Chapter 7 Notes
Page 1
Variable Costing
Absorption
As we have seen in previous chapters, when you
manufacture your own inventory, the cost of that
inventory includes all of the costs associated with
running the factory that produces the inventory.
Generally, no part of the factory cost is expensed.
Instead, it is capitalized as the cost of the inventory
produced. It is only expensed when the inventory is
sold. At that point the cost of the inventory becomes
Cost of Goods Sold. This system is referred to as
Absorption Costing. It is also know as “Full Costing” and
“Full-Absorption Costing”.
The thought is that the
inventory absorbs all of the factory costs fully.
As we have seen, inventory costs are made up of the following under Absorption
Costing:
•
•
•
Direct Labor;
Direct Materials; and
Manufacturing Overhead (regardless of whether it is fixed or variable).
GAAP requires that a firm must use Absorption Costing for all of its financial statements
that are released to outside parties.
An alternative system to Absorption Costing is Variable Costing. Although GAAP does
not permit Variable Costing, Variable Costing is still widely used by companies for
internal purposes (e.g., in order to evaluate the performance of a manager, a product or
a division).
With Variable Costing, the cost of the inventory produced includes only:
•
•
•
Direct Labor;
Direct Material; and
Variable Manufacturing Overhead.
Under Variable Costing, Fixed Manufacturing Overhead is not treated as part of the cost
of the inventory produced. Instead, Fixed Manufacturing Overhead is expensed in the
current period. Currently expensing a cost is often referred to as treating it as a “period
cost”. Capitalizing a cost as part of the cost of inventory is often referred to as treating it
as a “product cost”.
The exclusion of Fixed Manufacturing Overhead from the cost of inventory makes Cost
of Goods Sold a purely Variable Cost.
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Chapter 7 Notes
Page 2
Variable Costing vs. Absorption Costing
In addition to having a different definition of inventory cost, Variable Costing uses a
different Income Statement format. With a Variable Costing Income Statement, we
group expenses into Variable Costs and Fixed Costs. The Variable Costing Income
Statement first reports a company's Sales Revenue reduced by its Variable Costs. This
difference is referred to as the "Contribution Margin." The Contribution Margin
represents the dollar amount that a company’s operations “contribute” to help pay its
Fixed Costs. The Variable Costing Income Statement then reduces the company’s
Contribution Margin by its Fixed Costs.
This Contribution Margin Format used by Variable Costing is different from the
traditional Multi-Step Income Statement associated with Absorption Costing. A
comparison of the two formats appears below:
ABSORPTION COSTING
Sales Revenue
-Cost of Goods Sold
Gross Margin or Gross Profit
-Selling, General and Administrative Expenses
Operating Profits
VARIABLE COSTING
Sales Revenue
-Variable Costs and Expenses
Contribution Margin
-Fixed Costs and Expenses
Operating Profits
Assume that Lucy’s Chocolate Factory, Inc. has the following costs, sales and
production:
Units Produced:
Units Sold:
Price Per Unit:
Direct Materials:
Direct Labor:
Variable Manufacturing Overhead:
Fixed Manufacturing Overhead:
Variable Sell., Gen. & Adm. Exps.:
Fixed Sell., Gen. & Adm. Exps.:
Using Absorption Costing, each unit would cost the following:
Direct Materials:
Direct Labor:
Variable Manufacturing Overhead:
Fixed Manufacturing Overhead:
Total Costs
Divide By Number of Units Produced
Cost Per Unit
$50,000
$30,000
$20,000
$50,000
$150,000
÷10,000
$15
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10,000
10,000
$25
$50,000
$30,000
$20,000
$40,000
$30,000
$30,000
Chapter 7 Notes
Page 3
Using Variable Costing, each unit would cost the following:
Direct Materials:
Direct Labor:
Variable Manufacturing Overhead:
Total Costs
Divide By Number of Units Produced
Cost Per Unit
$50,000
$30,000
$20,000
$100,000
÷10,000
$10
The difference in cost of the units under the Absorption Costing Method ($15) and the
Variable Costing Method ($10) is equal to the Fixed Manufacturing Overhead per unit
($5), which is included in inventory cost under Absorption Costing and is excluded from
inventory cost under Variable Costing.
Assuming that Lucy sold all of the units that it produced, you would have the following
Income Statements produced by the two methods:
Absorption Costing Income Statement
Variable Costing Income Statement
(25x10K)
(25x10K)
Sales Revenue:
$250,000
Sales Revenue: $250,000
(15x10K) Less VC:
COGS:
-150,000
(10x10K)
VCOGS:
-100,000
VSG&Adm:
-30,000
Gross Margin:
$100,000
Contrib.Marg:
$120,000
(30K+30K) Less FC:
Less: SG&Adm:
-60,000
F MO/H:
-50,000
F SG&Adm:
-30,000
Oper. Profits:
$40,000
Oper. Profits:
$40,000
As you can see, both methods produce the same Operating Profits. (This statement
assumes that either: (i) your manufacturing costs are the same in the current period and
prior periods, or (ii) you are using LIFO).
On the other hand, if the number of units that you sell differs from the number of units
produced in this period, then the Operating Profits reported using the two methods will
differ.
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Chapter 7 Notes
Page 4
Assume that Lucy sold only one-half of its production. Because the number of units
sold are one-half of the units that were sold previously then Lucy’s Variable Costs and
Sales Revenue would be one-half of the figures reported above.
Absorption Costing Income Statement
Variable Costing Income Statement
½ (25x10K) Sales Revenue: $125,000 ½ (25x10K)
Sales Revenue: $125,000
½ (15x10K) Less VC:
COGS:
-75,000
VCOGS:
-50,000 ½ (10x10K)
½ (30K)
VSG&Adm:
-15,000
Gross Margin:
$50,000
Contrib.Marg:
$60,000
(30K+ ½ 30K) Less FC:
Less: SG&Adm:
-45,000
F MO/H:
-50,000
F SG&Adm:
-30,000
Oper. Profits:
$5000
Oper. Profits:
-$20,000
The difference in the Operating Profits reported by the two methods is attributable to the
different treatment of Fixed Manufacturing Overhead allocated to the unsold units under
Absorption Costing. With Variable Costing, the entire Fixed Manufacturing Overhead
Cost ($50,000) is expensed in the current period. With Absorption Costing, the Fixed
Manufacturing Overhead is divided into a per unit cost ($5) and added to the Variable
Cost of each unit ($10) to produce the total cost of each unit manufactured ($15). When
only half of the units are sold, then only half of the Fixed Manufacturing Overhead is
expensed. The difference between the Operating Profits reported using the two
methods [$5,000 – (-$20,000) = $25,000] is equal to the amount of Fixed Manufacturing
Overhead that is added to the cost of the unsold units:
Fixed Manufacturing Overhead Per Unit x Unsold Units
$5 x 5,000 = $25,000
Because the Fixed Manufacturing Overhead that is not expensed is added to the cost of
the inventory, the inventory cost is $25,000 higher using Absorption Costing than it is
using Variable Costing. With Absorption Costing the inventory cost is $15 per unit and
the cost of the 5,000 unsold units is $75,000. On the other hand, with Variable Costing,
the inventory cost is $10 per unit, and the cost of the 5,000 unsold units is $50,000.
Potential Abuse of Absorption Costing
As you will recall from our discussion of Cost Behavior, with a linear cost function, the
Variable Cost per unit does not change as production increases (V=Vx↑/x↑) because the
total Variable Costs (numerator) go up proportionately as you produce more units
(denominator). On the other hand, the Fixed Cost per unit drops as you produce more
units [(FC per unit)↓=F/(x↑)] because you are dividing the same amount of Fixed Costs
by a larger denominator as you increase your production.
As noted above, Fixed Manufacturing Costs are part of the cost of inventory with
Absorption Costing. The total cost of each unit (both fixed and variable) will drop as you
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Chapter 7 Notes
Page 5
produce more units because of the fact that you are reducing the fixed portion of that
cost. By increasing the number of units that it produces, a firm can lower its inventory
cost per unit and thereby lower its Cost of Goods Sold and increase its profits. The
freedom to produce inventory solely to generate higher profits is a license to print your
own money.
For example, assume that Ye Old Mint Co. prints
commemorative coins. Its cost function is $5,000 +
$1 per unit produced, and each coin can be sold for
$1.90. If Ye Old Mint produces 10,000 units, the total
cost to produce 10,000 units is $15,000 [$5,000 +
($1x10,000)], and the cost of each unit is $1.50. Mint
will make 40 cents on each unit sold ($1.90 - $1.50)
at this production level. On the other hand, if it
produces 50,000 units, then the total cost to produce
50,000 units is $55,000 [$5,000 + ($1x50,000)], and
the cost of each unit is $1.10. Mint will make 80
cents on each unit that it sells at this production level
($1.90 - $1.10). As you can see, Mint doubled its
First U.S. Mint
profits under Absorption Costing without selling any
more units merely by producing more inventory.
Produce & Sell 10,000 units
Sales Revenue:
$19,000 (1.90x10K)
COGS:
-15,000 ($1.5x10K)
Oper. Profits:
$4,000 (40¢x10K)
Produce 50,000 Units & Sell 10,000 Units
(1.9x10K)
Sales Revenue:
$19,000
($1.10x10K)
COGS:
-11,000
(80¢x10K)
Oper. Profits:
$8,000
A number of managers and companies have discovered that they can increase profits
through overproduction of units, and they have produced more inventory than they need
solely for the purpose of boosting their Operating Profits.
This manipulation of profits is not possible with Variable Costing. With Variable Costing,
all Fixed Costs (including Fixed Manufacturing Overhead) are expensed in the year
incurred. The cost of your inventory is made up solely of Variable Costs. Regardless of
the number of units that you produce, the inventory cost (Variable Cost) stays the same.
If Mint produces 10,000 units, the total cost to produce the units is $10,000 ($1 x
10,000), and each unit costs $1. If Mint produces 50,000 units, the total cost to produce
the units is $50,000 ($1 x 50,000), which is still $1 per unit.
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Chapter 7 Notes
Page 6
With Variable Costing, Mint would report $4,000 of Operating Profits regardless of the
number of units produced:
Produce & Sell 10,000 units
Sales Revenue:
$19,000 (1.90x10K)
($1x10K)
VCOGS:
-10,000
Contrib. Marg:
$9,000
F MO/H:
-5,000
Oper. Profits:
$4,000
Produce 50,000 Units & Sell 10,000 Units
(1.90x10K)
Sales Revenue:
$19,000
($1x10K)
VCOGS:
-10,000
Contrib. Marg:
$9,000
F MO/H:
-5,000
Oper. Profits:
$4,000
Variable Costing always produces the same amount of Operating Profits as that
generated using Absorption Costing when 10,000 units were produced and sold
($4,000). For this reason, the Operating Profits reported using Variable Costing are
compared to the Operating Profits reported using Absorption Costing. The Operating
Profits produced by Variable Costing tells you the amount of Operating Profits that
would have been reported using Absorption Costing if the manager (or firm) had only
produced enough units to meet sales demands. It exposes the manipulation of
Operating Profits produced by making unsold units.
Although, producing unneeded units improves Operating Profits, this overproduction is
actually detrimental to the firm. The unsold units are not free. The firm expended the
Variable Costs needed to produce the units. Thus, you are tying up valuable resources
in the cost of the unsold inventory (as well as the cost to store the unsold inventory) that
could be used elsewhere. The current trend in inventory management is to try to
reduce inventory levels and thereby reduce such inventory and storage costs (e.g., the
growing popularity of the Just In Time Inventory System).
Moreover, once you produce this excess inventory, you cannot sell it without hurting
your Operating Profits in the year of sale. If you ever sell more units than you produce,
then Variable Costing will have higher Operating Profits than those produced using
Absorption Costing.
Assume that Ye Old Mint Co. has the following production and sales levels:
First Year
Second Year
Units Produced
50,000
10,000
Units Sold
10,000
50,000
As noted previously, the following inventory costs is produced at the following
production levels using Absorption Costing and Variable Costing:
First Year
Second Year
Units Produced
50,000
10,000
Absorption Costing
$1.10 per unit
$1.50 per unit
Variable Costing
$1 per unit
$1 per unit
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Chapter 7 Notes
Page 7
In the first year, Absorption Costing will report Operating Profits that are $4,000 higher
than those reported using Variable Costing:
Absorption Costing
Variable Costing
(1.90x10K)
Sales Revenue:
$19,000
Sales Revenue:
$19,000 (1.90x10K)
($1x10K)
COGS:
-11,000 ($1.10x10K) VCOGS:
-10,000
(80¢x10K) Contrib. Marg:
Oper. Profits:
$8,000
$9,000
F MO/H:
-5,000
Oper. Profits:
$4,000
The difference in Operating Profits is due to transferring $4,000 of Fixed Manufacturing
Overhead away from Cost of Goods Sold to the cost of the unsold inventory, which is an
asset on the Balance Sheet. Note that when Mint produces 50,000 units, the Fixed
Manufacturing Overhead ($5,000) is spread over all of those units and produces a per
unit cost of 10¢ ($5,000/50,000):
F MO/H per Unit
X Unsold Units
10¢ X 40,000
= Absorption Costing Profits exceed Variable
Costing Profits by:
= $4,000
As you can see, when you produce more units than you sell, then your Operating Profits
are higher using Absorption Costing than those produced using Variable Costing. In the
second year, however, Mint sells more units than it produces, and the opposite is true:
Absorption Costing
Variable Costing
(1.9x50K) Sales Revenue:
Sales Revenue:
$95,000
$95,000
COGS:
-59,000 ($1.10x40K)+ VCOGS:
-50,000
Oper. Profits:
$36,000
($1.5 x 10K)
(80¢x10K)
Contrib. Marg:
F MO/H:
Oper. Profits:
(1.90x50K)
($1x50K)
$45,000
-5,000
$40,000
Now, all of the Fixed Manufacturing Overhead that was not expensed (and was placed
in inventory) during the first year under Absorption Costing now moves to Cost of Goods
Sold. This makes Mint’s expenses $4,000 higher than they are using Variable Costing.
Recall that with Variable Costing all of the Fixed Manufacturing Overhead was
expensed in the first year, which is why the Operating Profits reported using Variable
Costing were lower in the first year. Variable Costing has no deferred Fixed
Manufacturing Overhead Cost that is recaptured upon the sale of the inventory.
F MO/H per Unit
X Unsold Units
10¢ X -40,000
= Absorption Costing Profits exceed Variable
Costing Profits by:
= -$4,000
This time we dipped into inventory levels. Thus, there are negative unsold units. The
negative amount of profits indicates that the Variable Costing Method produces
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Chapter 7 Notes
Page 8
Operating Profits that are $4,000 higher than those reported using the Absorption
Method.
Variable Costing Example
The following information relates to Robin Toy Co:
Sales Price:
Variable Costs and Expenses:
Direct Labor:
Direct Materials:
Variable Manufacturing Overhead:
Variable Selling, General &
Administrative Expenses:
Fixed Costs and Expenses:
Fixed Manufacturing Overhead:
Fixed Selling, General &
Administrative Expenses:
$15
$1/ unit produced
$2/ unit produced
$1/ unit produced
$2/ unit sold
$60,000
$40,000
What are the Operating Profits of Robin if it manufactures and sells 10,000 units using
both Absorption Costing and Variable Costing?
The first thing that you should always do with these problems is to calculate the Cost of
Goods Manufactured per unit using each method.
Absorption Costing:
Direct Materials:
Direct Labor:
Variable Manufacturing Overhead:
Fixed Manufacturing Overhead:
$ 20,000
10,000
10,000
60,000
Total Manufacturing Cost:
Divide By The Number of Units Produced:
$100,000
÷10,000
Manufacturing Cost Per Unit:
(2x10,000)
(1x10,000)
(1x10,000)
$10
Variable Costing:
Direct Materials:
Direct Labor:
Variable Manufacturing Overhead:
Total Manufacturing Cost:
Divide By The Number of Units Produced:
Manufacturing Cost Per Unit:
$ 20,000
10,000
10,000
(2x10,000)
(1x10,000)
(1x10,000)
$40,000
÷10,000
$4
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Chapter 7 Notes
Page 9
Note that the Fixed Manufacturing Overhead per unit is $6 ($60,000/10,000 units),
which is the difference between the costs produced by the two methods ($10 - $4 = $6).
As we have seen before, because Robin sold exactly the number of units that it
manufactured, the two methods produce the same Operating Profits:
ABSORPTION COSTING
Sales Revenue:
$150,000 (15x10K)
Cost of Goods Sold:
-100,000 (10x10K)
Gross Margin:
Selling & Administrative:
$50,000
-$60,000
Operating Profits:
-$10,000
(40K+(2x10K))
VARIABLE COSTING
Sales Revenue:
$150,000
Var. COGS:
Var Sell. & Adm:
-40,000
-20,000
Contribution Margin:
$90,000
Fxd. Manuf. OH:
Fxd. Sell. & Adm:
-60,000
-40,000
Operating Profits:
-10,000
(15x10K)
(4x10K)
(2x10K)
Now, let us examine what happens when Robin doubles its production to 20,000 units.
Assume that it still sells 10,000 units. Again, you must first calculate the Cost of Goods
Manufactured per unit for each method.
Absorption Costing:
Direct Materials:
Direct Labor:
Variable Manufacturing Overhead:
Fixed Manufacturing Overhead:
$ 40,000
20,000
20,000
60,000
Total Manufacturing Cost:
Divide By The Number of Units Produced:
$140,000
÷20,000
Manufacturing Cost Per Unit:
(2x20,000)
(1x20,000)
(1x20,000)
$7
Note what happened to the cost of one unit under Absorption Costing when we
increased production. It decreased from $10 to $7. This difference is due solely to the
Fixed Manufacturing Overhead. The Fixed Manufacturing Overhead has now dropped
to $3 per unit ($60,000/20,000 units) from the previous $6 per unit.
Variable Costing:
Direct Materials:
Direct Labor:
Variable Manufacturing Overhead:
Total Manufacturing Cost:
Divide By The Number of Units Produced:
Manufacturing Cost Per Unit:
$ 40,000
20,000
20,000
(2x20,000)
(1x20,000)
(1x20,000)
$80,000
÷20,000
$4
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Chapter 7 Notes
Page 10
Note that the inventory cost of one unit did not change under Variable Costing.
Because Robin sold less units than it manufactured, the two methods produce different
Operating Profits figures:
ABSORPTION COSTING
VARIABLE COSTING
Sales Revenue:
Cost of Goods Sold:
$150,000
-70,000
(15x10K)
(7x10K)
Sales Revenue:
Gross Margin:
Selling & Administrative:
$80,000
-$60,000
(40K+(2x10K))
Contribution Margin:
$90,000
Fxd. Manuf. OH:
Fxd. Sell. & Adm:
-60,000
-40,000
Operating Profits:
-10,000
Operating Profits:
$20,000
Var. COGS:
Var Sell. & Adm:
$150,000
-40,000
-20,000
(15x10K)
(4x10K)
(2x10K)
Note that the Operating Profits produced using Variable Costing did not change. It
stayed at a loss of $10,000. The Operating Profits reported using Absorption Costing
improved from the original loss of $10,000 to a profit of $20,000. Why? Robin did not
produce more revenue than before. This $30,000 increase in the Operating Profits
came solely from reducing the cost of Robin’s inventory from $10 per unit to $7 per unit.
Remember that Variable Costing expenses all of the Fixed Manufacturing Overhead.
However, with Absorption Costing, the Fixed Manufacturing Overhead ($3 per unit) that
is attributable to the unsold units (10,000 units) was removed from the expenses on the
Income Statement and added to the cost of Inventory on the Balance Sheet:
Fixed Manufacturing Overhead Per Unit x Unsold Units
$3 x 10,000 = $30,000
So, Absorption Costing allowed Robin to reduce its total expenses by $30,000 as a
result of its production of unneeded units. Variable Costing did not permit such a
reduction in expenses.
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