978-1337119207 Chapter 20 Part 1

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371

chapter

20(6)

Variable Costing for

Management Analysis

______________________________________________

OPENING COMMENTS

After studying the chapter, your students should be able to:

1. Describe and illustrate reporting income from operations under absorption and variable costing.

operations.

3. Describe management’s use of absorption and variable costing.

segments.

quantity and price factors.

6. Describe and illustrate contribution margin analysis for service businesses.

ADM: Describe and illustrate the use of segment analysis and earnings before interest, taxes,

depreciation, and amortization (EBITDA) in evaluating a company’s performance

KEY TERMS

absorption costing

contribution margin

contribution margin analysis

controllable costs

EBITDA

Chapter 20(6) Variable Costing for Management Analysis 372

manufacturing margin

market segment

noncontrollable costs

quantity factor

sales mix

unit price (cost) factor

variable cost of goods sold

variable costing

STUDENT FAQS

 How can you tell if a cost item is variable or fixed?

 What is the difference in variable and absorption costing on the income statement again? I’m just not

getting it.

 What is absorption costing?

 What is variable costing?

 Why is only the variable cost used in cost of goods manufactured under the variable or direct costing

method?

 Why is variable costing not used for external reporting?

 How do you arrive at manufacturing margin?

 How do you arrive at contribution margin in relation to manufacturing margin?

 When sales exceed production, what will be the difference between variable and absorption costing?

 When production exceeds sales, what will be the difference between variable and absorption costing?

OBJECTIVE 1

Describe and illustrate reporting income from operations under absorption and variable

costing.

SYNOPSIS

Two reporting formats are available for reporting operating income: absorption costing and variable

costing. First, absorption costing is defined and an income statement template is provided to illustrate its

application. Note that the absorption costing format organizes expenses by business function:

manufacturing, selling, and administration. Likewise, variable costing is defined and illustrated. Note that

the variable costing format organizes expenses by behavior pattern: variable and fixed. Exhibit 1

summarizes the key difference between the two formats, the treatment of fixed factory overhead. Next,

the chapter introduces Martinez Company and proceeds to prepare two sets of income statements, one

absorption costing-based and one variable costing-based for three scenarios: Case 1: Production = Sales

(see Exhibits 2 and 3); Case 2: Production > Sales (Exhibit 4); and Case 3: Production < Sales (Exhibit 5).

Chapter 20(6) Variable Costing for Management Analysis 373

Exhibit 6 presents a summary of the impact on reported operating income in an interesting easy–to–

remember graphical format.

Chapter 20(6) Variable Costing for Management Analysis 374

Key Terms and Definitions

expenses.

 Manufacturing Margin—The variable cost of goods sold deducted from sales.

 Variable Cost of Goods Sold—Consists of direct materials, direct labor, and variable factory

overhead for the units sold.

 Variable Costing—The concept that considers the cost of products manufactured to be

Relevant Check Up Corner and Exhibits

 Exhibit 1—Absorption Costing Versus Variable Costing

 Exhibit 2—Absorption Costing Income Statement

 Exhibit 3—Variable Costing Income Statement

 Exhibit 4—Units Manufactured Exceed Units Sold

SUGGESTED APPROACH

Explain that the name given to the manufacturing cost system your students have been learning is

absorption costing. Under absorption costing, all costs necessary to manufacture a product are “absorbed”

by the product (included in the product’s reported cost). This includes both fixed and variable

manufacturing costs.

expenses.

Two points merit special emphasis. First, the only difference between variable and absorption costing is

the treatment of fixed overhead. Second, while variable costing is often the most useful system to aid

company management in making decisions, it is not allowed for external financial reporting. Financial

absorption costing.

The group learning activity below will ask your students to review the income statement under absorption

costing. It will also introduce them to income reporting under variable costing.

Chapter 20(6) Variable Costing for Management Analysis 375

GROUP LEARNING ACTIVITY—Absorption and Variable Costing

To review absorption costing, ask your students to prepare an income statement for Laurens Incorporated,

using the data on TM 20(6)-1. Instruct them to prepare the income statement using the format they have

learned in previous chapters. This approach is called absorption costing. Under absorption costing, both

fixed and variable manufacturing costs are included in the cost of goods sold. The solution to this activity

is provided on the top half of TM 20(6)-2.

Next use TM 20(6)-3 to describe the format of the income statement that supports a variable costing

approach. This format is also called a contribution margin format income statement. Emphasize the

following computations from this income statement:

Sales—Variable COGS = Manufacturing Margin

Contribution Margin—Fixed Costs = Income from Operations

Remind students that these calculations are consistent with the computation of contribution margin, which

they learned in Chapter 19(5): Sales—Total Variable Costs = Contribution Margin.

OBJECTIVE 2

Describe and illustrate the effects of absorption and variable costing on analyzing income

from operations.

SYNOPSIS

As shown in Objective 1, income differences arise when the number of units produced does not equal the

8 presents variable costing statements with the same profit comparisons. The key teaching point is that

inventory buildups (production > sales) can increase profit under absorption costing without any increase

in unit sales while such buildups have no impact on profit under variable costing. Further, the only way to

increase profit under variable costing (given no change in costs and selling prices) is to increase unit

Chapter 20(6) Variable Costing for Management Analysis 376

Relevant Check Up Corner and Exhibits

 Exhibit 7—Absorption Costing Income Statements for Two Production Levels

SUGGESTED APPROACH

If your students can predict the effect that changes in inventory levels will have on net income under

absorption and variable costing, they will have mastered this learning objective. Begin your discussion of

this objective by asking your students to identify problems that may occur if a manufacturing company

produces too much inventory. List their responses on the board. Next, use the income statements for

net income.

CLASS DISCUSSION—Variable vs. Absorption Costing

Point out the $30,000 difference between the two income statements on TM 20(6)-2. Remind your

students that Laurens produced 22,000 units, but sold 20,000 units, during the period reported on the

income statement. Ask your students to examine the income statements, silently on their own, and look

before sharing them with the class.

Through discussion, bring the class to a consensus that the $30,000 difference is the fixed cost of the

2,000 units produced but not sold ($15/unit × 2,000 units). Under full absorption costing, this $30,000

cost is allocated to the units in the ending finished goods inventory. Therefore, it is carried on the balance

Next, refer your students to Exhibits 7 and 8 in the text. These exhibits further emphasize the impact on

net income caused by producing more units than sold. The company illustrated in these exhibits, Frand

Manufacturing Company, sold 20,000 units. Exhibit 7, which illustrates absorption costing, shows

Frand’s net income if 20,000 and 25,000 units are produced. By producing an extra 5,000 units, net

Absorption Costing

Ask your students to write a response to the following question [TM 20(6)-4]:

DBR Manufacturing rewards the company’s plant manager with a year-end bonus based

on the increase in the plant’s net income. For purposes of determining the manager’s

Chapter 20(6) Variable Costing for Management Analysis 377

bonus, should net income be calculated using variable costing or absorption costing?

Support your recommendation.

Possible response: In this case the net income should be calculated using variable costing.

The plant manager could manipulate the net income by over producing inventory and

carrying this cost on the balance sheet in the finished goods inventory. This over

financial statements in future periods.

OBJECTIVE 3

Describe management’s use of absorption and variable costing.

SYNOPSIS

This objective examines the usefulness of the two alternative reporting formats for making decisions

variable costing for that purpose. For production planning, both formats are needed. Short-run decisions

are often based on an incremental analysis. Understanding how costs and revenues behave is essential to

determining incremental costs and revenues. Thus, variable costing is needed. On the other hand,

absorption costing may be more useful for long-run production planning especially if existing capacity

in the next learning objective.

Key Terms and Definitions

 Controllable Costs—Costs that can be influenced (increased, decreased, or eliminated) by

someone such as a manager or factory worker.

 Market Segment—A portion of business that can be assigned to a manager for profit

responsibility.

Relevant Check Up Corner and Exhibits

 Exhibit 9—Accounting Reports and Management Decisions

Chapter 20(6) Variable Costing for Management Analysis 378

SUGGESTED APPROACH

LECTURE AID—Benefits of Variable Costing

One benefit of variable costing is the ability to isolate the impact of changes in sales volume on profits.

TM 20(6)-5 shows an income statement for Laurens Incorporated, assuming sales of 20,000 units and

30,000 units. Point out that as volume increases, only variable costs change. This is clearly evident from

the variable costing income statement.

responsible manager(s).

GROUP LEARNING ACTIVITY—Pricing Products and Planning Production

The text emphasizes that pricing and production decisions can vary, depending on whether a manager is

evaluating the short run or the long run. In the long run, product prices must be set high enough to

TM 20(6)-6 presents data for Webster Manufacturing, a company that makes ingots. Webster has the

opportunity to take on a one-time special order at a price that is above the variable cost of manufacturing

its product, but below the absorption cost. Divide your class into groups and ask each group to prepare an

income statement for Webster Manufacturing reflecting profits with and without the special order.

on TM 20(6)-7.

When reviewing this analysis, emphasize that the special order did not affect fixed costs. Therefore, the

only income statement items that changed were revenues and variable manufacturing costs. As long as an

order provides a positive contribution margin (revenue exceeds variable costs), the order will increase the

the incremental profit is $30,000 (which is $7 – $4 = $3 × 10,000 = $30,000).