Variable Costing

Chapter 6

Variable Costing: A Tool for Management

Two general approaches are used in manufacturing companies for costing products for the purposes of valuing inventories and cost of goods sold. One approach is the absorption costing. Absorption costing is generally used for external financial reports. The other approach, called variable costing, is preferred by some managers for internal decision making and must be used when an income statement is prepared in the contribution format. Ordinarily, absorption costing and variable costing produce different figures for net operating income, and the difference can be quite large. In addition to showing how these two methods differ, we will consider the arguments for and against each costing method and we will show how management decisions can be affected by the costing method chosen.

 

Overview of Absorption and Variable Costing

The contribution format income statement and cost – volume profit (CVP) analysis are valuable management tools. Both of these tools emphasize cost behavior and require that managers carefully distinguish between variable and fixed costs. Absorption costing assigns both variable and fixed manufacturing costs to products – mingling them in a way that makes it difficult for managers to distinguish between them. In contrast, variable costing focuses on cost behavior – clearly separating fixed from variable costs. One of the strengths of variable costing is that it harmonizes with both the contribution approach and the CVP concepts.

 

Variable Costing

Under variable costing, only those manufacturing costs that vary with output are treated as product costs. This would usually include direct materials, direct labor, and the variable portion of manufacturing overhead. Fixed manufacturing overhead is not treated as a product cost under this method. Rather, fixed manufacturing overhead is treated as a period cost and, like selling and administrative expenses, it is expensed in its entirety each period. Consequently, the cost of a unit of product in inventory or in cost of goods sold under the variable costing method does not contain any fixed manufacturing overhead cost. Variable costing is sometimes referred to as direct costing or marginal costing.

 

Selling and Administrative Expense

To complete this summary comparison of absorption and variable costing, we need to briefly consider the handling of selling and administrative expenses. These expenses are never treated as product costs, regardless of the costing method. Thus, under absorption and variable costing, variable and fixed selling and administrative expenses are always treated as period costs and are expensed as incurred.

Exhibit 6 – 1 summarizes the classification of costs under both absorption and variable costing.

Exhibit 6 – 1 Cost Classifications – Absorption versus Variable Costing

 

Unit Cost Computations

To illustrate the computation of unit product costs under both absorption and variable costing, consider Boley Company, a small company that produces a single product and that has the following cost structure:

Number of units produced each year	6,000
Variable costs per unit:
Direct materials	$2
Direct labor	$4
Variable manufacturing overhead	$1
Variable selling and administrative expenses	$3
Fixed costs per year:
Fixed manufacturing overhead	$30,000
Fixed selling and administrative expenses	$10,000

Required:

1. Compute the unit product cost under absorption costing.
2. Compute the unit product cost under variable costing.

Solution

Absorption Costing
Direct materials	$ 2
Direct labor	4
Variable manufacturing overhead	1
Total variable manufacturing cost	7
Fixed manufacturing overhead ($30,000/6,000 units of product)	5
Unit product cost	$12
Variable Costing
Direct materials	$ 2
Direct labor	4
Variable manufacturing overhead	1
Unit product cost	$ 7
(Under variable costing, the $30,000 fixed manufacturing overhead is a period expense along with selling and administrative expenses.)

Under the absorption costing method, all manufacturing costs, variable and fixed, are included when determining the unit product cost. Thus, if the company sells a unit of product and absorption costing is being used, then $12 (consisting of $7 variable cost and $5 fixed cost) will be deducted on the income statement as cost of goods sold. Similarly, any unsold units will be carried as inventory on the balance sheet at $12 each.

Under the variable costing method, only the variable manufacturing costs are included in product costs. Thus, if the company sells a unit of product, only $7 will be deducted as cost of goods sold, and unsold units will be carried as inventory on the balance sheet at only $7 each.

 

Income Comparison of Absorption and Variable Costing

Exhibit 6 – 2 displays income statements prepared under the absorption and variable costing approaches. In preparing these statements, we use the data for Boley Company presented earlier, along with other information about the company as given below:

Units in beginning inventory	0
Units produced	6,000
Units sold	5,000
Units in ending inventory	1,000
Selling price per unit	$20
Selling and administrative expenses:
Variable per unit	$3
Fixed per year	$10,000

Exhibit 6 – 2 Comparison of Absorption and Variable Costing – Boley Company

Absorption Costing
Sales (5,000 units × $20 per unit)		$100,000
Cost of goods sold:
Beginning inventory	$ 0
Add cost of goods manufactured (6,000 units x $12 per unit)	72,000
Goods available for sale	72,000
Less ending inventory (1,000 units x $12 per unit)	12,000*
Cost of goods sold		60,000
Gross margin		40,000
Selling and administrative expenses: (5,000 units x $3 per unit variable + $10,000 fixed)		25,000
Net operating income		$ 15,000
Variable Costing
Sales (5,000 units x $20 per unit)		$100,000
Variable expenses:
Variable cost of goods sold:
Beginning inventory	$ 0
Add variable manufacturing costs(6,000 units x $7 per unit)	42,000
Goods available for sale	42,000
Less ending inventory(1,000 units x $7 per unit)	7,000*
Variable cost of goods sold	35,000
Variable selling and administrative expenses (5,000 units x $3 per unit)	15,000	5 0,000
Contribution margin		50,000
Fixed expenses:
Fixed manufacturing overhead	30,000
Fixed selling and administrative expenses	10,000	4 0,000
Net operating income		$ 10,000

*Note the difference in ending inventories. Fixed manufacturing overhead cost at $5 per unit is included under the absorption approach. This explains the difference in ending inventory and in net operating income (1,000 units x $5 per unit = $5,000).

Several observations should be made concerning the income statements in Exhibit 6 – 2. First, the net operating incomes under the two costing methods are not the same. The net operating income under absorption costing is higher than under variable costing by $5,000. Why is this? Under absorption costing, each of the units produced during the period is assigned $5 of fixed manufacturing overhead cost. This is true of the 1,000 units in ending inventory as well as the 5,000 units that were sold. Consequently, the ending inventory under absorption costing contains $5,000 of fixed manufacturing overhead and the cost of goods sold contains $25,000 of fixed manufacturing overhead. In contrast, the entire $30,000 of fixed manufacturing overhead is expensed under variable costing. As a direct result, the net operating income under variable costing is $5,000 higher than under absorption costing. In effect, the $5,000 of fixed manufacturing overhead in ending inventory under absorption costing is deferred to the future period in which these units are sold. This $5,000 of fixed manufacturing overhead cost in the ending inventory is referred to as fixed manufacturing overhead cost deferred in inventory. In general, under absorption costing, when inventories increase, some of the fixed manufacturing costs of the current period are reported on the balance sheet as part of the ending inventories rather than on the income statement as part of cost of goods sold.

Second, the absorption costing income statement makes no distinction between fixed and variable costs – a distinction that is crucial for CVP analysis and for much of the planning and control concepts discussed in later chapters. It is difficult or even impossible to determine from an absorption costing income statement which costs are variable and which are fixed. In contrast, on a variable costing income statement the fixed and variable costs are explicitly identified – making CVP analysis far easier.

The difference between the absorption and variable costing approaches to accounting for fixed manufacturing costs centers on timing. Advocates of variable costing say that fixed manufacturing costs should be expensed immediately in total, whereas advocates of absorption costing say that fixed manufacturing costs should be charged against revenues gradually as units of product are sold. Any units of product not sold under absorption costing result in fixed manufacturing costs being inventoried and carried forward on the balance sheet as assets to the next period.

 

Exhibit 6 – 5 Comparative Income Effects – Absorption and Variable Costing

Relation between Production and Sales for the Period	Effect on	Relation between Absorption and Variable Costing Net Operating Income
Production = Sales	No change in inventories	Absorption costing      =        Variable costing net operating income            net operating income
Production > Sales	Inventories increase	Absorption costing      >        Variable costing net operating income            net operating income *
Production < Sales	Inventories decrease	Absorption costing      <        Variable costing net operating income            net operating income †
*Net operating income is higher under absorption costing, since fixed manufacturing overhead cost is deferred in inventory under absorption costing as inventories increase. †Net operating income is lower under absorption costing, since fixed manufacturing overhead cost is released from inventory under absorption costing as inventories

 

Effect of Changes in Production on Net Operating Income

In the Emerald Isle Knitters example in the preceding section, production was constant and sales fluctuated over the three – year period. Since sales fluctuated, the income statements presented in Exhibit 6 – 4 allowed us to see the effect of changes in sales on net operating income under both variable and absorption costing.

To further investigate the differences between variable and absorption costing let us put together the hypothetical example in Exhibit 6 – 7. In this hypothetical example, sales are constant and production fluctuates (the opposite of Exhibits 6 – 3 and 6 – 4). The purpose of Exhibit 6 – 7 and the income statements shown in Exhibit 6 – 8 is to illustrate the effect of changes in production on net operating income under both variable and absorption costing.

 

Exhibit 6 – 7 Basic Data to Demonstrate the Sensitivity of Costing Methods to Changes in Production

 

Basic Data
Selling price per unit sold	$20
Variable manufacturing cost per unit produced	$ 7
Fixed manufacturing overhead costs per year	$150,000
Variable selling and administrative expenses per unit sold	$ 1
Fixed selling and administrative expenses per year	$90,000

 

	Year 1	Year 2	Year 3
Units in beginning inventory	0	0	5,000
Units produced	25,000	30,000	20,000
Units sold	25,000	25,000	25,000
Units in ending inventory	0	5,000	0
Unit Product Costs	Year 1	Year 2	Year 3
Under variable costing (variable manufacturing costs only)	$ 7.00	$ 7.00	$ 7.00
Under absorption costing:
Variable manufacturing costs	$ 7.00	$ 7.00	$ 7.00
Fixed manufacturing overhead costs($150,000 spread over the number of units produced in each year)	6.00	5.00	7.50
Total absorption cost per unit	$13.00	$12.00	$14.50

 

Variable Costing

Net operating income is not affected by changes in production under variable costing. Notice from Exhibit 6 – 8 that net operating income is the same for all three years under variable costing, although production exceeds sales in one year and is less than sales in another year. In short, a change in production has no impact on net operating income when variable costing is used.

 

Absorption Costing

Net operating income is affected by changes in production under absorption costing. As shown in Exhibit 6 – 8, net operating income under absorption costing goes up in Year 2 and then goes down in Year 3. Note particularly that net operating income goes up and down between these two years even though the same number of units is sold in each year. The reason for this effect can be traced to fixed manufacturing overhead costs that shift between periods under absorption costing as a result of changes in inventory.

As shown in Exhibit 6 – 7, production exceeds sales in Year 2, resulting in an increase of 5,000 units in inventory. Each unit produced during Year 2 is assigned $5 in fixed manufacturing overhead costs (see the unit cost computations in Exhibit 6 – 7). Therefore, $25,000 (5,000 units x $5 per unit) of the fixed manufacturing overhead costs of Year 2 are not expensed in that year but rather are added to the inventory account (along with the variable manufacturing costs). The net operating income of Year 2 rises sharply, because these costs are deferred in inventories, even though the same number of units is sold in Year 2 as in the other years.

The reverse effect occurs in Year 3. Since sales exceed production in Year 3, that year is forced to cover all of its own fixed manufacturing overhead costs as well as the fixed manufacturing overhead costs carried forward in inventory from Year 2. A substantial drop in net operating income during Year 3 results from the release of fixed manufacturing overhead costs from inventories despite the fact that the same number of units is sold in that year as in the other years.

Exhibit 6 – 8 Absorption and Variable Costing Income Statements – Changes in Production Scenario.

Absorption Costing	Year 1		Year 2		Year 3
Sales (25,000 units)		$500,000		$500,000		$500,000
Cost of goods sold:
Beginning inventory	0		0		$60,000
Add cost of goods manufactured (25,000 units x $13 per unit)	325,000		360,000		290,000
Goods available for sale	325,000		360,000		350,000
Less ending inventory (5,000 units x $13 per unit)	0		60,000†		0
Cost of goods sold		325,000*		300,000*		350,000*
Gross margin		175,000		200,000		150,000
Selling and administrative expenses		115,000 *		115,000 *		115,000 *
Net operating income		$60,000		$85,000		$35,000
*Cost of goods manufactured: Year 1: 25,000 units x $13.00 per unit = $325,000. Year 2: 30,000 units x $12.00 per unit = $360,000. Year 3: 20,000 units x $14.50 per unit = $290,000. †Ending inventory, Year 2: 5,000 units x $12 per unit = $60,000.
Variable Costing
Sales (25,000 units)		$500,000		$500,000		$500,000
Variable expenses:
Variable cost of goods sold:
Beginning inventory	$ 0		$ 0		$35,000
Add variable manufacturing costs at $7 per unit produced	175,000		210,000		140,000
Goods available for sale	175,000		210,000		175,000
Less ending inventory(5,000 units x $7 per unit)	0		3 5,000*		0
Variable cost of goods sold	175,000		175,000		175,000
Variable selling and administrative expenses ($1 per unit sold)	25,000	200,000	2 5,000	200,000	25,000	200,000
Contribution margin		300,000		300,000		300,000
Fixed expenses:
Fixed manufacturing overhead	150,000		150,000		150,000
Fixed selling and administrative expenses	90,000	240,000	90,000	240,000	90,000	240,000
Net operating income		$60,000		$ 60,000		$60,000
*Ending inventory, Year 2: 5,000 units x $7 per unit = $35,000.