Chapter 5 Cost Behavior: Analysis and Use
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This chapter discusses cost behavior analysis and how to classify costs as either variable or fixed. Variable costs change proportionally with activity levels, while fixed costs remain constant over a relevant range of activity. The chapter provides examples of variable costs like materials and fixed costs like rent. It also discusses mixed costs that have both fixed and variable components. Managers can use scattergraph plots of total cost versus activity levels to diagnose the behavior of different costs. The goal is to understand how costs change with production volumes to aid in planning and decision making.
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Chapter 5 Cost Behavior: Analysis and Use
- 1. CChhaapptteerr 55 Cost Behavior: Analysis and Use
- 2. Learning Objective LLOO11 To understand how fixed and variable costs behave and how to use them to predict costs.
- 3. Types of Cost Behavior Patterns RReeccaallll tthhee ssuummmmaarryy ooff oouurr ccoosstt bbeehhaavviioorr ddiissccuussssiioonn ffrroomm CChhaapptteerr 11.. Summary of Variable and Fixed Cost Behavior Cost In Total Per Unit Variable Total variable cost is Variable cost per unit remains proportional to the activity the same over wide ranges level within the relevant range. of activity. Total fixed cost remains the same even when the activity Fixed cost per unit goes Fixed level changes within the down as activity level goes up. relevant range.
- 4. The Activity Base A measure of what A measure of what causes the incurrence of a variable cost causes the incurrence of a variable cost UUnniittss pprroodduucceedd UUnniittss pprroodduucceedd Miles driven Miles driven Machine hours Machine hours Labor hours Labor hours
- 5. True Variable Cost Example A variable cost is a cost whose total dollar amount varies in direct proportion to changes in the activity level. Your total long distance telephone bill is based on how many minutes you talk. Minutes Talked Total Long Distance Telephone Bill
- 6. Types of Cost Behavior Patterns RReeccaallll tthhee ssuummmmaarryy ooff oouurr ccoosstt bbeehhaavviioorr ddiissccuussssiioonn ffrroomm CChhaapptteerr 11.. Summary of Variable and Fixed Cost Behavior Cost In Total Per Unit Variable Total variable cost is Variable cost per unit remains proportional to the activity the same over wide ranges level within the relevant range. of activity. Total fixed cost remains the same even when the activity Fixed cost per unit goes Fixed level changes within the down as activity level goes up. relevant range.
- 7. Variable Cost Per Unit Example A variable cost remains constant if expressed on a per unit basis. The cost per minute talked is constant. For example, 10¢ per minute. Minutes Talked Telephone Charge Per Minute
- 8. Extent of Variable Costs The proportion of variable costs differs across organizations. For example . . . AA ppuubblliicc uuttiilliittyy wwiitthh llaarrggee iinnvveessttmmeennttss iinn eeqquuiippmmeenntt wwiillll tteenndd ttoo hhaavvee ffeewweerr vvaarriiaabbllee ccoossttss.. AA mmaannuuffaaccttuurriinngg ccoommppaannyy wwiillll oofftteenn hhaavvee mmaannyy vvaarriiaabbllee ccoossttss.. AA mmeerrcchhaannddiissiinngg ccoommppaannyy uussuuaallllyy wwiillll hhaavvee aa hhiigghh pprrooppoorrttiioonn ooff vvaarriiaabbllee ccoossttss lliikkee ccoosstt ooff ssaalleess.. AA sseerrvviiccee ccoommppaannyy wwiillll nnoorrmmaallllyy hhaavvee aa hhiigghh pprrooppoorrttiioonn ooff vvaarriiaabbllee ccoossttss..
- 9. Examples of Variable Costs 11.. MMeerrcchhaannddiissiinngg ccoommppaanniieess –– ccoosstt ooff ggooooddss ssoolldd.. 22.. MMaannuuffaaccttuurriinngg ccoommppaanniieess –– ddiirreecctt mmaatteerriiaallss, ddiirreecctt llaabboorr, aanndd vvaarriiaabbllee oovveerrhheeaadd.. 33.. MMeerrcchhaannddiissiinngg aanndd mmaannuuffaaccttuurriinngg ccoommppaanniieess –– ccoommmmiissssiioonnss, sshhiippppiinngg ccoossttss, aanndd cclleerriiccaall ccoossttss ssuucchh aass iinnvvooiicciinngg.. 44.. SSeerrvviiccee ccoommppaanniieess –– ssuupppplliieess, ttrraavveell, aanndd cclleerriiccaall..
- 10. Volume Cost True Variable Cost Direct materials is a true or proportionately variable cost because the amount used during a period will vary in direct proportion to the level of production activity.
- 11. Step-Variable Costs A resource that is obtainable oonnllyy iinn llaarrggee cchhuunnkkss ((ssuucchh aass mmaaiinntteennaannccee wwoorrkkeerrss)) aanndd wwhhoossee ccoossttss iinnccrreeaassee oorr ddeeccrreeaassee oonnllyy iinn rreessppoonnssee ttoo ffaaiirrllyy wwiiddee cchhaannggeess iinn aaccttiivviittyy iiss kknnoowwnn aass aa sstteepp--vvaarriiaabbllee ccoosstt.. Volume Cost
- 12. Step-Variable Costs Small changes in the level of production are not likely to have any effect on the number of Volume Cost maintenance workers employed.
- 13. Step-Variable Costs Only fairly wide changes in the activity level will cause a change in the number of maintenance workers employed Volume Cost
- 14. The Linearity Assumption and the Relevant Range Relevant Range A straight line closely approximates a curvilinear variable cost line within the relevant range. Activity Total Cost EEccoonnoommiisstt’’ss CCuurrvviilliinneeaarr CCoosstt FFuunnccttiioonn AAccccoouunnttaanntt’’ss SSttrraaiigghhtt--LLiinnee AApppprrooxxiimmaattiioonn ((ccoonnssttaanntt uunniitt vvaarriiaabbllee ccoosstt))
- 15. Types of Cost Behavior Patterns LLeett’’ss llooookk aatt ffiixxeedd ccoosstt bbeehhaavviioorr oonn tthhee nneexxtt ssccrreeeennss.. Summary of Variable and Fixed Cost Behavior Cost In Total Per Unit Variable Total variable cost is Variable cost per unit remains proportional to the activity the same over wide ranges level within the relevant range. of activity. Total fixed cost remains the same even when the activity Fixed cost per unit goes Fixed level changes within the down as activity level goes up. relevant range.
- 16. Number of Local Calls Monthly Basic Telephone Bill Total Fixed Cost Example A fixed cost is a cost whose ttoottaall ddoollllaarr aammoouunntt rreemmaaiinnss ccoonnssttaanntt aass tthhee aaccttiivviittyy lleevveell cchhaannggeess.. YYoouurr mmoonntthhllyy bbaassiicc tteelleepphhoonnee bbiillll iiss pprroobbaabbllyy ffiixxeedd aanndd ddooeess nnoott cchhaannggee wwhheenn yyoouu mmaakkee mmoorree llooccaall ccaallllss..
- 17. Types of Cost Behavior Patterns RReeccaallll tthhee ssuummmmaarryy ooff oouurr ccoosstt bbeehhaavviioorr ddiissccuussssiioonn ffrroomm CChhaapptteerr 11.. Summary of Variable and Fixed Cost Behavior Cost In Total Per Unit Variable Total variable cost is Variable cost per unit remains proportional to the activity the same over wide ranges level within the relevant range. of activity. Total fixed cost remains the same even when the activity Fixed cost per unit goes Fixed level changes within the down as activity level goes up. relevant range.
- 18. Fixed Cost Per Unit Example Average fixed costs per unit decrease as the activity level increases. The fixed cost per local call decreases as more local calls are made. Number of Local Calls Monthly Basic Telephone Bill per Local Call
- 19. Types of Fixed Costs Examples Advertising and Research and Development Examples Depreciation on Buildings and Equipment and Real Estate Taxes Discretionary May be altered in the short-term by current managerial decisions Committed Long-term, cannot be significantly reduced in the short-term.
- 20. The Trend Toward Fixed Costs The trend in many industries is toward greater fixed costs relative to variable costs. AAss mmaacchhiinneess ttaakkee oovveerr mmaannyy mmuunnddaannee ttaasskkss pprreevviioouussllyy ppeerrffoorrmmeedd bbyy hhuummaannss,, ““kknnoowwlleeddggee wwoorrkkeerrss”” aarree ddeemmaannddeedd ffoorr tthheeiirr mmiinnddss rraatthheerr tthhaann tthheeiirr mmuusscclleess.. KKnnoowwlleeddggee wwoorrkkeerrss tteenndd ttoo bbee ssaallaarriieedd,, hhiigghhllyy--ttrraaiinneedd aanndd ddiiffffiiccuulltt ttoo rreeppllaaccee.. TThhee ccoosstt ttoo ccoommppeennssaattee tthheessee vvaalluueedd eemmppllooyyeeeess iiss rreellaattiivveellyy ffiixxeedd rraatthheerr tthhaann vvaarriiaabbllee..
- 21. Is Labor a Variable or a Fixed Cost? The behavior of wage and salary costs can differ across countries, depending on labor regulations, labor contracts, and custom. In France, Germany, China, and Japan, management has little flexibility in adjusting the size of the labor force. Labor costs are more fixed in nature. In the United States and the United Kingdom, management has greater latitude. Labor costs are more variable in nature.
- 22. Fixed Costs and Relevant Range 90 Thousands of Dollars 0 1,000 2,000 3,000 Rent Cost in Rented Area (Square Feet) 60 30 0 Relevant Range Total cost doesn’t change for a wide range of activity, and then jumps to a new higher cost for the next higher range of activity.
- 23. Fixed Costs and Relevant Range The relevant range of activity for a fixed cost is the range of activity over which the graph of the cost is flat. EExxaammppllee:: OOffffiiccee ssppaaccee iiss aavvaaiillaabbllee aatt aa rreennttaall rraattee ooff $$3300,,000000 ppeerr yyeeaarr iinn iinnccrreemmeennttss ooff 11,,000000 ssqquuaarree ffeeeett.. AAss tthhee bbuussiinneessss ggrroowwss,, mmoorree ssppaaccee iiss rreenntteedd,, iinnccrreeaassiinngg tthhee ttoottaall ccoosstt..
- 24. Fixed Costs and Relevant Range HHooww ddooeess tthhiiss ttyyppee ooff ffiixxeedd ccoosstt ddiiffffeerr ffrroomm aa sstteepp-- vvaarriiaabbllee ccoosstt?? SStteepp--vvaarriiaabbllee ccoossttss ccaann bbee aaddjjuusstteedd mmoorree qquuiicckkllyy aanndd .. .. .. TThhee wwiiddtthh ooff tthhee aaccttiivviittyy sstteeppss iiss mmuucchh wwiiddeerr ffoorr tthhee ffiixxeedd ccoosstt..
- 25. Quick Check 1. 2. 3. 4. Which of the following statements about cost behavior are true? 1. Fixed costs per unit vary with the level of activity. 2. Variable costs per unit are constant within the relevant range. 3. Total fixed costs are constant within the relevant range. 4. Total variable costs are constant within the relevant range.
- 26. 1. 2. 3. 4. Quick Check Which of the following statements about cost behavior are true? 1. Fixed costs per unit vary with the level of activity. 2. Variable costs per unit are constant within the relevant range. 3. Total fixed costs are constant within the relevant range. 4. Total variable costs are constant within the relevant range.
- 27. Variable Cost per KW Fixed Monthly Utility Charge Mixed Costs Activity (Kilowatt Hours) Total Utility Cost X Y A mixed cost has both fixed and variable components. Consider your utility costs. Total mixed cost
- 28. Variable Cost per KW Fixed Monthly Utility Charge Activity (Kilowatt Hours) Total Utility Cost X Y Mixed Costs Total mixed cost
- 29. Mixed Costs Example IIff yyoouurr ffiixxeedd mmoonntthhllyy uuttiilliittyy cchhaarrggee iiss $$4400,, yyoouurr vvaarriiaabbllee ccoosstt iiss $$00..0033 ppeerr kkiilloowwaatttt hhoouurr,, aanndd yyoouurr mmoonntthhllyy aaccttiivviittyy lleevveell iiss 22,,000000 kkiilloowwaatttt hhoouurrss,, wwhhaatt iiss tthhee aammoouunntt ooff yyoouurr uuttiilliittyy bbiillll?? Y = a + bX Y = $40 + ($0.03 × 2,000) Y = $100
- 30. Analysis of Mixed Costs AAAAccccccccoooouuuunnnntttt AAAAnnnnaaaallllyyyyssssiiiissss aaaannnndddd tttthhhheeee EEEEnnnnggggiiiinnnneeeeeeeerrrriiiinnnngggg AAAApppppppprrrrooooaaaacccchhhh EEaacchh Each aaccccoouunntt account iiss ccllaassssiiffiieedd aass eeiitthheerr vvaarriiaabbllee oorr ffiixxeedd bbaasseedd oonn tthhee aannaallyysstt’’ss kknnoowwlleeddggee ooff hhooww tthhee aaccccoouunntt bbeehhaavveess.. CCoosstt eessttiimmaatteess aarree bbaasseedd oonn aann eevvaalluuaattiioonn ooff pprroodduuccttiioonn mmeetthhooddss,, aanndd mmaatteerriiaall,, llaabboorr aanndd oovveerrhheeaadd rreeqquuiirreemmeennttss..
- 31. Learning Objective LLOO22 To use a scattergraph plot to diagnose cost behavior.
- 32. The Scattergraph Method PPlloott tthhee ddaattaa ppooiinnttss oonn aa ggrraapphh ((ttoottaall ccoosstt vvss.. aaccttiivviittyy)).. * 0 1 2 3 4 * Maintenance Cost 1,000’s of Dollars 20 10 0 * * * * * * * * Patient-days in 1,000’s X Y
- 33. The Scattergraph Method Draw a line through the data DDrraaww aa lliinnee tthhrroouugghh tthhee ddaattaa ppooiinnttss wwiitthh aabboouutt aann eeqquuaall nnuummbbeerrss ooff ppooiinnttss aabboovvee aanndd bbeellooww tthhee lliinnee.. * 0 1 2 3 4 * Maintenance Cost 1,000’s of Dollars 20 10 0 * * * * * * * * Patient-days in 1,000’s X Y
- 34. The Scattergraph Method UUssee Use oonnee one ddaattaa data ppooiinntt point ttoo to eessttiimmaattee estimate tthhee the ttoottaall total lleevveell ooff aaccttiivviittyy aanndd tthhee ttoottaall ccoosstt.. TToottaall mmaaiinntteennaannccee ccoosstt == $$1111,,000000 * Intercept = Fixed cost: $10,000 0 1 2 3 4 * Maintenance Cost 1,000’s of Dollars 20 10 0 * * * * * * * * Patient-days in 1,000’s X Y PPaattiieenntt ddaayyss == 880000
- 35. The Scattergraph Method MMaakkee Make aa a qquuiicckk quick eessttiimmaattee estimate ooff of vvaarriiaabbllee variable ccoosstt ppeerr uunniitt aanndd ddeetteerrmmiinnee tthhee ccoosstt eeqquuaattiioonn.. Total maintenance at 800 patients $ 11,000 Less: Fixed cost 10,000 Estimated total variable cost for 800 patients $ 1,000 Variable cost per unit = $1,000 800 = $$11..2255//ppaattiieenntt--ddaayy YYYY ==== $$$$11110000,,,,000000000000 ++++ $$$$1111....22225555XXXX TTTToooottttaaaallll mmmmaaaaiiiinnnntttteeeennnnaaaannnncccceeee ccccoooosssstttt NNNNuuuummmmbbbbeeeerrrr ooooffff ppppaaaattttiiiieeeennnntttt ddddaaaayyyyssss
- 36. Learning Objective LLOO33 To analyze a mixed cost using the high-low method.
- 37. The High-Low Method Assume the following hours of maintenance work and the total maintenance costs for six months.
- 38. The High-Low Method TThhee vvaarriiaabbllee ccoosstt ppeerr hhoouurr ooff mmaaiinntteennaannccee iiss eeqquuaall ttoo tthhee cchhaannggee iinn ccoosstt ddiivviiddeedd bbyy tthhee cchhaannggee iinn hhoouurrss.. Hours Total Cost High 800 $ 9,800 Low 500 7,400 Change 300 $ 2,400 $2,400 = $$88..0000//hhoouurr 300
- 39. The High-Low Method Total Fixed Cost = TToottaall CCoosstt –– TToottaall VVaarriiaabbllee CCoosstt TToottaall FFiixxeedd CCoosstt == $$99,,880000 –– (($$88//hhoouurr ×× 880000 hhoouurrss)) TToottaall FFiixxeedd CCoosstt == $$99,,880000 –– $$66,,440000 TToottaall FFiixxeedd CCoosstt == $$33,,440000
- 40. The High-Low Method The Cost Equation for Maintenance YY == $$33,,440000 ++ $$88..0000XX
- 41. Quick Check Sales salaries and commissions are $10,000 when 80,000 units are sold, and $14,000 when 120,000 units are sold. Using the high-low method, what is the variable portion of sales salaries and commission? a. $0.08 per unit b. $0.10 per unit c. $0.12 per unit d. $0.125 per unit
- 42. Quick Check Sales salaries and commissions are $10,000 when 80,000 units are sold, and $14,000 when 120,000 units are sold. Using the high-low method, what is the variable portion of sales salaries and commission? a. $0.08 per unit b. $0.10 per unit Units Cost c. $0.12 per unit d. $0.125 per unit High level 120,000 $ 14,000 Low level 80,000 10,000 Change 40,000 $ 4,000 $4,000 ÷ 40,000 units = $0.10 per unit
- 43. Quick Check Sales salaries and commissions are $10,000 when 80,000 units are sold, and $14,000 when 120,000 units are sold. Using the high-low method, what is the fixed portion of sales salaries and commissions? a. $ 2,000 b. $ 4,000 c. $10,000 d. $12,000
- 44. Quick Check Sales salaries and commissions are $10,000 when 80,000 units are sold, and $14,000 when 120,000 units are sold. Using the high-low method, what is the fixed portion of sales salaries and commissions? a. $ 2,000 b. $ 4,000 c. $10,000 d. $12,000
- 45. Least-Squares Regression Method A method used to analyze mixed costs if a scattergraph plot reveals an approximately linear relationship between the X and Y variables. TThhiiss mmeetthhoodd uusseess aallll ooff tthhee ddaattaa ppooiinnttss ttoo eessttiimmaattee tthhee ffiixxeedd aanndd vvaarriiaabbllee ccoosstt ccoommppoonneennttss ooff aa mmiixxeedd ccoosstt.. TThhee ggooaall ooff tthhiiss mmeetthhoodd iiss ttoo ffiitt aa ssttrraaiigghhtt lliinnee ttoo tthhee ddaattaa tthhaatt mmiinniimmiizzeess tthhee ssuumm ooff tthhee ssqquuaarreedd eerrrroorrss..
- 46. Least-Squares Regression Method SSooffttwwaarree ccaann bbee uusseedd ttoo ffiitt aa rreeggrreessssiioonn lliinnee tthhrroouugghh tthhee ddaattaa ppooiinnttss.. TThhee ccoosstt aannaallyyssiiss oobbjjeeccttiivvee iiss tthhee ssaammee:: YY == aa ++ bbXX The output from the regression analysis can be used to create an equation that enables you to estimate total costs at any activity level.
- 47. Comparing Results From the Three Methods TThhee tthhrreeee mmeetthhooddss jjuusstt ddiissccuusssseedd pprroovviiddee sslliigghhttllyy ddiiffffeerreenntt eessttiimmaatteess ooff tthhee ffiixxeedd aanndd vvaarriiaabbllee ccoosstt ccoommppoonneennttss ooff tthhee mmiixxeedd ccoosstt.. TThhiiss iiss ttoo bbee eexxppeecctteedd bbeeccaauussee eeaacchh mmeetthhoodd uusseess ddiiffffeerreenntt aammoouunnttss ooff tthhee ddaattaa ppooiinnttss ttoo pprroovviiddee eessttiimmaatteess.. LLeeaasstt--ssqquuaarreess rreeggrreessssiioonn pprroovviiddeess tthhee mmoosstt aaccccuurraattee eessttiimmaattee bbeeccaauussee iitt uusseess aallll tthhee ddaattaa ppooiinnttss..
- 48. Learning Objective LLOO44 To prepare an income statement using the contribution format.
- 49. The Contribution Format Income Statement LLeett’’ss ppuutt oouurr kknnoowwlleeddggee ooff ccoosstt bbeehhaavviioorr ttoo wwoorrkk bbyy pprreeppaarriinngg aa ccoonnttrriibbuuttiioonn ffoorrmmaatt iinnccoommee ssttaatteemmeenntt..
- 50. The Contribution Format Total Unit Sales Revenue $ 100,000 $ 50 Less: Variable costs 60,000 30 Contribution margin $ 40,000 $ 20 Less: Fixed costs 30,000 Net operating income $ 10,000 TThhee ccoonnttrriibbuuttiioonn mmaarrggiinn ffoorrmmaatt eemmpphhaassiizzeess ccoosstt bbeehhaavviioorr.. CCoonnttrriibbuuttiioonn mmaarrggiinn ccoovveerrss ffiixxeedd ccoossttss aanndd pprroovviiddeess ffoorr iinnccoommee..
- 51. Uses of the Contribution Format TThhee ccoonnttrriibbuuttiioonn iinnccoommee ssttaatteemmeenntt ffoorrmmaatt iiss uusseedd aass aann iinntteerrnnaall ppllaannnniinngg aanndd ddeecciissiioonn mmaakkiinngg ttooooll.. WWee wwiillll uussee tthhiiss aapppprrooaacchh ffoorr:: 11.. CCoosstt--vvoolluummee--pprrooffiitt aannaallyyssiiss ((CChhaapptteerr 66)).. 22.. BBuuddggeettiinngg ((CChhaapptteerr 77)).. 33.. SSppeecciiaall ddeecciissiioonnss ssuucchh aass pprriicciinngg aanndd mmaakkee--oorr-- bbuuyy aannaallyyssiiss ((CChhaapptteerr 1111))..
- 52. The Contribution Format Comparison of the Contribution Income Statement with the Traditional Income Statement Traditional Approach Contribution Approach (costs organized by function) (costs organized by behavior) Sales $ 100,000 Sales $ 100,000 Less cost of goods sold 70,000 Less variable expenses 60,000 Gross margin $ 30,000 Contribution margin $ 40,000 Less operating expenses 20,000 Less fixed expenses 30,000 Net operating income $ 10,000 Net operating income $ 10,000 UUsseedd pprriimmaarriillyy ffoorr eexxtteerrnnaall rreeppoorrttiinngg.. UUsseedd pprriimmaarriillyy bbyy mmaannaaggeemmeenntt..
- 53. Learning Objective LLOO55 To use variable costing to prepare a contribution format income statement and contrast absorption costing and variable costing. (Appendix 5A)
- 54. Appendix 5A CChhaapptteerr 55 Variable Costing
- 55. Overview of Absorption and Variable Costing Direct Materials Direct Labor Variable Manufacturing Overhead Fixed Manufacturing Overhead Variable Selling and Administrative Expenses Fixed Selling and Administrative Expenses Variable Costing Absorption Costing Product Costs Period Costs Product Costs Period Costs
- 56. Quick Check Which method will produce the highest values for work in process and finished goods inventories? a. Absorption costing. b. Variable costing. c. They produce the same values for these inventories. d. It depends.
- 57. Quick Check Which method will produce the highest values for work in process and finished goods inventories? a. Absorption costing. b. Variable costing. c. They produce the same values for these inventories. d. It depends.
- 58. Unit Cost Computations HHaarrvveeyy CCoommppaannyy pprroodduucceess aa ssiinnggllee pprroodduucctt wwiitthh tthhee ffoolllloowwiinngg iinnffoorrmmaattiioonn aavvaaiillaabbllee:: 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: Manufacturing overhead $ 150,000 Selling & administrative expenses $ 100,000
- 59. Unit Cost Computations UUnniitt pprroodduucctt ccoosstt iiss ddeetteerrmmiinneedd aass ffoolllloowwss:: Absorption Costing SSeelllliinngg aanndd aaddmmiinniissttrraattiivvee eexxppeennsseess aarree aallwwaayyss ttrreeaatteedd aass ppeerriioodd eexxppeennsseess aanndd ddeedduucctteedd ffrroomm rreevveennuuee aass iinnccuurrrreedd.. Variable 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
- 60. Income Comparison of Absorption and Variable Costing Let’s assume the following additional information for Harvey Company. 20,000 units were sold during the year at a price of $30 each. There were no units in beginning inventory. Now, let’s compute net operating income using both absorption and variable costing.
- 61. Absorption Costing 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 operating income $ 120,000
- 62. Variable Costing Variable Costing Variable manufacturing costs only. Sales (20,000 × $30) $ 600,000 Less variable expenses: Beginning inventory $ - Add COGM (25,000 × $10) 250,000 Goods available for sale 250,000 Less ending inventory (5,000 × $10) 50,000 Variable cost of goods sold 200,000 Variable selling & administrative All fixed manufacturing overhead is expensed. 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 operating income $ 90,000
- 63. Income Comparison of Absorption and Variable Costing Let’s compare the methods. Cost of Goods Sold Ending Inventory Period Expense Total Absorption costing Variable mfg. costs $ 200,000 $ 50,000 $ - $ 250,000 Fixed mfg. costs 120,000 30,000 - 150,000 $ 320,000 $ 80,000 $ - $ 400,000 Variable costing Variable mfg. costs $ 200,000 $ 50,000 $ - $ 250,000 Fixed mfg. costs - - 150,000 150,000 $ 200,000 $ 50,000 $ 150,000 $ 400,000
- 64. Comparing the Two Methods We can reconcile the difference between absorption and variable income as follows: Variable costing net operating income $ 90,000 Add: Fixed mfg. overhead costs deferred in inventory (5,000 units × $6 per unit) 30,000 Absorption costing net operating income $ 120,000 Fixed mfg. Overhead $150,000 Units produced = 2 5 , 0 0 0 u n i t s = $6.00 per unit
- 65. Extended Comparison of Income Data Here is information about the operation of Harvey Company for the second year. Number of units produced 25,000 Number of units sold 30,000 Units in beginning inventory 5,000 Unit sales price $ 30 Variable costs per unit: Direct materials, direct labor variable mfg. overhead $ 10 Selling & administrative expenses $ 3 Fixed costs per year: Manufacturing overhead $ 150,000 Selling & administrative expenses $ 100,000
- 66. Unit Cost Computations SSiinnccee Since tthheerree there wwaass was nnoo cchhaannggee iinn tthhee vvaarriiaabbllee ccoossttss ppeerr uunniitt,, ttoottaall ffiixxeedd ccoossttss,, oorr tthhee nnuummbbeerr ooff uunniittss pprroodduucceedd,, tthhee uunniitt ccoossttss rreemmaaiinn uunncchhaannggeedd.. Absorption Costing Variable 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
- 67. Absorption Costing Absorption Costing Sales (30,000 × $30) $ 900,000 Less cost of goods sold: Beg. inventory (5,000 × $16) $ 80,000 Add COGM (25,000 × $16) 400,000 Goods available for sale 480,000 Less ending inventory - 480,000 Gross margin 420,000 Less selling & admin. exp. Variable (30,000 × $3) $ 90,000 Fixed 100,000 190,000 Net operating income $ 230,000 TThheessee aarree tthhee 2255,,000000 uunniittss pprroodduucceedd iinn tthhee ccuurrrreenntt ppeerriioodd..
- 68. Variable Costing Variable Costing VVaarriiaabbllee mmaannuuffaaccttuurriinngg ccoossttss oonnllyy.. 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 Less ending inventory - Variable cost of goods sold 300,000 Variable selling & administrative AAllll ffiixxeedd mmaannuuffaaccttuurriinngg oovveerrhheeaadd iiss eexxppeennsseedd.. 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 operating income $ 260,000
- 69. Comparing the Two Methods We can reconcile the difference between absorption and variable income as follows: Variable costing net operating income $ 260,000 Deduct: Fixed manufacturing overhead costs released from inventory (5,000 units × $6 per unit) 30,000 Absorption costing net operating income $ 230,000 Fixed mfg. Overhead $150,000 Units produced = 2 5 , 0 0 0 u n i t s = $6.00 per unit
- 70. Income Comparison Costing Method 1st Period 2nd Period Total Absorption $ 120,000 $ 230,000 $ 350,000 Variable 90,000 260,000 350,000
- 71. Summary of Key Insights Relation between Effect Relation between production on variable and and sales iniventory absorption income Inventory Absorption Production > Sales increases > Variable Inventory Absorption Production < Sales decreases < Variable Absorption Production = Sales No change = Variable
- 72. End of Chapter 5
Editor's Notes
- Chapter 5: Cost Behavior: Analysis and Use. Managers who understand how costs behave are better able to predict costs and make decisions under various circumstances. This chapter explores the meaning of fixed, variable and mixed costs (the relative proportions of which define an organization’s cost structure). It also introduces the income statement prepared using the contribution format.
- Learning objective number 1 is to understand how fixed and variable costs behave and how to use them to predict costs.
- We introduced this table in Chapter 1. Let’s concentrate on variable costs in total. Recall that total variable cost is proportional to the activity level within the relevant range. As activity increases total variable cost increases, and as activity decreases total variable cost decreases.
- &lt;number&gt; An activity base (also called a cost driver) is a measure of what causes the incurrence of variable costs. As the level of the activity base increases, the variable cost increases proportionally. Variable costs may be caused by a variety of different activity bases. Gasoline consumption in your car is largely determined by the number of miles driven and the speed at which you travel.
- A true variable cost is one whose total dollar amount varies in direct proportion to changes in the level of activity. On your land-line, your total long distance telephone bill is determined by the number of minutes you talk. An activity base, or cost driver, is a measure of what causes the incurrence of variable costs. As the level of activity base increases, the variable cost increases proportionally.
- On a per unit basis, variable costs remain the same over a wide range of activity.
- A variable cost remains constant if expressed on a per unit basis. For your land-line, the cost per long-distance minute talked may remain the same at 10¢ per minute.
- &lt;number&gt; A public utility like Florida Power and Light, with large investments in equipment, will tend to have fewer variable costs. A manufacturing company like Black and Decker will often have many variable costs associated with the manufacture and distribution of its products to customers. A merchandising company like Wal-Mart will usually have a high proportion of variable costs such as the cost of merchandise purchased for resale. Some service companies, such as restaurants, have a high proportion of variable costs due to their raw material costs. Other service companies, such as an architectural firm, have a high proportion of fixed costs in the form of highly trained salaried employees.
- &lt;number&gt; Here are some examples of variable costs we are likely to find in different types of businesses: 1. Merchandising companies cost of goods sold. 2. Manufacturing companies direct materials, direct labor, and variable overhead. 3. Merchandising and manufacturing companies commissions, shipping costs, and clerical costs such as invoicing. 4. Service companies supplies, travel, and clerical.
- Recall that we talked earlier about how true variable costs vary directly and proportionately with changes in activity. Direct material is an example of a cost that behaves in a true variable pattern. Now let’s look at what are known as step-variable costs.
- &lt;number&gt; A step variable cost remains constant within a narrow range of activity, so it tends to look like a fixed cost. Maintenance workers are often considered to be a variable cost, but this labor cost does not behave as a true variable cost. Fairly wide changes in the level of production will cause a change in the number of maintenance workers employed and the total maintenance cost.
- &lt;number&gt; For a step-variable cost, total cost increases to a new higher level when we reach the next higher range of activity. For example, a maintenance worker is obtainable only as a whole person who is capable of working approximately 2,000 hours per year.
- &lt;number&gt; Only fairly wide changes in the level of activity will cause a change in a step-variable cost. Maintenance workers are obtainable only in large chunks of a whole person who is capable of working approximately 2,000 hours a year.
- Part IEconomists correctly point out that many costs that accountants classify as variable costs actually behave in a curvilinear fashion. Part IIIn many important decisions, accountants tend to treat costs as linear in nature. Part IIIAs long as the company is operating within the relevant range of activity, the accountant’s approximation of the economist’s curvilinear cost function seems to work quite well.The relevant range is the range of activity within which the assumptions made about cost behavior are valid.
- Now let’s look at fixed costs. Total fixed costs remain constant within the relevant range of activity.
- If you have a land-line in your home, you pay a flat connection fee that is the same every month. This fee is fixed because it does not change in total, regardless of the number of calls made.
- Finally, fixed cost per unit decreases as activity level goes up.
- As you make more and more local calls, the connection fee cost per call decreases. If your connection fee is $15 and you make one local call per month, the average connection fee is $15 per call. However, if you make 100 calls per month, the average connection fee drops to 15¢ per call.
- Part IOne type of fixed cost is known as committed fixed costs. These are long-term fixed costs that cannot be significantly reduced in the short-term. Some examples include depreciation on equipment and buildings and real estate taxes. Part IIAnother type of fixed cost is known as discretionary fixed costs. These types of fixed costs may be altered in the short-term by current management decisions. Some examples of discretionary fixed costs include advertising and research and development costs. For example, some construction companies may lay off workers during months with minimal customer demand. However, other construction companies may opt to retain their workers all year. A cost may be discretionary or committed depending on management’s strategy.
- &lt;number&gt; Part I In many industries, we see a trend toward greater fixed costs relative to variable costs. In the past fifteen years, we have seen computers and robotics take over many mundane tasks previously performed by humans. For example, H&R Block employees used to fill out tax returns for customers by hand. Now, computer software is used to complete tax returns. Safeway and Kroger employees used to key-in prices by hand on cash registers. Now, barcode readers enter price and other product information automatically. Part II In today’s world economy, knowledge workers are in demand for their experience and knowledge, rather than for their muscle. Most knowledge workers tend to be salaried, highly trained, and very difficult to replace. The cost of these valued employees tends to be fixed rather than variable.
- &lt;number&gt; In much of Europe, China, and Japan, management has little flexibility in adjusting the size of the labor force. Labor costs tend to be viewed as more fixed than variable. In recent years, we have seen some changes in management’s flexibility. In the U.S. and United Kingdom, management has much greater latitude to adjust the size of the labor force. Labor costs in some industries are still viewed as more variable than fixed.
- Fixed costs only stay constant in total within the relevant range of activity. As we adjust the relevant range of activity upward or downward, we see changes in total fixed costs. These upward or downward adjustments are generally very wide.
- An example of changes in total fixed costs might be rent for office space. A company can rent 1,000 square feet of office space for $30,000 per year. If the company fills its current space and needs additional office space, the next 1,000 square feet will cost an additional $30,000 per year. So when a company needs 1,000 square feet of office space, the fixed office rent is $30,000. If another 1,000 square feet are needed, the fixed office rent will be $60,000.
- &lt;number&gt; The question becomes, how do changes in fixed costs outside the relevant range differ from step-variable costs? Step-variable costs can be adjusted more quickly and the width of the change in activity is much wider for changes in fixed costs. For example, a step-variable cost such as maintenance workers may have steps with a width of 40 hours a week. However, fixed costs may have steps that have a width of thousands or tens-of-thousands of hours of activity.
- See how you do on this question. There can be more than one correct answer. Be careful and take your time.
- Number 4 is not correct because total variable costs increase as activity increases, within the relevant range and decrease as activity decreases, within the relevant range.
- A mixed cost has both a fixed and variable element. When you pay your utility bill, you know that a portion of your total bill is fixed. This is the standard monthly utility charge. The variable portion of your utility costs depends upon the number of kilowatt hours you consume. Your total utility bill has both a fixed and variable element. The graph demonstrates the nature of a normal utility bill.
- The mixed cost line can be expressed with the equation Y equals A plus B times X. This equation should look familiar, from your algebra and statistics classes. Based on this equation, Y is the total mixed cost; A is the total fixed cost (or the vertical intercept of the line); B is the variable cost per unit of activity (or the slope of the line); and X is the actual level of activity. In our utility example, Y is the total mixed cost; A is the total fixed monthly utility charge; B is the cost per kilowatt hour consumed, and X is the number of kilowatt hours consumed.
- &lt;number&gt; Part IRead through this short question to see if you can calculate the total utility bill for the month.Part IIHow did you do? The total bill is $100.
- In account analysis, we can analyze mixed costs by looking at each account and classifying the cost as variable, fixed or mixed based on the cost behavior over time. A more sophisticated way to analyze the nature of costs is to ask our engineers to evaluate each cost in terms of production methods, material requirements, labor usage and overhead.
- Learning objective number 2 is to use a scattergraph plot to diagnose cost behavior.
- A scattergraph plot is a quick and easy way to isolate the fixed and variable components of a mixed cost.The first step is to identify the cost, which is referred to as the dependent variable, and plot it on the Y axis. The activity, referred to as the independent variable, is plotted on the X axis. The second step is to analyze the data points on the scattergraph to see if they are linear, such that a straight line can be drawn that approximates the relation between cost and activity. If the plotted data points do not appear to be linear, do not analyze the data any further. If there does appear to be a linear relationship between the level of activity and cost, we will continue our analysis.
- The third step is to draw a straight line where, roughly speaking, an equal number of points reside above and below the line. Make sure that the straight line goes through at least one data point on the scattergraph.
- Part I The fourth step is to identify the Y intercept. This is where the straight line crosses the Y axis and is equal to the estimate of total fixed costs. In this case, the fixed costs are $10,000. Part IIThe fifth step is to estimate the variable cost per unit of the activity, which in this example is the cost per patient day. In our case, we used the first data point that was on the straight line. From this point, we estimate the total number of patient days and the total maintenance cost. Part IIIOur estimate of the total number of patient days at this data point is 800, and the estimate of the total maintenance cost is $11,000. We will use this information to estimate the variable cost per patient day.
- Part I Now, subtract the fixed cost from the total estimated cost for eight hundred patient days. We arrive at an estimated total variable cost or $1,000 for 800 patients. Part IIDivide the total variable cost by the 800 patients and we have determined that the variable cost per patient day is $1.25. We can use this information to setup of basic cost equation. Part IIOur maintenance cost equation tells us that Y, the total maintenance cost is equal to $10,000, the total fixed cost, plus $1.25 times X, the number of patient days.
- Learning objective number 3 is to analyze a mixed cost using the high-low method.
- The high-low method can be used to analyze mixed costs if a scattergraph plot reveals an approximately linear relationship between the X and Y variables. We will use the data shown in the Excel spreadsheet to determine the fixed and variable portions of maintenance costs. We have collected data about the number of hours of maintenance and total cost incurred.Let’s use the information on this slide and see how the high-low method works.
- Part I The first step in the process is to identify the high level of activity and the low level of activity. You can see that the high level of activity is 800 hours and the low level of activity is 500 hours. The second step is to determine the total costs associated with the two chosen points. The total cost for the high and low levels of activity is $9,800 and $7,400, respectively. Part II The third step is to calculate the change in the cost between the two data points and divide it by the change in activity level between the two data points. In our case, the change in level of activity is 300 hours and the change in total cost is $2,400. Part III The variable cost per unit of activity is determined by dividing the change in total cost by the change in activity. For our maintenance example, we divide $2,400 by 300 hours and determine that the variable cost per hour of maintenance is $8.
- Part IThe fourth step is to take the total cost, at either activity level, and deduct the variable cost component. The residual represents the estimate of total fixed costs. Here is the equation we will use to calculate total fixed cost. Part IIWe can substitute known data to estimate total fixed cost. We know that total costs are $9,800 at the high level of activity. Total variable cost is $6,400, which is computed by multiplying the $8 variable cost per unit by the 800 hours of maintenance. Part III By solving the equation, we see that total fixed cost is equal to $3,400.
- Step five is to construct an equation to estimate total maintenance cost at any level of activity within the relevant range. Our basic equation of Y is equal to $3,400 (our total fixed cost) plus $8 times the actual level of activity. You can verify the equation by calculating total maintenance costs at 500 hours, the low level of activity. It will be worth your time to make the calculation.
- See if you can apply what we have just discussed to determine the variable portion of sales salaries and commissions for this company.
- The correct answer is 10¢ per unit.
- Using the same data, calculate the total fixed cost portion of sales salaries and commissions.
- The calculation for the answer is a bit more complex, but we see that total fixed cost equals $2,000.
- &lt;number&gt; The least-squares regression method is a more sophisticated approach to isolating the fixed and variable portion of a mixed cost. The least-squares method uses all the data points, instead of just a few. The basic goal of this method is to fit a straight line to the data that minimizes the sum of the squared errors. The regression errors are the vertical deviations from the data points to the regression line.
- The formulas that are used for least-squares regression are complex. Fortunately, computer software can perform the calculations quickly. The observed values of the X and Y variables are entered into the computer program and all necessary calculations are made. Output from the regression analysis can be used to create the equation that enables us to estimate total costs at any activity level.
- &lt;number&gt; The three methods we discussed for isolating the fixed and variable portions of a mixed cost yield slightly different results. The most accurate estimate is provided by the least-squared regression method. Less accurate results are usually associated with the scattergraph. The high-low method provides results that fall somewhere in the middle of the other two methods.
- Learning objective number 4 is to prepare an income statement using the contribution format.
- &lt;number&gt; The contribution approach provides an income statement format geared directly to cost behavior, which has been the focus of discussion in this chapter. This statement is used for internal purposes.
- This approach separates costs into fixed and variable. Sales minus variable costs equals contribution margin. The contribution margin minus fixed costs equals net operating income.
- This approach is used as an internal planning and decision-making tool, and will be discussed further in the chapters shown on your screen.
- The contribution approach differs from the traditional approach covered in Chapter 1. The traditional approach organizes costs in a functional format. Costs relating to production, administration and sales are grouped together without regard to their cost behavior. The traditional approach is used primarily for external reporting purposes.
- Learning objective number 5 is to use variable costing to prepare a contribution format income statement and contrast absorption costing and variable costing.
- Appendix 5A: Variable Costing In this appendix, we will show you how to use Microsoft Excel to determine the key variables necessary for least-squares regression. As you have seen, we need three pieces of information: the estimated variable cost per unit (the slope of the line), the estimated fixed cost (the intercept), and R squared. Let’s get started. We think you will find that using Microsoft Excel is quite easy.
- Absorption costing (also called full costing) charges products with all manufacturing costs, regardless of whether the costs are fixed or variable. The cost of a unit of product consists of all four types of manufacturing costs — direct material, direct labor, variable manufacturing overhead, and fixed manufacturing overhead. Since no distinction is made between variable and fixed costs, absorption costing is not well suited for cost-volume-profit analysis. Variable costing (also called direct costing) charges products with only the variable manufacturing costs. The cost of a unit of product consists of the three variable manufacturing costs — direct material, direct labor, and variable manufacturing overhead. Variable costing is consistent with the contribution format income statement, and it supports cost-volume-profit analysis because of its emphasis on separating variable and fixed costs. The only difference in the two approaches is the treatment of fixed manufacturing overhead. With absorption costing, fixed manufacturing overhead is a product cost. With variable costing, fixed manufacturing overhead is a period cost. Note that selling and administrative costs are treated as period costs with both absorption costing and variable costing. Think about the impact of each method on inventory values, and then answer the following question.
- To answer this question correctly, recall which method includes more manufacturing costs in the unit product cost.
- Unit product costs are in both work in process and finished goods inventories. Absorption costing results in the highest inventory values because it treats fixed manufacturing overhead as a product cost. Using variable costing, fixed manufacturing overhead is expensed as incurred and never becomes a part of the product cost.
- Harvey Company makes twenty-five thousand units of a single product. Variable manufacturing costs total $10 per unit. Variable selling and administrative expenses are $3 per unit. Fixed manufacturing overhead for the year is $150,000, and fixed selling and administrative expenses for the year are $100,000.
- With variable costing, only the $10 per unit variable manufacturing costs (direct material, direct labor, and variable manufacturing overhead) are product costs. With absorption costing, we include all production costs, variable and fixed. To compute the per unit amount of fixed manufacturing overhead, we divide $150,000 of fixed manufacturing overhead by the 25,000 units manufactured. Selling and administrative expenses are always treated as period expenses and deducted from revenue as incurred.
- We need some additional information to allow us to prepare income statements for Harvey Company: Twenty thousand units were sold during the year. There were no units in beginning inventory. Now, let’s prepare income statements for Harvey Company. We will start with an absorption income statement.
- Harvey had no beginning inventory and sold only 20,000 of the 25,000 units produced, leaving 5,000 units in ending inventory. The sales price is $30 per unit, so sales revenue for the 20,000 sold is $600,000 The computation of cost of goods sold on your screen starts with beginning inventory, adds cost of goods manufactured and subtracts ending inventory. We could also compute cost of goods sold directly by multiplying 20,000 units sold times the $16 unit cost. We subtract cost of goods sold from sales to get the $280,000 gross margin. We subtract selling and administrative expenses from gross margin to get absorption cost net operating income of $120,000. The $60,000 variable selling and administrative expense is computed by multiplying 20,000 units sold times $3 per unit. The $100,000 fixed administrative expense was given earlier. Net operating income is $120,000.
- Now, let’s examine a variable cost income statement. Notice that this is a contribution format statement. First, we subtract all variable expenses from sales to get contribution margin. The first variable expense is variable cost of goods sold, which is computed using only the $10 per unit variable manufacturing cost. The next variable expense is the variable selling and administrative expense. It is computed as before, 20,000 units sold at $3 per unit. After computing contribution margin, we subtract fixed expenses to get the $90,000 variable cost net operating income. Note that all of the $150,000 of fixed manufacturing overhead is expensed as a lump sum under variable costing.
- The only difference between the two methods is the treatment of fixed manufacturing overhead. Absorption costing treats fixed manufacturing overhead as a product cost using an overhead rate of $6 per unit. As a result, $30,000 of fixed manufacturing overhead is left in inventory as a part of the cost of the 5,000 unsold units. Income computed using variable costing expenses all $150,000 of the fixed manufacturing overhead as a period expense. None of the fixed manufacturing overhead remains in inventory with variable costing. The variable costing inventory of $50,000 is computed by multiplying the $10 per unit variable product cost times the 5,000 unsold units.
- The difference between absorption cost net operating income and variable cost net operating income results from the $30,000 of fixed manufacturing overhead remaining in inventory as part of the cost of the 5,000 unsold units, using absorption costing. Using variable costing, this $30,000 is expensed in the period resulting in a net operating income that is $30,000 less than absorption cost net operating income. The $30,000 can be computed by multiplying the 5,000 unsold units times the $6 fixed manufacturing overhead cost per unit. We can reconcile the difference between the two methods by adding the $30,000 to the $90,000 variable cost income to get the $120,000 absorption cost net operating income.
- In the second year, Harvey Company again makes 25,000 units of the same product, but sells 30,000 units. Last year&apos;s 5,000 unit ending inventory becomes this year&apos;s beginning inventory. The sales price is the same as last year, $30 per unit. Variable manufacturing costs total $10 per unit. Variable selling and administrative expenses are $3 per unit. Fixed manufacturing overhead for the year is $150,000, and fixed selling and administrative expenses for the year are $100,000.
- With variable costing, only the $10 per unit variable manufacturing costs (direct material, direct labor, and variable manufacturing overhead) are product costs. With absorption costing, we include fixed manufacturing overhead in product costs. To compute the per unit amount of fixed manufacturing overhead, we divide $150,000 of fixed manufacturing overhead by the 25,000 units manufactured. Since there was no change in the per unit variable costs, total fixed costs, or the number of units produced, the unit costs remain unchanged.
- Harvey sold 30,000 units in the second year, 25,000 units produced in the second year plus 5,000 units from beginning inventory. The sales price is $30 per unit, so sales revenue for the 30,000 units sold is $900,000. The computation of cost of goods sold on your screen starts with beginning inventory, adds cost of goods manufactured and subtracts ending inventory. We could also compute cost of goods sold directly by multiplying 30,000 units sold times the $16 unit cost. We subtract cost of goods sold from sales to get the $420,000 gross margin. We subtract selling and administrative expenses from gross margin to get absorption cost net operating income of $230,000. The $90,000 variable selling and administrative expense is computed by multiplying 30,000 units sold times $3 per unit. The $100,000 fixed administrative expense was given. Net operating income is $230,000.
- Now, let’s examine a variable cost income statement for the second year. Again, notice that this is a contribution format statement. First, we subtract all variable expenses from sales to get contribution margin. The first variable expense is variable cost of goods sold, which is computed using only the $10 per unit variable manufacturing cost. The next variable expense is the variable selling and administrative expense. It is computed as before, 30,000 units sold at $3 per unit. After computing contribution margin, we subtract fixed expenses to get the $260,000 variable cost net operating income. Note that all of the $150,000 of fixed manufacturing overhead is expensed as a lump sum.
- The difference between absorption cost net operating income and variable cost net operating income results from the $30,000 of fixed manufacturing overhead released from beginning inventory, using absorption costing. Using variable costing, this $30,000 was expensed in the first year, never becoming a part of the inventory value. The $30,000 can be computed by multiplying the 5,000 from inventory times the $6 fixed manufacturing overhead cost per unit. We can reconcile the difference between the two methods by subtracting the $30,000 from the $260,000 variable cost income to get the $230,000 absorption cost net operating income.
- For the two-year time period, both methods report the same total income, $350,000, because for the two-year period total sales of 50,000 units equals total production of 50,000 units. Although sales and production may differ in any given year, over an extended period of time, sales cannot exceed production, nor can production greatly exceed sales. The shorter the time period, the more the net operating income figures will tend to differ.
- On your screen is a summary of what we have observed over the two-year period. When production is greater than sales, as in Harvey’s year 1, absorption income is greater than variable costing income. When production is less than sales, as in Harvey’s year 2, absorption costing income is less than variable costing income. When production equals sales, the two methods report the same net operating income.
- End of Chapter 5.