.
Number of units produced annually........................... 25,000
Variable costs per unit:
Direct materials, direct labor, and variable
manufacturing overhead ..................................... $10
Selling and administrative expense ......................... $3
Fixed costs per year:
Fixed manufacturing overhead ............................... $150,000
Fixed selling & administrative expense.................... $100,000

Unit product costs are computed as follows:

Absorption Variable
Costing Costing
Direct materials, direct labor, and
variable manufacturing overhead ....... $10 $10
Fixed manufacturing overhead
($150,000 25,000 units)................. 6 0
Total unit product cost......................... $16 $10

Selling and administrative expenses are always treated as period costs

and are expensed in the current period; they are not treated as product
costs under either costing method.

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TM 7-5

INCOME STATEMENT COMPARISON

Harvey Company had no beginning inventory, produced 25,000 units,

and sold 20,000 units last year.
Absorption Costing
Sales (20,000 units $30 per unit) ............... $600,000
Less cost of goods sold:
Beginning inventory ................................... $ 0
Add COGM (25,000 units $16 per unit)..... 400,000
Goods available for sale.............................. 400,000
Less ending inventory
(5,000 units $16 per unit)..................... 80,000 320,000
Gross margin ............................................... 280,000
Less selling and administrative expense
(20,000 units $3 per unit + $100,000) ..... 160,000
Net operating income ................................... $120,000

Variable Costing
Sales (20,000 units $30 per unit) ............... $600,000
Less variable expenses:
Variable cost of goods sold:
Beginning inventory ................................ $ 0
Add variable manufacturing costs
(25,000 units $10 per unit)................ 250,000
Goods available for sale .......................... 250,000
Less ending inventory
(5,000 $10 per unit).......................... 50,000
Variable cost of goods sold ......................... 200,000
Variable selling and administrative expense
(20,000 units $3 per unit)..................... 60,000 260,000
Contribution margin...................................... 340,000
Less fixed expenses:
Fixed manufacturing overhead .................... 150,000
Fixed selling and administrative expense...... 100,000 250,000
Net operating income ................................... $ 90,000

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TM 7-6

INCOME STATEMENT COMPARISON (contd)

Cost of Ending
Goods Sold Inventory
Absorption costing
Variable manufacturing costs
(20,000 units $10 per unit) ... $200,000
(5,000 units $10 per unit) ..... $50,000
Fixed manufacturing overhead
(20,000 units $6 per unit) ..... 120,000
(5,000 units $6 per unit) ....... 30,000
Total ........................................ $320,000 $80,000

Variable costing
Variable manufacturing costs
(20,000 units $10 per unit) ... $200,000
(5,000 units $10 per unit) ..... $50,000
Total ......................................... $200,000 $50,000

RECONCILIATION OF NET OPERATING INCOMES:

Variable costing net operating income.......... $ 90,000
Add: Fixed manufacturing overhead cost
deferred in inventory under absorption
costing (5,000 units $6 per unit)............ 30,000
Absorption costing net operating income ...... $120,000

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TM 7-7

EXTENDED EXAMPLEFLUCTUATING SALES

EXAMPLE: Holland Company produces a single product.

Number of units produced annually ................. 5,000

Variable costs per unit:
Direct materials, direct labor, and variable
manufacturing overhead............................ $5
Selling and administrative expense ............... $1
Fixed costs per year:
Fixed manufacturing overhead...................... $15,000
Fixed selling and administrative expense ....... $21,000

Unit product costs are computed as follows:

Absorption Variable
Costing Costing
Direct materials, direct labor, and variable
manufacturing overhead ....................... $5 $5
Fixed manufacturing overhead
($15,000 5,000 units)........................ 3
Total unit product cost ............................ $8 $5

Income statements using both costing methods over a three-year period

are provided on the following transparency. (Note the computation of the
variable cost of goods sold on the variable costing income statements. The
method used is simpler than the method used in the previous example.)

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TM 7-8

FLUCTUATING SALES (contd)

Year 1 Year 2 Year 3

Units in beginning inventory .................. 0 0 1,000
Units produced..................................... 5,000 5,000 5,000
Units sold ............................................ 5,000 4,000 6,000
Units in ending inventory ...................... 0 1,000 0

Absorption costing
Sales (@ $15 per unit) .......................... $75,000 $60,000 $90,000
Less cost of goods sold:
Beginning inventory (@ $8 per unit) .... 0 0 8,000
Add COGM (@ $8 per unit) ................. 40,000 40,000 40,000
Goods available for sale...................... 40,000 40,000 48,000
Less ending inventory (@ $8 per unit) . 0 8,000 0
Cost of goods sold ................................ 40,000 32,000 48,000
Gross margin ....................................... 35,000 28,000 42,000
Less selling and administrative expense . 26,000 25,000 27,000
Net operating income ........................... $ 9,000 $ 3,000 $15,000

Variable costing
Sales (@ $15 per unit) .......................... $75,000 $60,000 $90,000
Less variable expenses:
Variable COGS (@ $5 per unit)............ 25,000 20,000 30,000
Variable selling and administrative
expenses (@ $1 per unit)................. 5,000 4,000 6,000
Total variable expenses......................... 30,000 24,000 36,000
Contribution margin.............................. 45,000 36,000 54,000
Less fixed expenses:
Fixed manufacturing overhead ............ 15,000 15,000 15,000
Fixed selling and administrative
expense.......................................... 21,000 21,000 21,000
Total fixed expenses ............................. 36,000 36,000 36,000
Net operating income ........................... $ 9,000 $ 0 $18,000

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TM 7-9

FLUCTUATING SALES (contd)

RECONCILING NET OPERATING INCOME:

Year 1 Year 2 Year 3
Variable costing net operating income............. $9,000 $ 0 $18,000
Add: Fixed manufacturing overhead cost
deferred in inventory under absorption
costing (1,000 units $3 per unit)............... 3,000
Deduct: Fixed manufacturing overhead cost
released from inventory under absorption
costing (1,000 units $3 per unit)............... (3,000)
Absorption costing net operating income ......... $9,000 $3,000 $15,000

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TM 7-10

COMPARATIVE INCOME EFFECTS

VARIABLE AND ABSORPTION COSTING

Relation Between
Relation Between Variable and Absorption
Production and Sales Costing Net Operating Incomes
Production = Sales Absorption costing NI =
(No change in inventory) Variable costing NI
Production > Sales Absorption costing NI >
(Inventory increases) Variable costing NI *
Production < Sales Absorption costing NI <
(Inventory decreases) Variable costing NI #

* Net operating income will be higher under absorption costing since fixed
manufacturing overhead cost will be deferred in inventory under absorption
costing.
# Net operating income will be lower under absorption costing since fixed
manufacturing overhead cost will be released from inventory under
absorption costing.

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TM 7-11

EXTENDED EXAMPLEFLUCTUATING PRODUCTION

EXAMPLE: Suppose all of the facts are the same as in the previous example
of Holland Company except that production and sales are as follows:

Year 1 Year 2 Year 3

Units in beginning inventory ............... 0 0 1,000
Units produced .................................. 5,000 6,000 4,000
Units sold .......................................... 5,000 5,000 5,000
Units in ending inventory .................... 0 1,000 0

Unit product costs are computed as follows:

Year 1 Year 2 Year 3
Absorption costing
Direct materials, direct labor, and
variable manufacturing overhead...... $5.00 $5.00 $5.00
Fixed manufacturing overhead
($15,000 5,000 units)................... 3.00
($15,000 6,000 units)................... 2.50
($15,000 4,000 units)................... 3.75
Unit product cost ............................... $8.00 $7.50 $8.75

Variable costing
Direct materials, direct labor, and
variable manufacturing overhead...... $5.00 $5.00 $5.00
Unit product cost ............................... $5.00 $5.00 $5.00

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TM 7-12

FLUCTUATING PRODUCTION (contd)

Year 1 Year 2 Year 3

Absorption costing
Sales (@ $15 per unit) ............................. $75,000 $75,000 $75,000
Less cost of goods sold:
Beginning inventory .............................. 0 0 7,500
Add COGM ........................................... 40,000 45,000 35,000
Goods available for sale......................... 40,000 45,000 42,500
Less ending inventory ........................... 0 7,500 0
Cost of goods sold ................................... 40,000 37,500 42,500
Gross margin .......................................... 35,000 37,500 32,500
Less selling and administrative expense .... 26,000 26,000 26,000
Net operating income .............................. $ 9,000 $11,500 $6,500

Variable costing
Sales (@ $15 per unit) ............................. $75,000 $75,000 $75,000
Less variable expenses:
Variable COGS (@ $5 per unit)............... 25,000 25,000 25,000
Variable selling and administrative
expense (@ $1 per unit) ..................... 5,000 5,000 5,000
Total variable expenses............................ 30,000 30,000 30,000
Contribution margin................................. 45,000 45,000 45,000
Less fixed expenses:
Fixed manufacturing overhead ............... 15,000 15,000 15,000
Fixed selling and administrative expense. 21,000 21,000 21,000
Total fixed expenses ................................ 36,000 36,000 36,000
Net operating income .............................. $ 9,000 $ 9,000 $ 9,000

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TM 7-13

FLUCTUATING PRODUCTION (contd)

RECONCILING NET OPERATING INCOME:

Year 1 Year 2 Year 3
Variable costing net operating income......... $9,000 $9,000 $9,000
Add: Fixed manufacturing overhead cost
deferred in inventory under absorption
costing (1,000 units $2.50 per unit) ...... 2,500
Deduct: Fixed manufacturing overhead cost
released from inventory under absorption
costing (1,000 units $2.50 per unit) ...... (2,500)
Absorption costing net operating income ..... $9,000 $11,500 $6,500

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TM 7-14

JIT AND ABSORPTION COSTING

Differences in net operating income between absorption and variable

costing occur when production doesnt equal sales.
Under true JIT, production isnt started until a customer order is
received. As a result, inventories are reduced drastically and changes in
inventories are small.
As a consequence, the difference between absorption and variable
costing net operating incomes is reduced under JIT.
Under JIT, it is also less likely that absorption costing income will move
in the opposite direction from sales due to changes in inventories.

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TM 7-15

ADVANTAGES OF VARIABLE COSTING

+ Variable costing is easy to use with CVP analysis.

+ With variable costing, changes in levels of inventories do not affect net
operating income.
+ Absorption costing unit product costs may be misinterpreted by
managers as variable costs.
+ In variable costing, fixed costs are highlighted rather than buried in cost
of goods sold and inventories.
+ Variable costing is usually easier to understand than absorption costing.
+ Variable costing is easier to use in controlling costs as will be discussed
in later chapters.
+ Variable costing net operating income is closer to net cash flow than
absorption costing net operating income. This is particularly important in
companies experiencing difficulties with cash flows.
- But, variable costing is usually not considered acceptable for external
financial reports. If absorption costing must be used for mandatory
external reports is it worth the trouble to maintain a different costing
system for internal reports?

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