Variable Costing:

A Tool for Management

Chapter 7
Overview of Absorption
and Variable Costing
Absorption Variable
Costing Costing
Direct Materials
Product
Product Direct Labor
Costs
Costs Variable Manufacturing Overhead

Fixed Manufacturing Overhead

Period
Period Variable Selling and Administrative Expenses
Costs
Costs Fixed Selling and Administrative Expenses
Quick Check 
Which
Which method
method will
will produce
produce the
the highest
highest values
values for
for work
work
in
in process
process and
and finished
finished goods
goods inventories?
inventories?
a.
a. Absorption
Absorption costing.
costing.
b.
b. Variable
Variable costing.
costing.
c.
c. They
They produce
produce the the same
same values
values for
for these
these
inventories.
inventories.
d.
d. ItIt depends.
depends. .. ..
Quick Check 
Which
Which method
method will
will produce
produce the
the highest
highest values
values for
for work
work
in
in process
process and
and finished
finished goods
goods inventories?
inventories?
a.
a. Absorption
Absorption costing.
costing.
b.
b. Variable
Variable costing.
costing.
c.
c. They
They produce
produce the the same
same values
values for
for these
these
inventories.
inventories.
d.
d. ItIt depends.
depends. .. ..
Unit Cost Computations
Harvey Company produces a single product
with the following information available:

Number of units produced annually 25,000

Variable costs per unit:
Direct materials, direct labor,
and variable mfg. overhead $ 10
Selling & administrative expenses $ 3

Fixed costs per year:

Manufacturing overhead $ 150,000
Selling & administrative expenses $ 100,000
Unit Cost Computations
Unit product cost is determined as follows:
Absorption Variable
Costing Costing
Direct materials, direct labor,
and variable mfg. overhead $ 10 $ 10
Fixed mfg. overhead
($150,000 ÷ 25,000 units) 6 -
Unit product cost $ 16 $ 10

Under absorption costing, selling and administrative

expenses are
always treated as period expenses and deducted from
revenue as incurred.
Income Comparison of
Absorption and Variable Costing
Let’s assume the following additional information for
Harvey Company.
• 20,000 units were sold during the year at a price of $30 each.
• There were no units in beginning inventory.

Now, let’s compute net operating

income using both absorption
and variable costing.
Absorption Costing

Absorption Costing
Sales (20,000 × $30) $ 600,000
Less cost of goods sold:
Beginning inventory $ -
Add COGM (25,000 × $16) 400,000
Goods available for sale 400,000
Ending inventory (5,000 × $16) 80,000 320,000
Gross margin 280,000
Less selling & admin. exp.
Variable (20,000 × $3) $ 60,000
Fixed 100,000 160,000
Net operating income $ 120,000
Variable Costing
Variable
manufacturing
Variable Costing
costs only.
Sales (20,000 × $30) $ 600,000
Less variable expenses:
Beginning inventory $ -
Add COGM (25,000 × $10) 250,000
All fixed
Goods available for sale 250,000 manufacturing
Less ending inventory (5,000 × $10) 50,000 overhead is
Variable cost of goods sold 200,000 expensed.
Variable selling & administrative
expenses (20,000 × $3) 60,000 260,000
Contribution margin 340,000
Less fixed expenses:
Manufacturing overhead $ 150,000
Selling & administrative expenses 100,000 250,000
Net operating income $ 90,000
Comparing the Two Methods
Cost of
Goods Ending Period
Sold Inventory Expense Total
Absorption costing
Variable mfg. costs $ 200,000 $ 50,000 $ - $ 250,000
Fixed mfg. costs 120,000 30,000 - 150,000
$ 320,000 $ 80,000 $ - $ 400,000

Variable costing
Variable mfg. costs $ 200,000 $ 50,000 $ - $ 250,000
Fixed mfg. costs - - 150,000 150,000
$ 200,000 $ 50,000 $ 150,000 $ 400,000
Comparing the Two Methods
We can reconcile the difference between
absorption and variable income as follows:

Variable costing net operating income $ 90,000

Add: Fixed mfg. overhead costs
deferred in inventory
(5,000 units × $6 per unit) 30,000
Absorption costing net operating income $ 120,000

Fixed mfg. Overhead $150,000

= = $6.00 per unit
Units produced 25,000 units
Extended Comparisons of Income Data Harvey Company Year
Two
Number of units produced 25,000
Number of units sold 30,000
Units in beginning inventory 5,000
Unit sales price $ 30
Variable costs per unit:
Direct materials, direct labor
variable mfg. overhead $ 10
Selling & administrative
expenses $ 3
Fixed costs per year:
Manufacturing overhead $ 150,000
Selling & administrative
expenses $ 100,000
Unit Cost Computations
Absorption Variable
Costing Costing
Direct materials, direct labor,
and variable mfg. overhead $ 10 $ 10
Fixed mfg. overhead
($150,000 ÷ 25,000 units) 6 -
Unit product cost $ 16 $ 10

Since there was no change in the variable costs

per unit, total fixed costs, or the number of
units produced, the unit costs remain unchanged.
Absorption Costing
Absorption Costing
Sales (30,000 × $30) $ 900,000
Less cost of goods sold:
Beg. inventory (5,000 × $16) $ 80,000
Add COGM (25,000 × $16) 400,000
Goods available for sale 480,000
Less ending inventory - 480,000
Gross margin 420,000
Less selling & admin. exp.
Variable (30,000 × $3) $ 90,000
Fixed 100,000 190,000
Net operating income $ 230,000

These are the 25,000 units

produced in the current period.
Variable Costing Variable
manufacturing
costs only. Variable Costing
Sales (30,000 × $30) $ 900,000
Less variable expenses:
Beg. inventory (5,000 × $10) $ 50,000
Add COGM (25,000 × $10) 250,000 All fixed
Goods available for sale 300,000
manufacturing
Less ending inventory -
overhead is
Variable cost of goods sold 300,000
expensed.
Variable selling & administrative
expenses (30,000 × $3) 90,000 390,000
Contribution margin 510,000
Less fixed expenses:
Manufacturing overhead $ 150,000
Selling & administrative expenses 100,000 250,000
Net operating income $ 260,000
Comparing the Two Methods
We can reconcile the difference between
absorption and variable income as follows:

Variable costing net operating income $ 260,000

Deduct: Fixed manufacturing overhead
costs released from inventory
(5,000 units × $6 per unit) 30,000
Absorption costing net operating income $ 230,000

Fixed mfg. Overhead $150,000

= = $6.00 per unit
Units produced 25,000 units
Comparing the Two Methods

Costing Method 1st Period 2nd Period Total

Absorption $ 120,000 $ 230,000 $ 350,000
Variable 90,000 260,000 350,000
Summary of Key Insights
Relation between Effect Relation between
production on variable and
and sales iniventory absorption income
Inventory Absorption
Production > Sales increases >
Variable
Inventory Absorption
Production < Sales decreases <
Variable
Absorption
Production = Sales No change =
Variable
Effect of Changes in Production
on Net Operating Income
Let’s
Let’srevise
revisethe
theHarvey
HarveyCompany
Companyexample.
example.

In the previous example,

25,000 units were produced each year,
but sales increased from 20,000 units in year
one to 30,000 units in year two.

In this revised example,

production will differ each year while
sales will remain constant.
Effect of Changes in Production
Harvey Company Year One
Number of units produced 30,000
Number of units sold 25,000
Unit sales price $ 30
Variable costs per unit:
Direct materials, direct labor
variable mfg. overhead $ 10
Selling & administrative
expenses $ 3
Fixed costs per year:
Manufacturing overhead $ 150,000
Selling & administrative
expenses $ 100,000
Unit Cost Computations for Year One
Unit product cost is determined as follows:

Absorption Variable
Costing Costing
Direct materials, direct labor,
and variable mfg. overhead $ 10 $ 10
Fixed mfg. overhead
($150,000 ÷ 30,000 units) 5 -
Unit product cost $ 15 $ 10

Since
Sincethe
thenumber
numberofofunits
unitsproduced
producedincreased
increased
in
inthis
thisexample,
example,while
whilethe
thefixed
fixedmanufacturing
manufacturingoverhead
overhead
remained
remainedthethesame,
same,the
theabsorption
absorptionunit
unitcost
costisisless.
less.
Absorption Costing: Year One

Absorption Costing
Sales (25,000 × $30) $ 750,000
Less cost of goods sold:
Beginning inventory $ -
Add COGM (30,000 × $15) 450,000
Goods available for sale 450,000
Ending inventory (5,000 × $15) 75,000 375,000
Gross margin 375,000
Less selling & admin. exp.
Variable (25,000 × $3) $ 75,000
Fixed 100,000 175,000
Net operating income $ 200,000
Variable Costing: Year One
Variable
manufacturing
Variable Costing
costs only.
Sales (25,000 × $30) $ 750,000
Less variable expenses:
Beginning inventory $ -
Add COGM (30,000 × $10) 300,000
All fixed
Goods available for sale 300,000 manufacturing
Less ending inventory (5,000 × $10) 50,000 overhead is
Variable cost of goods sold 250,000 expensed.
Variable selling & administrative
expenses (25,000 × $3) 75,000 325,000
Contribution margin 425,000
Less fixed expenses:
Manufacturing overhead $ 150,000
Selling & administrative expenses 100,000 250,000
Net operating income $ 175,000
Effect of Changes in Production
Harvey Company Year Two
Number of units produced 20,000
Number of units sold 25,000
Units in beginning inventory 5,000
Unit sales price $ 30
Variable costs per unit:
Direct materials, direct labor
variable mfg. overhead $ 10
Selling & administrative
expenses $ 3
Fixed costs per year:
Manufacturing overhead $ 150,000
Selling & administrative
expenses $ 100,000
Unit Cost Computations for Year Two
Unit product cost is determined as follows:

Absorption Variable
Costing Costing
Direct materials, direct labor,
and variable mfg. overhead $ 10 $ 10
Fixed mfg. overhead
($150,000 ÷ 20,000 units) 7.50 -
Unit product cost $ 17.50 $ 10

Since
Sincethe
thenumber
numberof ofunits
unitsproduced
produceddecreased
decreasedin inthe
the
second
secondyear,
year,while
whilethe
thefixed
fixedmanufacturing
manufacturingoverhead
overhead
remained
remainedthe
thesame,
same,the
theabsorption
absorptionunit
unitcost
costisisnow
nowhigher.
higher.
Absorption Costing: Year Two
Absorption Costing
Sales (25,000 × $30) $ 750,000
Less cost of goods sold:
Beg. inventory (5,000 × $15) $ 75,000
Add COGM (20,000 × $17.50) 350,000
Goods available for sale 425,000
Less ending inventory - 425,000
Gross margin 325,000
Less selling & admin. exp.
Variable (25,000 × $3) $ 75,000
Fixed 100,000 175,000
Net operating income $ 150,000

These are the 20,000 units produced in the current

period at the higher unit cost of $17.50 each.
Variable Costing: Year Two
Variable
manufacturing
costs only. Variable Costing
Sales (25,000 × $30) $ 750,000
Less variable expenses:
Beg. inventory (5,000 × $10) $ 50,000
Add COGM (20,000 × $10) 200,000 All fixed
Goods available for sale 250,000
manufacturing
Less ending inventory -
overhead is
Variable cost of goods sold 250,000
expensed.
Variable selling & administrative
expenses (25,000 × $3) 75,000 325,000
Contribution margin 425,000
Less fixed expenses:
Manufacturing overhead $ 150,000
Selling & administrative expenses 100,000 250,000
Net operating income $ 175,000
Comparing the Two Methods

Costing Method Year One Year Two Total

Absorption $ 200,000 $ 150,000 $ 350,000
Variable 175,000 175,000 350,000

Conclusions
 Net operating income is not affected by changes in
production using variable costing.
 Net operating income is affected by changes in production
using absorption costing even though the number of units
sold is the same each year.
Impact on the Manager
Opponents
Opponentsof ofabsorption
absorptioncosting
costingargue
arguethat
that
shifting
shiftingfixed
fixedmanufacturing
manufacturingoverhead
overheadcosts
costs
between
betweenperiods
periodscan
canlead
leadto
tofaulty
faultydecisions.
decisions.

These
Theseopponents
opponentsargue
arguethat
thatvariable
variablecosting
costingincome
income
statements
statementsareareeasier
easierto
tounderstand
understandbecause
becausenetnetoperating
operating
income
incomeisisonly
onlyaffected
affectedby
bychanges
changesininunit
unitsales.
sales.This
This
produces
producesnet
netoperating
operatingincome
incomefigures
figuresthat
thatare
are
more
moreconsistent
consistentwith
withmanagers’
managers’expectations.
expectations.
CVP Analysis, Decision Making
and Absorption costing
Absorption costing does not support CVP analysis
because it essentially treats fixed manufacturing
overhead as a variable cost by assigning a per unit
amount of the fixed overhead to each unit of production.

Treating
Treatingfixed
fixedmanufacturing
manufacturingoverhead
overheadas asaa
variable
variablecost
costcan:
can:
•• Lead
Leadto
tofaulty
faultypricing
pricingdecisions
decisionsandandkeep-or-drop
keep-or-drop
decisions.
decisions.
•• Produce
Producepositive
positivenet
netoperating
operatingincome
incomeeveneven
when
whenthethenumber
numberof ofunits
unitssold
soldisisless
lessthan
thanthe
the
breakeven
breakevenpoint.
point.
External Reporting and Income Taxes
To
Toconform
conformtoto
IFRS
IFRSrequirements,
requirements,
absorption
absorptioncosting
costingmust
mustbebeused
usedfor
for
external
externalfinancial
financialreports
reportsin
inthe
the
United
UnitedStates.
States.

Since
Sincetop
topexecutives
executives
are
areusually
usuallyevaluated
evaluatedbased
basedonon
external
externalreports
reportsto
toshareholders,
shareholders,
they
theymay
mayfeel
feelthat
thatdecisions
decisions
should
shouldbebebased
basedon
on
absorption
absorptioncost
costincome.
income.
Advantages of Variable Costing
and the Contribution Approach
Consistent with
CVP analysis.
Management finds Net operating income
it more useful. is closer to
net cash flow.
Consistent with standard
costs and flexible budgeting.
Advantages
Easier to estimate profitability
of products and segments.
Impact of fixed
costs on profits Profit is not affected by
emphasized. changes in inventories.
Variable versus Absorption Costing
Fixed manufacturing
costs must be assigned Fixed manufacturing
to products to properly costs are capacity costs
match revenues and and will be incurred
costs. even if nothing is
produced.

Absorption Variable
Costing Costing
Impact of JIT Inventory Methods
In a JIT inventory system . . .

Production
tends to equal
sales . . .

So, the difference between variable and

absorption income tends to disappear.