CHAPTER 19
VARIABLE COSTING AND
PERFORMANCE REPORTING
Student Learning Objectives and Related Assignment Materials*
Student Learning Objectives
Discussion
Questions
Quick
Studies Exercises
Problems**
(A & B set)
Beyond the
Numbers
Conceptual objectives:
C1. Describe how absorption
costing can result in
overproduction.
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C2. Explain the role of variable
costing in pricing special
orders.
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Analytical objectives:
A1. Use variable costing in pricing
special orders.
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Procedural objectives:
P1. Compute unit cost under both
absorption and variable costing.
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P2. Prepare and analyze an income
statement using absorption
costing and using variable
costing.
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P3. Convert income under variable
costing to the absorption cost
basis.
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P4. Determine product selling price
based on absorption costing.
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Additional Information on Related Assignment Material
Connect (Available on the instructor’s course-specific website) repeats all numerical Quick
Studies, all Exercises and Problems Set A. Connect provides new numbers each time the Quick
Study, Exercise or Problem is worked. It allows instructors to monitor, promote, and assess
student learning. It can be used in practice, homework, or exam mode.
Synopsis of Chapter Revision
Happy Family Brands UPDATED opener
Added new discussion of the three-step process to determine product selling price in the
“Setting Prices” section
Added short section on sources of data for CVP Analysis when preparing incomes
statement under variable costing versus absorption costing
Replaced previous break-even Decision Analysis example with special-order example
using IceAge Company
3 new Quick Studies and 4 new Exercises
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Chapter Outline Notes
I. Introducing Variable Costing and Absorption Costing – under the
traditional costing approach, absorption costing, or full costing,
products absorb all costs incurred to product them which can result in
misleading product cost information for decision-making. Under
variable costing only costs that change in total with changes in
production level are included in product costs.
A. Under both methods direct materials, direct labor and variable
overhead are included in product costs.
B. Key difference is in treatment of fixed overhead.
C. Fixed overhead is included in product costs under absorption costs
and included in period expenses under variable costing.
D. Computing Unit Cost
1. For absorption costing, the product cost per unit consists of
direct labor, direct materials, variable overhead, and fixed
overhead.
2. For variable costing, the product cost per unit consists of direct
labor, direct materials and variable overhead. Fixed overhead
costs are treated as period costs and recorded as expense in the
period incurred.
3. The difference between the two costing methods is the
exclusion of fixed overhead from product cost for variable
costing.
II. Income Reporting Implications
A. Units Produced Equal Units Sold
1. The income statement under variable costing is referred to as
the contribution margin income statement. The expenses
are grouped according to cost behavior.
2. Contribution Margin Report is a performance report that
excludes fixed expenses and net income and focuses on
revenue minus variable costs.
3. Under absorption costing, the expenses are grouped according
to cost function.
4. When quantity produced equals quantity sold, there is no
difference in total costs assigned, but there is a difference in
what categories receive these costs.
B. Units Produced Exceed Units Sold
1. Under variable costing, the entire fixed overhead is treated as
an expense in computing income.
2. Under absorption costing, the fixed overhead cost is allocated
to each unit.
3. When production exceeds sales, the fixed overhead cost
allocated to these units is carried as part of the cost of ending
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Chapter Outline
inventory and is not expensed until future periods when
reported in cost of goods sold when the products are sold.
4. Income under absorption costing is higher than income
under variable costing when units produced exceed units
sold because of the greater fixed overhead cost allocated
to ending inventory.
Notes
C. Units Produced are Less Than Units Sold
1. Ending inventory under absorption costing is higher than
under variable costing.
2. Income under absorption costing is less than income under
variable costing.
3. Cost differences extend to both cost of goods sold and period
costs.
D. Summarizing Income Reporting
1. Differences in income are due to timing.
2. Income will be different whenever the quantity produced and
quantity sold are different.
3. Income under absorption costing is higher when more units
are produced relative to sales and is lower when fewer units
are produced than sold.
4. Since production and sales are seldom exactly equal, we
normally see differences in income for these two methods
extending over several years.
5. Converting Reports Under Variable Costing to Absorption
Costing – an income statement using the variable costing
method is restated under absorption costing by adding the
fixed overhead cost in ending inventory and subtracting the
fixed overhead cost in beginning inventory.
E. Converting Income Under Variable Costing to Absorption
Costing – an income statement using the variable costing method
is restated under absorption costing by adding the fixed overhead
cost in ending inventory and subtracting the fixed overhead cost in
beginning inventory.
III. Comparing Variable Costing and Absorption Costing
A. Planning Production
1. Production levels should be based on reliable sales forecasts.
Over-production and inventory build-up can occur because
many companies link manager bonuses to income computed
under absorption costing since this is how income is reported
to shareholders per GAAP.
2. Inventory build-up leads to increased costs in storage,
financing, and obsolescence. If excess inventory is never sold,
it will be disposed of at a loss.
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Chapter Outline Notes
3. Managers cannot increase income under variable costing by
merely increasing production without increasing sales.
4. Under absorption costing, fixed overhead per unit is lower
when more units are produced so fixed overhead cost is
allocated to more units. If these excess units are not sold, the
fixed overhead cost allocated to these units is not expensed
until a future period when these units are sold.
5. Reported income under variable costing is not affected by
production level changes because all fixed production costs
are expensed in the year incurred. Under this method,
companies increase income by selling more units since it is
not possible to increase income just by producing more units
and creating excess inventory.
B. Setting Prices
1. Cost information is a crucial factor in setting prices.
2. Over the long run, the selling price must be high enough to
cover all costs and still provide an acceptable return to
shareholders.
3. We use a 3-step process to determine product selling prices:
a. Determine the product cost per unit using absorption
costing.
b. Determine the target markup on product cost per unit.
c. Add the target markup to the product cost to find the target
selling price.
C. Controlling Costs
1. A cost is controllable if a manager has the power to determine
or at least markedly affect the amount incurred. An effective
cost control practice is to hold managers responsible only for
their controllable costs.
2. Uncontrollable costs are not within the manager’s control or
influence.
3. Variable production costs and fixed production costs are
controlled at different levels of management.
4. Variable selling and administrative costs are usually controlled
at a level of management different from that which controls
fixed selling and administrative costs.
5. Higher-level managers usually make fixed costs decisions.
6. Lower–level managers usually make most variable cost
decisions.
7. An income statement prepared in the contribution format
highlights the impact of each cost element for income which
makes it easier to identify problem areas and take cost control
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Chapter Outline
measures by appropriate levels of management. This approach is
also useful in evaluating the performance of managers of different
segments within a company.
D. Limitations of Reports Using Variable Costing – Absorption
costing is the only acceptable basis for external reporting under
both U.S. GAAP and IFRS. For income tax purposes, absorption
costing is the only acceptable basis for filings with the IRS under
the Tax Reform Act of 1986.
Notes
IV. Variable Costing for Service Firms – variable costing also applies to
service companies. Service companies do not have inventory but a
focus on variable costs is still useful for managerial decisions.
V. Global View – U.S. multination companies must change their business
processes when moving their operations to international locations.
McDonald’s and Yum Brands offer delivery services in heavily
populated cities which discourage the building of drive-through
facilities which would increase fixed overhead costs. As fixed
overhead costs decrease, the difference in net income that would result
from applying variable costing versus absorption costing also
decreases.
VI. Decision Analysis – Pricing Special Orders
A. Over the long run, prices must cover all fixed and variable costs.
B. Over the short run, fixed production costs do not change in
production levels.
C. With excess capacity, increases in production level will increase
variable production costs, but not fixed costs.
D. Managers should, therefore, try to maintain long-run price on
existing orders to cover all production costs and should accept
special orders as long as the special order price exceeds variable
cost.
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Chapter 19 Alternative Demonstration Problem
Major Company began operations on January 1, 2015. Cost and sales information
for its first two calendar years are summarized below:
Manufacturing costs:
Direct materials $50 per unit
Direct labor $25 per unit
Factory overhead costs for the year:
Variable overhead $10 per unit
Fixed overhead $1,000,000
Nonmanufacturing costs:
Variable selling and administrative $10 per unit
Fixed selling and administrative $5,000,000
Production and sales data:
Units produced, 2015 100,000 units
Units sold, 2015 80,000 units
Units in ending inventory, 2015 20,000 units
Units produced, 2016 60,000 units
Units sold, 2016 80,000 units
Units in ending inventory, 2016 0 units
Sales price per unit $500 per unit
Required:
1. Prepare an income statement for the company for 2015 under absorption
costing.
2. Prepare an income statement for the company for 2015 under variable
costing.
3. Prepare an income statement for the company for 2016 under absorption
costing.
4. Prepare an income statement for the company for 2016 under variable
costing.
5. Prepare a schedule to convert variable costing income to absorption
costing income for the years 2015 and 2016.
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Solution: Chapter 19 Alternative Demonstration Problem #1
Compute unit costs for 2015 under the two costing methods as follows:
Absorption Costing Variable Costing
Direct materials per unit $50 $50
Direct labor per unit 25 25
Overhead per unit
1. Absorption costing income statement for 2015:
Major Corporation
Income Statement
For Year Ended December 31, 2015
Sales (80,000 x $500) $40,000,000
Cost of goods sold (80,000 x $95) 7,600,000
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Solution: Chapter 19 Alternative Demonstration Problem #1, Continued
2. Variable costing income statement for 2015:
Major Corporation
Income Statement (Contribution Format)
For Year Ended December 31, 2015
Sales (80,000 x $500) $40,000,000
Variable expenses
Variable production costs (80,000 x $85) $6,800,000
Variable selling and administrative costs
(80,000 x $10) 800,000 $7,600,000
Compute unit costs for 2016 under the two costing methods as follows:
Absorption Costing Variable Costing
Direct materials per unit $50 $50
Direct labor per unit 25 25
Overhead per unit
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3. Absorption costing income statement for 2016:
Major Corporation
Income Statement
For Year Ended December 31, 2016
Sales (80,000 x $500) $40,000,000
Cost of goods sold
From beginning inventory (20,000 x $95) $1,900,000
5,000,000
Net income $26,199,800
4. Variable costing income statement for 2016:
Major Corporation
Income Statement (Contribution Format)
For Year Ended December 31, 2016
Sales (80,000 x $500) $40,000,000
Variable expenses
Variable production costs (80,000 x $85) $6,800,000
Variable selling and administrative costs
(80,000 x $10) 800,000 $7,600,000
5. Conversion of variable costing income to absorption costing income:
2015 2016
Variable costing income $26,400,000 $26,400,000
Add: Fixed overhead cost deferred in
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