Variable Costing: A Tool for Management

Introduction to Variable Costing

Overview of the Chapter

  • Focus: Variable costing as a tool for management.

  • Content covers differences between variable costing and absorption costing, unit product cost computation under each method, income statement preparation using both costing methods, and reconciliation of net operating incomes with explanations for the differing amounts.

  • Page references: Chapter 6 spanning pages 253-263.

Learning Objectives

  1. Difference Between Costing Methods

    • Explain how variable costing differs from absorption costing.

    • Compute unit product costs under both methods.

  2. Income Statement Preparation

    • Prepare income statements using both variable and absorption costing methods.

  3. Net Operating Income Reconciliation

    • Reconcile net operating incomes derived from the two methods and discuss reasons for differences.

Costing Methods Overview

  • Actual Costing:

    • Uses actual expenditures for direct materials, direct labor, variable and fixed manufacturing overhead to determine product costs.

  • Normal Costing:

    • Uses actual expenditures for direct materials and direct labor, with estimated expenditures for variable and fixed manufacturing overhead through predetermined overhead rates.

  • Standard Costing:

    • Applies previously established standard quantities and costs for direct material, direct labor, variable manufacturing overhead (VMOH), and fixed manufacturing overhead (FMOH) to determine product costs.

Common Feature of Costing Methods

  • All methods include all manufacturing costs (Direct Materials (DM), Direct Labor (DL), VMOH, and FMOH) termed Absorption Costing (full costing).

Variable Costing Explained

  • Definition: A product costing approach where:

    1. The cost of a product includes only direct materials, direct labor, and variable manufacturing overhead.

    2. Fixed manufacturing overhead is not allocated to products; instead, it is treated as an expense of the period and deducted directly from the gross margin.

  • Components in Variable Costing:

    • Product Costs:

    • Direct Material

    • Direct Labor

    • Variable Manufacturing Overhead

    • Period Costs:

    • Fixed Manufacturing Overhead

    • Selling and Administrative Expenses (both variable and fixed).

Simplifying Assumptions for the Chapter

  1. Actual costing will be used rather than normal costing.

  2. Actual number of units produced will serve as the allocation base for assigning actual fixed manufacturing overhead costs to products.

  3. Both variable manufacturing costs per unit and total fixed manufacturing overhead cost remain constant over the period.

Comparison of Variable and Absorption Costing

  • Direct Costs:

    • Variable Costing

    • Includes only direct materials, direct labor, variable manufacturing overhead.

    • Absorption Costing

    • Includes variable and fixed manufacturing costs.

  • Inventories:

    • Variable costing results in lower values for work in process and finished goods inventories compared to absorption costing.

Income Statement Preparation

Formats Under Absorption and Variable Costing

  • Absorption Costing Format:

    • Sales

    • Less Cost of Goods Sold (COGS) = Gross Margin

    • Less Selling & Administrative Expenses = Net Operating Income

  • Variable Costing Format:

    • Sales

    • Less Variable Costs = Contribution Margin

    • Less Fixed Expenses = Net Operating Income

Higher Values of Net Operating Income

  • Differences in net operating income between variable and absorption costing may not necessarily align.

Income Statement Example for Harvey Company

  • Given Information:

    • Units Sold: 20,000

    • Selling Price per Unit: $30

    • No initial inventory.

Absorption Costing Calculation:

  • Sales:
    20,000 ext{ units} imes 30 = 600,000

  • COGS:
    20,000 ext{ units} imes 16 = 320,000

  • Gross Margin: 280,000

  • Less Selling & Administrative Expenses:

    • Variable: 20,000 ext{ units} imes 3 = 60,000

    • Fixed: 100,000

  • Net Operating Income:
    280,000 - 160,000 = 120,000

Variable Costing Calculation:

  • Sales:
    20,000 ext{ units} imes 30 = 600,000

  • Less Variable Expenses:

    • Variable COGS: 20,000 ext{ units} imes 10 = 200,000

    • Variable Selling & Administrative Expenses: 20,000 ext{ units} imes 3 = 60,000

  • Total Variable Expenses: 260,000

  • Contribution Margin: 600,000 - 260,000 = 340,000

  • Less Fixed Expenses:

    • Fixed Manufacturing Overhead: 150,000

    • Fixed Selling & Administrative Expenses: 100,000

  • Net Operating Income:
    340,000 - 250,000 = 90,000

Reconciliation of Income:

  • Variable Costing Net Operating Income: 90,000

  • Add: Deferred Fixed Overhead Costs in Inventory:

    • 5,000 ext{ units} imes 6 = 30,000

  • Absorption Costing Net Operating Income: 120,000

Explanation for Differences

  • The variance arises from the treatment of fixed manufacturing overhead costs: under variable costing, they are expensed in the period incurred. Under absorption costing, they are allocated to products and associated with inventory.

Extended Comparison Example: Harvey Company - Year Two

  • Sales: 30,000 units

  • Selling Price: $30 each

  • Analysis of Income:

    • For both costing methods, compute net operating income using similar methods as shown in initial examples.

Example Case: Maximus Corp

  • Description: Shows effects of fixed manufacturing overhead and how it is allocated (5,000 units produced) on income reporting under both costing strategies.

Summary of Key Insights

  • Recognize fundamental differences between variable and absorption costing.

  • Understand unit computation implications on inventory values and net income reporting.

  • Importance of reconciling net operating income to understand financial positions.