Chapter

7
Variable Costing:
A Tool for Management
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LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1. Explain how variable costing differs from
absorption costing and compute unit product costs
under each method.
2. Prepare income statements using both variable and
absorption costing.
3. Reconcile variable costing and absorption costing
net operating incomes, and explain why the two
amounts differ.
4. Understand the advantages and disadvantages of
both variable and absorption costing.
5. Explain how the use of JIT reduces the difference
in reported net operating income under the variable
and absorption costing methods.
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Overview of Absorption and

Variable Costing

The only cost of driving my car

on a 200 kilometre trip today is
$12 for gasoline.

Variable
Costing
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 7-4

Overview of Absorption and

Variable Costing
No! You must consider these costs too!
Cost Per month Per day
Car payment $ 300.00 $ 10.00
Insurance 60.00 2.00

Absorption
Costing
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 7-5

Overview of Absorption and

Variable Costing
You’re wrong. I have the car
payment and the insurance
payment even if I do
not make the trip.

Variable
Costing
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 7-6

Overview of Absorption and

Variable Costing
Who’s right?
How should we treat the car
payment and the insurance?

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 7-7

Overview of Absorption and

Variable Costing
Absorption Variable
Costing Costing

Direct materials
Direct labour Product costs
Product costs Variable mfg. overhead

Fixed mfg. overhead

Period costs
Period costs Selling & admin. exp.

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 7-8

Overview of Absorption and

Variable Costing
Let’s put some numbers to the
issue and see if it sharpens
our understanding.

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 7-9

Unit Cost Computations

Harvey Co. produces a single product with
the following information available:

Number of units produced annually 25,000

Variable costs per unit:
Direct materials, direct labour,
and variable mfg. overhead $ 10
Selling & administrative expenses $ 3

Fixed costs per year:

Manufacturing overhead $ 150,000
Selling & administrative expenses $ 100,000

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 7-10

Unit Cost Computations

Unit product cost is determined as follows:

Absorption Variable
Costing Costing
Direct materials, direct labour,
and variable mfg. overhead $ 10 $ 10
Fixed mfg. overhead
($150,000 ÷ 25,000 units) 6 -
Unit product cost $ 16 $ 10

Selling and administrative expenses are

always treated as period expenses and
deducted from revenue.
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 7-11

Income Comparison of Absorption

and Variable Costing
Harvey Co. had no beginning inventory, produced
25,000 units, and sold 20,000 units this year.
Absorption Costing
Sales (20,000 × $30) $ 600,000
Less cost of goods sold:
Beginning inventory $ -
Add COGM (25,000 × $16) 400,000
Goods available for sale 400,000
Ending inventory (5,000 × $16) 80,000 320,000
Gross margin 280,000
Less selling & admin. exp.
Variable
Fixed
Net income

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 7-12

Income Comparison of Absorption

and Variable Costing
Harvey Co. had no beginning inventory, produced
25,000 units, and sold 20,000 units this year.
Absorption Costing
Sales (20,000 × $30) $ 600,000
Less cost of goods sold:
Beginning inventory $ -
Add COGM (25,000 × $16) 400,000
Goods available for sale 400,000
Ending inventory (5,000 × $16) 80,000 320,000
Gross margin 280,000
Less selling & admin. exp.
Variable (20,000 × $3) $ 60,000
Fixed 100,000 160,000
Net income $ 120,000

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 7-13

Income Comparison of Absorption

and Variable Costing
Now let’s look at variable costing by Harvey Co.
Variable
Variable Costing
Sales (20,000 × $30)
costs $ 600,000
Less variable expenses: only.
Beginning inventory $ - All fixed
Add COGM (25,000 × $10) 250,000 manufacturing
Goods available for sale 250,000
Ending inventory (5,000 × $10) 50,000
overhead is
Variable cost of goods sold 200,000 expensed.
Variable selling & administrative
expenses (20,000 × $3) 60,000 260,000
Contribution margin 340,000
Less fixed expenses:
Manufacturing overhead $ 150,000
Selling & administrative expenses 100,000 250,000
Net income $ 90,000
© McGraw-Hill Ryerson Limited., 2004
 7-14

Income Comparison of Absorption

and Variable Costing
Let’s compare the methods.
Cost of
Goods Ending Period
Sold Inventory Expense Total
Absorption costing
Variable mfg. costs $ 200,000 $ 50,000
Fixed mfg. costs 120,000 30,000
$ 320,000 $ 80,000

Variable costing
Variable mfg. costs $ 200,000 $ 50,000
Fixed mfg. costs - -
$ 200,000 $ 50,000

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 7-15

Income Comparison of Absorption

and Variable Costing
Let’s compare the methods.
Cost of
Goods Ending Period
Sold Inventory Expense Total
Absorption costing
Variable mfg. costs $ 200,000 $ 50,000 $ - $ 250,000
Fixed mfg. costs 120,000 30,000 - 150,000
$ 320,000 $ 80,000 $ - $ 400,000

Variable costing
Variable mfg. costs $ 200,000 $ 50,000 $ - $ 250,000
Fixed mfg. costs - - 150,000 150,000
$ 200,000 $ 50,000 $ 150,000 $ 400,000

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Reconciliation

We can reconcile the difference between

absorption and variable income as follows:

Variable costing net income $ 90,000

Add: Fixed mfg. overhead costs
deferred in ending inventory
(5,000 units × $6 per unit) 30,000
Absorption costing net income $ 120,000

Fixed mfg. overhead $150,000

= = $6.00 per unit
Units produced 25,000
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 7-17

Extending the Example

Let’s look at the

second year
of operations
for Harvey
Company.

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 7-18

Harvey Co. Year 2

In its second year of operations, Harvey Co.
started with an inventory of 5,000 units,
produced 25,000 units, and sold 30,000 units.
Number of units produced annually 25,000
Variable costs per unit:

Direct materials, direct labour,

variable mfg. overhead $ 10
Selling & administrative
expenses $ 3
Fixed costs per year:
Manufacturing overhead $ 150,000
Selling & administrative
expenses $ 100,000
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 7-19

Harvey Co. Year 2

Unit product cost is determined as follows:

Absorption Variable
Costing Costing
Direct materials, direct labour,
and variable mfg. overhead $ 10 $ 10
Fixed mfg. overhead
($150,000 ÷ 25,000 units) 6 -
Unit product cost $ 16 $ 10

No change in Harvey’s
cost structure.
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 7-20

Harvey Co. Year 2

Now let’s look at Harvey’s income statement

assuming absorption costing is used.

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 7-21

Harvey Co. Year 2

Absorption Costing
Sales (30,000 × $30) $ 900,000
Less cost of goods sold:
Beg. inventory (5,000 × $16) $ 80,000
Add COGM (25,000 × $16) 400,000
Goods available for sale 480,000
Ending inventory - 480,000
Gross margin 420,000
Less selling & admin. exp.
Variable (30,000 × $3) $ 90,000
Fixed 100,000 190,000
Net income $ 230,000

These are the 25,000 units

produced in the current period.
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 7-22

Harvey Co. Year 2

Next, we’ll look at Harvey’s income statement

assuming is used.

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Harvey Co. Year 2

Variable
costs Variable Costing
Sales (30,000 × $30) only. $ 900,000
Less variable expenses:
Beg. inventory (5,000 × $10) $ 50,000
Add COGM (25,000 × $10) 250,000 All fixed
Goods available for sale 300,000 manufacturing
Ending inventory - overhead is
Variable cost of goods sold 300,000 expensed.
Variable selling & administrative
expenses (30,000 × $3) 90,000 390,000
Contribution margin 510,000
Less fixed expenses:
Manufacturing overhead $ 150,000
Selling & administrative expenses 100,000 250,000
Net income $ 260,000

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 7-24

Reconciliation

We can reconcile the difference between

absorption and variable income as follows:

Variable costing net income $ 260,000

Less: Fixed mfg. overhead costs
released from beginning inventory
(5,000 units × $6 per unit) (30,000)
Absorption costing net income $ 230,000

Fixed mfg. overhead $150,000

= = $6.00 per unit
Units produced 25,000
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 7-25

Summary

Income Comparison

Costing Method 1st Period 2nd Period Total

Absorption $ 120,000 $ 230,000 $ 350,000
Variable 90,000 260,000 350,000

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Summary
Relation between Effect Relation between
production on variable and
Year and sales iniventory absorption income
Inventory Absorption
1st Production > Sales increases by >
year 25,000 > 20,000 5,000 units. Variable
Inventory Absorption
2nd Production < Sales decreases <
year 25,000 < 30,000 to zero. Variable
Both Absorption
years Production = Sales No change =
combined 50,000 = 50,000 Variable

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Advantages of Variable Costing

Consistent with
CVP analysis.
Management finds it Net income is closer
easy to understand. to net cash flow.

Consistent with standard

Advantages costs and flexible budgeting.

Easier to estimate profitability

of products and segments.
Impact of fixed
costs on profits Profit is not affected by
emphasized. changes in inventories.
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 7-28

Variable versus Absorption Costing

All manufacturing costs Fixed costs are
must be assigned to not really the costs
products to properly of any particular
match revenues and costs. product.

Absorption Variable
Costing Costing
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 7-29

Variable versus Absorption Costing

Amortization, taxes, These are capacity
insurance, and salaries costs and will be
are just as essential to incurred if nothing
products as variable costs. is produced.

Absorption Variable
Costing Costing
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 7-30

Variable versus Absorption Costing

I guess we won’t be
solving this controversy
today!

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 7-31

Impact of JIT Inventory Methods

In a JIT inventory system . . .

Production
tends to equal
sales . . .

So, the difference between variable and

absorption income tends to disappear.
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 7-32

End of Chapter 7

© McGraw-Hill Ryerson Limited., 2004