Warren Reeve Duchac Financial and Managerial Accounting 13e Variable Costing for Management Analysis 20 C H A P T E R

WarrenReeveDuchac

Financial and Managerial Accounting 13e

Variable Costing for Management Analysis20

C H A P T E R

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Absorption Costing

• Absorption costing is required under generally accepted accounting principles.

• Under absorption costing, the cost of goods manufactured consists of the following:o Direct materialso Direct laboro Fixed and variable factory overhead

• In the financial statements, these costs are included in the cost of goods sold (income statement) and inventory (balance sheet).

Variable Costing(slide 1 of 2)

• Under variable costing, sometimes called direct costing, the cost of goods manufactured consists of the following:o Direct materialso Direct laboro Variable factory overhead

• Under variable costing, fixed factory overhead costs are treated as a period expense.



Variable Costing(slide 2 of 2)

• The reporting of income from operations under variable costing is as follows:

o Manufacturing margin is the excess of sales over variable cost of goods sold:

o Variable cost of goods sold consists of direct materials, direct labor, and variable factory overhead for the units sold.

o Contribution margin is the excess of manufacturing margin over variable selling and administrative expenses:

o Subtracting fixed costs from contribution margin yields income from operations:

Units Manufactured versus Units Sold

• When the number of units manufactured equals the number of units sold, income from operations will be the same under both methods.

• When units manufactured exceed the units sold, the variable costing income from operations will be less than it is for absorption costing.

• When units manufactured are less than the number of units sold, the variable costing income from operations will be greater than that of absorption costing.


Effects on Income from Operations under Absorption and Variable Costing(slide 1 of 3)






Income Analysis Under Absorption and Variable Costing(slide 1 of 4)

• When the units manufactured are greater than the units sold, finished goods inventory increases.o Under absorption costing, a portion of this

increase is related to the allocation of fixed manufacturing overhead to ending inventory.



• Assume that Frand Manufacturing Company has no beginning inventory and sales are estimated to be 20,000 units at $75 per unit. Also, assume that sales will not change if more than 20,000 units are manufactured.

• Frand’s management is evaluating whether to manufacture 20,000 units (Proposal 1) or 25,000 units (Proposal 2). The costs and expenses related to each proposal appear on the following slide.


Absorption Costing Income Statements for Two Production Levels



• The income statements on the previous slide shows that Frand Manufacturing Company can increase income from operations by $80,000 ($280,000 – $200,000) by simply increasing finished goods inventory by 5,000 units.

• The $80,000 increase in income from operations under Proposal 2 is caused by the allocation of the fixed manufacturing costs of $400,000 over a greater number of units manufactured.



• Under variable costing, income from operations is $200,000, regardless of whether 20,000 units or 25,000 units are manufactured. o This is because no fixed manufacturing costs

are allocated to the units manufactured. Instead, all fixed manufacturing costs are treated as a

period expense.


Controlling Costs(slide 1 of 2)

• All costs are controllable in the long run by someone within a business.

• However, not all costs are controllable at the same level of management.

• For a level of management, controllable costs are costs that can be influenced (increased or decreased) by management at that level.

• Noncontrollable costs are costs that another level of management controls.


Controlling Costs(slide 2 of 2)

• Variable manufacturing costs are controlled by operating management.

• In contrast, fixed manufacturing overhead costs are normally controlled at a higher level of management.

• Since fixed costs and expenses are reported separately under variable costing, variable costing reports are normally more useful than absorption costing reports for controlling costs.


Pricing Products(slide 1 of 2)

• Many factors enter into determining the selling price of a product. However, the cost of making the product is significant in all pricing decisions.

• In the short run, fixed costs cannot be avoided. Thus, the selling price of a product should at least be equal to the variable costs of making and selling it.

• Since variable costing reports variable and fixed costs and expenses separately, it is often more useful than absorption costing for setting short-run prices.


Pricing Products(slide 2 of 2)

• In the long run, a company must set its selling price high enough to cover all costs and expenses (variable and fixed) and generate income.

• Since absorption costing includes fixed and variable costs in the cost of manufacturing a product, absorption costing is often more useful than variable costing for setting long-term prices.


Planning Production

• In the short run, planning production is limited to existing capacity. In many cases, operating decisions must be made quickly before opportunities are lost. o For example, a company with seasonal demand for its

products may have an opportunity to obtain an off-season order.

The relevant factors for such a short-run decision are the additional revenues and the additional variable costs associated with the order.

o Since variable costing reports contribution margin, it is often more useful than absorption costing in such cases.

• In the long run, planning production can include expanding existing capacity. Thus, when analyzing and evaluating long-run sales and operating decisions, absorption costing, which considers fixed and variable costs, is often more useful.


Analyzing Market Segments

• A market segment is a portion of a company that can be analyzed using sales, costs, and expenses to determine its profitability. o Examples of market segments include sales

territories, products, salespersons, and customers.

• Absorption costing is often used for long-term analysis of market segments, while variable costing is often used for short-term analysis of market segments.



Sales Territory Profitability Analysis

• Sales territory profitability analysis may lead management to do the following:o Reduce costs in lower-profit sales territorieso Increase sales efforts in higher-profit

territories

• The contribution margin ratio is computed as follows:

Product Profitability Analysis

• A company should focus its sales efforts on products that will provide the maximum total contribution margin.

• Product profitability analysis is often used by management in making decisions regarding product sales and promotional efforts.


Salesperson Profitability Analysis

• A salesperson profitability report is useful in evaluating sales performance.o Such a report normally includes total sales,

variable cost of goods sold, variable selling expenses, contribution margin, and contribution margin ratio for each salesperson.

• Other factors should also be considered in evaluating salespersons’ performance.


Contribution Margin Analysis(slide 1 of 2)

• Contribution margin analysis focuses on explaining the differences between planned and actual contribution margins.

• A difference between the planned and actual contribution margin may be caused by an increase or a decrease in:o Saleso Variable costs

• An increase or a decrease in sales or variable costs may in turn be due to an increase or a decrease in the:o Number of units soldo Unit sales price or unit cost


Contribution Margin Analysis(slide 2 of 2)

• Quantity factor is the effect of a difference in the number of units sold, assuming no change in unit sales price or unit cost.

• Unit price factor, or unit cost factor, is the effect of a difference in unit sales price or unit cost on the number of units sold.


Reporting Income from Operations Using Variable Costing for a Service Company

• Unlike a manufacturing company, a service company does not make or sell a product. o Since service companies have no inventory,

they do not use absorption costing to allocate fixed costs.

o In addition, variable costing reports of service companies do not report a manufacturing margin.

• A cost is classified as a fixed or variable cost according to how it changes relative to an activity base.o A common activity for a manufacturing firm is

the number of units produced.o Most service firms use several activity bases.


Contribution Margin Analysis Report—Service Company


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Warren Reeve Duchac Financial and Managerial Accounting 13e Variable Costing for Management Analysis 20 C H A P T E R