Accounting: The Language of Business - Vol. 1 (Part 127)

“It has been my experience that competency in mathematics, both in numerical manipulations and in understanding its conceptual foundations (accounting), enhances a person’s ability to handle the more ambiguous and qualitative relationships that dominate our day-to-day financial decision-making.”

—Alan Greenspan

Cost Behavior and Cost-Volume-Profit Analysis (Part I)

by

Charles Lamson

Variable Costing

For financial reporting to external uses, the cost of manufactured products normally consists of direct materials, direct labor, and factory overhead. The reporting of all these costs as product costs, called absorption costing, is required under generally accepted accounting principles. However, variable costing or direct costing reporting may be used in decision-making.

As a brief recap, Recall from previous posts that variable costs are costs that change as the quantity of the good or service that a business produces changes. Variable costs are the sum of marginal costs (The marginal cost is the change in the total cost that arises when the quantity produced is incremented, the cost of producing additional quantity.) over all units produced. They can also be considered normal costs. Fixed costs (Fixed costs, also known as indirect costs or overhead costs, are business expenses that are not dependent on the level of goods or services produced by the business. They tend to be recurring, such as interest or rents being paid per month.) and variable costs make up the two components of total cost. 

Bearing all that in mind, in variable costing, the cost of goods manufactured is composed only of variable costs. For units produced, variable costs normally include direct materials, direct labor, and variable factory overhead. Fixed factory overhead costs are related to the productive capacity of the manufacturing plant and are normally not affected by the number of units produced. In a variable costing income statement, fixed factory overhead costs do not become a part of the cost of goods manufactured. Instead, fixed factory overhead costs are treated as a period expense [Period costs are costs that cannot be capitalized on a company's balance sheet. In other words, they are expensed in the period incurred and appear on the income statement. Period costs are also called period expenses (corporatefinanceinstitute.com).].

To illustrate preparing a variable costing income statement, assume that 15,000 units were manufactured and sold at a price of $50 and the costs were as follows:

Exhibit 9 shows the variable costing income statement prepared from these data. The computations are shown in parentheses.

 In a variable costing income statement, the manufacturing margin is the excess of sales over the variable cost of goods sold. In Exhibit 9, the manufacturing margin is $375,000 ($750,000 sales - $375,000 variable cost of goods sold). The variable selling and administrative expenses of $75,000 are deducted from the manufacturing margin to yield the contribution margin of $300,000. Income from operations of $100,000 is then determined by deducting fixed costs from the contribution margin.

Exhibit 10 shows the absorption costing income statement prepared from the same data. The absorption costing income statement does not distinguish between variable and fixed costs. All manufacturing costs are included in the cost of goods sold. Deducting the cost of goods sold from sales yields the gross profit. Deducting the selling and administrative expenses from gross profit yields the income from operations.

EXHIBIT 10 Absorption Costing Income Statement

In Exhibits 9 and 10, 15,000 units were manufactured and sold. Both the absorption and the variable costing income statements reported the same income from operations of $100,000. Thus, when the number of the units manufactured equals the number of the units sold, income from operations will be the same under both methods.

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

To illustrate this latter case, assume that In the preceding example only 12,000 units of the 15,000 units manufactured were sold. Exhibit 11 shows the two income statements that result. The $30,000 difference in the amount of income from operations ($70,000 - $40,000) is due to the different treatment of the fixed manufacturing costs. The entire amount of the $150,000 of fixed manufacturing costs is included as a period expense in the variable costing statement. The ending inventory in the absorption costing statement includes $30,000 (3,000 * $10) of fixed manufacturing costs. This $30,000, by being included in inventory, is thus excluded from the current cost of goods sold and deferred to another period.

EXHIBIT 11 Units Manufactured Exceed Units Sold

A similar analysis verifies that income from operations under variable costing is greater than income from operations under absorption costing when the units manufactured are less than the units sold. In both cases where sales and production differ, finished goods inventory will also be different under absorption costing and variable costing. As a result, increases or decreases in income from operations due to changes in inventory levels would be misinterpreted by managers using absorption costing income statements as operating efficiencies or inefficiencies. This is one of the reasons that variable costing rather than absorption costing is used by managers for decision-making purposes.

Variable costing is especially useful to managers for cost control, product pricing, and production planning purposes.  

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 846-849*

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