MA10e IPPTChap008

CHAPTER 8
Variable Costing
and the Costs of
Quality and
Sustainability
Copyright 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Learning Objective 1
8-2
8-2
Absorption Costing
A system of accounting for costs in which both
fixed and variable production costs are
considered product costs.
Fixed
Costs
Product
Variable
Costs
8-3
Variable Costing
A system of cost accounting that only assigns
the variable cost of production to products.
Fixed
Costs
Product
Variable
Costs
8-4
Absorption and Variable Costing

Absorption
Costing
Product costs
Variable
Costing
Direct materials
Direct labor
Variable mfg. overhead
Product costs
Fixed mfg. overhead

Period costs
Period costs
Selling & Admin. exp.
8-5

Absorption
Costing
Product costs
Variable
Costing
Direct materials
Direct labor
Variable mfg. overhead
Product costs
Fixed mfg. overhead

Period costs
Period costs
Selling & Admin. exp.
The difference between absorption and variable

costing is the treatment of fixed manufacturing overhead.
8-6
8-7

Lets put some numbers to an example and
see what we can learn about the difference
between absorption and variable costing.
8-8

Mellon Co. produces a single product with
the following information available:
Number of units produced annually
Variable costs per unit:
Direct materials, direct labor
and variable mfg. overhead
Selling & administrative
expenses
Fixed costs per year:
Mfg. overhead
expenses
25,000
10
$ 150,000
$ 100,000
8-9

Unit product cost is determined as follows:
Direct materials, direct labor, and

variable mfg. overhead
Fixed mfg. overhead
($150,000 25,000 units)
Unit product cost
Absorption
Costing
Variable
Costing
10
10
6
16
10
Selling and administrative expenses are

always treated as period expenses and
deducted from revenue.
8-10
Absorption Costing
Income Statements
Mellon Co. had no beginning inventory, produced 25,000
units, and sold 20,000 units this year at $30 each.
Absorption Costing
Sales (20,000 $30)
Less cost of goods sold:
Beginning inventory
Add COGM
Goods available for sale
Ending inventory
Gross margin
Less selling & admin. exp.
Variable
Fixed
Net income
$ 600,000
8-11
Absorption Costing
Income Statements
Absorption Costing
Sales (20,000 $30)
Beginning inventory
$
Add COGM (25,000 $16)
400,000
$ 400,000
Ending inventory (5,000 $16)
80,000
Gross margin
Variable
Fixed
Net income
$ 600,000
320,000
$ 280,000
8-12
Absorption Costing
Income Statements
Absorption Costing
Sales (20,000 $30)
Beginning inventory
$
Add COGM (25,000 $16)
400,000
$ 400,000
80,000
Gross margin
Variable (20,000 $3)
$ 60,000
Fixed
100,000
Net income
$ 600,000
320,000
$ 280,000
160,000
$ 120,000
8-13
8-14
Variable Costing
Income Statements
Now lets look at variable costing by Mellon Co.
Variable Costing
Sales (20,000 $30)
Less variable expenses:
Beginning inventory
$
Add COGM
Ending inventory
Variable cost of goods sold
Variable selling & administrative
expenses
Contribution margin
Less fixed expenses:
Manufacturing overhead
Selling & administrative expenses
Net income
$ 600,000
-
8-15
Variable Costing
Income Statements
We exclude the
Variable
Costing
fixed
manufacturing
$ 600,000
overhead.
Sales (20,000 $30)

Beginning inventory
$
Add COGM (25,000 $10)
250,000
$ 250,000
50,000
$ 200,000
expenses
Contribution margin
Net income
8-16
Variable Costing
Income Statements
Variable Costing
Sales (20,000 $30)
Beginning inventory
Add COGM (25,000 $10)
expenses (20,000 $3)
Contribution margin
Net income
$ 600,000
$
250,000
$ 250,000
50,000
$ 200,000
60,000
$ 150,000
100,000
260,000
$ 340,000
250,000
$ 90,000
8-17
Comparing Absorption and

Variable Costing
Lets compare the methods.
Cost of
Goods
Sold
Ending
Inventory
Period
Expense
Total
Absorption costing
Variable mfg. costs $ 200,000
Fixed mfg. costs
120,000
$ 320,000
Variable costing
Fixed mfg. costs
$ 200,000
8-18

Variable Costing
Cost of
Goods
Sold
Ending
Inventory
Period
Expense
Absorption costing
Fixed mfg. costs
120,000
$ 320,000
$ 50,000
30,000
$ 80,000
Variable costing
Fixed mfg. costs
$ 200,000
$ 50,000
$ 50,000
Total
150,000
$ 150,000
8-19

Variable Costing
Cost of
Goods
Sold
Ending
Inventory
Period
Expense
Absorption costing
Fixed mfg. costs
120,000
$ 320,000
$ 50,000
30,000
$ 80,000
Variable costing
Fixed mfg. costs
$ 200,000
$ 50,000
$ 50,000
150,000
$ 150,000
Total
$ 250,000
150,000
$ 400,000
$ 250,000
150,000
$ 400,000
8-20
8-21
Reconciling Income Under

We can reconcile the difference between absorption
and variable net income as follows:
Variable costing net income
Add: Fixed mfg. overhead costs
deferred in inventory
(5,000 units $6 per unit)
Absorption costing net income
Fixed mfg. overhead

$150,000
=
Units produced
25,000
90,000
30,000
120,000
= $6.00 per unit

8-22
8-23
Cost-Volume-Profit Analysis
CVP includes all fixed costs to compute
breakeven.
Variable costing and CVP are consistent as both
treat fixed costs as a lump sum.

Absorption costing defers fixed costs into
inventory.
Absorption costing is inconsistent with CVP
because absorption costing treats fixed costs on a

per unit basis.
8-24
8-25
Extending the Example
Lets look at
the second
year of
operations
for Mellon
Company.
8-26
Mellon Co. Year 2

In its second year of operations, Mellon Co. started
with an inventory of 5,000 units, produced 25,000
units, and sold 30,000 units at $30 each.
Number of units produced annually
Variable costs per unit:
Direct materials, direct labor
expenses
Fixed costs per year:
Mfg. overhead
expenses
25,000
10
$ 150,000
$ 100,000
8-27
Mellon Co. Year 2

Unit product cost is determined as follows:
Direct materials, direct labor,

Fixed mfg. overhead
($150,000 25,000 units)
Unit product cost
Absorption
Costing
Variable
Costing
10
10
6
16
10
There has been no

change in Mellons
cost structure.
8-28
Mellon Co. Year 2

Now lets look at Mellons income statement
assuming absorption costing is used.
8-29
Mellon Co. Year 2
Units in ending inventory from the previous period.

Absorption Costing
Sales (30,000 $30)

Beg. inventory (5,000 x $16)
Add COGM (25,000 $16)
Ending inventory
Gross margin
Fixed
Net income
$ 900,000
$ 80,000
400,000
$ 480,000
-
$ 90,000
100,000
480,000
$ 420,000
190,000
$ 230,000
8-30
Mellon Co. Year 2

Absorption Costing
Sales (30,000 $30)
Beg. inventory (5,000 x $16)
Add COGM (25,000 $16)
Ending inventory
Gross margin
Fixed
Net income
$ 900,000
$ 80,000
400,000
$ 480,000
-
$ 90,000
100,000
480,000
$ 420,000
190,000
$ 230,000
25,000 units produced in the current period.

8-31
Mellon Co. Year 2

Next, well look at Mellons income statement
assuming variable costing is used.
8-32
Mellon Co. Year 2

Variable Costing
Sales (30,000 $30)
Beg. inventory (5,000 $10)
Add COGM (25,000 $10)
Ending inventory
expenses (30,000 $3)
Contribution margin
Net income
$ 900,000
$
50,000
250,000
$ 300,000
$ 300,000
90,000
$ 150,000
100,000
390,000
$ 510,000
250,000
$ 260,000
Excludes fixed manufacturing overhead.

8-33
Summary
Income Comparison
Costing Method
Absorption
Variable
1st Period
$ 120,000
90,000
2nd Period
$ 230,000
260,000
Total
$ 350,000
350,000
In the first period, production (25,000 units)

was greater than sales (20,000).
In the second period, production (25,000 units)
was less than sales (30,000).
8-34
Summary
Income Comparison
Costing Method
Absorption
Variable
1st Period
$ 120,000
90,000
2nd Period
$ 230,000
260,000
Total
$ 350,000
350,000
For the two-year period, total absorption

income and total variable income are the same.
8-35
Summary
Lets see if we can get an overview of
what we have done.
8-36
Summary Comparison of
Absorption (AC) and Variable
Costing (VC)
This was the case in the first period when production

of 25,000 units was greater than sales of 20,000 units.
Inventory increased from zero to 5,000 units and
$120,000 absorption income was greater than
$90,000 variable income.
8-37
Costing (VC)
In the second period sales of 30,000 units

were greater than production of 25,000.
8-38
Costing (VC)
Inventory decreased from 5,000 units to zero,

and $230,000 absorption income was less
than $260,000 variable income.
8-39
Costing (VC)
Total
Production versus
Sales
Produced > Sold
Inventory
Effect
Increase
Period Expense Effect

Fixed mfg.
costs expensed
AC
Fixed mfg.
< costs expensed
VC
Profit Effect
AC > VC
Fixed mfg. unitsFixed

mfg.
For the two-year period,
produced
Produced < Sold
Decrease
expensed > costs expensed
AC <
equals units
sold, costs
so total
absorption
income
AC
VC
equals total variable income.
Produced = Sold
No change
Fixed mfg.
Fixed mfg.
costs expensed = costs expensed
AC
VC
VC
AC = VC
8-40
Evaluation of Variable Costing

Management finds it
easy to understand.
Advantages
Impact of fixed
costs on profits
emphasized.
Consistent with
CVP analysis.
Emphasizes contribution in
short-run pricing decisions.
Profit for period not

affected by changes
in fixed mfg. overhead.
8-41
Evaluation of Absorption Costing

Fixed manufacturing overhead is
treated the same as the other product
costs, direct material and direct labor.
Advantages
Consistent with long-run

pricing decisions that must
cover full cost.
External reporting
and income tax law
require absorption costing.
8-42
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.
8-43
8-44
Costs of Assuring Quality
Grade
Grade refers to the

extent of its
capabilities in
performing an
intended purpose, in
relation to other
products with the
same functional use.
Quality
Quality of design refers

to how well it is conceived
or designed for its
intended use.
Quality of conformance
refers to the extent to
which a product meets
the specification of its
design.
8-45
There are four types of quality costs.

Prevention costs are the costs of preventing
defects.
Appraisal costs are the costs of determining
whether defects exist.
Internal failure costs are the costs of repairing
defects found prior to product delivery.
External failure costs are those costs incurred
after product delivery.
8-46
8-47
8-47
What is the Optimal Level

of Product Quality?
The optimal level of product quality is reached when:

Prevention costs
+ Appraisal costs
Internal failure costs

+ External failure costs
8-48
ISO 9000 Standards

ISO 9000 standards require that a
company have a well-defined quality
control system in place and that the target
level of product quality is consistently
maintained.
These standards have been
adopted in the US and other
countries.
8-49
8-50
Costs of Environmental
Sustainability
Sustainable development includes business
activity that produces the goods and services

needed in the present without limiting the ability
of future generations to meet their meets.
Environmental costs are the costs of dealing
with environmental issues, such as BPs costs in
cleaning up the companys spill in the Gulf of
Mexico.
Environmental cost management is the
strategic implantation of systems for identifying,
measuring, controlling, and reducing the private
environmental costs borne by a company or
other organization.
8-51
Environmental costs may be

categorized in several ways:
Private environmental costs are those borne
by a company or individual. Social

environmental costs are those borne by the
public at large.
Visible environmental costs are those that
are known and clearly identified as tied to
environmental issues. Hidden social
environmental costs cannot be clearly tied to
environmental issues.
8-52
Visible and hidden environmental costs may be

further classified into one of three types.
Monitoring costs include the costs of monitoring the
regulatory environmental as well as monitoring the

production process to determine if pollution is being
generated.
Abatement costs include costs to reduce or eliminate
pollution.
Remediation costs include on-site and off-site
remediation costs. On-site remediation includes costs
of reducing or preventing the discharge into the
environment of pollutants that have been generated
in the production process. Off-site remediation
includes the costs of reducing or eliminating
pollutants from the environment after they have been
discharged.
8-53
End of Chapter 8
TheEnd
8-54

MA10e IPPTChap008

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

MA10e IPPTChap008

Uploaded by

Copyright:

Available Formats

CHAPTER 8

Absorption and Variable Costing

Fixed mfg. overhead

Selling & Admin. exp.

Absorption and Variable Costing

Fixed mfg. overhead

Selling & Admin. exp.

The difference between absorption and variable

Absorption and Variable Costing

Absorption and Variable Costing

Absorption and Variable Costing

Direct materials, direct labor, and

Selling and administrative expenses are

Now lets look at variable costing by Mellon Co.

Sales (20,000 $30)

Comparing Absorption and

Comparing Absorption and

Comparing Absorption and

Reconciling Income Under

Fixed mfg. overhead

= $6.00 per unit

treat fixed costs as a lump sum.

because absorption costing treats fixed costs on a

Extending the Example

Mellon Co. Year 2

Mellon Co. Year 2

Direct materials, direct labor,

There has been no

Mellon Co. Year 2

Mellon Co. Year 2

Units in ending inventory from the previous period.

Sales (30,000 $30)

Mellon Co. Year 2

25,000 units produced in the current period.

Mellon Co. Year 2

Mellon Co. Year 2

Excludes fixed manufacturing overhead.

In the first period, production (25,000 units)

For the two-year period, total absorption

This was the case in the first period when production

In the second period sales of 30,000 units

Inventory decreased from 5,000 units to zero,

Produced > Sold

Period Expense Effect

Fixed mfg. unitsFixed

Evaluation of Variable Costing

Profit for period not

Evaluation of Absorption Costing

Consistent with long-run

Impact of JIT Inventory

So, the difference between variable and

Costs of Assuring Quality

Grade refers to the

Quality of design refers

There are four types of quality costs.

What is the Optimal Level

The optimal level of product quality is reached when:

Internal failure costs

ISO 9000 Standards

activity that produces the goods and services

Environmental costs may be

by a company or individual. Social

Visible and hidden environmental costs may be