Chapter 8 Variable Costing.docx

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University of Waterloo
Accounting & Financial Management
AFM 102
Tom Vance

08 – variablecosting Chapter 8: Variable Costing Overview of Absorption and Variable Cost Absorption andVariablecosting  absorption costing: a costing method that includes all manuf. costs (DM, DL, var. and fixed o’head) in the cost of a unit of product  aka full cost method  allocates a portion of fixed manufacturing overhead cost to each unit of product, along with the variable manufacturing costs  variable costing: a costing method that includes only var. manuf. costs (DM, DL and var. manuf. o’head) in the cost of a unit of product  aka direct costing or marginal costing  fixed manufacturing overhead is not treated as a product cost under this method and is treated as a period cost like S&A Selling and Administrative Expense absorption costing variable costing product costs direct materials product costs direct labour var. manuf. o’head fixed. manuf. o’head period costs period costs var. s&a expense fixed s&a expense Unit Cost Computations  under absorption costing method, all manuf. costs (var and fixed) are included  absorption unit cost = DM/unit + DL/unit + var. manuf. o’head/unit + fixed manuf. o’head/units produced  under variable costing method, only var. manuf. costs are included  variable unit cost = DM/unit + DL/unit + var. manuf. o’head/unit Income Comparison of Absorption andVariable Costing  fixed manuf. o’head cost deferred in inventory: the portion of the fixed manuf. o’head cost of a period that goes into inventory under the absorption costing method as a result of production exceeding sales  under the absorption costing method, if there is an ending inventory, the fixed manuf. costs associated with the inventory will be carried forward as a balance sheet account (inventory) instead of a cost/expense  fixed manuf. ohead cost of the current period is deferred in inventory to the next period  when production exceeds sales, absorption income will be higher than variable income  the OI difference is (units produced – units sold) × (unit cost[A] – unit cost[V])  absorption costing income makes no distinction between fixed and variable costs and is not well suited for CVP computations  variable costing method blends well with the contribution approach to the income statement, and could be used immediately in CVP computations Extended Comparison of Income Data When production and salesare equal  operating income for both absorption and variable costing method is the same page 1 of 5 08 – variablecosting  the only difference that can exist between the 2 costing method is the amount of fixed manuf. ohead recog- nized as expense  when everything produced is sold, all fixed manuf. o’head assigned to the units of production under absorp- tion costing becomes part of the COGS When production exceedssales  absorption income > variable income  for absorption, part of the fixed manuf. ohead costs of the current period are deferred in inventory (lowering the COGS)  for variable, all of the fixed manuf. ohead [of the current year] are included in COGS When production isless than sales  absorption income < variable income  fixed manuf. ohead cost released from inventory: the portion of fixed manuf. o’head cost of a prior period that becomes an expense of the current period under absorption costing method as a result of sales exceed- ing production  for absorption, fixed manuf. ohead costs from prior periods are released (increasing COGS)  for variable, only the fixed manuf. ohead of the current year are included in COGS In the long run  the cumulative operating income figures reported under absorption and variable costing method will tend to be the same  in the long run, sales and production will not exceed each other (can’t sell more than produced, won’t produce so much that the firm cannot sell all) Variable costing vs.Absorption costing Variable Absorption  OI is not affected by changes in production  OI is affected by changes in production  all fixed manuf. o’head of the current year are in-  caused by the shifting of fixed manuf. o’head costs cluded in the COGS for that year between periods as a result of changes in inventory Reconciliation of Variable Costing and Absorption Costing Year 1 Year 2 Year 3 Variable costing OI 60 000 60 000 60 000 Add fixed manuf. o’head costs deferred in 0 60 000 0 inventory under absorption Deduct fixed manuf. o’head costs released 0 0 (60 000) from inventory under absorption Absorption costing OI 60 000 120 000 0 Choosing a Costing Method The Impact onthe Manager  shifting manuf. o’head costs between period is confusing and can lead to misinterpretations  managers might wonder why operating income went up when sales fell  result of lower selling costs? more efficient operations?  variable costing income statements are clear and easy to understand  essentially, revenue drives income for variable costing operating income CVP Analysisand Absorption Costing  abs costing used for both internal and external reports  firms use abs costing because it focuses on full costing of units of product page 2 of 5 08 – variablecosting  weakness: inability to work well with CVP analysis  absorption break-even analysis would require the analysis of these 2 drivers: sales and production  must determine various levels for each driver, break-even could be determined Decision Making  fixed manuf. o’head costs appear to be variable with respect to the number of units sold  leads to managerial problems: inappropriate pricing decisions, and decisions to drop a product that are actu- ally profitable Advantagesof VariableCosting and theContribution Approach  data required for CVP analysis can be taken directly from a CM income statement  profit for a period is not affected by changes in inventories  unit product costs do not contain fixed costs  impact of fixed costs on profits is emphasized and appears explicitly  easy to estimate profitability of products, customers, and other segments of the business  ties in with cost control methods (standard costs and flexible budgets)  closer to net cash flow than abs costing Impact of Lean Production  when companies use lean production methods, problems with differing operating income are reduced  that is, the difference between abs income and variable income is reduced
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