Variable Costing and Analysis Chapter 19

Overview of Costing Methods

• Two main product costing methods:
  • Variable Costing:
  • Includes direct materials, direct labor, and variable overhead.
  • Absorption Costing:
  • Includes direct materials, direct labor, variable overhead, and fixed overhead.
  • Required by GAAP for external reporting, but can mislead product cost information and managerial decisions.

Key Learning Objectives

• Learning Objective P1:
  • Compute unit cost under both absorption and variable costing.
• Learning Objective P2:
  • Prepare and analyze income statements using both costing methods.
• Learning Objective P3:
  • Determine product selling prices and analyze special orders.
• Learning Objective A1:
  • Apply contribution margin ratio for business decisions.
• Learning Objective A2:
  • Convert income statements from variable costing to absorption costing.

Computing Unit Product Cost

• Understanding the computation of unit product costs under both absorption and variable costing is fundamental.
• Exhibits 19.1 to 19.3 demonstrate the methodologies involved in these computations.

Income Reporting Under Costing Methods

• Analyzing income statements:
  • When Units Produced = Units Sold (Inventory Unchanged):
  • The reported income under both methods will be the same.
  • When Units Produced > Units Sold (Inventory Increase):
  • Differences in income may arise due to the treatment of fixed overhead costs in absorption costing.
  • When Units Produced < Units Sold (Inventory Decrease):
  • Again, the two methods may yield different income figures.
• Exhibits 19.4 to 19.7 help visualize these scenarios.

Planning Production under Absorption Costing

• Understanding the implications of absorption costing:
  • Can lead to overproduction, influencing both income and cost management.
• Exhibits 19.8 to 19.10 provide insight into the results of production planning decisions in relation to income.

Setting Target Price for Products

• Three-step process to determine selling price:
  1. Calculate the product cost per unit using absorption costing.
  2. Determine the target markup on product cost per unit.
  3. Add the target markup to find the target selling price.
• Companies must cover all fixed and variable costs over the long run.

Analyzing Special Orders

• Analysis is needed to accept special orders:
  • Accept if the selling price exceeds variable costs in the short run.

Contribution Margin Ratio

• Contribution margin ratio: Defined as the percentage of sales remaining after variable expenses are deducted.
• Critical for business decisions.
  • Can influence choices like increasing selling prices, decreasing variable costs, and enhancing sales efforts.
• Analysis of contribution margin by product line informs managerial strategies and decisions.

Converting Income from Variable to Absorption Costing

• Important for compliance with external reporting standards, particularly taxes.
• Formula: Income under variable costing converted to absorption costing.
• Refer to Exhibits 19A.1 and 19A.2 for applications of this conversion in practice.

Conclusion

• Understanding the distinctions between variable and absorption costing is essential for accurate accounting and informed decision-making in business.