Managerial Accounting

Weygandt, Kieso, & Kimmel

Prepared by
Karleen Nordquist..
The College of St. Benedict...
and St. John’s University...

with contributions by
Marianne Bradford..
The University of Tennessee...
Gregory K. Lowry….
Macon Technical Institute…..

John Wiley & Sons, Inc.

 Chapter 5

Cost-Volume-Profit Relationships
 Chapter 5
Cost-Volume-Profit Relationships
After studying this chapter, you should be able to:
1 Distinguish between variable and fixed costs.
2 Explain the meaning and importance of the relevant
range.
3 Explain the concept of mixed costs.
4 State the five components of cost-volume-profit
analysis.
5 Indicate the meaning of contribution margin and the
ways it may be expressed.
 Chapter 5
Cost-Volume-Profit Relationships
After studying this chapter, you should be able to:
6 Identify the three ways that the break-even point may
be determined.
7 Define margin of safety and give the formulas for
computing it.
8 Give the formulas for determining sales required to
earn target net income.
9 Describe the essential features of a cost-volume-profit
income statement.
 Preview of Chapter 5

COST-VOLUME-
Cost Behavior Analysis
PROFIT
• Variable Costs
RELATIONSHIPS
• Fixed Costs
• Relevant Range
• Mixed Costs
• Identifying Variable and Fixed
Costs
 Preview of Chapter 5

Cost-Volume-Profit
COST-VOLUME- Analysis
PROFIT • Basic Components
RELATIONSHIPS • Contribution Margin
• Break-Even Analysis
• Margin of Safety
• Target Net Income
• Changes in Business
Environment
• CVP Income Statement
 Cost Behavior Analysis
 Cost behavior analysis is the study of how specific costs
respond to changes in the level of activity within a
company.
 The starting point in cost behavior analysis is measuring the
key activities in the company’s business.
 Activity levels may be expressed in terms of
– sales dollars (retail company),
– miles driven (trucking company),
– room occupancy (hotel), or
– number of dance classes taught (dance studio).
 Cost Behavior Analysis
 For an activity level to be useful in cost
behavior analysis, there should be correlation
between changes in the level or volume of
activity and changes in the costs.
 The activity level selected is referred to as the
activity (or volume) index.
 The activity index identifies the activity that
causes changes in the behavior of costs.
 Study Objective 1

Distinguish between variable and

fixed costs.
 Variable Costs
Variable costs are costs that vary in total
directly and proportionately with changes in the
activity level.

A variable cost may also be defined as a cost

that remains the same per unit at every level
of activity.
 Variable Costs
 Damon Company manufactures radios that contain a $10 digital
clock. The activity index is the number of radios produced. As
each radio is manufactured, the total cost of the clocks increases
by $10. (a) (b)
Total Variable Costs Unit Variable Costs
(Digital Clocks) (Digital Clocks)

$100 $25

Cost (per unit)

20
Cost (000)

80
60 15

40 10

20 5

0 0
0 2 4 6 8 10 0 2 4 6 8 10
Illustration 5-1 Radios produced in (000) Radios produced in (000)
 Fixed Costs
Fixed costs are costs that remain the same in
total regardless of changes in the activity level.

Since fixed costs remain constant in total as

activity changes, fixed costs per unit vary
inversely with activity. As volume increases,
unit cost declines and vice versa.
 Fixed Costs
 Damon Company leases all of its productive facilities at a cost of
$10,000 per month. Total fixed costs of the facilities will
remain constant at every level of activity.
(a) (b)
Total Fixed Costs Fixed Costs Per Unit
(Rent Expense) (Rent Expense)

$25 $5

Cost (per unit)

Cost (000)

20 4
15 3
10 2
5 1
0 0
0 2 4 6 8 10 0 2 4 6 8 10
Radios produced in (000) Radios produced in (000)
Illustration 5-2
 Study Objective 2

Explain the meaning and

importance of the relevant range.
 Nonlinear Behavior of
Variable and Fixed Costs
In the previous two slides, the assumption was made that total variable costs
and total fixed costs were linear, and straight lines were used to represent
both types of costs. A straight-line relationship does not usually exist for
variable costs throughout the entire range of activity.
In the real world, the
(a) (b)
relationship between variable
Total Variable Costs Total Fixed Costs
cost behavior and changes in Curvilinear Nonlinear
the activity level is often
curvilinear, as shown in part
(a) on the right. The
behavior of total fixed costs
Cost ($)

Cost ($)
through all levels of activity
is shown in part (b).

0 20 40 60 80 100 0 20 40 60 80 100
Illustration 5-3 Activity level (%) Activity level (%)
 Linear Behavior Within
Relevant Range
Operating at zero or at 100% capacity is the exception for most
companies. Companies usually operate over a narrower range – such
as 40-80% of capacity. The relevant range of the activity index is the
range over which a company expects to operate during a year.
(a) (b)
Within this range, as Total Variable Costs Total Fixed Costs
Curvilinear Nonlinear
shown in both
diagrams to the right, a Relevant
Range
Relevant
Range
straight-line
Cost ($)

Cost ($)
relationship normally
exists for both fixed
and variable costs.
0 20 40 60 80 100 0 20 40 60 80 100
Illustration 5-4 Activity level (%) Activity level (%)
 Study Objective 3

Explain the concept of mixed costs.

 Mixed Costs
Mixed costs contain both a variable cost
element and a fixed cost element.

Sometimes called semivariable costs, mixed

costs change in total but not proportionately
with changes in the activity level.
 Behavior of a Mixed Cost
The rental of a U-Haul truck is a good example of a mixed cost.

Local rental terms for a

$200
U-Haul truck are $50 per day
plus $.50 per mile. The per e
150 Lin
diem charge is a fixed cost o st
lC
with respect to miles driven, To
t a
Cost 100
while the mileage charge is a Variable Cost Element
variable cost. The graphic
50
presentation of the rental
Fixed Cost Element
cost for a one-day rental is
0
shown on the right. 0 50 100 150 200
Miles
250 300

Illustration 5-5
 Mixed Cost Classification
for CVP Analysis
 In CVP analysis, it is assumed that mixed costs must
be classified into their fixed and variable elements.
 Firms usually ascertain variable and fixed costs on an
aggregate basis at the end of a time period, using
the company’s past experience with the behavior of
the mixed cost at various activity levels.
 The high-low method is a mathematical method that
uses the total costs incurred at the high and low levels
of activity.
 The High-Low Method
The steps in calculating fixed and variable costs under
this method are as follows:
1 Determine variable cost per unit from the following
formula:
Change in High minus Low Variable Cost
Total Costs  Activity Level = per Unit

Illustration 5-6

2 Determine the fixed cost by subtracting the total variable

cost at either the high or the low activity level from the
total cost at that activity level.
 The High-Low Method:
Step 1
To illustrate, assume that Metro Transit Company has the
following maintenance costs and mileage data for its fleet of
busses over a 4-month period:
Month Miles Driven Total Cost Month Miles Driven Total Cost
January 20,000 $30,000 March 35,000 $49,000
February 40,000 $48,000 April 50,000 $63,000
Illustration 5-7
The high and low levels of activity are 50,000 miles in April and 20,000 miles
in January. The difference in maintenance costs at these levels is $33,000
($63,000-$30,000) and the difference in miles is 30,000 (50,000 - 20,000).
Therefore, for Metro Transit, variable cost per unit is $1.10, computed as
follows:

$33,000  30,000 = $1.10

 The High-Low Method:
Step 2
Metro Transit Company would compute the fixed portion of
its maintenance costs as shown below:

Activity Level
High Low
Total Cost $63,000 $30,000
Less: Variable costs
(50,000 x $1.10) 55,000
(20,000 x $1.10) 22,000
Total fixed costs $ 8,000 $ 8,000 Illustration 5-8

Maintenance costs are therefore $8,000 per month plus $1.10

per mile. For example at 45,000 miles, estimated maintenance
costs would be $49,500 variable (45,000 x $1.10), and $8,000
fixed.
 The High-Low Method
 The high-low method generally produces
a reasonable estimate for analysis.
 However, it does not produce a precise
measurement of the fixed and variable !
elements in a mixed cost because other
activity levels are ignored in the
computation.
 Study Objective 4

State the five components of cost-

volume-profit analysis.
 Cost-Volume Profit
Analysis
 Cost-volume-profit (CVP) analysis is the study of the effects
of changes of costs and volume on a company’s profits.
 CVP analysis involves a consideration of the
interrelationships among the following components:
– Volume or activity level
– Unit selling price
– Variable cost per unit
– Total fixed costs
– Sales mix
 CVP Assumptions
The following assumptions underlie each CVP application:
When these assumptions are not valid, the results of CVP analysis
may be inaccurate.
1 The behavior of both costs and revenues is linear throughout the
relevant range of the activity index.
2 All costs can be classified as either variable or fixed with
reasonable accuracy.
3 Changes in activity are the only factors that affect costs.
4 All units produced are sold.
5 When more than one type of product is sold, total sales will be in
a constant sales mix.
 CVP Analysis
In CVP analysis applications, the term cost includes
manufacturing costs plus selling and administrative expenses.

 We will use Vargo Video Company as an example.

Relevant data for the VCRs made by this company are as
follows:

Unit selling price $500

Unit variable costs $300
Total monthly fixed costs $200,000

Illustration 5-10
 Study Objective 5

Indicate the meaning of contribution

margin and the ways it may be
expressed.
 Contribution Margin
One of the key relationships in CVP analysis is contribution
margin (CM). Contribution margin is the amount of
revenue remaining after deducting variable costs. The
CM is then available to cover fixed costs and to contribute
income for the company.
 For example, assume that Vargo Video sells 1,000 VCRs in
one month, sales are $500,000 (1,000 x $500) and variable
costs are $300,000 (1,000 x $300). Thus, contribution margin
is $200,000, computed as follows: Illustration 5-11

Contribution
Sales
- Variable Costs = Margin

$500,000 - $300,000 = $200,000

 Unit Contribution Margin
Views differ as to the best way to express contribution
margin (CM). Some favor a per unit basis.
 At Vargo Video, the contribution margin per unit is $200.

Illustration 5-12

Unit Variable Contribution

Unit Selling Price
- Cost = Margin per Unit

$500 - $300 = $200

 CM per unit indicates that for every VCR sold, Vargo Video will have $200
to cover fixed costs and contribute to income.
 Contribution Margin Ratio
Others prefer to use a contribution margin ratio.
 At Vargo Video, the contribution margin ratio is 40%.
Illustration 5-13


Contribution Contribution
Margin per Unit
Unit Selling Price = Margin Ratio

$200  $500 = 40%

 The CM ratio means that 40 cents of each sales dollar ($1 x 40%) is
available to apply to fixed costs and to contribute to income.
 Study Objective 6

Identify the three ways that the break-

even point may be determined.
 Break-Even Analysis
 The second key relationship in CVP analysis
is the break-even point, which is the level of
activity where total revenues equals total
costs, both fixed and variable.
 Since no income is involved when the break-
even point is the objective, the analysis is
often referred to as break-even analysis.
 Break-Even Analysis
 The break-even point can be:
– Computed from a mathematical equation.
– Computed by using contribution margin.
– Derived from a CVP graph.
 The break-even point can be expressed in
either sales dollars or sales units.
 Break-Even Analysis:
Mathematical Equation
In its simplest form, the equation for break-
even sales is:

Break-even Sales = Variable Costs + Fixed Costs

Illustration 5-14
 Break-Even Analysis:
Mathematical Equation for Dollars
The break-even point in dollars is found by expressing
variable costs as a percentage of unit selling price.

 For Vargo Video, the percentage is 60% ($300  $500). Sales must be $500,000 for Vargo
Video to break even. The computation to determine sales dollars at the break-even point is:

X = .60X + $200,000
.40X = $200,000
X = $500,000
where:
X = sales dollars at the break-even point
.60 = variable costs as a percentage of unit selling price
$200,000 = total fixed costs
Illustration 5-15
 Break-Even Analysis:
Mathematical Equation for Units
The break-even point in units can be computed
directly from the mathematical equation by using
unit selling prices and unit variable costs. Vargo
must sell 1,000 units to break even. The
computation is:
$500X = $300X + $200,000
$200X = $200,000
X = 1,000 units
where:
X = sales volume
$500 = unit selling price
$300 = variable cost per unit
$200,000 = total fixed costs
Illustration 5-16
 Break-Even Analysis:
Mathematical Equation Proof

The accuracy of the previous computations can be

proved as follows:

Sales (1,000 x $500) $500,000

Total costs:
Variable (1,000 x $300) $300,000
Fixed 200,000 500,000
Net Income $ -0-

Illustration 5-16
 Break-Even Analysis:
CM Technique for Units
Because we know that CM equals total revenues less variable costs, it follows that at the break-
even point, contribution margin must equal total fixed costs.
When the CM per unit is used, the formula to compute break-even point in units is shown below:

 Once again, the CM per unit for Vargo Video is $200.

Contribution Break-even Point

Fixed Costs
 Margin per Unit = in Units

$200,000  $200 = 1,000

 Break-Even Analysis:
CM Technique for Dollars
When the CM ratio is used, the formula to compute
break-even point in dollars is shown below:

 Again, the CM ratio for Vargo Video is 40%.

Contribution Break-even Point

Fixed Costs
 Margin Ratio = in Dollars

$200,000  40% = $500,000

 Break-Even Analysis:
Graphic Presentation
 An effective way to derive the break-even
point is to prepare a break-even graph.
 The graph is referred to as a cost-volume-
profit (CVP) graph since it shows costs,
volume, and profits.
 Break-Even Analysis:
Graphic Presentation
The construction of the graph, using the Vargo Video Company data, is as
follows:
1 Plot the total revenue line starting at the zero activity level.
2 Plot the total fixed cost by a horizontal line.
3 Plot the total cost line starting at the fixed cost line at zero activity and
increasing the amount by the variable cost at each level of activity.
4 Determine the break-even point from the intersection of the total cost
line and the total revenue line.
In addition to identifying the break-even point, the CVP graph shows both
the net income and net loss areas. Thus, the amount of income or loss at
each level of sales can be derived from the total sales and total cost lines.
 CVP Graph
In the graph to the
right, sales volume is
shown on the Sales Line

horizontal axis. This $900 Profit

axis needs to extend 700

Area Total Cost
Break-even Point Line
to the maximum level 600
Dollars (000)

of expected sales.
500
Both total revenues
400
(sales) and total costs
(fixed plus variable) 300

are recorded on the 200

Loss
Fixed Cost
Line
vertical axis. 100
Area

200 400 600 800 1000 1200 1400 1600 1800

Units of Sales Illustration 5-20
 Study Objective 7

Define margin of safety and give the

formulas for computing it.
 Margin of Safety
The margin of safety is another relationship that
may be calculated in CVP analysis. Margin
of safety is the difference between actual or
expected sales and sales at the break-even
point
This relationship measures the “breathing room”
or “cushion” that management has in order to
break even if actual sales fail to materialize.
 Margin of Safety
The margin of safety may be expressed in dollars or as a ratio.
 Assuming that actual (expected) sales for Vargo Video are
$750,000, the computations are:
Margin of Safety in Dollars

Actual (Expected) Margin of Safety

Sales - Break-even Sales = in Dollars

$750,000 - $500,000 = $250,000

Margin of Safety Ratio


Margin of Safety Actual (Expected) Margin of Safety
in Dollars Sales = Ratio

$250,000  $750,000 = 33%

 Study Objective 8

Give the formulas for determining

sales required to earn target net
income.
 Target Net Income
 Management usually sets an income objective
for individual product lines. This objective,
called target net income, is extremely useful to
management because it indicates the sales
necessary to achieve a specified level of income.
 The amount of sales necessary to achieve target
net income can be determined from each of the
approaches used in determining break-even
sales.
 Target Net Income:
Mathematical Equation
We know that at the break-even point no profit or loss results for the company. By
adding a factor for target net income to the break-even equation, we obtain the
formula shown below for determining required sales.

Target
Required Variable Fixed
Sales = Costs + Costs + Net
Income

Illustration 5-23

Required sales may be expressed in either sales dollars or sales units.

 Target Net Income:
Mathematical Equation
Assuming the target net income is $120,000 for Vargo Video,
the computation of required sales in dollars is as follows:
X = .60X + $200,000 + $120,000
.40X = $320,000
X = $800,000
where:
X = required sales
.60 = variable costs as a percentage of unit selling price
$200,000 = total fixed costs
$120,000 = target net income
Illustration 5-24

The sales volume in units at the target income level is found

by dividing the sales dollars by the unit selling price.
$800,000  $500 = $1,600
 Target Net Income:
CM Technique
As in the case of break-even sales, the sales required to meet
a target net income can be computed in either dollars or units.

 The formula using the CM ratio for Video Vargo is as follows:

Fixed Costs +
Contribution
Required Sales
= Target Net
Income
 Margin Ratio

$320,000 = 40%  $800,000

 Target Net Income:
Graphic Presentation
 A CVP graph can also be used to derive the
sales required to meet target net income.
 In the profit area of the graph, the distance
between the sales line and the total cost line at
any point equals net income. Required sales
are found by analyzing the differences
between the two lines until the desired net
income is found.
 CVP and Changes in the
Business Environment
 Business conditions change rapidly and management
must respond intelligently to these changes.
 CVP analysis can be used in responding to change.
 The original VCR sales and cost data for Vargo
Video Company are shown below.

Unit selling price $ 500

Unit variable cost $ 300
Total fixed costs $ 200,000
Break-even sales $ 500,000 or 1,000 units
Illustration 5-26
 CVP and Changes in the
Business Environment: Case I
 A competitor is offering a 10% discount on the selling price of its
VCRs. Management must decide whether or not to offer a similar
discount.
 Question: What effect will a 10% discount on selling price have on
the break-even point for VCRs?
 Answer: A 10% discount on selling price reduces the selling price
per unit to $450 [$500 – ($500 x 10%)]. Variable cost per unit
remains unchanged at $300. Therefore, the contribution margin per
unit is $150. Assuming no change in fixed costs, break-even sales
are 1,333 units, calculated as follows:

Fixed Costs ÷ Contribution Margin per Unit = Break-even Sales

$ 200,000 ÷ $ 150 = 1,333 units (rounded)

Illustration 5-27
 CVP and Changes in the
Business Environment: Case II
 Management invests in new robotic equipment that will significantly
lower the amount of direct labor required to make the VCRs. It is
estimated that total fixed costs will increase 30% and that variable
cost per unit will decrease 30%.
 Question: What effect will the new equipment have on the sales
volume required to break even?
 Answer: Total fixed costs become $260,000 [$200,000 + ($200,000
x 30%)], and variable cost per unit is now $210 [$300 – ($300,000 x
30%)]. The new break-even point about 900 units, calculated as
follows:

Fixed Costs ÷ Contribution Margin per Unit = Break-even Sales

$ 260,000 ÷ ($500 - $210) = 900 units (rounded)

Illustration 5-28
 CVP and Changes in the
Business Environment: Case III
 An increase in the price of raw materials will increase the unit variable cost of
VCRs by an estimated $25. Management is striving to hold the line on the
selling price of the VCRs, and plans a cost-cutting program that will save
$17,500 in fixed costs per month. Vargo Video Company is currently realizing
monthly net income of $80,000 on sales of 1,400 VCRs.
 Question: What increase in sales will be needed to to maintain the same level
of net income?
 Answer: The variable cost per unit increases to $325 ($300 + $25), and fixed
costs are reduced to $182,500 ($200,000 – $17,500). Because of the change in
variable cost, the variable cost becomes 65% of sales ($325 ÷ $500). Using the
equation for target net income, required sales are calculated to be $750,000, as
follows:
Required Sales = Variable Costs + Fixed Costs + Target Net Income
X = .65X + $182,500 + $80,000
.35X = $262,500
X = $750,000
Illustration 5-29
 Study Objective 9

Describe the essential features of a

cost-volume-profit income statement.
 CVP Income Statement
 The CVP income statement classifies costs
and expenses as variable or fixed and
specifically reports contribution margin in the
body of the statement.
 The CVP income statement format is
sometimes called the contribution margin
format.
 This format is for internal management use
only.
 CVP Income Statement
 For purposes of illustrating the CVP income
statement, assume that Vargo Video Company
reaches its target net income of $120,000. From an
analysis of the transactions, the following
information is obtained on the $680,000 of costs
that were incurred in June:
Variable Fixed Total
Cost of goods sold $ 400,000 $ 120,000 $ 520,000
Selling expenses 60,000 40,000 100,000
Administrative expenses 20,000 40,000 60,000
$ 480,000 $ 200,000 $ 680,000

Illustration 5-30
 Traditional versus CVP
Income Statement
 The CVP income statement and the traditional
income statement based on this data are shown side-
by-side on the next slide.
 Note that net income is the same ($120,000) in both
of the statements.
 The major difference is the format for the expenses.
 Also, the traditional statement shows gross profit,
whereas the CVP statement shows contribution
margin.
 Traditional versus CVP
Income Statement

Traditional Format CVP Format

Sales $ 800,000 Sales $ 800,000
Cost of goods sold 520,000 Variable expenses
Gross profit 280,000 Cost of goods sold $ 400,000
Operating expenses Selling expenses 60,000
Selling expenses $ 100,000 Administrative expenses 20,000
Administrative expenses 60,000 Total variable expenses 480,000
Total operating expenses 160,000 Contribution margin 320,000
Net income $ 120,000 Fixed expenses
Cost of goods sold 120,000
Selling expenses 40,000
Administrative expenses 40,000
Total fixed expenses 200,000
Net income $ 120,000

Illustration 5-31
Appendix 5A

Variable Costing
 Appendix 5A
Study Objective 10

Explain the difference between

absorption costing and variable
costing.
 Absorption versus Variable
Costing
 All manufacturing costs are charged to and absorbed by
the product under full or absorption costing. This is how
costs were handled in previous chapters.
 Under variable costing only direct materials, direct labor,
and variable manufacturing overhead costs are considered
product costs. Fixed manufacturing overhead costs are
recognized as period costs when incurred.
 The difference between absorption costing and variable
costing is graphically shown below.
Absorption Costing Variable Costing
Fixed
Product Cost Manufacturing Period Cost
Overhead
Illustration 5A-1
 Absorption versus Variable
Costing: An Illustration
 As an illustration, Premium Products Corporation manufactures a
polyurethane sealant called Fix-it for car windshields. Relevant
data for Fix-it in January 1996, the first month of production, is as
follows:
– Selling Price: $20 per unit.
– Units: Produced 30,000; sold 20,000; beginning inventory zero.
– Variable unit costs: Manufacturing $9 (direct materials $5,
direct labor $3, and variable overhead $1) and selling and
administrative expenses $2.
– Fixed costs: Manufacturing overhead $120,000, and selling and
administrative expenses $15,000.
 Absorption versus Variable
Costing: Unit Production Cost
 The per unit production cost under each costing
approach is:
Absorption Variable
Type of Cost Costing Costing
Direct materials $ 5 $ 5
Direct labor 3 3
Variable manufacturing overhead 1 1
Fixed manufacturing overhead ($120,000 ÷ 30,000 units produced) 4 0
Total unit cost $ 13 $ 9

Illustration 5A-2

 The difference in total unit cost of $4 ($13 - $9) occurs because fixed
manufacturing costs are a product cost under absorption costing
and a period cost under variable costing.
 Absorption versus Variable
Costing: Effects on Income
 The income statements under the two costing
approaches are shown on the next two slides.
 Income from operations under absorption costing is
$40,000 higher than under variable costing ($85,000 –
$45,000). There is a $40,000 difference in the ending
inventories ($130,000 under absorption costing and
$90,000 under variable costing).
 Under absorption costing, $40,000 of the fixed overhead
costs have been deferred to a future period as a product
cost.
Absorption Costing Income
Statement

Sales (20,000 units X $20) $ 400,000

Cost of goods sold
Inventory, January 1 $ –0–
Cost of goods manufactured (30,000 units X $13) 390,000
Cost of goods available for sale 390,000
Inventory, January 31 (10,000 units X $13) 130,000
Cost of goods sold (20,000 units X $13) 260,000
Gross profit 140,000
Selling and administrative expenses
(Variable 20,000 units X $2 + fixed $15,000) 55,000
Income from operations $ 85,000
Illustration 5A-3
Variable Costing Income
Statement

Sales (20,000 units X $20) $ 400,000

Variable expenses
Variable cost of goods sold
Inventory, January 1 –0–
Variable manufacturing costs (30,000 units X $9) 270,000
Cost of goods available for sale 270,000
Inventory, January 31 (10,000 units X $9) 90,000
Variable cost of goods sold 180,000
Variable selling and administrative expenses
(20,000 units X $2) 40,000
Total variable expenses 220,000
Contribution margin 180,000
Fixed expenses
Manufacturing overhead 120,000
Selling and administrative expenses 15,000
Total fixed expenses 135,000
Illustration
Income from operations $ 45,000
5A-4
Summary of Income Effects
Circumstances Income Under

Absorption Costing Variable Costing

=
Units Produced = Units Sold

>
Units Produced > Units Sold

<
Units Produced < Units Sold
Illustration 5A-5
 Rationale for Variable
Costing
 The rationale for variable costing focuses on the purpose
of fixed manufacturing costs, which is to have productive
facilities available for use.
 Defenders of absorption costing justify the assignment of
fixed manufacturing overhead costs to inventory on the
basis that these costs are as much a cost of getting a
product ready for sale as direct materials or direct
labor.
 The use of variable costing in product costing is
acceptable only for internal use by management.
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 Chapter 5
Cost-Volume-Profit Relationships