Chapter 8

Variable Costing
and the Costs of
Quality and
Sustainability

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 Absorption and Variable Costing
Absorption Variable
Costing Costing

Direct materials
Direct labor Product costs
Product costs Variable mfg. overhead

Fixed mfg. overhead

Period costs
Period costs Selling & Admin. exp.

8-2
 Absorption and Variable Costing
Absorption Variable
Costing Costing

Direct materials
Direct labor Product costs
Product costs Variable mfg. overhead

Fixed mfg. overhead

Period costs
Period costs Selling & Admin. exp.

The difference between absorption and variable

costing is the treatment of fixed manufacturing overhead.
8-3
Absorption and Variable Costing
Mellon Co. 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:
Mfg. overhead $ 150,000
Selling & administrative
expenses $ 100,000

8-4
Absorption and Variable Costing
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

Selling and administrative expenses are

always treated as period expenses and
deducted from revenue.
8-5
 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) $ 600,000
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

8-6
 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) $ 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
Fixed
Net income

8-7
 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) $ 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 income $ 120,000

8-8
Variable Costing
Income Statements
Now lets look at variable costing by Mellon Co.

Variable Costing
Sales (20,000 $30) $ 600,000
Less variable expenses:
Beginning inventory $ -
Add COGM
Goods available for sale
Ending inventory
Variable cost of goods sold
Variable selling & administrative
expenses
Contribution margin
Less fixed expenses:
Manufacturing overhead
Selling & administrative expenses
Net income

8-9
Variable Costing
Income Statements
Now lets look at variable costing by Mellon Co.
We exclude the
fixed manufacturing
Variable Costing
Sales (20,000 $30) $ 600,000
Less variable expenses: overhead.
Beginning inventory $ -
Add COGM (25,000 $10) 250,000
Goods available for sale $ 250,000
Ending inventory (5,000 $10) 50,000
Variable cost of goods sold $ 200,000
Variable selling & administrative
expenses
Contribution margin
Less fixed expenses:
Manufacturing overhead
Selling & administrative expenses
Net income

8-10
Variable Costing
Income Statements
Now lets look at variable costing by Mellon Co.

Variable Costing
Sales (20,000 $30) $ 600,000
Less variable expenses:
Beginning inventory $ -
Add COGM (25,000 $10) 250,000
Goods available for sale $ 250,000
Ending inventory (5,000 $10) 50,000
Variable cost of goods sold $ 200,000
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 income $ 90,000

8-11
Reconciling Income Under
Absorption and Variable Costing
We can reconcile the difference between absorption
and variable net income as follows:

Variable costing net income $ 90,000

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

Fixed mfg. overhead $150,000

= = $6.00 per unit
Units produced 25,000
8-12
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.

8-13
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 25,000
Variable costs per unit:
Direct materials, direct labor
and variable mfg. overhead $ 10
Selling & administrative
expenses $ 3
Fixed costs per year:
Mfg. overhead $ 150,000
Selling & administrative
expenses $ 100,000

8-14
Mellon Co. Year 2
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

There has been no

change in Mellons
cost structure. 8-15
Mellon Co. Year 2
Units in ending inventory from the previous period.
Absorption Costing
Sales (30,000 $30) $ 900,000
Less cost of goods sold:
Beg. inventory (5,000 x $16) $ 80,000
Add COGM (25,000 $16) 400,000
Goods available for sale $ 480,000
Ending inventory - 480,000
Gross margin $ 420,000
Less selling & admin. exp.
Variable (30,000 $3) $ 90,000
Fixed 100,000 190,000
Net income $ 230,000

8-16
Mellon Co. Year 2

Absorption Costing
Sales (30,000 $30) $ 900,000
Less cost of goods sold:
Beg. inventory (5,000 x $16) $ 80,000
Add COGM (25,000 $16) 400,000
Goods available for sale $ 480,000
Ending inventory - 480,000
Gross margin $ 420,000
Less selling & admin. exp.
Variable (30,000 $3) $ 90,000
Fixed 100,000 190,000
Net income $ 230,000

25,000 units produced in the current period.

8-17
Mellon Co. Year 2
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
Goods available for sale $ 300,000
Ending inventory -
Variable cost of goods sold $ 300,000
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 income $ 260,000

Excludes fixed manufacturing overhead.

8-18
Summary
Income Comparison

Costing Method 1st Period 2nd Period Total

Absorption $ 120,000 $ 230,000 $ 350,000
Variable 90,000 260,000 350,000

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).
8-19
Summary
Income Comparison

Costing Method 1st Period 2nd Period Total

Absorption $ 120,000 $ 230,000 $ 350,000
Variable 90,000 260,000 350,000

For the two-year period, total absorption

income and total variable income are the same.

8-20
Evaluation of Variable Costing
Management finds it Consistent with
easy to understand. CVP analysis.

Emphasizes contribution in
Advantages short-run pricing decisions.

Impact of fixed Profit for period not

costs on profits affected by changes
emphasized. in fixed mfg. overhead.
8-21
Evaluation of Absorption Costing
Fixed manufacturing overhead is
treated the same as the other product
costs, direct material and direct labor.

Consistent with long-run

Advantages pricing decisions that must
cover full cost.

External reporting
and income tax law
require absorption costing.
8-22
 Costs of Assuring Quality
Grade Quality

Grade refers to the

extent of its Quality of design refers
capabilities in to how well it is conceived
or designed for its
performing an intended use.
intended purpose, in Quality of conformance
relation to other refers to the extent to
products with the which a product meets
same functional use. the specification of its
design.

8-23
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.
8-24
What is the Optimal Level
of Product Quality?

The optimal level of product quality is reached when:

Prevention costs = Internal failure costs

+ Appraisal costs + External failure costs

8-25
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.
8-26
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.

8-27
 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.
8-28