Variable Costing

A. Alternative Income Statement Presentations

1. Absorption Costing--under absorption costing all product costs are
assigned to the units produced and are expensed when the units are sold
a. Format--under absorption costing revenues are first reduced by all
product cost to arrive at an intermediate figure called gross
margin and then reduced by all period costs to arrive at a final
net income figure
Sales
- Cost of Goods Sold:
Direct Materials
Direct Labor
Variable Manufacturing Overhead
Fixed Manufacturing Overhead
= Gross Margin
- Selling and Administrative Expenses:
Variable Selling and Administrative Expenses
Fixed Selling and Administrative Expenses
= Net Income
b. Application--absorption costing is a more effective tool for long-
run decision making since it focuses attention on revenues and
total production costs
2. Variable Costing--under variable costing variable product costs are
assigned to the units produced and expensed when the units are sold and
fixed product costs are treated as period costs and expensed when
incurred
a. Format--under variable costing revenues are first reduced by all
variable costs to arrive at an intermediate figure called
contribution margin and then reduced by all fixed costs to arrive
at a final net income figure
Sales
- Variable Costs:
Variable Cost of Goods Sold:
Direct Materials
Direct Labor
Variable Manufacturing Overhead
Variable Selling and Administrative Expenses
= Contribution Margin
- Fixed Costs:
Fixed Manufacturing Overhead
Fixed Selling and Administrative Expenses
= Net Income
b. Application--variable costing is a more effective tool for short-
run decision making since it focuses on revenues and variable costs

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B. Comparison of Absorption Costing Versus Variable Costing
1. Production > Sales--if the number of units produced is greater than the
number of units sold, absorption costing will produce a higher net
income since the fixed manufacturing overhead costs assigned to the
increase in inventory will not be expensed during the current period
a. Illustration--a corporation uses a standard costing system;
standards are $1 per unit for direct materials, $7 per unit for
direct labor, $2 per unit for variable manufacturing overhead, and
$300,000 for fixed manufacturing overhead; normal capacity is
100,000 units; beginning inventory was 0 units; during the year
100,000 units were produced and 90,000 units were sold at $20 per
unit; during the year actual manufacturing costs were equal to
standard; during the year fixed selling and administrative expenses
were $200,000 and variable selling and administrative expenses were
$4 per unit
Absorption Costing:
Production Cost Per Unit = 1 + 7 + 2 + 300,000 / 100,000 = 13

Sales 1,800,000
(90,000 x 20)
Cost of Goods Sold at Standard 1,170,000
(90,000 x 13) _ _
Gross Margin 630,000
Selling and Administrative Expenses 560,000
(200,000 + 90,000 x 4) _ _
Net Income _ 70,000

Variable Costing:
Production Cost Per Unit = 1 + 7 + 2 = 10

Sales 1,800,000
(90,000 x 20)
Variable Costs:
Variable Cost of Goods Sold at Standard 900,000
(90,000 x 10)
Variable Selling and Administrative Expenses 360,000 1,260,000
(90,000 x 4) _ _ _ _
Contribution Margin 540,000
Fixed Costs:
Fixed Manufacturing Overhead 300,000
Fixed Selling and Administrative Expenses _ 200,000 _ 500,000
Net Income _ 40,000

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Reconciliation of Net Income:
Fixed
Change Overhead
In Per
Inventory Unit
(100,000 – 90,000) x 3 = 30,000

2. Production < Sales--if the number of units produced is less than the
number of units sold, absorption costing will produce a lower net
income since the fixed manufacturing overhead costs assigned to the
decrease in inventory will be expensed during the current period in
addition to the fixed manufacturing overhead costs assigned to the unit
produced during the current period
a. Illustration--a corporation uses a standard costing system;
standards are $1 per unit for direct materials, $7 per unit for
direct labor, $2 per unit for variable manufacturing overhead, and
$300,000 for fixed manufacturing overhead; normal capacity is
100,000 units; beginning inventory was 10,000 units; during the
year 100,000 units were produced and 105,000 units were sold at $20
per unit; during the year actual manufacturing costs were equal to
standard; during the year fixed selling and administrative expenses
were $200,000 and variable selling and administrative expenses were
$4 per unit
Absorption Costing:
Production Cost Per Unit = 1 + 7 + 2 + 300,000 / 100,000 = 13

Sales 2,100,000
(105,000 x 20)
Cost of Goods Sold at Standard 1,365,000
(105,000 x 13) _ _
Gross Margin 735,000
Selling and Administrative Expenses 620,000
(200,000 + 105,000 x 4) _ _
Net Income _ 115,000

Variable Costing:
Production Cost Per Unit = 1 + 7 + 2 = 10

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 Sales 2,100,000
(105,000 x 20)
Variable Costs:
Variable Cost of Goods Sold at Standard 1,050,000
(105,000 x 10)
Variable Selling and Administrative Expenses 420,000 1,470,000
(105,000 x 4) _ _ _ _
Contribution Margin 630,000
Fixed Costs:
Fixed Manufacturing Overhead 300,000
Fixed Selling and Administrative Expenses _ 200,000 _ 500,000
Net Income _ 130,000

Reconciliation of Net Income:

Fixed
Change Overhead
In Per
Inventory Unit
(100,000 – 105,000) x 3 = (15,000)

3. Production Not Equal To Normal Capacity--if the number of units

produced is not equal to normal capacity, under/overapplied fixed
manufacturing overhead will result under absorption costing and will be
treated as an adjustment to cost of goods sold if they are relatively
small
a. Illustration--a corporation uses a standard costing system;
standards are $1 per unit for direct materials, $7 per unit for
direct labor, $2 per unit for variable manufacturing overhead, and
$300,000 for fixed manufacturing overhead; normal capacity is
100,000 units; beginning inventory was 5,000 units; during the
year 98,000 units were produced and 95,000 units were sold at $20
per unit; during the year actual manufacturing costs were equal to
standard; during the year fixed selling and administrative expenses
were $200,000 and variable selling and administrative expenses were
$4 per unit

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Absorption Costing:
Production Cost Per Unit = 1 + 7 + 2 + 300,000 / 100,000 = 13

Sales 1,900,000
(95,000 x 20)
Cost of Goods Sold:
Cost of Goods Sold at Standard 1,235,000
(95,000 x 13)
Overhead Variance 6,000 1,241,000
(300,000 – 98,000 x 3) _ _ _ _
Gross Margin 659,000
Selling and Administrative Expenses 580,000
(200,000 + 95,000 x 4) _ _
Net Income _ 79,000

Variable Costing:
Production Cost Per Unit = 1 + 7 + 2 = 10

Sales 1,900,000
(95,000 x 20)
Variable Costs:
Variable Cost of Goods Sold at Standard 950,000
(95,000 x 10)
Variable Selling and Administrative Expenses 380,000 1,330,000
(95,000 x 4) _ _ _ _
Contribution Margin 570,000
Fixed Costs:
Fixed Manufacturing Overhead 300,000
Fixed Selling and Administrative Expenses _ 200,000 _ 500,000
Net Income _ 70,000

Reconciliation of Net Income:

Fixed
Change Overhead
In Per
Inventory Unit
(98,000 – 95,000) x 3 = 9,000

4. Actual Costs Not Equal To Standard Costs--if actual costs are not equal
to standard costs, materials, labor, variable manufacturing overhead,
and fixed manufacturing overhead variances will result; under
absorption costing all variances will be treated as an adjustment to
cost of goods sold if they are relatively small; under variable costing
the materials, labor, and variable overhead variances will be treated
as an adjustment to variable cost of goods sold if they are relatively
small

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 a. Illustration--a corporation uses a standard costing system and LIFO
for inventory valuation purposes; standards are $1 per unit for
direct materials, $7 per unit for direct labor, $2 per unit for
variable manufacturing overhead, and $300,000 for fixed
manufacturing overhead; normal capacity is 100,000 units; beginning
inventory was 7,000 units; during the year 95,000 units were
produced and 90,000 units were sold at $20 per unit; during the
year actual direct materials costs were $19,000 higher than
standard, actual direct labor costs were equal $9,500 lower than
standard, actual variable manufacturing overhead was $194,750, and
actual fixed manufacturing overhead was $313,500; during the year
fixed selling and administrative expenses were $200,000 and
variable selling and administrative expenses were $4 per unit
Absorption Costing:
Production Cost Per Unit = 1 + 7 + 2 + 300,000 / 100,000 = 13

Sales 1,800,000
(90,000 x 20)
Cost of Goods Sold:
Cost of Goods Sold at Standard 1,170,000
(90,000 x 13)
Materials Variance 19,000
Labor Variance ( 9,500)
Overhead Variance 33,250 1,212,750
(194,750 + 313,500 – 95,000 x 5) _ _ _ _
Gross Margin 587,250
Selling and Administrative Expenses 560,000
(200,000 + 90,000 x 4) _ _
Net Income _ 27,250

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Variable Costing:
Production Cost Per Unit = 1 + 7 + 2 = 10

Sales 1,800,000
(90,000 x 20)
Variable Costs:
Variable Cost of Goods Sold:
Variable Cost of Goods Sold at
Standard 900,000
(90,000 x 10)
Materials Variance 19,000
Labor Variance ( 9,500)
Variable Overhead Variance 4,750 914,250
(194,750 – 95,000 x 2) _ _
Variable Selling and Administrative Expenses 360,000 1,274,250
(95,000 x 4) _ _ _ _
Contribution Margin 525,750
Fixed Costs:
Fixed Manufacturing Overhead 313,500
Fixed Selling and Administrative Expenses _ 200,000 _ 513,500
Net Income _ 12,250

Reconciliation of Net Income:

Fixed
Change Overhead
In Per
Inventory Unit
(95,000 – 90,000) x 3 = 15,000

5. Variance Proration--if actual costs are not equal to standard costs and
the resulting variances are relatively large, the variances are
prorated to the units produced during the current period
a. Illustration--a corporation uses a standard costing system and LIFO
for inventory valuation purposes; standards are $1 per unit for
direct materials, $7 per unit for direct labor, $2 per unit for
variable manufacturing overhead, and $300,000 for fixed
manufacturing overhead; normal capacity is 100,000 units; beginning
inventory was 7,000 units; during the year 95,000 units were
produced and 90,000 units were sold at $20 per unit; during the
year actual direct materials costs were $19,000 higher than
standard, actual direct labor costs were equal $9,500 lower than
standard, actual variable manufacturing overhead was $194,750, and
actual fixed manufacturing overhead was $313,500; during the year
fixed selling and administrative expenses were $200,000 and
variable selling and administrative expenses were $4 per unit

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Absorption Costing:
Production Cost Per Unit = 1 + 7 + 2 + 300,000 / 100,000 = 13

Sales 1,800,000
(90,000 x 20)
Cost of Goods Sold:
Cost of Goods Sold at Standard 1,170,000
(90,000 x 13)
Materials Variance 18,000
(90,000 / 95,000 x 19,000)
Labor Variance ( 9,000)
(90,000 / 95,000 x 9,500)
Overhead Variance 31,500 1,210,500
(90,000 / 95,000 x (194,750 + 313,500 –
95,000 x 5)) _ _ _ _
Gross Margin 589,500
Selling and Administrative Expenses 560,000
(200,000 + 90,000 x 4) _ _
Net Income _ 29,500

Actual Production Cost Per Unit:

Direct Materials = 1 + 19,000 / 95,000 = 1.20
Direct Labor = 7 – 9,500 / 95,000 = 6.90
Variable Manufacturing Overhead = 194,750 / 95,000 = 2.05
Fixed Manufacturing Overhead = 313,500 / 95,000 = _3.30
13.45

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Variable Costing:
Production Cost Per Unit = 1 + 7 + 2 = 10

Sales 1,800,000
(90,000 x 20)
Variable Costs:
Variable Cost of Goods Sold:
Variable Cost of Goods Sold at
Standard 900,000
(90,000 x 10)
Materials Variance 18,000
(90,000 / 95,000 x 19,000)
Labor Variance ( 9,000)
(90,000 / 95,000 x 9,500)
Variable Overhead Variance 4,500 913,500
(90,000 / 95,000 x (194,750 –
95,000 x 2)) _ _
Variable Selling and Administrative Expenses 360,000 1,273,500
(95,000 x 4) _ _ _ _
Contribution Margin 526,500
Fixed Costs:
Fixed Manufacturing Overhead 313,500
Fixed Selling and Administrative Expenses _ 200,000 _ 513,500
Net Income _ 13,000

Actual Production Cost Per Unit:

Direct Materials = 1 + 19,000 / 95,000 = 1.20
Direct Labor = 7 – 9,500 / 95,000 = 6.90
Variable Manufacturing Overhead = 194,750 / 95,000 = _2.05
10.15

Reconciliation of Net Income:

Fixed
Change Overhead
In Per
Inventory Unit
(95,000 – 90,000) x 3.30 = 15,000

C. Costing Systems
1. Normal Costing--under normal costing actual direct materials and direct
labor costs are assigned to the units produced and manufacturing
overhead costs are assigned to the units produced using the
predetermined overhead rate and the actual basis for allocation
a. Small Variances--if the under/overapplied manufacturing overhead is
relatively small, it is treated as an adjustment to cost of goods
sold
b. Large Variances--if the under/overapplied manufacturing overhead is

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 relatively large, it is prorated to the units produced
2. Standard Costing--under standard costing standard direct materials and
direct labor costs are assigned to the units produced and manufacturing
overhead costs are assigned to the units produced using the
predetermined overhead rate and the standard basis for allocation
a. Small Variances--if the direct materials, direct labor, and
manufacturing overhead variances are relatively small, they are
treated as an adjustment to cost of goods sold
b. Large Variances-- if the direct materials, direct labor, and
manufacturing overhead variances are relatively large, they are
prorated to the units produced
3. Actual Costing--under actual costing, actual direct materials, direct
labor, and manufacturing overhead costs are assigned to the units
produced

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