Variable Costing
An approach to measuring profitability that avoids the problemsinherent in making fixed overhead look like a variable cost isvariable costing. Variable costing (sometimes called directcosting) assigns only unit-level variable manufacturing costs tothe product; these costs include direct materials, direct labor,and variable overhead. Fixed overhead is treated as a period costand is not inventoried with the other product costs. Instead, it isexpensed in the period incurred.
The result of treating fixed manufacturing overhead as a periodexpense is to reduce the factory costs that are inventoriable.Under variable costing, only direct materials, direct labor, andvariable overhead are inventoried. (Remember that marketing andadministrative expenses are never inventoried-whether variable orfixed.)
Example: Fender Company showed the followingunit costs for its product:
Direct materials $1.15 Direct labor 0.60 Variable overhead 0.22 Fixed overhead* 2.44 *Based on capacity of 29,800units.
Last year, Fender made 29,800 units and sold 27,700 units at aprice of $9.01. Selling and administrative expense equaled $49,170(all fixed). Beginning Finished Goods Inventory contained 410 unitswith cost of $1,808.10.
Cost of one unit under variablecosting = Direct materials + Direct labor +Variable overhead = $1.15 + $0.60 + $0.22 =$1.97 Units in ending Finished GoodsInventory = 410 + 29,800 - 27,700 = 2,510units Ending Finished GoodsInventory = 2,510 Ã $1.97 = $4,944.70
The income statement for Fender Company is as follows:
Sales $249,577 Variable cost of Goods Sold ($1.97Ã 27,700) 54,569 Contribution margin $195,008 Less: Fixed overhead 72,712 Selling andadministrative expense 49,170 121,882 Variable-costing operatingincome $73,126
Notice that all of the fixed factory overhead of $72,712 ($2.44Ã 29,800) and the variable cost of manufacturing for the units sold($1.97 Ã 27,700 units sold) appear on the variable-costing incomestatement. None of the fixed factory overhead is attached to unsoldunits added to Finished Goods inventory because the fixed overheadis treated as a period expense. Only the variable cost ofmanufacturing ($1.97 Ã 2,100) is added to Finished Goods inventory- attached to the 2,100 units that were produced but not sold.
1. Under variable costing, ifbeginning Finished Goods Inventory equaled zero, the value ofending Finished Goods Inventory would be $?? . 2. Ignoring question 1 above,if Fender Company sold 30,020 units, there wouldbe units in ending Finished Goods Inventory with a valueof $?? (round to the nearest cent).
Reconciling the Difference Between Absorption andVariable Costing
When inventories change from the beginning to the end of theperiod, the two costing approaches will give different operatingincomes. The reason for this is that absorption costing assignsfixed manufacturing overhead to units produced. If those units aresold, the fixed overhead appears on the income statement under costof goods sold. If the units are not sold, the fixed overhead goesinto inventory. Under variable costing, however, all fixed overheadfor the period is expensed. As a result, absorption costing allowsmanagers to manipulate operating income by producing for inventory.Let's compare the income statements under the two methods forFender Company.
Example: Fender Company showed the followingunit costs for its product:
Direct materials $1.15 Direct labor 0.60 Variable overhead 0.22 Fixed overhead* 2.44 *Based on capacity of 29,800units.
Last year, Fender made 29,800 units and sold 27,700 units at aprice of $9.01. Selling and administrative expense equaled $49,170(all fixed). Beginning Finished Goods Inventory contained 410 unitswith cost of $1,808.1.
Absorption-CostingIncome Variable CostingIncome Sales $249,577.00 Sales $249,577.00 COGS ($4.41 Ã 27,700) 122,157.00 Variable COGS ($1.97 Ã 27,700) 54,569.00 Gross margin $127,420.00 Contribution margin $195,008.00 Less: Fixed overhead 72,712 Selling & admin.exp 49,170 Selling & admin. exp. 49,170 Operating income $78,250.00 Operating income $73,126.00
There is a difference of $5,124 between the absorption-costingoperating income and the variable-costing operating income. This$5,124 is caused by the different treatment of fixed factoryoverhead. Under absorption costing, the 2,100 units added to endinginventory took not only the $1.97 of variable manufacturing cost,but also $2.44 per unit in fixed overhead. Under variable costing,however, all the fixed factory overhead of $72,712 was expensed.None of it was added to units going into ending inventory.
Absorption-costing income -Variable-costing income = Change in inventory à fixedoverhead rate = 2,100 units à $2.44 = $5,124
What if more units are sold than are produced? That is, what ifending inventory is less than beginning inventory? Let's look atthe comparative income statement assuming Fender sells 29,890units.
Absorption-CostingIncome Variable CostingIncome Sales $269,308.9 Sales $269,308.9 COGS ($4.41 Ã 29,890) 131,814.9 Variable COGS ($1.97 Ã 29,890) 58,883.3 Gross margin $137,494 Contribution margin $210,425.6 Less: Fixed overhead 72,712 Selling & admin.exp 49,170 Selling & admin. exp. 49,170 Operating income $88,324 Operating income $88,543.6
Now we see that variable-costing income is higher thanabsorption costing income. This is because each of the 90 unitsthat came out of inventory had $2.44 of fixed overhead attached.However, this did not occur under variable costing.
Absorption-costing income -Variable-costing income = Change in inventory à fixedoverhead rate = 90 units à $2.44 = $219.60
The following table summarizes the impact of changes ininventory on the difference between absorption-costing income andvariable-costing income.
Changes in Inventoryunder Absorption and Variable Costing If Then Production > Sales Absorption-costing income >Variable-costing income Production < Sales Variable-costing income >Absorption-costing income Production = Sales Absorption-costing income =Variable-costing income
The variable-costing income statement has an advantage inaddition to providing better signals regarding performance. It alsoprovides more useful information for management decision making.For example, how much more will Fender Company earn if it sells onemore unit? Under absorption costing, the per-unit gross profit is$4.60 ($9.01 - $4.41). However, that figure includes some fixedoverhead, and fixed overhead will not change if another unit isproduced and sold. The variable-costing gives more usefulinformation. Additional contribution margin of the extra unit is$7.04 ($9.01 - $1.97). The key insight of variable costing is thatfixed expenses do not change as units produced and sold change.Therefore, while the variable-costing income statement cannot beused for external reporting, it is a valuable tool for somemanagement decisions.
Variable Costing
An approach to measuring profitability that avoids the problemsinherent in making fixed overhead look like a variable cost isvariable costing. Variable costing (sometimes called directcosting) assigns only unit-level variable manufacturing costs tothe product; these costs include direct materials, direct labor,and variable overhead. Fixed overhead is treated as a period costand is not inventoried with the other product costs. Instead, it isexpensed in the period incurred.
The result of treating fixed manufacturing overhead as a periodexpense is to reduce the factory costs that are inventoriable.Under variable costing, only direct materials, direct labor, andvariable overhead are inventoried. (Remember that marketing andadministrative expenses are never inventoried-whether variable orfixed.)
Example: Fender Company showed the followingunit costs for its product:
| Direct materials | $1.15 |
| Direct labor | 0.60 |
| Variable overhead | 0.22 |
| Fixed overhead* | 2.44 |
| *Based on capacity of 29,800units. |
Last year, Fender made 29,800 units and sold 27,700 units at aprice of $9.01. Selling and administrative expense equaled $49,170(all fixed). Beginning Finished Goods Inventory contained 410 unitswith cost of $1,808.10.
| Cost of one unit under variablecosting | = Direct materials + Direct labor +Variable overhead |
| = $1.15 + $0.60 + $0.22 =$1.97 | |
| Units in ending Finished GoodsInventory | = 410 + 29,800 - 27,700 = 2,510units |
| Ending Finished GoodsInventory | = 2,510 Ã $1.97 = $4,944.70 |
The income statement for Fender Company is as follows:
| Sales | $249,577 | |
| Variable cost of Goods Sold ($1.97Ã 27,700) | 54,569 | |
| Contribution margin | $195,008 | |
| Less: | ||
| Fixed overhead | 72,712 | |
| Selling andadministrative expense | 49,170 | 121,882 |
| Variable-costing operatingincome | $73,126 |
Notice that all of the fixed factory overhead of $72,712 ($2.44Ã 29,800) and the variable cost of manufacturing for the units sold($1.97 Ã 27,700 units sold) appear on the variable-costing incomestatement. None of the fixed factory overhead is attached to unsoldunits added to Finished Goods inventory because the fixed overheadis treated as a period expense. Only the variable cost ofmanufacturing ($1.97 Ã 2,100) is added to Finished Goods inventory- attached to the 2,100 units that were produced but not sold.
| 1. | Under variable costing, ifbeginning Finished Goods Inventory equaled zero, the value ofending Finished Goods Inventory would be $?? . |
| 2. | Ignoring question 1 above,if Fender Company sold 30,020 units, there wouldbe units in ending Finished Goods Inventory with a valueof $?? (round to the nearest cent). |
Reconciling the Difference Between Absorption andVariable Costing
When inventories change from the beginning to the end of theperiod, the two costing approaches will give different operatingincomes. The reason for this is that absorption costing assignsfixed manufacturing overhead to units produced. If those units aresold, the fixed overhead appears on the income statement under costof goods sold. If the units are not sold, the fixed overhead goesinto inventory. Under variable costing, however, all fixed overheadfor the period is expensed. As a result, absorption costing allowsmanagers to manipulate operating income by producing for inventory.Let's compare the income statements under the two methods forFender Company.
Example: Fender Company showed the followingunit costs for its product:
| Direct materials | $1.15 |
| Direct labor | 0.60 |
| Variable overhead | 0.22 |
| Fixed overhead* | 2.44 |
| *Based on capacity of 29,800units. |
Last year, Fender made 29,800 units and sold 27,700 units at aprice of $9.01. Selling and administrative expense equaled $49,170(all fixed). Beginning Finished Goods Inventory contained 410 unitswith cost of $1,808.1.
| Absorption-CostingIncome | Variable CostingIncome | |||
|---|---|---|---|---|
| Sales | $249,577.00 | Sales | $249,577.00 | |
| COGS ($4.41 Ã 27,700) | 122,157.00 | Variable COGS ($1.97 Ã 27,700) | 54,569.00 | |
| Gross margin | $127,420.00 | Contribution margin | $195,008.00 | |
| Less: | Fixed overhead | 72,712 | ||
| Selling & admin.exp | 49,170 | Selling & admin. exp. | 49,170 | |
| Operating income | $78,250.00 | Operating income | $73,126.00 | |
There is a difference of $5,124 between the absorption-costingoperating income and the variable-costing operating income. This$5,124 is caused by the different treatment of fixed factoryoverhead. Under absorption costing, the 2,100 units added to endinginventory took not only the $1.97 of variable manufacturing cost,but also $2.44 per unit in fixed overhead. Under variable costing,however, all the fixed factory overhead of $72,712 was expensed.None of it was added to units going into ending inventory.
| Absorption-costing income -Variable-costing income | = Change in inventory à fixedoverhead rate |
| = 2,100 units à $2.44 = $5,124 |
What if more units are sold than are produced? That is, what ifending inventory is less than beginning inventory? Let's look atthe comparative income statement assuming Fender sells 29,890units.
| Absorption-CostingIncome | Variable CostingIncome | |||
|---|---|---|---|---|
| Sales | $269,308.9 | Sales | $269,308.9 | |
| COGS ($4.41 Ã 29,890) | 131,814.9 | Variable COGS ($1.97 Ã 29,890) | 58,883.3 | |
| Gross margin | $137,494 | Contribution margin | $210,425.6 | |
| Less: | Fixed overhead | 72,712 | ||
| Selling & admin.exp | 49,170 | Selling & admin. exp. | 49,170 | |
| Operating income | $88,324 | Operating income | $88,543.6 | |
Now we see that variable-costing income is higher thanabsorption costing income. This is because each of the 90 unitsthat came out of inventory had $2.44 of fixed overhead attached.However, this did not occur under variable costing.
| Absorption-costing income -Variable-costing income | = Change in inventory à fixedoverhead rate |
| = 90 units à $2.44 = $219.60 |
The following table summarizes the impact of changes ininventory on the difference between absorption-costing income andvariable-costing income.
| Changes in Inventoryunder Absorption and Variable Costing | |
|---|---|
| If | Then |
| Production > Sales | Absorption-costing income >Variable-costing income |
| Production < Sales | Variable-costing income >Absorption-costing income |
| Production = Sales | Absorption-costing income =Variable-costing income |
The variable-costing income statement has an advantage inaddition to providing better signals regarding performance. It alsoprovides more useful information for management decision making.For example, how much more will Fender Company earn if it sells onemore unit? Under absorption costing, the per-unit gross profit is$4.60 ($9.01 - $4.41). However, that figure includes some fixedoverhead, and fixed overhead will not change if another unit isproduced and sold. The variable-costing gives more usefulinformation. Additional contribution margin of the extra unit is$7.04 ($9.01 - $1.97). The key insight of variable costing is thatfixed expenses do not change as units produced and sold change.Therefore, while the variable-costing income statement cannot beused for external reporting, it is a valuable tool for somemanagement decisions.
Related questions
Bell Company manufactures and sells a single product. Cost datafor the product follow: |
| Variable costs perunit: | ||
| Direct materials | $ | 3 |
| Direct labor | 12 | |
| Variable factory overhead | 3 | |
| Variable selling andadministrative | 3 | |
| Total variable costsper unit | $ | 21 |
| Fixed costs permonth: | ||
| Fixed manufacturingoverhead | $ | 120,000 |
| Fixed selling andadministrative | 166,000 | |
| Total fixed cost permonth | $ | 286,000 |
The product sells for $48 per unit.Production and sales data for May and June, the first two months ofoperations, are as follows: |
| Units Produced | Units Sold | |
| May | 24,000 | 20,000 |
| June | 24,000 | 28,000 |
Income statements prepared by theaccounting department, using absorption costing, are presentedbelow: |
| May | June | |||
| Sales | $ | 960,000 | $ | 1,344,000 |
| Cost of goodssold | 460,000 | 644,000 | ||
| Gross margin | 500,000 | 700,000 | ||
| Selling andadministrative expenses | 226,000 | 250,000 | ||
| Net operatingincome | $ | 274,000 | $ | 450,000 |
| Required: |
| 1. | Determine the unit product cost under absorption costing andvariable costing. |
| Unit Product Cost | ||
| Absorption costing | ||
| Variablecosting | ||
| 2. | Prepare contribution format variable costing income statementsfor May and June. (Input all amounts as positive valuesexcept losses which should be indicated by a minussign.) |
| Variable Costing Income Statement | ||
| May | June | |
| (Click toselect)SalesFixed manufacturing overheadVariable cost of goodssoldNet operating income (loss)Contribution marginFixed selling andadministrative expensesVariable selling and administrativeexpenses | $ | $ |
| Variableexpenses: | ||
| (Click toselect)SalesContribution marginNet operating income (loss)Variablecost of goods soldFixed selling and administrative expensesDirectmaterialsFixed manufacturing overhead | ||
| (Click toselect)Contribution marginSalesFixed selling and administrativeexpensesFixed manufacturing overheadNet operating income(loss)Variable selling and administrative expensesDirectmaterials | ||
| Total variableexpenses | ||
| (Click toselect)Gross marginContribution margin | ||
| Fixed expenses: | ||
| (Click to select)Variableselling and administrative expensesFixed manufacturingoverheadDirect materialsContribution marginSalesNet operatingincome (loss)Variable cost of goods sold | ||
| (Click to select)Fixedselling and administrative expensesVariable cost of goodssoldDirect materialsVariable selling and administrative expensesNetoperating income (loss)Contribution marginSales | ||
| Total fixedexpenses | ||
| Net operating income(loss) | $ | $ |
| 3. | Reconcile the variable costing and absorption costing netoperating incomes. (Loss amounts and amounts to be deductedshould be indicated with a minus sign.) |
| Reconciliation of Variable Costing and Absorption Costing NetOperating Incomes | ||
| May | June | |
| Variable costing netoperating income (loss) | $ | $ |
| Add (deduct) fixedmanufacturing overhead cost deferred in (released from) inventory under absorption costing | ||
| Absorption costingnet operating income (loss) | $ | $ |
1. ABC Company must sell 1,000 units to break even with its current contribution margin of $.50 per unit. How will breakeven change if the contribution margin increases?
A. The number of units needed to break even will decrease.
B. The number of units needed to break even will increase.
C. The number of units needed to break even will remain the same.
D. There is not enough information to know how break even units will change.
2. Segment margin is sales minus:
A.variable expenses.
B.traceable fixed expenses.
C. variable expenses and common fixed expenses.
D. variable expenses and traceable fixed expense
3. DC Construction has two divisions: Remodeling and New Home Construction. Each division has an on-site supervisor who is paid a salary of $82,000 annually and a salaried estimator who is paid $46,000 annually. The corporate office has two office administrative assistants who are paid salaries of $50,000 and $37,000 annually. The president's salary is $153,000. How much of these salaries are common fixed expenses?
A. $153,000
B. $87,000
C. $308,000
D. $240,000
4. ABC Company, which has only one product, has provided the following data concerning its most recent month of operations. It produced 6,200 units and sold 6,000 units. There was no beginning inventory.
| Variable (per unit) | Fixed (total) | |
| Direct Materials | $15 | |
| Direct Labor | $5 | |
| Manufacturing Overhead | $8 | $148,800 |
| Selling & Administrative | $7 | $81,840 |
What is the unit product cost under absorption costing?
A. $52.00
B. $52.80
C. $59.00
D. $28.00
5. Under variable costing, fixed manufacturing overhead costs
A. are deferred in inventory when production exceeds sales
B. are always treated as period costs
C. are released from inventory when production exceeds sales
D. are ignored
