ACCTG 1B Chapter Notes - Chapter CH. 20 Variable Costing for Management Analysis: Total Absorption Costing, Contribution Margin, Variable Cost

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:

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.

The income statement for Fender Company is as follows:

Notice that all of the fixed factory overhead of $72,712 ($2.44× 29,800) and the variable cost of manufacturing for the units sold($1.97 × 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 × 2,100) is added to Finished Goods inventory- attached to the 2,100 units that were produced but not sold.

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:

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.

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.

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.

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.

The following table summarizes the impact of changes ininventory on the difference between absorption-costing income andvariable-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.

Absorption and Variable Costing Income Statements for Two Months and Analysis

During the first month of operations ended July 31, Head Gear Inc. manufactured 26,800 hats, of which 25,500 were sold. Operating data for the month are summarized as follows:

During August, Head Gear Inc. manufactured 24,200 designer hats and sold 25,500 hats. Operating data for August are summarized as follows:

Required:

1a. Prepare an income statement for July using the absorption costing concept. Enter all amounts as positive numbers.

1b. Prepare an income statement for August using the absorption costing concept. Enter all amounts as positive numbers.

2a. Prepare an income statement for July using the variable costing concept. Enter all amounts as positive numbers.

2b. Prepare an income statement for August using the variable costing concept. Enter all amounts as positive numbers.

3a. For July, income from operations reported under costing is less than costing due to part of manufacturing costs that are expensed.

3b. When large changes in inventory levels occur from one period to the next, it is possible for management to misinterpret such increases (or decreases) in income from operations as due to changes in:

costs.

prices.

sales volume.

"sales volume", "prices" and "costs" are correct.

None of these choices is correct.

The correct answer is:

4. Based on your answers to (1) and (2), did Head Gear Inc. operate more profitably in July or in August? Explain.

Head Gear Inc. was under the variable costing concept. The difference in income reported under the absorption costing concept is due to allocating to the .

The information below representsthe beginning and ending inventory amounts along with theproduction and sales for the month in umbrella units

Beginning Inventory: 0 Umbrellas

Production: 80,000 Umbrellas

Sales: 60,000 Umbrellas

Ending Inventory: 20,000 Umbrellas

The Hampshire Company manufactures umbrellas that sell for$12.50 each. In 2014, the company made and sold 60,000 umbrellas.The company had fixed manufacturing costs of $216,000. It also hadfixed costs for administration of $79,525. The per-unit costs ofeach umbrella are as follows:

Using the information

Prepare a variable costing income statement.

Prepare an absorption costing income statement.

Direct Materials: $3.00

Direct Labor: $1.50

Variable Manufacturing Overhead:$0.40

Variable Selling Expenses: $1.10