Variable
e Costing By Dr. Micha
ael Constas
s
18
Page 1
Pricing
g and Pro
ofitabilitty Analy
ysis
Absorption
n
As we have
h
seen
n in previo
ous chapte
ers, when you
manufactture your own inve
entory, the
e cost of that
inventory
y includes all of the
e costs a
associated with
running the facto
ory that p
produces the inven
ntory.
Generally
y, no partt of the fa
actory costt is expen
nsed.
Instead, it is capita
alized as tthe cost o
of the inven
ntory
produced
d. It is on
nly expense
ed when the invento
ory is
sold. Att that pointt the cost o
of the inve
entory beco
omes
Cost of Goods So
old. This system is referred to
o as
Absorptio
on Costing. It is also kknow as “Fu
ull Costing”” and
“Full-Absorption Co
osting”. T
The thought is thatt the
inventory
y absorbs all of the facctory costs ffully.
As we have seen
n, inventory
y costs are
e made up
p of the fo
ollowing un
nder Absorption
Costing::



Direct
D
Laborr;
Direct
D
Materrials; and
Manufacturin
M
ng Overhea
ad (regardle
ess of whetther it is fixe
ed or variab
ble).
GAAP re
equires tha
at a firm mu
ust use Absorption Cossting for alll of its finan
ncial statem
ments
that are released to
o outside pa
arties.
An alterrnative systtem to Abso
orption Cos
sting is Varriable Costting. Althou
ugh GAAP does
not perm
mit Variable Costing, Variable Costing
C
is still widelyy used by companiess for
internal purposes (e.g., in order to evaluate the perrformance o
of a manager, a produ
uct or
a divisio
on).
With Variable Costing, the cos
st of the inv
ventory prod
duced inclu
udes only:



Direct
D
Laborr;
Direct
D
Materrial; and
Variable
V
Manufacturing
g Overhead
d.
Under Variable
V
Cos
sting, Fixed
d Manufactu
uring Overh
head is not treated as part of the cost
of the in
nventory pro
oduced. In
nstead, Fixe
ed Manufa cturing Ove
erhead is e
expensed in
n the
current period.
p
Currently expensing a co
ost is often referred to
o as treating
g it as a “pe
eriod
cost”. Capitalizing
C
p of the cost
c
of inve ntory is ofte
en referred to as treatting it
a cost as part
as a “pro
oduct cost”.
The exc
clusion of Fixed Manuffacturing Overhead
O
fro
om the cosst of invento
ory makes Cost
of Goods Sold a pu
urely Variab
ble Cost.
Please send
s
comm
ments and corrections
c
to
t me at [email protected]
Variable
e Costing By Dr. Micha
ael Constas
s
Page 2
Variable Costin
ng vs. Abs
sorption Costing
In addition to haviing a differrent definitiion of inve
entory cost,, Variable C
Costing usses a
differentt Income Statement
S
format.
f
With
W
a Varia
able Costin
ng Income Statementt, we
group expenses in
nto Variable
e Costs an
nd Fixed Costs. The Variable C
Costing Inccome
Stateme
ent first repo
orts a company's Sale
es Revenue
e reduced b
by its Varia
able Costs. This
differenc
ce is referred to as
s the "Co
ontribution Margin." The Contrribution Ma
argin
represen
nts the dollar amountt that a com
mpany’s op
perations “ccontribute” to help pa
ay its
Fixed Costs.
C
The
e Variable Costing Income Stat ement then
n reduces the compa
any’s
Contribu
ution Margin
n by its Fixe
ed Costs.
This Co
ontribution Margin Fo
ormat used by Variable Costiing is diffe
erent from
m the
traditional Multi-Sttep Income Stateme
ent associa
ated with Absorption
n Costing. A
comparison of the two
t
formats
s appears below:
b
ABSOR
RPTION CO
OSTING
Sales Revenue
oods Sold
-Cost of Go
Gross Margin or Grross Profit
-Selliing, Genera
al and Adm
ministrative Expenses
E
Operating Profits
VA
ARIABLE COSTING
Sales Reve
enue
-Varriable Costss and Expenses
Contribution Ma
argin
-F
Fixed Costss and Expenses
O
Operating Profits
Assume
e that Lucy’s Chocolate Facto
ory, Inc. ha
as the folllowing cossts, sales and
production:
Units Produced:
Units Sold:
Price Per Unit:
Directt Materials:
Directt Labor:
Variab
ble Manufaccturing Ove
erhead:
Fixed Manufactu
uring Overhead:
Variab
ble Sell., Ge
en. & Adm.. Exps.:
Fixed Sell., Gen.. & Adm. Exxps.:
C
eac
ch unit wou
uld cost the following:
Using Absorption Costing,
Direct Materials:
M
Direct La
abor:
Variable
e Manufactu
uring Overh
head:
Fixed Manufacturin
ng Overhea
ad:
Total Co
osts
Divide By
B Number of Units Pro
oduced
Cost Per Unit
$50,000
$30,000
$20,000
$50,000
$150
0,000
÷10
0,000
$15
Please send
s
comm
ments and corrections
c
to
t me at [email protected]
10
0,000
10
0,000
$25
$50
0,000
$30
0,000
$20
0,000
$40
0,000
$30
0,000
$30
0,000
Variable Costing By Dr. Michael Constas
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) Sales Revenue: $250,000
(25x10K)
Sales Revenue:
$250,000
(15x10K)
COGS:
-150,000
Less VC:
(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.
Please send comments and corrections to me at [email protected]
Variable Costing By Dr. Michael Constas
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
Please send comments and corrections to me at [email protected]
Page 5
Variable
e Costing By Dr. Micha
ael Constas
s
produce
e more units because of the factt that you a
are reducin
ng the fixed
d portion off that
cost. By
y increasing the numb
ber of units
s that it pro
oduces, a firm can low
wer its inven
ntory
cost perr unit and thereby
t
low
wer its Cos
st of Goodss Sold and
d increase its profits. The
freedom
m to produce
e inventory
y solely to generate
g
hiigher profitss is a licen
nse to print your
own money.
For example,
e
a
assume tha
at Ye Old Mint Co. p
prints
comm
memorative coins. Itss cost functtion is $5,0
000 +
$1 pe
er unit prod
duced, and each coin can be solld for
$1.90
0. If Ye Old Mint produ
uces 10,000
0 units, the total
cost to
t produce
e 10,000 units is $15
5,000 [$5,000 +
($1x10,000)], an
nd the cosst of each
h unit is $1.50.
w make 4
40 cents o
on each un
nit sold ($1.90 Mint will
$1.50
0) at this prroduction le
evel. On th
he other han
nd, if
it pro
oduces 50 ,000 unitss, then the
e total cosst to
produ
uce 50,00
00 units is $55,00
00 [$5,000
0 +
($1x5
50,000)], an
nd the cosst of each
h unit is $1.10.
Mint will
w make 8
80 cents on
n each unit that it sells at
this production
p
level ($1.9
90 - $1.10)). As you can
First U.S. Mint
see, Mint dou bled its p
profits und
der Absorption
Costing without sellling any mo
ore units merely by pro
roducing mo
ore invento
ory.
Pro
oduce & Se
ell 10,000 units
u
K)
Sales Revenue:
$19,000 (1.90x10K
($1.5x10K
K)
COGS
S:
-15,000
K)
Oper. Profits:
$4,000 (40¢x10K
Produce
e 50,000 Units & Selll 10,000 Un
nits
(1.9x1
10K)
Sales R
Revenue:
$19,000
($1.10x1
10K)
COGS:
-11,000
(80¢x1
10K)
Oper. P
Profits:
$8,000
A number of mana
agers and companies
c
have disco
overed thatt they can increase profits
through overproduc
ction of unitts, and they
y have prod
duced more
e inventory than they n
need
or the purpo
ose of boos
sting their Operating
O
Profits.
solely fo
This ma
anipulation of
o profits is not possib
ble with Varriable Costing. With Va
ariable Cossting,
all Fixed
d Costs (in
ncluding Fix
xed Manuffacturing O
Overhead) a
are expenssed in the year
incurred
d. The cost of your inventory is made
m
up sollely of Varia
able Costs.. Regardless of
the num
mber of units
s that you produce,
p
the
e inventoryy cost (Varia
able Cost) sstays the sa
ame.
If Mint produces 10,000
1
unitts, the tota
al cost to produce th
he units is $10,000 (($1 x
10,000),, and each unit costs $1.
$ If Mint produces 5
50,000 unitss, the total cost to produce
the units
s is $50,000
0 ($1 x 50,0
000), which
h is still $1 p
per unit.
Please send
s
comm
ments and corrections
c
to
t me at [email protected]
Variable Costing By Dr. Michael Constas
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
Please send comments and corrections to me at [email protected]
Variable Costing By Dr. Michael Constas
Page 7
In the first year, Absorption Costing will report Operating Profits that are $4,000 higher
than those reported using Variable Costing:
Variable Costing
Absorption 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
Please send comments and corrections to me at [email protected]
Variable
e Costing By Dr. Micha
ael Constas
s
Page 8
Operatin
ng Profits that are $4,000
$
high
her than th
hose reporrted using the Absorption
Method.
Variable Costin
ng Examp
ple
The follo
owing inform
mation relates to Robin Toy Co:
Sales Price:
P
Variable
e Costs and
d Expenses
s:
Direct
D
Laborr:
Direct
D
Materrials:
Variable
V
Man
nufacturing
g Overhead:
Variable
V
Selling, Generral &
Administtrative Expe
enses:
Fixed Costs
C
and Expenses:
E
Fixed Manuffacturing Ov
verhead:
g, General &
Fixed Selling
Administtrative Expe
enses:
$15
$1/ unit produced
$2/ unit produced
$1/ unit produced
$2/ unit sold
0
$60,000
$40,000
0
What arre the Operrating Profitts of Robin
n if it manuffactures an
nd sells 10,000 units u
using
both Abs
sorption Co
osting and Variable
V
Co
osting?
The firstt thing that you should
d always do
o with these
e problems is to calcu
ulate the Co
ost of
Goods Manufacture
M
ed per unit using each
h method.
Absorptiion Costing
g:
Direct Matterials:
Direct Lab
bor:
Variable Manufacturi
M
ing Overhead:
Fixed Man
nufacturing Overhead::
$ 20,0
000
10,0
000
10,0
000
60,0
000
Total Man
nufacturing Cost:
Divide By The Numb
ber of Units Produced:
$100,000
÷10,000
Manufactu
uring Cost Per
P Unit:
(2x10,,000)
(1x10,,000)
(1x10,,000)
$10
e Costing:
Variable
Direct Matterials:
Direct Lab
bor:
Variable Manufacturi
M
ing Overhead:
Total Man
nufacturing Cost:
Divide By The Numb
ber of Units Produced:
Manufactu
uring Cost Per
P Unit:
$ 20,0
000
10,0
000
10,0
000
(2x10,,000)
(1x10,,000)
(1x10,,000)
$40,000
÷10,000
$4
Please send
s
comm
ments and corrections
c
to
t me at [email protected]
Variable Costing By Dr. Michael Constas
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
Please send comments and corrections to me at [email protected]
Variable Costing By Dr. Michael Constas
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.
Dropping A Division or Product
When we discussed Relevant Costing, we saw that costs that do not disappear when a
product or division is dropped (unavoidable costs) are not relevant in making a decision
about whether to drop a division or product. Only costs that disappear when a product
or division is dropped (avoidable costs) are relevant. The Variable Costing Income
Statement helps to isolate avoidable and unavoidable costs because Variable Costs, by
definition, are avoidable costs. If you reduce your production, by dropping a division or
a product, these costs will go down. Although the Absorption Income Statement mixes
Fixed Costs and Variable Costs, the Variable Costing Income Statement isolates the
two types of costs. The Contribution Margin is relevant in making a decision about
Please send comments and corrections to me at [email protected]
Variable Costing By Dr. Michael Constas
Page 11
dropping a division or product. If the division or product has a negative Contribution
Margin, then it should be dropped.
Although it is relevant, the Contribution Margin, however, is not the only information that
you need to know. As we have seen previously, Fixed Costs can be divided into two
classes:

Common Fixed Costs – the Fixed Costs that are common to all divisions or
products and that will not disappear if a product or division is dropped
(unavoidable); and

Direct Fixed Costs – the Fixed Costs that can be traced to a product or division
and that will disappear if a product or division is dropped (avoidable).
As we have noted previously, because Direct Fixed Costs will be reduced if you drop a
division or product, they are therefore relevant to the decision of whether to discontinue
a product or division.
Assume that Carmen’s Banana Business, Inc. produces and
sells three popular banana products: Bananas, Banana Bread,
and Banana Pudding. Carmen has the following revenue and
costs (numbers in thousands):
Sales Revenue:
Variable Costs:
Manager Salaries:
Rent:
Product Margin /Oper. Prof.
Fruit Bread Pudding
Total
$600
$400
$400 $1,400
-100
-100
-200
-400
-50
-50
-50
-150
-200
-200
-700
-300
$150
50
-50
$150
In an Absorption Income Statement, the Variable and Fixed Costs would be
commingled, and the Product Margin of the Banana Pudding (-50) would suggest that it
should be dropped.
Please send comments and corrections to me at [email protected]
Variable Costing By Dr. Michael Constas
Page 12
When a Variable Costing Income Statement is used, however, it becomes less clear
that the Banana Pudding product line should be dropped:
Sales Revenue:
Less Variable Costs:
Variable Costs:
Contribution Margin:
Less Fixed Costs:
Manager Salaries:
Rent:
Operating Profits:
Fruit Bread
$600
$400
-100
$500
-100
$300
Pudding
Total
$400 $1,400
-200
-400
$200 $1,000
-150
-700
$150
The Banana Pudding’s positive Contribution Margin indicates that the revenue produced
from selling the pudding is sufficient to: (i) pay the Variable Costs incurred in the
production of the pudding, as well as (ii) pay part of the Fixed Costs of the Company.
Unfortunately, a Variable Costing Income Statement does not contain any information
regarding whether Fixed Costs are avoidable (Direct Fixed Costs) or unavoidable
(Common Fixed Costs). This must be added to the Variable Costing Income Statement.
Direct Fixed Costs should be allocated to a division or product. Only Common Fixed
Costs should appear only in the “Total” column. In the above example, assume that the
rent is a Common Fixed Cost and the salaries of the managers represent Direct Fixed
Costs.
Sales Revenue:
Less Variable Costs:
Variable Costs:
Contribution Margin:
Less Direct Fixed Costs:
Manager Salaries:
Product Margin:
Less Common Fixed Costs:
Rent:
Operating Profits:
Fruit Bread
$600
$400
Pudding
Total
$400 $1,400
-100
$500
-100
$300
-200
-400
$200 $1,000
-50
$450
-50
$250
-50
$150
-150
$850
-700
$150
This modified Variable Costing Income Statement segregates Direct Fixed Costs from
Common Fixed Costs. This format makes it clear that the Banana Pudding product line
should not be dropped.
It shows that Banana Pudding contributes $150,000 to
Carmen’s Operating Profits.
Please send comments and corrections to me at [email protected]
Variable Costing By Dr. Michael Constas
Page 13
Since Carmen has only $150,000 of Operating Profits, if Banana Pudding is dropped,
then Carmen’s Operating Profits will disappear (150,000 – 150,000 = 0):
Fruit Bread
Sales Revenue:
Less Variable Costs:
Variable Costs:
Contribution Margin:
Less Fixed Costs:
Manager Salaries:
Product Margin:
Rent:
Operating Profits:
Total
$600
$400 $1.000
-100
$500
-100
$300
-200
$800
-50
$450
-50
$250
-100
$700
-700
$0
Please send comments and corrections to me at [email protected]
Variable Costing By Dr. Michael Constas
Page 14
PROBLEMS
E-1. In an income statement prepared as an internal report using the variable costing
method, variable selling and administrative expenses would:
A) not be used.
B) be treated the same as fixed selling and administrative expenses.
C) be used in the computation of net operating income but not in the
computation of the contribution margin.
D) be used in the computation of the contribution margin.
E-2. If the number of units produced exceeds the number of units sold, then net
operating income under absorption costing will:
A) be equal to the net operating income under variable costing.
B) be greater than net operating income under variable costing.
C) be equal to the net operating income under variable costing plus total fixed
manufacturing costs.
D) be equal to the net operating income under variable costing less total fixed
manufacturing costs.
Use the following to answer questions E-3 through E-6:
Janos Company, which has only one product, has provided the following data
concerning its most recent month of operations:
Selling price .............................................
$111
Units in beginning inventory ...................
Units produced .........................................
Units sold .................................................
Units in ending inventory ........................
300
2,000
2,200
100
Variable costs per unit:
Direct materials.....................................
Direct labor ...........................................
Variable manufacturing overhead .........
Variable selling and administrative ......
$29
30
4
9
Fixed costs:
Fixed manufacturing overhead .............
Fixed selling and administrative ...........
$34,000
39,600
The company produces the same number of units every month, although the
sales in units vary from month to month. The company's variable costs per unit
and total fixed costs have been constant from month to month.
Please send comments and corrections to me at [email protected]
Variable Costing By Dr. Michael Constas
Page 15
E-3. What is the unit product cost for the month under variable costing?
A) $63
B) $80
C) $72
D) $89
E-4. What is the unit product cost for the month under absorption costing?
A) $80
B) $72
C) $63
D) $89
E-5. What is the net operating income for the month under variable costing?
A) $8,800
B) $12,200
C) $1,700
D) $24,800
E-6. What is the net operating income for the month under absorption costing?
A) $8,800
B) $24,800
C) $1,700
D) $12,200
Use the following to answer questions E-7 through E-10:
Kosco Corporation's absorption costing income statement for March follows:
Kosco Corporation
Income Statement
For the Month Ended March 31
Sales (2,400 units)....................................................
Cost of goods sold:
Beginning Inventory (100 units)...........................
Add Cost of Goods Manufactured (2,500 units)...
Goods Available for Sale ......................................
Less Ending Inventory (200 units)........................
Cost of Goods Sold ..................................................
Gross Margin ...........................................................
Less Selling and Administrative Expenses:
Fixed .....................................................................
Variable .................................................................
Net Operating Income..............................................
$48,000
$ 1,000
25,000
26,000
2,000
24,000
24,000
7,200
9,600
Please send comments and corrections to me at [email protected]
16,800
$ 7,200
Variable Costing By Dr. Michael Constas
Page 16
During March, the company's variable production costs were $8 per unit and its
fixed manufacturing overhead totaled $5,000.
E-7. Net operating income under the variable costing method for March would be:
A) $7,200.
B) $7,000.
C) $7,600.
D) $6,800.
E-8. The contribution margin per unit during March was:
A) $8.
B) $12.
C) $10.
D) $3.
E-9. The break-even point in units for the month under variable costing would be:
A) 600 units.
B) 900 units.
C) 1,017 units.
D) 1,525 units.
E-10. The dollar value of Kosco's ending inventory on March 31 under variable costing
would be:
A) $1,600.
B) $2,400.
C) $2,000.
D) $3,400.
Please send comments and corrections to me at [email protected]
Variable Costing By Dr. Michael Constas
P-1
Page 17
Assume that a company has four divisions, which performed as reported below.
Sales:
Variable Costs
Fixed Costs
Operating Profit
A
B
C
D
Total
$1,000 $2,000 $1,000 $1,000
-660 -1,200
-800
-400
-300
-300
-300 -600
$50
$200
-$100
$300 $450
Sixty percent of the Fixed Costs allocated to each division costs are common to
the company as a whole (e.g., the president's salary). These costs are allocated
using the relative sales of each of the divisions. Forty percent of the Fixed
Costs are specific to the division listed. The company's president, who never
had Cost Accounting, has decided to drop any unprofitable divisions. This
economy is stagnant and all revenues and costs remain the same each year.
Apart from the President’s decision, should the company drop any division?
What is going to happen if the company follows this edict in the first year?
What is going to happen if the company follows this edict in the second year?
What is going to happen if the company follows this edict in the third year?
What is going to happen if the company follows this edict in the fourth year?
Is there a fifth year?
P-2
Wilmont Company's executive committee was meeting to select a new vicepresident of operations. The leading candidate was Howard Kimball, manager of
Wilmont's largest division. Howard had been divisional manager for three years.
The president of Wilmont, Larry Olsen, was impressed with the significant
improvements in the division's profits since Howard had assumed command. In
the first year of operations, divisional profits had increased by 20 percent. They
had shown significant improvements for the following two years as well.
To bolster support for Howard, the company's president circulated the following
divisional income statements (dollars in thousands):
1995
1996
1997
Sales (in thousands):
Less: Cost Of Goods Sold:*
$30,000
(26,250)
$32,000
(26,400)
$34,000
(27,200)
Gross Margin
Less: Selling and Administrative:**
$ 3,750
(3,000)
$ 5,600
(3,600)
$ 6,800
(3,800)
Operating Profit:
* Assumes a LIFO inventory flow
** All costs are fixed
$
$ 2,000
$ 3,000
750
"As you can see," Larry observed at a meeting, "Howard has increased profits
Please send comments and corrections to me at [email protected]
Variable Costing By Dr. Michael Constas
Page 18
by a factor of four since 1995. That's by far the most impressive performance of
any divisional manager. We could certainly use someone with that kind of drive.
I definitely believe that Howard should be the new vice-president."
"I'm not quite as convinced that Howard's performance is as impressive as it
appears," responded Bill Peters, the vice-president of finance. "I could hardly
believe that Howard's division could show the magnitude of improvement
revealed by the income statements, so I asked the divisional controller to supply
some additional information. As the data suggest, the profits realized by
Howard's division may be attributable to a concerted effort to produce for
inventory. In fact, I believe it can be shown that the division is actually showing a
loss each year and that real profits have declined by as much as 15 percent
since 1995."
Peters then showed the following information:
1995
1996
1997
Sales (units):
150,000
160,000
170,000
Production*:
200,000
250,000
300,000
Fixed Manuf. OH:
$15,000,000 $15,000,000 $15,000,000
Fixed Manufacturing
$75
$60
$50
Overhead Rate:
Unit Variable Production
$100
$105
$110
Costs
* Represents both expected and actual production. Fixed overhead
rates are computed using expected actual production.
1. Explain what Bill Peters meant by "producing for inventory."
2. Recast the income statements in a variable-costing format. Now how does
the performance of the division appear?
3. Reconcile the differences in the income figures using the two methods for
each of the three years.
4. If you were a shareholder, how could you detect income increases that are
caused mainly by production for inventory?
Please send comments and corrections to me at [email protected]
Variable Costing By Dr. Michael Constas
P-3
Page 19
Jackson, Inc. has just completed its first year of operations. The unit costs are
as follows:
Manufacturing costs (per unit):
Direct Materials
Direct Labor
Variable Manufacturing Overhead
Fixed Manufacturing Overhead
Total
Non-Manufacturing costs:
$ 4.00
10.50
3.00
4.50
(2 lbs. @ $2)
(1.5 hrs @ $7)
(1.5 hrs @ $2)
(1.5 hrs @ $3)
$22.00
Variable:
Fixed:
10% of Sales
$200,000
During the year, the company had the following activity:
Units Produced
Units Sold
Unit Selling Price
Direct Labor Hours Worked
25,000
20,000
$40
37,500
Actual Fixed Manufacturing Overhead was $10,000 greater than the budgeted
Fixed Manufacturing Overhead. Actual Variable Manufacturing Overhead was
$5,000 greater than budgeted Variable Manufacturing Overhead. The company
used an expected actual activity level of 37,500 Direct Labor Hours to compute
the predetermined overhead application rates. Assume that any overhead
variances (e.g., $10,000 fixed overhead variance and $5,000 variable overhead
variance) are added to Cost of Goods Sold when the underlying cost (Fixed
Manufacturing Overhead or Variable Manufacturing Overhead) is added to
COGS.
1. Compute the unit cost using (a) Absorption Costing and (b) Variable Costing.
2. Prepare an Absorption Costing Income Statement.
3. Prepare a Variable Costing Income Statement.
4. Reconcile the difference between the two Income Statements.
Please send comments and corrections to me at [email protected]
Variable Costing By Dr. Michael Constas
P-4
Page 20
Nancy Henderson has just been appointed manager of Palmroy's glass
products division. She has two years to make the division profitable. If the
division is still showing a loss after two years, it will be eliminated, and Nancy
will be reassigned as an assistant divisional manager in another division. The
divisional income statement for the most recent year is given below.
Sales
Less: Variable Expenses
$5,350,000
-4,750,000
Contribution Margin
Less: Direct Fixed Expenses
$ 600,000
-$750,000
Divisional margin
Less: Common fixed expenses (allocated)
-$150,000
-200,000
Divisional Operating Loss
-$350,000
Upon arriving at the division, Nancy requested the following data on the
division's three products:
Sales (units):
Unit Selling Price:
Unit Variable Cost:
Direct Fixed Costs:
Product A
Product B
Product C
10,000
$150
$100
$100,000
20,000
$140
$110
$500,000
15,000
$70
$103.33
$150,000
She also gathered data on a proposed new product (Product D). If this product
is added, it would displaced one of the current products. The quantity that could
be produced and sold would equal the quantity sold of the product it displaces,
although demand limits the maximum quantity that could be sold to 20,000
units. Because of specialized production equipment, it is not possible for the
new product to displace part of the production of a second product.
The information on Product D is as follows:
Unit Selling Price:
Unit variable Cost:
Direct Fixed Costs:
$ 70
$ 30
$ 640,000
1. Prepare segmented income statements for Products A, B, and C.
2. Determine the products that Nancy should produce for the coming year.
Prepare segmented income statements that prove your combination is the
best for the division. By how much will profits improve given the combination
that you selected? (Hint: Your combination may include one, two, or three
products.)
Please send comments and corrections to me at [email protected]
Variable Costing By Dr. Michael Constas
P-5
Page 21
"This makes no sense at all," said Bill Sharp, president of Essex Company. "We
sold the same number of units this year as we did last year, yet our profits have
more than doubled. Who made the goof -- the computer or the people who
operate it?" The statements to which Mr. Sharp was referring are shown below
(absorption costing basis):
2001
2002
Sales (20,000 units each year)
$700,000 $700,000
Less cost of goods sold
460,000
400,000
Gross margin
$240,000 $300,000
Less selling and administrative expenses
$200,000
200,000
Income before income taxes
$40,000 $100,000
The company was organized on January 1, 2001, so the previous statements
show the results of its first two years of operation. In the first year, the company
produced and sold 20,000 units; in the second year, the company again sold
20,000 units, but it increased production in order to have a stock of units on
hand, as shown here:
2002
2001
Production in units
20,000
25,000
Sales in units
20,000
20,000
Variable production cost per unit
$8
$8
Fixed overhead costs (total)
$300,000 $300,000
Fixed overhead costs are applied to units of product on a basis of each year's
production. (The company produces and sells a single product.) Variable selling
and administrative expense are $1 per unit sold.
Required:
A. Compute the manufacturing cost of single unit of product for year 2002
under both absorption costing and variable costing.
B. What is the value of ending inventory in 2002 under full cost and variable
cost?
C. What is the income before taxes in 2002 using variable costing?
D. Reconcile the income in 2002 under the two methods?
Please send comments and corrections to me at [email protected]
Variable Costing By Dr. Michael Constas
P-6
Page 22
The following information was made available concerning the four departments
of the Roast Company.
Sales
Var. COGS
Oper. Exps.:
Fixed
Variable
Dept. A.
$ 50,000
(30,000)
Dept. B.
$ 20,000
(10,000)
Dept. C.
$100,000
(70,000)
Dept. D.
$ 70,000
(45,000)
(10,000)
(8,000)
------------
(4,000)
(3,000)
------------
( 8,000)
(22,000)
------------
(14,000)
(12,000)
------------
Operating
Profit (Loss):
2,000
3,000
0
(1,000)
=======
=======
=======
=======
Chuck Roast, the president of the company, has decided that one department
must be dropped. One-half of the fixed costs shown above are direct fixed
costs.
Assuming a department must be dropped,
which department should be dropped so
as to give the greatest benefit to the company?
__________
Explain how you reached your decision. Show computations.
What will be the company's operating profit after the
department is dropped?
__________
What do you think of Chuck Roast's decision to drop a department?
SOLUTIONS
E-1
The answer is d. All variable costs and expenses are subtracted from Sales
Revenue to produce the contribution margin.
E-2
The answer is b. The amount by which the operating income reported under
absorption costing exceeds the operating income reported under variable costing
is given by the following formula.
Fixed Factory Overhead Per Unit x Unsold Units
E-3
The answer is a. Variable costing only includes variable manufacturing costs in
the cost of a product. ($29 + $30 + 4 = $63).
E-4
The answer is a. Absorption costing includes all manufacturing costs in the cost
of a product. This would include all of the variable manufacturing costs ($63) plus
the fixed manufacturing cost per unit of $17. ($34,000/2,000 units produced).
That is $80.
Please send comments and corrections to me at [email protected]
Variable Costing By Dr. Michael Constas
E-5
The answer is b.
Sales Revenue:
Less Variable Costs:
Variable COGS:
Var. S,G&Adm:
Contribution Margin:
Less Fixed Costs:
Fixed Manf. Costs:
Fixed S,G&Adm:
Operating Profit
E-6
Page 23
$244,200 ($111 x 2,200)
$138,600
19,800
($63 x 2,200)
($9 x 2,200)
-158,400
$85,800
$34,000
39,600
-73,600
$12,200
The answer is a.
You could do an absorption costing income statement or you could use the
formula that I showed you in class:
Fixed Manufacturing Overhead Per Unit x Unsold Units:
$17 x -200 = -$3,400
The fact that you dipped into inventory (sold more than you produced) means
that variable costing operating is higher than absorption costing operating profit.
That is why it is shown as negative numbers.
$12,200 - $3,400 = $8,800
E-7
The answer is b.
You could do a variable costing income statement or you could use the formula
that I showed you in class. Fixed Overhead per unit is $2 ($5,000/2,500 units):
Fixed Manufacturing Overhead Per Unit x Unsold Units:
$2 x 100 = $200
$7,200 - $200 = $7,000
Please send comments and corrections to me at [email protected]
Variable Costing By Dr. Michael Constas
E-8
Page 24
The answer is a.
Sales Revenue:
Less Variable Costs:
Variable COGS:
Var. S,G&Adm:
$48,000
$19,200
9,600
($8 x 2,400)
-28,800
$19,200
Contribution Margin:
Contribution Margin per Unit:
E-9
$8 ($19,200/2,400)
The answer is d.
X = Fixed Costs / Contribution Margin Per Unit
Fixed Costs = $5,000 + $7,200 = $12,200
Break Even point = $12,200/8 = 1,525 units.
E-10 The answer is a.
$8 x 200 = $1,600.
P-1
Sales:
Variable Costs
Contribution Margin
Direct Fixed Costs
Division Profit:
Common Fixed Costs:
Operating Profit
A
B
C
D
Total
$1,000 $2,000 $1,000 $1,000
-660 -1,200
-800
-400
$340
$800
$200
$600
-240
-120
-120
-120
$220
$560
$80
$480 $1340
$900
$440
Each division has a positive Operating Profit. No division should be dropped.
If you drop Division C in the first year:
Sales:
Variable Costs:
Fixed Costs:
Operating Profit:
A
B
D
Total
$1,000 $2,000 $1,000
-660 -1,200
-400
-690
-345
-345
-$5
$110
$255 $360
Please send comments and corrections to me at [email protected]
Variable Costing By Dr. Michael Constas
Page 25
If you drop Division A in the second year:
B
D
Total
Sales:
$2,000 $1,000
Variable Costs:
-1,200 -400
Fixed Costs:
-840 -420
Operating Profit:
-$40 $180 $140
If you drop Division B in the third year:
Sales:
Variable Costs:
Fixed Costs:
Operating Profit:
D
$1,000
-400
-1,020
-$420
Total
-$420
If you drop Division D in the fourth year, then there is no fifth year.
P-2
1. When you produce more inventory than you are selling, then fix costs are
being treated as assets and not being expensed.
2.
Sales
Less Var. COGS:
(100x150K)
1996
1997
1995
$30,000
$32,000
$34,000
-15,000 (105x160K) -16,800 (110x170K) -18,700
Contrib. Margin
Less Fixed Costs:
Fixed Manufacturing OH:
Fixed S&A Expense:
$15,000
$15,200
$15,300
-15,000
3,000
-15,000
-3,600
-15,000
-3,800
Operating Profit:
-$3,000
-$3,400
-$3,500
3. The difference in income between full-absorption costing method and the
variable costing method is due to the different treatment of the fixed factory
overhead attributable to unsold units.
1995 = $75 x 50,000 = $3,750
1996 = $60 x 90,000 = $5,400
1997 = $50 x 130,000 = $6,500
4. On the balance sheet check the % of inventory to sales.
Please send comments and corrections to me at [email protected]
Variable Costing By Dr. Michael Constas
Page 26
P-3
1. a. Absorption manufacturing cost per unit:
Direct Materials:
Direct Labor:
Variable Manufacturing Overhead:
Fixed Manufacturing Overhead:
$ 4.00
10.50
3.00
4.50
Total:
$22.00
(2 lbs. @ $2)
(1.5 hrs @ $7)
(1.5 hrs @ $2)
(1.5 hrs @ $3)
b. Variable manufacturing cost per unit:
Direct Materials:
Direct Labor:
Variable Manufacturing Overhead:
$ 4.00
10.50
3.00
Total:
$17.50
(2 lbs. @ $2)
(1.5 hrs @ $7)
(1.5 hrs @ $2)
2. Absorption Costing Income Statement:
Revenue:
Less Cost of Goods Sold:
$800,000
-455,000
(20,000 x $40)
((20,000 x $22) + 10,000 + 5000)
Gross Margin:
Less Selling & Adm.Expenses:
$345,000
-280,000
[200,000 + (.1 x 800,000)]
Operating Profit:
$65,000
3. Variable Costing Income Statement:
Revenue
Less Variable Costs:
Variable Cost of Goods Sold
Variable Selling and Adm Expenses
$800,000
(20,000 x $40)
-355,000
-80,000
[(20,000 x 17.50) + 5,000]
(800,000 x .1)
Contribution Margin:
Less Fixed Costs:
Fixed Selling and Administrative
Expenses:
Fixed Manufacturing Overhead:
$365,000
Operating Profit:
-200,000
-122,500
[(25,000 x 4.5) + 10,000]
$42,500
4. Unsold Units x Fixed Manufacturing Overhead per Unit:
5,000 x (4.5) = $22,500
Please send comments and corrections to me at [email protected]
Variable Costing By Dr. Michael Constas
Page 27
P-4
Sales
Less Variable Costs:
A
B
C
$1,500 $2,800 $1,050
-1,000 -2,200 -1,550
Contribution Margin
Less Fixed Costs:
$500
-100
$600
-500
-$500
-150
Operating Profit:
$400
$100
-$650
Product C has a negative contribution margin, so the firm should drop C.
If D replaces C, then 15,000 units of D would be produced and sold:
D
$1,050
-450
Sales
Less Variable Costs:
Contrib. Margin
Less Fixed Costs:
$600
-640
Product Margin:
-$40
D has a positive contribution margin, however, the fixed costs are higher than the
contribution margin. These are direct fixed costs, and the firm can save the $640
if it doesn't make product D. It would be better just to drop C.
If product D replaced product B, then D would sell more units, and can cover its
direct fixed costs:
D
Sales
Less Variable Costs:
Contrib. Margin
Less Fixed Costs:
Product Margin:
$1,400
-600
$800
-640
$160
Product D could make $60 more than product B. So the firm would be best to
drop C and replace B with D.
Please send comments and corrections to me at [email protected]
Variable Costing By Dr. Michael Constas
P-5.
Page 28
A.
Full/Absorption Costing
Variable Production Costs:
Fixed Overhead Costs:
Total Manufacturing Costs:
Number of Units Produced:
Production Cost Per Unit:
Variable Costing
Variable Production Costs:
Number of Units
Variable Production Cost Per Unit
$8 x 25,000
$200,000
300,000
$500,000
25,000
$20
$8 x 25,000
$200,000
25,000
$8
B.
Ending Inventory is:
Units Produced:
Units Sold:
Ending Inventory
25,000
-20,000
5,000
Use Production Cost Per Unit for Variable & Full/Absorption Costing
Full: 5,000 x $20 = $100,000 Variable: 5,000 x $8 = $40,000
C.
Variable Costing
Sales
Less: Variable Costs:
Variable Production Costs:
Variable Selling & Administrative Expenses:
Contribution Margin
Fixed Costs
Fixed Manufacturing Costs:
Fixed Selling & Administrative Expenses:
Operating Income:
$700,000
$8 x 20,000
$1 x 20,000
$200K - $20K
Please send comments and corrections to me at [email protected]
-$160,000
-$20,000
$520,000
-$300,000
-$180,000
$40,000
Variable Costing By Dr. Michael Constas
D.
Page 29
Fixed Production Overhead Costs Per Unit: $300,000/25,000 = $12.00
The difference between Variable Costing and Full/Absorption Costing is
equal to: Fixed O/H Per Unit x Unsold Units
There is a $60,000 difference between the Full/Absorption Costing method
($100,000) and the Variable Costing method ($40,000).
Fixed O/H Per Unit ($12) x Unsold Units (5,000) = 60,000
P-6.
Sales
Var. Costs:
Var. COGS
Var. Oper.
CM
Dir. Fixed
Dept. Margin
Common Fixed
Operating Profit:
Dept. A.
$ 50,000
Dept. B.
$ 20,000
Dept. C.
$100,000
Dept. D.
$ 70,000
(30,000)
(8,000)
$12,000
(5,000)
$7,000
(10,000)
(3,000)
$7,000
(2,000)
$5,000
(70,000)
(22,000)
$8,000
(4,000)
$4,000
(45,000)
(12,000)
$13,000
(7,000)
$6,000
Total
$22,000
-18,000
$4,000
A.
You would look at the Department Margin. The lowest one is C’s $4,000.
So, you would drop Department C.
B.
You have an operating profit of $4,000 with all of the departments. If you
drop Department C, then you will lose its Department Margin ($4,000).
This will drop the company’s operating profit to $0.
C.
This is a bad decision.
Please send comments and corrections to me at [email protected]