Chapter 5: Variable Costing Notes

Chapter 5: Basic Principles

Variable Costing

  • Variable costing is also known as marginal costing, direct costing, or contribution margin costing.
  • It's an extension of Cost-Volume-Profit (CVP) analysis.
  • It follows the basic assumptions of marginal costing (CVP analysis) except when production doesn't equal sales.
  • Variable costing includes variable production costs as part of the product cost, while direct costing includes all costs directly identified with the segment as product costs.
  • Variable costing focuses on the contribution margin, while direct costing emphasizes segment margin.
  • Unit costs from the preceding period are assumed to be the same in the current period (constant unit costs).

Treatment of Fixed Overhead, Costs, and Expenses

Absorption Costing
  • Fixed overhead is treated as a product cost, inventoriable cost, or deferrable cost.
  • The cost is assigned to the product and charged against sales when units are sold.
  • If units are unsold, the cost is deferred in inventory.
  • This aligns with the principle of matching costs against revenues.
Variable Costing
  • Fixed overhead is treated as a period cost, meaning it is expensed immediately.
  • Fixed overhead is charged against revenues regardless of whether the units are sold or unsold.
  • This follows the immediate recognition principle.
  • The rationale is that fixed overhead would be incurred regardless of production, so it shouldn't be treated as a product cost.
Direct Materials, Direct Labor, and Variable Overhead
  • These are product costs in both absorption and variable costing systems.
Variable and Fixed Expenses
  • These are period costs in both absorption and variable costing systems.

Computation Guidelines

Computation of Unit Costs:
Absorption Costing (AC)
  • Unit variable production costs (direct materials, direct labor, and variable factory overhead) + Unit fixed overhead (Budgeted fixed OH / Normal capacity) = Unit costs
Variable Costing (VC)
  • Unit variable production costs = Unit costs

Computation of Operating Income

Absorption Costing (AC)
  • Sales = Quantity Sold (QS) x Unit Sales Price (USP)
  • Variable Cost of Goods Sold (CGS) = Quantity Sold (QS) x Unit Variable Costs (UVC)
  • Fixed Overhead = Quantity Sold (QS) x Unit Fixed Costs (UFC)
  • Variable Expenses = Quantity Sold (QS) x Unit Variable Expense (UVE)
  • Fixed Expenses = Normal Capacity (NC) x Unit Fixed Expense (UFE)
  • Operating Income = Sales - Variable CGS - Fixed OH - Variable Expenses - Fixed Expenses
Variable Costing (VC)

  • Sales = QS×USPQS \times USP

  • Variable CGS = QS×UVCQS \times UVC

  • Fixed OH = NC×UFCNC \times UFC

  • Variable Expenses = QS×UVEQS \times UVE

  • Fixed Expenses = NC×UFENC \times UFE

  • Operating Income = Sales - Variable CGS - Fixed OH - Variable Expenses - Fixed Expenses

  • Where:

    • NC = Normal Capacity
    • QS = Quantity Sold
    • USP = Unit Sales Price
    • UVC = Unit Variable Costs
    • UFC = Unit Fixed Costs
    • UVE = Unit Variable Expense
    • UFE = Unit Fixed Expense

  • Cost of ending inventory = Ending inventory in units x Unit cost

Reconciliation of Operating Income (Absorption vs. Variable Costing)

Production Model
  • Production - Sales = Change in Inventory
  • Change in Inventory x Unit Fixed Costs = Change in Operating Income (P<em>xP<em>x AC - P</em>xP</em>x VC)
Inventory Model
  • Beginning Inventory (P<em>xP<em>x AC - P</em>xP</em>x VC) - Ending Inventory (P<em>xP<em>x AC - P</em>xP</em>x VC) = Change in Operating Income
Costs Model
  • Fixed Overhead Charged under AC (QS×UFXCQS \times UFXC) - Fixed Overhead Charged under VC (NC×UFXCNC \times UFXC) = Change in Operating Income [(QS−NC)×UFXC][(QS - NC) \times UFXC]

Treatment of Cost Variances and Volume Variances

  • Unfavorable (UF) cost variances are added to CGS at standard or deducted from operating income.
  • Favorable (F) cost variances are deducted from CGS at standard or added to operating income.
  • Volume variance is included only in the absorption costing operating income.

Computation of Operating Income with Cost Variances

Absorption Costing (AC)
  • Sales = QS×USPQS \times USP
  • Variable CGS = QS×UVCQS \times UVC
  • Fixed OH = QS×UFCQS \times UFC
  • Variable Production Costs Variances: Unfavorable (UF) or Favorable (F)
  • Volume Variance = Unfavorable (UF) or Favorable (F)
  • Fixed Expenses = NC×UFENC \times UFE
  • Operating Income = Sales - Variable CGS - Fixed OH +/- Variable Production Costs Variances +/- Volume Variance - Fixed Expenses
Variable Costing (VC)
  • Sales = QS×USPQS \times USP
  • Variable CGS = QS×UVCQS \times UVC
  • Fixed OH = NC×UFCNC \times UFC
  • Variable Production Costs Variances: Unfavorable (UF) or Favorable (F)
  • Fixed Expenses = NC×UFENC \times UFE
  • Operating Income = Sales - Variable CGS - Fixed OH +/- Variable Production Costs Variances - Fixed Expenses

Volume Variance

  • Volume variance = (Normal capacity in units - Actual capacity in units) x Unit fixed costs
  • Volume variance in units = under(over) absorbed x Unit fixed costs
  • Volume variance in pesos = Units Fixed (UF) or Favorable (F)

Sales and Variable Costing, Production and Absorption Costing

Variable Costing Income Follows Sales:
  • If Sales > Production, Variable Costing Operating Income Increases; AC Operating Income is greater than VC.
  • If Sales < Production, Variable Costing Operating Income Decreases; AC Operating Income is lower than VC.
Absorption Costing Income Follows Production:
  • If Production > Sales, Absorption Costing Operating Income Increases; AC Operating Income is greater than VC.
  • If Production < Sales, Absorption Costing Operating Income Decreases; AC Operating Income is lower than VC.

Straight Problems Example

Golden Company
  • Selling price: P160 per unit
  • Normal capacity: 50,000 units
Variable Costs per Unit:
  • Direct materials: P25
  • Direct labor: P40
  • Manufacturing overhead: P45
  • Selling and administrative: P10
Fixed Costs per Unit:
  • Manufacturing overhead: P20
  • Selling and administrative: P15 (based on normal capacity)
  • Cases show Production and Sales with different amounts.
Solution Guide:
  • Unit variable costs = P25 + P40 + P45 = P110
  • Budgeted fixed costs = 50,000 units x P20 = P1,000,000
  • Budgeted fixed expenses = 50,000 units x P15 = P750,000
Accounting for the Change in Operating Income
  • Change in operating income = Change in inventory x Unit fixed cost
  • Change in operating income = (Production−Sales)×UnitFixedCost(Production - Sales) \times Unit Fixed Cost

Melanie Company Example

Data:
  • Beginning inventory: 200 units
  • Units Produced: 4,400
  • Normal Capacity: 4,000 units
  • Units sold: 4,300
  • Sales Price: P500 / unit
  • Variable S&A: 5% of sales
  • Fixed S&A: P160,000
  • Direct Materials cost/unit: P80
  • Direct Labor cost/unit: P170
  • Variable Overhead/unit: P20
  • Fixed Overhead (total): P340,000
  • Direct Materials Variances: P30,000 UF
  • Direct Labor Variances: P7,500 F
  • Variable OH controllable variance: P22,000 UF
Solution Guide:
  • Normal Capacity = 4,000 units
  • Actual Capacity = 4,400 units
  • Under(Over) absorbed capacity : −UF(F)=(400)F- UF(F) = (400) F
  • UfxOH=(P340,000/4,000units)=P85UfxOH = (P340,000 / 4,000 units) = P 85
  • Volume in pesos : −UF(F)=P(34,000)F- UF(F) = P(34,000) F
Cost of ending inventory:
  • Ending inventory in units = 200+4,400−4,300=300units200 + 4,400 - 4,300 = 300 units
  • Absorption costing = 300units×(P270+P85)=P106.500300 units \times (P270 + P85) = P106.500
  • Variable costing = 300units×P270=P81,000300 units \times P270 = P 81,000
Reconciliation of the change in operating income:
  • Change in inventory (4,400−4,300=100units4,400 - 4,300 = 100 units
  • UfxOH=P85UfxOH = P 85
  • Change in net income = P8,500P8,500
  • Variable costing method produces a lower income since sales are lower than production.
  • Absorption costing method has a higher income over that of the variable costing method.