Chapter 19 Study Notes - Variable Costing and Analysis

Conceptual C1: Describe how absorption costing can lead to overproduction.
Analytical A1: Apply contribution margin ratio for business decisions.
Analytical A2: Convert income under variable costing to income under absorption costing.
Procedural P1: Compute unit cost under both absorption and variable costing.
Procedural P2: Prepare and analyze an income statement using absorption costing and variable costing.
Procedural P3: Determine product selling price and analyze special orders.

Product Costing Methods:
- Variable Costing: Includes only direct materials, direct labor, and variable overhead costs.
- Absorption Costing: Includes direct materials, direct labor, and both variable and fixed overhead costs.
- GAAP Requirements: Absorption costing is mandated for external financial reporting; however, it may result in misleading information about product costs and can lead to poor managerial decisions.

Exhibits & Diagrams (Exhibit 19.1, 19.2, 19.3) - illustrate methods used to compute unit costs under both absorption and variable costing.

Income Reporting Scenarios:
- Units Produced Equal Units Sold (Inventory Units Unchanged):
- Reflects stable operations where no inventory surplus or deficiency affects income.
- Exhibits (Exhibit 19.4).
- Units Produced Exceed Units Sold (Inventory Units Increase):
- Reflects overproduction that can inflate reported income under absorption costing, leading to potential mismanagement decisions based on misleading financial figures.
- Exhibits (Exhibit 19.5).
- Units Produced Less Than Units Sold (Inventory Units Decrease):
- Results in decreased inventory, impacting income reporting positively when fixed costs are spread over fewer units.
- Exhibits (Exhibit 19.6).
Summarizing Income Reporting: (Exhibit 19.7)
- Summary of financial implications of different production and sales scenarios on income.

Overproduction Discussion:
- Absorption costing can incentivize overproduction since fixed manufacturing overhead is allocated to each unit produced.
- Planning Production Aspects:
- Income Reporting Under Absorption Costing (Exhibit 19.9)
- Income Reporting Under Variable Costing (Exhibit 19.10)

Setting Target Price:
- Three-Step Pricing Process:
1. Determine the product cost per unit using absorption costing.
2. Determine the target markup on product cost per unit.
3. Add the target markup to the product cost to derive the target selling price.
- Special Orders Analysis:
- Need to cover all fixed and variable costs for long-term sustainability.
- For short-run considerations, a special order may be accepted if the selling price exceeds variable costs alone.
- Exhibits illustrating these concepts (Exhibit 19.12).

Contribution Margin Ratio: Definition - The percentage of sales remaining after deducting variable expenses.
Impact of Contribution Margin by Product Line:
- Analyzing contribution margins can assist managers in decision-making, such as:
- Adjusting selling prices per unit.
- Reducing variable costs of goods sold per unit.
- Enhancing sales efforts for a given product line.
- Relevant exhibits to elucidate these concepts (Exhibit 19.14, 19.15).

Requirement for Absorption Costing: Companies must present financials according to absorption costing for external and tax reporting.
Conversion Formula: Income under variable costing can be adjusted to absorption costing as per given formulas and methods detailed in associated exhibits (Exhibit 19A.1, 19A.2).

This chapter discussed the critical differences between variable and absorption costing methodologies, their implications on management accounting decisions, and the strategic importance of understanding cost reports and contribution margins in business contexts.