Variable Costing: A Tool for

Management
 Learning Objectives
• Explain how variable costing differs from absorption costing
• Compute the unit product cost under each method
• Prepare income statements using variable and absorption
costing, and reconcile the two income figures
• Describe how fixed overhead costs are deferred in, and
released from, inventory under absorption costing
• Explain the advantages and limitations of variable and
absorption costing
• Prepare a segmented income statement and use it.
• Compute companywide and segment break-even points.
• Prepare income statements using super-variable costing and
reconcile this approach with variable costing.
 Variable Vs. Absorption Costing

Variable Absorption
Costing Costing
Direct Materials
Product
Direct Labor Product
Costs
Variable Manufacturing Overhead Costs
Fixed Manufacturing Overhead
Period
Variable Selling and Administrative Expenses Period
Costs
Fixed Selling and Administrative Expenses Costs
 Quick Test

• Which method will produce the highest values

for work in process and finished goods
inventories?
a. Absorption costing.
b. Variable costing.
c. They produce the same values for these
inventories.
d. It depends. . .
 Quick Test

• Which method will produce the highest values

for work in process and finished goods
inventories?
a. Absorption costing.
b. Variable costing.
c. They produce the same values for these
inventories.
d. It depends. . .
 Variable Vs. Absorption Costing Example

Mickey produces a product with a selling price of $100/unit.

The following information is available for the first year.

Number of units produced this year 40,000

Number of units sold this year 35,000
Variable costs per unit:
Direct materials, direct labor,
and variable mfg. overhead $ 40
Selling & administrative expenses $ 6
Fixed costs per year:
Manufacturing overhead $ 1,000,000
Selling & administrative expenses $ 290,000
 Unit Cost Calculations

Selling and administrative expenses are

always treated as period costs.
Income Statement – Absorption Costing
Fixed
Full mfg.
manufacturing
costs
Sales (35,000 × $100) overhead is
$ 3,500,000
Less cost of goods sold: allocated
Beginning inventory $ -
Add COGM (40,000 × $65) 2,600,000
Goods available for sale 2,600,000
Ending inventory (5,000 × $65) 325,000 2,275,000
Gross margin 1,225,000
Less selling & admin. exp.
Variable (35,000 x $6) $ 210,000
Fixed 290,000 500,000
Net income $ 725,000
Income Statement – Variable Costing
Variable
mfg. costs
only

All fixed
manufacturing
overhead is
expensed
Variable Vs. Absorption Costing Example

In its second year of operation, Mickey accumulated

the following information:
Number of units produced this year 40,000
Number of units sold this year 42,000
Variable costs per unit:
Direct materials, direct labor,
and variable mfg. overhead $ 40
Selling & administrative expenses $ 6
Fixed costs per year:
Manufacturing overhead $ 1,000,000
Selling & administrative expenses $ 290,000
 Unit Cost Calculations

Absorption Variable
Costing Costing
Direct materials, direct labor,
and variable mfg. overhead $ 40 $ 40
Fixed mfg. overhead
($1000,000 ÷ 40,000 units) 25 -
Unit product cost $ 65 $ 40

Selling and administrative expenses are

always treated as period costs.
Income Statement – Absorption Costing
Full mfg. Fixed
costs manufacturing
Sales (42,000 × $100) overhead is
$ 4,200,000
Less cost of goods sold: allocated
Beginning inven. (5,000 x $65) $ 325,000
Add COGM (40,000 × $65) 2,600,000
Goods available for sale 2,925,000
Ending inven. (3,000 × $65) 195,000 2,730,000
Gross margin 1,470,000
Less selling & admin. exp.
Variable (42,000 x $6) $ 252,000
Fixed 290,000 542,000
Net income $ 928,000
Income Statement – Variable Costing
Variable
mfg. costs
only

All fixed
manufacturing
overhead is
expensed
 Notes
• If production > sales (inventory level increases),
income (absorption) > income (variable).
– Fixed overhead is partially deferred in
inventory under absorption costing.
• If production < sales (inventory level decreases),
income (absorption) < income (variable).
– Deferred fixed overhead is released to income
statement under absorption costing.
• If production = sales (inventory level is the same),
Income (absorption) = Income (variable).
 Reconciliation
• In general, the difference in income between
absorption and variable costing is the change in
inventory value under absorption minus the
change in inventory value under variable costing.
• However, if unit cost does not change (or if there
is no beginning inventory), then:
– Income (absorption) - Income (variable) =
Fixed overhead per unit * Change in inventory
level
– where, change in inventory level =
production - sales, or EI - BI, in units.
 Reconciliation
We can reconcile the difference between
absorption and variable income as follows:
 Reconciliation
Alternatively, we can reconcile the differences
between absorption and variable income as follows:
 Arguments For Variable Costing
• Should we allocate Fixed overhead to units of
output?
– Is fixed overhead a product cost (an asset) or a
period cost (an expense)?
• Variable costing approach blends well (ties in) with
CVP analysis, budgeting, segment reporting, etc.
• Income under absorption costing may be
manipulated by changing the production level.
• In 1970s and 1980s, variable costing was used for
internal use, but the trend is reversing because fixed
overhead is becoming a major part of product cost.
 Impact of JIT Inventory System
In a JIT inventory system . . .

production
tends to equal
sales . . .

So, the difference between variable and

absorption income tends to disappear.
 Segment – Definition and Overview

• A segment is any part of an entity for which it is

useful to collect revenue, cost, or profit data.
• A segment can be

A Sales Territory A Service Center A Customer

Dental
Dental office
office
 Segment Reporting
• Segment reporting refers to reports (income
statements) that focus on various segments of an
entity.
• The objective of segment reporting is to provide
information on the profitability of segments.
• An entity can be segmented based on:
– a single criterion at a time (e.g., product lines,
products, sales territories)
– multiple criteria, or
– a combination.
 Segmenting an Entity – Example

Regal Company Produc

t
Lines
C o m p u te r A p p lia n c e T e le v is io n
D iv is io n D iv is io n D iv is io n Products

R e g u la r B ig S c r e e n

U .S . S a le s F o r e ig n S a le s U .S . S a le s F o r e ig n S a le s

Sales
Territories
 Segment Income Statement
• Segment income statement follows the
contribution approach.
• The fixed costs are, however, further divided into
traceable and common.
– Traceable (Direct) costs of a segment are costs
that are directly related to that segment or can
be reasonably allocated to it.
– Common (Indirect) costs are costs that are not
directly related to any segment and cannot be
reasonably allocated to segments.
 Identifying Traceable Fixed Costs

Traceable costs would disappear over time if the

segment itself disappeared.
No computer No computer
division means . . . division manager
 Identifying Common Fixed Costs

Common costs would not disappear if the

segment were eliminated.

No computer We still have a

division but . . . company president.
 Segment Income Statement

Company Television Appliance Computer

Sales $600,000 $300,000 $100,000 $200,000
Variable CGS (215,000) ( 90,000) (75,000) (50,000)
Other V.C. (100,000) ( 60,000) (10,000) (30,000)
Contribution margin 285,000 150,000 15,000 120,000
Traceable F.C. (180,000) ( 90,000) (10,000) ( 80,000)
Segment margin 105,000 60,000 5,000 40,000
Common F.C. ( 25,000)
Net Income 80,000
 Segment Income Statement
• Each segment is charged only for its traceable costs.
Common costs of the organization are not
charged/allocated to segments.
• Traceable costs can become common if the company is
divided into smaller segments.
• Contribution margin data is useful as a short-term
planning tool since it:
– reveals the effect of a change in sales volume on
income
– facilitates decisions on temporary uses of capacity,
special orders, and product promotion
 Segment Income Statement
• Segment margin represents the amount that the
segment contributes toward the recovery of the
common F.C. and then earning a profit.
• Segment margin is the best gauge of the long-run
profitability of a segment. It is useful for:
– long-run capacity changes and pricing decisions
– evaluating segments’ performance (i.e., decisions to
retain or eliminate segments)
– evaluating segment managers’ performance (some
would argue that committed FC should be excluded)
Quick Test
 Quick Test

• How much of the common fixed cost of $200,000

can be avoided by eliminating the bar?
a. None of it.
b. Some of it.
c. All of it.
 Quick Test

• How much of the common fixed cost of $200,000

can be avoided by eliminating the bar?
a. None of it.
b. Some of it.
c. All of it.
 Hindrances of Proper Cost Assignment

• Omission of some costs in the assignment process

– All costs, manufacturing or not, should be assigned.
• Use of inappropriate methods for cost allocation
– Traceable costs should not be allocated.
– Costs that are not easily traceable should not be
allocated on an arbitrary basis.
– Allocation base should be appropriate.
• Assignment of common costs of the organization
– Common cost of the organization arise because of
overall operating activities and should not be assigned.
 Companywide and Segment
Break-Even Points
• Companywide break-even point is computed by
dividing the sum of the company’s traceable fixed
expenses and common fixed expenses by the
company’s overall contribution margin ratio.
• A segment’s break-even point is computed by
dividing its traceable fixed expenses by its
contribution margin ratio.
 Variable vs. Super-Variable Costing
• Super-variable costing classifies all direct labor
and manufacturing overhead costs as fixed period
costs and only direct materials as a variable
product cost.
Super-
Variable Variable
Costing Costing
Product
Product Direct Materials
Cost
Costs Direct Labor
Period
Period Fixed Manufacturing Overhead
Costs
Costs Fixed Selling and Administrative Expenses