Chapter 6
VARIABLE COSTING:
A TOOL FOR
MANAGEMENT
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Overview of Absorption and
Variable Costing
Absorption
Costing
Variable
Costing
Direct Materials
Product
Costs
Product
Costs
Direct Labor
Variable Manufacturing Overhead
Fixed Manufacturing Overhead
Period
Costs
Variable Selling and Administrative Expenses
Period
Costs
Fixed Selling and Administrative Expenses
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Unit Cost Computations
Harvey Company produces a single product
with the following information available:
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Unit Cost Computations
Unit product cost is determined as follows:
Under absorption costing, all production costs, variable
and fixed, are included when determining unit product
cost. Under variable costing, only the variable
production costs are included in product costs.
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Income Comparison of
Absorption and Variable Costing
Let’s assume the following additional information
for Harvey Company.
• 20,000 units were sold during the year at a price
of $30 each.
• There is no beginning inventory.
Now, let’s compute net operating
income using both absorption
and variable costing.
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Absorption Costing
Fixed manufacturing overhead deferred in
inventory is 5,000 units × $6 = $30,000.
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Variable Costing
Variable
manufacturing
Variable Costing
costs only.
Sales (20,000 × $30)
Less variable expenses:
Beginning inventory
$
Add COGM (25,000 × $10)
250,000
Goods available for sale
250,000
Less ending inventory (5,000 × $10)
50,000
Variable cost of goods sold
200,000
Variable selling & administrative
expenses (20,000 × $3)
60,000
Contribution margin
Less fixed expenses:
Manufacturing overhead
$ 150,000
Selling & administrative expenses 100,000
Net operating income
$ 600,000
All fixed
manufacturing
overhead is
expensed.
260,000
340,000
250,000
$ 90,000
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Comparing the Two Methods
We can reconcile the difference between
absorption and variable income as follows:
Variable costing net operating income $ 90,000
Add: Fixed mfg. overhead costs
deferred in EI (5,000*$6)
30,000
Ded: Fixed mfg. overhead costs
deferred in BI
Absorption costing net operating income $ 120,000
Fixed mfg. overhead
$150,000
=
= $6 per unit
Units produced
25,000 units
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Extended Comparisons of Income
Data Harvey Company – Year Two
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Unit Cost Computations
Since the variable costs per unit, total fixed costs,
and the number of units produced remained
unchanged, the unit cost computations also
remain unchanged.
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Absorption Costing
Unit product
cost.
Absorption Costing
Sales (28,000 × $30)
Less cost of goods sold:
Beg. inventory (5,000 × $16)
Add COGM (25,000 × $16)
Goods available for sale
Less ending inventory
Gross margin
Less selling & admin. exp.
Variable (28,000 × $3)
Fixed
Net operating income
$ 840,000
$ 80,000
400,000
480,000
32,000
$ 84,000
100,000
448,000
392,000
184,000
$ 208,000
Fixed manufacturing overhead released from
inventory is 5,000 units × $6 = $30,000.
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Variable Costing
Variable
manufacturing
costs only.
All fixed
manufacturing
overhead is
expensed.
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Comparing the Two Methods
We can reconcile the difference between
absorption and variable income as follows:
Variable costing net operating income
$ 260,000
Add: Fixed mfg OH costs from EI
(12,000)
Ded: Fixed mfg. OH costs from BI
30,000
Absorption costing net operating income $ 208,000
Fixed mfg. overhead
$150,000
=
= $6 per unit
Units produced
25,000 units
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Comparing the Two Methods
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Summary of Key Insights
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Absorption Costing vs Variable Costing

Absorption costing (also called full costing) – CGS
includes DM, DL,VOH, and FOH for those units sold
(CGS absorbs all manufacturing costs)

Absorption costing I/S (Required by
GAAP, IRS for external reporting
Sales Revenue
- CGS
(DM + DL+FOH+VOH)
Gross Margin
- Mktg & Admin Exp (including variable and fixed)
Net income
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Variable Costing


Variable costing (also called direct costing) – CGS
includes DM, DL, and VOH for those units sold (CGS
includes only variable manufacturing costs)
Variable costing I/S
Sales revenue
- VC CGS
(DM, DL,VOH)
- VC Mktg & Admin
Contribution Margin
- FC Mfg (FOH)
- FC Mktg & Admin
Net income or operating profit
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Advantages and disadvantages of AC vs
VC: Impact on the Manager
Opponents of absorption costing argue that
shifting fixed manufacturing overhead costs
between periods can lead to faulty decisions.
These opponents argue that variable costing 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.
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CVP Analysis, Decision Making
and Absorption costing
Absorption costing does not dovetail with CVP analysis, nor
does it support decision making. It treats fixed manufacturing
overhead as a variable cost. It assigns per unit fixed
manufacturing overhead costs to production.
Treating fixed manufacturing overhead as a
variable cost can:
• Lead to faulty pricing decisions and faulty
keep-or-drop decisions.
Assigning per unit fixed manufacturing overhead
costs to production can:
• Potentially produce positive net operating income
even when the number of units sold is less than
the breakeven point.
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Benefits of Absorption Costing: External
Reporting and Income Taxes
To conform to
GAAP requirements,
absorption costing must be used for
external financial reports in the
Under the Tax
United States.
Reform Act of 1986,
absorption costing must be
used when filling out
Since top executives
income tax returns.
are typically evaluated based on
earnings reported to shareholders
in external reports, they may feel that
decisions should be based on
absorption costing data.
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Advantages of Variable Costing
and the Contribution Approach
Management finds
it more useful.
Consistent with
CVP analysis.
Net operating income
is closer to
net cash flow.
Consistent with standard
costs and flexible budgeting.
Advantages
Easier to estimate profitability
of products and segments.
Impact of fixed
costs on profits
emphasized.
Profit is not affected by
changes in inventories.
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Variable versus Absorption Costing
Fixed manufacturing
costs must be assigned
to products to properly
match revenues and
costs.
Absorption
Costing
Fixed manufacturing
costs are capacity costs
and will be incurred
even if nothing is
produced.
Variable
Costing
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Impact of Lean Production
When companies use Lean Production . . .
Production
tends to equal
sales . . .
So, the difference between variable and
absorption income tends to disappear.
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Variable Costing and the Theory of
Constraints (TOC)
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:
 Many companies have a commitment to guarantee
workers a minimum number of paid hours.
 Direct labor is usually not the constraint.
 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.
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Example: Profit under variable costing vs Absorption costing
DM=$3/unit, DL = $5/unit, VOH = $2/unit, FOH = $50 /year, Variable mktg = $2/unit, Fixed mktg =$10/year,
Selling price = $20/unit
20A
20B
20C
Units produced
10
10
10
Units sold
10
9
11
Under variable costing:
20A(P=S)
20B(P>S)
20C(P<S)
Sales
$200
$180
$220
-VC
120
108
_____
CM
80
72
______
-FC
60
60
______
NI
20
12
______
Under absorption costing:
Sales
-CGS
GM
-Mktg
NI
$200
150
50
30
20
$180
135
45
28
17
$220
______
______
______
______
Summary:
20A
20B
20C
When
P=S
P>S
P<S
Then
NIAC= NIVC NIAC> NIVC
NIAC< NIVC
The difference of NI between VC and AC is due to FOH ;Under VC: All FOH is expensed regardless of sales
Under AC: Allocate FOH between units sold (CGS) and units on hand (INV)
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End of Chapter 6
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