Chapter 20(5)Variable Costing for Management Analysis

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chapter

20(5)
Variable Costing for
Management Analysis
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OPENING COMMENTS
Frequently, managers complain that accounting systems designed to collect data needed for financial
reporting do not provide the best data for management decision making. If used properly, variable costing
can be a powerful management tool, providing the data relevant to management decisions. This chapter
introduces this costing system and presents several scenarios where it is favored over absorption costing.

After studying the chapter, your students should be able to:

1. Describe and illustrate reporting income from operations under absorption and variable costing.
2. Describe and illustrate the effects of absorption and variable costing on analyzing income from
operations.
3. Describe managements use of absorption and variable costing.
4. Use variable costing for analyzing market segments including product, territories, and salespersons
segments.
5. Use variable costing for analyzing and explaining changes in contribution margin as a result of
quantity and price factors.
6. Describe and illustrate the use of variable costing for service firms.

STUDENT FAQS
How can you tell if a cost item is variable or fixed?
What is the difference in variable and absorption costing on the income statement again? Im just not
getting it.
What is absorption costing?
What is variable costing?
68 Chapter 20(5)Variable Costing for Management Analysis

Why is only the variable cost used in cost of goods manufactured under the variable or direct costing
method?
Why is variable costing not used for external reporting?
How do you arrive at manufacturing margin?
How do you arrive at contribution margin in relation to manufacturing margin?
When sales exceed production, what will be the difference between variable and absorption costing?
When production exceeds sales, what will be the difference between variable and absorption costing?
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OBJECTIVE 1
Describe and illustrate reporting income from operations under absorption and variable
costing.

KEY TERMS
Absorption Costing Variable Cost of Goods Sold
Contribution Margin Variable Costing
Manufacturing Margin

SUGGESTED APPROACH
Explain that the name given to the manufacturing cost system your students have been learning is
absorption costing. Under absorption costing, all costs necessary to manufacture a product are absorbed
by the product (included in the products reported cost). This includes both fixed and variable
manufacturing costs.

This chapter introduces variable costing (also called direct costing), which is another approach used to
compute a products cost. Under variable costing, only variable manufacturing costs are included in the
product cost reported as cost of goods sold or ending inventory. These variable manufacturing costs are
direct materials, direct labor, and variable overhead (overhead costs that change as production volume
increases or decreases). All fixed costs, including fixed manufacturing overhead, are treated as period
expenses.

Two points merit special emphasis. First, the only difference between variable and absorption costing is
the treatment of fixed overhead. Second, while variable costing is often the most useful system to aid
company management in making decisions, it is not allowed for external financial reporting. Financial
statements prepared for shareholders and other external users must report product costs determined under
absorption costing.

The group learning activity below will ask your students to review the income statement under absorption
costing. It will also introduce them to income reporting under variable costing.

GROUP LEARNING ACTIVITYAbsorption and Variable Costing

To review absorption costing, ask your students to prepare an income statement for Laurens Incorporated,
using the data on TM 20(5)-1. Instruct them to prepare the income statement using the format they have
learned in previous chapters. This approach is called absorption costing. Under absorption costing, both
fixed and variable manufacturing costs are included in the cost of goods sold. The solution to this activity
is provided on the top half of TM 20(5)-2.

Next use TM 20(5)-3 to describe the format of the income statement that supports a variable costing
approach. This format is also called a contribution margin format income statement. Emphasize the
following computations from this income statement:
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Sales Variable COGS = Manufacturing Margin

Manufacturing Margin Variable Selling & Admin. Expenses = Contribution Margin

Contribution Margin Fixed Costs = Income from Operations

Remind students that these calculations are consistent with the computation of contribution margin, which
they learned in Chapter 19(4): Sales Total Variable Costs = Contribution Margin.

Next, ask your students to prepare a variable costing income statement for Laurens Incorporated, using
the format described on TM 20(5)-3. The solution is provided on the bottom half of TM 20(5)-2.
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OBJECTIVE 2
Describe and illustrate the effects of absorption and variable costing on analyzing income
from operations.

SUGGESTED APPROACH
If your students can predict the effect that changes in inventory levels will have on net income under
absorption and variable costing, they will have mastered this learning objective. Begin your discussion of
this objective by asking your students to identify problems that may occur if a manufacturing company
produces too much inventory. List their responses on the board. Next, use the income statements for
Laurens Incorporated on TM 20(5)-2 to help your students evaluate the impact of increasing inventory on
net income.

CLASS DISCUSSION Variable vs. Absorption Costing

Point out the $30,000 difference between the two income statements on TM 20(5)-2. Remind your
students that Laurens produced 22,000 units, but sold 20,000 units, during the period reported on the
income statement. Ask your students to examine the income statements, silently on their own, and look
for the reason the statements present a different net income. After a minute, ask them to share their ideas
with another student or in a group. This discussion time will allow students to finalize their answers
before sharing them with the class.

Through discussion, bring the class to a consensus that the $30,000 difference is the fixed cost of the
2,000 units produced but not sold ($15/unit 2,000 units). Under full absorption costing, this $30,000
cost is allocated to the units in the ending finished goods inventory. Therefore, it is carried on the balance
sheet as an asset. Under variable costing, this $30,000 is reported on the income statement as a period
expense. As a result, net income is $30,000 lower under variable costing.

Next, refer your students to Exhibits 5 and 6 in the text. These exhibits further emphasize the impact on
net income caused by producing more units than sold. The company illustrated in these exhibits, Frand
Manufacturing Company, sold 20,000 units. Exhibit 5, which illustrates absorption costing, shows Frands
net income if 20,000 and 25,000 units are produced. By producing an extra 5,000 units, net income is
increased by $80,000. Under absorption costing, increasing inventory levels increases net income. Exhibit
6 shows that under variable costing, net income is the same no matter how many units are produced.
Producing more units has no effect on net income under variable costing.

WRITING EXERCISEPerformance Evaluation under Variable and

Absorption Costing
Ask your students to write a response to the following question [TM 20(5)-4]:

DBR Manufacturing rewards the companys plant manager with a year-end bonus based
on the increase in the plants net income. For purposes of determining the managers
72 Chapter 20(5)Variable Costing for Management Analysis

bonus, should net income be calculated using variable costing or absorption costing?
Support your recommendation.

Possible response: In this case the net income should be calculated using variable
costing. The plant manager could manipulate the net income by over producing inventory
and carrying this cost on the balance sheet in the finished goods inventory. This over
production could be detrimental to the overall company goals and negatively impact
financial statements in future periods.

OBJECTIVE 3
Describe managements use of absorption and variable costing.

KEY TERMS
Controllable Costs
Market Segment
Noncontrollable Cost

SUGGESTED APPROACH
Although variable costing is not permitted for financial reporting, many managers find it useful for
management reporting and decision making. Variable costing tends to show costs in the same manner as
they are incurred: variable costs on a per-unit basis and fixed costs in total. Objective 3 presents several
scenarios where variable costing is more beneficial to management than absorption costing.

LECTURE AIDBenefits of Variable Costing

One benefit of variable costing is the ability to isolate the impact of changes in sales volume on profits.
TM 20(5)-5 shows an income statement for Laurens Incorporated, assuming sales of 20,000 units and
30,000 units. Point out that as volume increases, only variable costs change. This is clearly evident from
the variable costing income statement.

Another benefit of variable costing relates to cost control. Variable costs (direct materials used, labor
costs incurred) are controllable by operating management as they run the day-to-day operations of a
manufacturing plant. However, a higher level of management controls fixed costs. Operating managers
cannot control costs such as depreciation on factory machinery or salaries paid to engineering staff if they
do not have the authority to purchase fixed assets or hire engineers. Classifying costs as fixed or variable
on the income statement makes it easier to assign costs to the responsible manager(s).
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GROUP LEARNING ACTIVITYPricing Products and Planning Production

The text emphasizes that pricing and production decisions can vary, depending on whether a manager is
evaluating the short run or the long run. In the long run, product prices must be set high enough to
compensate a business for all of its operating costs and provide a reasonable profit. However, in the short
run, prices may be set below the optimal long-run price without reducing profits. In practice, a special
order decision will force managers to evaluate short-run prices.

TM 20(5)-6 presents data for Webster Manufacturing. Webster has the opportunity to take on a one-time
special order at a price that is above the variable cost of manufacturing its product, but below the
absorption cost. Divide your class into groups and ask each group to prepare an income statement for
Webster Manufacturing reflecting profits with and without the special order. Encourage them to use
variable costing when preparing this financial statement. A solution is presented on TM 20(5)-7.

When reviewing this analysis, emphasize that the special order did not affect fixed costs. Therefore, the
only income statement items that changed were revenues and variable manufacturing costs. As long as an
order provides a positive contribution margin (revenue exceeds variable costs), the order will increase the
companys profits.

WRITING EXERCISEPricing Products and Production Planning

After completing the group activity above, ask your students to write a memo to management explaining
why Webster Manufacturing should accept the special order, even though the selling price for the special
order will be below the products cost under absorption costing.

Possible response: As evidence by the analysis provided in TM 20(5)-7 accepting the special order will
increase projected income from operations by $30,000. The additional order will not affect current
projected sales, negatively impact production capacity to meet projected sales or increase fixed cost.
Contribution margins will be higher since the $7 price exceeds variable cost by $3 per unit. This
recommendation is a win-win for all parties; I highly recommend approval of the special order.

As an alternative, ask your students to write an answer to the following question [TM 20(5)-8]:

Should Webster Manufacturing decrease the selling price of its product to $7 for all of its
customers? The marketing manager has argued that this pricing strategy would allow the
company to attract new customers and capture a greater share of its market.

Possible response: Although fixed cost can be ignored in the short run to justify the special order
cost of $7 per unit, these cost cannot be ignored over the long run. At $7 per unit an additional
8334 (breakeven = fixed cost/contribution margin or 175000/3 = 58334) units would have to be
sold to breakeven. To get back to a model that would exceed existing projections for income from
operations, at $7 per unit Webster would have to sell over 100,000 units to increase income from
operations over the existing pricing model. This significant increase in production would most
likely increase fixed cost further adding to the argument against this pricing level.
74 Chapter 20(5)Variable Costing for Management Analysis

OBJECTIVE 4
Use variable costing for analyzing market segments including product, territories, and
salespersons segments.

KEY TERMS
Sales Mix

SUGGESTED APPROACH
Variable costing allows managers to evaluate the profitability of sales territories, products, or
salespersons. This is accomplished by computing the contribution margin and the contribution margin
ratio by territory, product, and/or salesperson. Since the text illustrates each of these profitability analyses,
ask your students to apply the same technique to a slightly different scenario: customer profitability.

GROUP LEARNING ACTIVITYCustomer Profitability

TM 20(5)-9 provides sales and cost data for SMC, Inc. Revenues and variable costs are listed by
customer. Ask your students to determine which of SMCs customers is most profitable. You may need to
remind them of the following formula:

Contribution Margin
Contribution Margin Ratio =
Sales Revenue

The solution to this problem is provided on TM 20(5)-10.

OBJECTIVE 5
Use variable costing for analyzing and explaining changes in contribution margin as a result
of quantity and price factors.

KEY TERMS
Contribution Margin Analysis Unit Price (Cost) Factor
Quantity Factor

SUGGESTED APPROACH
Contribution margin analysis is used to evaluate the differences between actual and planned contribution
margin. Any variance in revenue or variable cost can be explained by a change in quantity, a change in
price/cost, or both. Use the demonstration problem below to illustrate these calculations.
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DEMONSTRATION PROBLEMAnalyzing Contribution Margins

Assume that a manufacturing company had budgeted sales of $120,000 (10,000 units at $12). Actual sales
were $103,500 (9,000 units at $11.50). The $16,500 difference in revenue can be analyzed as follows:

Quantity Factor:
Decrease in number of units sold (1,000)
Planned selling price $12
Decrease due to quantity factor ($12,000)
Price Factor:
Decrease in unit sales price ($ 0.50)
Number of units sold 9,000
Decrease due to price factor ( 4,500)
Net Decrease in Sales Revenue ($16,500)

This analysis can also be applied to variable costs. Assume that the same manufacturing company had
budgeted its variable cost of goods sold at $50,000 (10,000 units at $5.00). Actual variable manufacturing
costs totaled $46,080 (9,000 units at $5.12). The $3,920 variance can be analyzed as follows:

Quantity Factor:
Decrease in number of units sold (1,000)
Planned variable manufacturing cost $5
Decrease due to quantity factor ($5,000)
Unit Cost Factor:
Increase in unit variable mfg. cost $ 0.12
Number of units sold 9,000
Increase due to unit cost factor 1,080
Net Decrease in Variable Cost of Goods Sold ($3,920)

OBJECTIVE 6
Describe and illustrate the use of variable costing for service firms.

SUGGESTED APPROACH
This learning objective applies the concepts illustrated in the chapter to a service organization. Therefore,
it provides an excellent review opportunity.

Handout 20(5)-1 presents information for a service business called Music for All Occasions. You can use
this handout to review any (or all) of the following concepts: (1) identifying the appropriate activity base
for variable costs, (2) market segment analysis, (3) computing contribution margin and income from
operations, or (4) contribution margin analysis. Simply provide copies of the handout to your students and
instruct them which analyses you want them to perform. Solutions are provided on Transparencies
20(5)-11 through 20(5)-16.
Handout 20(5)-1

Contribution Margin Reporting and Analysis for Service Firms

Music for All Occasions is a service business that provides musical groups to play at parties, wedding
receptions, etc. Customers can choose between a big swing-style band, a small jazz combo, or a rock
band. The price customers must pay depends on the style of band they choose and the number of hours
they want the band to perform.

Big Band Jazz Combo Rock Band

Number of Musicians 15 4 5
Price per Hour $650 $185 $200

The musicians in all groups are paid $20 per hour. The company employs one person who sets up the
equipment needed by the bands before each job (or gig) and dismantles the equipment at the end of the
job. This person is paid $125 to set up and tear down each job. The companys yearly costs are $5,000
for advertising, $7,000 for equipment rental and depreciation, and $9,500 for other administrative costs.

During 2014, Music for All Occasions performed the following jobs:

Big Band Jazz Combo Rock Band

Number of Jobs 32 97 88
Total Number of Hours for All Jobs 105 410 370

At the beginning of 2015, competition forced the owner of Music for All Occasions to change the price for
the Big Band to $575 per hour and reduce the number of musicians in the group to 12. The wage rate for
musicians in the Big Band was also raised to $25 per hour. Based on the former price of $650 per hour,
the owner estimated the Big Band would perform 35 jobs in 2015 totaling 115 hours. However, with the
reduced price, the Big Band actually played 50 jobs in 2015 for a total of 165 hours.

Perform the following analysis for Music for All Occasions:

1. Determine the cost behavior (fixed or variable) for all of the companys costs and identify the activity
base for the variable costs.
2. Prepare a report showing contribution margin and contribution margin ratio by type of band for 2014.
3. Prepare a variable costing income statement for the entire company for 2014. Be sure your income
statement shows both contribution margin and income from operations.
4. Prepare a contribution margin analysis report for only the Big Band for 2015 comparing planned
performance under the old price structure ($650 per hour with 15 musicians) and the actual
performance under the reduced price structure ($575 per hour with 12 musicians).