chapter
20(5)
Variable Costing for
Management Analysis
______________________________________________
OPENING COMMENTS
Frequently, managers complain that accounting systems designed to collect data needed for financial
reporting do not provide the best data for management decision making. If used properly, variable costing
can be a powerful management tool, providing the data relevant to management decisions. This chapter
introduces this costing system and presents several scenarios where it is favored over absorption costing.
After studying the chapter, your students should be able to:
2. Describe and illustrate the effects of absorption and variable costing on analyzing income from
operations.
4. Use variable costing for analyzing market segments including product, territories, and salespersons
segments.
6. Describe and illustrate the use of variable costing for service firms.
KEY TERMS
absorption costing
contribution margin
contribution margin analysis
controllable costs
manufacturing margin
market segment
noncontrollable costs
quantity factor
372 Chapter 20(5) Variable Costing for Management Analysis
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?
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
Chapter 20(5) Variable Costing for Management Analysis 373
Key Terms and Definitions
• Absorption Costing – The reporting of the costs of manufactured products, normally direct
materials, direct labor, and factory overhead, as product costs.
• Contribution Margin – Sales less variable costs and variable selling and administrative
expenses.
Relevant Example Exercises and Exhibits
• Example Exercise 20(5)-1 Variable Costing
• Example Exercise 20(5)-2 Variable Costing—Production Exceeds Sales
• Example Exercise 20(5)-3 Variable Costing—Sales Exceed Production
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.
This chapter introduces variable costing (also called direct costing), which is another approach used to
compute a product’s cost. Under variable costing, only variable manufacturing costs are included in the
product cost reported as cost of goods sold or ending inventory. These variable manufacturing costs are
direct materials, direct labor, and variable overhead (overhead costs that change as production volume
increases or decreases). All fixed costs, including fixed manufacturing overhead, are treated as period
expenses.
374 Chapter 20(5) Variable Costing for Management Analysis
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(5)-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(5)-2.
Next use TM 20(5)-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
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
number of units sold (resulting in inventory level changes). This objective explains why those differences
occur and cautions students against misinterpreting profit changes as operating efficiencies or
inefficiencies. The explanation is presented via an example in which Frand Manufacturing Company
Chapter 20(5) Variable Costing for Management Analysis 375
Relevant Example Exercises and Exhibits
• Example Exercise 20(5)-4 Analyzing Income Under Absorption and Variable Costing
• Exhibit 7 – Absorption Costing Income Statements for Two Production Levels
• Exhibit 8 – Variable Costing Income Statements for Three 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
Laurens Incorporated on TM 20(5)-2 to help your students evaluate the impact of increasing inventory on
net income.
CLASS DISCUSSION—Variable vs. Absorption Costing
Point out the $30,000 difference between the two income statements on TM 20(5)-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
for the reason the statements present a different net income. After a minute, ask them to share their ideas
with another student or in a group. This discussion time will allow students to finalize their answers
before sharing them with the class.
WRITING EXERCISE—Performance Evaluation under Variable and
Absorption Costing
Ask your students to write a response to the following question [TM 20(5)-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
376 Chapter 20(5) Variable Costing for Management Analysis
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
production could be detrimental to the overall company goals and negatively impact
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
related to controlling costs, setting selling prices, planning production, analyzing contribution margins,
and analyzing market segments. Exhibit 9 presents a graphical overview of this learning objective. For
controlling costs, the variable costing format is useful because typically variable costs are controllable by
management at the level of incurrence. However, fixed costs are normally controlled at a higher level of
management. For pricing products, it is important that the selling price in the long run be set high enough
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.
• Noncontrollable Costs – Costs that cannot be influenced (increased, decreased, or eliminated) by
someone such as a manager or factory worker.
Relevant Example Exercises and Exhibits
• Exhibit 9 – Accounting Reports and Management Decisions
Chapter 20(5) Variable Costing for Management Analysis 377
SUGGESTED APPROACH
Although variable costing is not permitted for financial reporting, many managers find it useful for
management reporting and decision making. Variable costing tends to show costs in the same manner as
they are incurred: variable costs on a per-unit basis and fixed costs in total. Objective 3 presents several
scenarios where variable costing is more beneficial to management than absorption costing.
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(5)-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.
Another benefit of variable costing relates to cost control. Variable costs (direct materials used and direct
labor and variable overhead costs incurred) are controllable by operating management as they run the
day-to-day operations of a manufacturing plant. However, a higher level of management controls fixed
costs. Operating managers cannot control costs such as depreciation on factory machinery or salaries paid
to engineering staff if they do not have the authority to purchase fixed assets or hire engineers.
Classifying costs as fixed or variable on the income statement makes it easier to assign costs to the
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
compensate a business for all of its operating costs and provide a reasonable profit. However, in the short
run, prices may be set below the optimal “long-run price” without reducing profits. In practice, a special
order decision will force managers to evaluate short-run prices.
378 Chapter 20(5) Variable Costing for Management Analysis
WRITING EXERCISE—Pricing Products and Production Planning
After completing the group activity above, ask your students to write a memo to management explaining
why Webster Manufacturing should accept the special order, even though the selling price for the special
order will be below the product’s cost under absorption costing.
Possible response: As evidence by the analysis provided in TM 20(5)-7 accepting the special order will
increase projected income from operations by $30,000. The additional order will not affect current
projected sales, negatively impact production capacity to meet projected sales or increase fixed cost.
Contribution margins will be higher since the $7 price exceeds variable costs by $3 per unit. This
recommendation is a win-win for all parties; I highly recommend approval of the special order.
As an alternative, ask your students to write an answer to the following question [TM 20(5)-8]:
Should Webster Manufacturing decrease the selling price of its product to $7 for all of its
customers? The marketing manager has argued that this pricing strategy would allow the
company to attract new customers and capture a greater share of its market.
OBJECTIVE 4
Use variable costing for analyzing market segments, including product, territories, and
salespersons segments.
SYNOPSIS
Objective 4 demonstrates the usefulness of variable costing for short-term analysis of market segments.
[Long-term analysis is covered in Chapter 26(11).] Variable costing-based market segment performance
reports are used for product pricing and deciding whether to discontinue a product. Companies also
prepare segment reports for geographic areas, customers, distribution channels, and salespersons. Camelot
Fragrance Company is used to illustrate sales territory reports (Exhibit 10), product line reports (Exhibit
11), and salespersons reports (Exhibit 12).
Key Terms and Definitions
• Sales Mix – The relative distribution of sales among the various products available for sale.
Chapter 20(5) Variable Costing for Management Analysis 379
Relevant Example Exercises and Exhibits
SUGGESTED APPROACH
Variable costing allows managers to evaluate the profitability of sales territories, products, or
salespersons. This is accomplished by computing the contribution margin and the contribution margin
ratio by territory, product, and/or salesperson. Since the text illustrates each of these profitability analyses,
ask your students to apply the same technique to a slightly different scenario: customer profitability.
GROUP LEARNING ACTIVITY—Customer Profitability
TM 20(5)-9 provides sales and cost data for SMC, Inc. Revenues and variable costs are listed by
customer. Ask your students to determine which of SMC’s customers is most profitable. You may need to
remind them of the following formula:
OBJECTIVE 5
Use variable costing for analyzing and explaining changes in contribution margin as a result
of quantity and price factors.
SYNOPSIS
Objective 5 demonstrates the usefulness of contribution margin analysis in planning and controlling
operations. Contribution analysis involves assessing the impact on contribution margin of volume
changes (assuming no change in selling prices or costs) and the impact of changes in selling prices or
costs (assuming no change in volume). Exhibit 13 presents a graphical summary of these concepts.
Finally, Noble Company is introduced to demonstrate the reconciliation between the company’s planned
contribution margin and the contribution margin that it actually earned (see Exhibit 14).
Key Terms and Definitions
• Contribution Margin Analysis – The systematic examination of the differences between planned
380 Chapter 20(5) Variable Costing for Management Analysis
Relevant Example Exercises and Exhibits
• Example Exercise 20(5)-6 Contribution Margin Analysis
• Exhibit 13 – Contribution Margin Analysis
• Exhibit 14 – Contribution Margin Analysis Report
SUGGESTED APPROACH
Contribution margin analysis is used to evaluate the differences between actual and planned contribution
margin. Any variance in revenue or variable cost can be explained by a change in quantity, a change in
price/cost, or both. Use the demonstration problem below to illustrate these calculations.
DEMONSTRATION PROBLEM—Analyzing Contribution Margins
The following demonstration problem is provided in TM 20(5)-17.
Case A: Assume that a manufacturing company had budgeted sales of $120,000 (10,000 units at $12).
Actual sales were $103,500 (9,000 units at $11.50).
OBJECTIVE 6
Describe and illustrate the use of variable costing for service firms.
SYNOPSIS
Objective 6 stresses the importance of variable costing for service companies. Several illustrations are
provided based on Blue Skies Airlines Inc. whose costs are listed in Exhibit 15. Exhibit 16 presents an
overall contribution margin income statement for the airline, while Exhibit 18 presents a segment
Chapter 20(5) Variable Costing for Management Analysis 381
contribution margin report for the company based on air routes (using data provided in Exhibit 17).
Finally, Exhibit 19 explores the impact of a decrease in the ticket price of its Chicago to Atlanta flight.
Relevant Example Exercises and Exhibits
• Exhibit 15 – Costs of Blue Skies Airlines Inc.
• Exhibit 16 – Variable Costing Income Statement for a Service Company
SUGGESTED APPROACH
This learning objective applies the concepts illustrated in the chapter to a service organization. Therefore,
it provides an excellent review opportunity.
Handout 20(5)-1 presents information for a service business called Music for All Occasions. You can use
Handout 20(5)-1
Contribution Margin Reporting and Analysis for Service Firms
Music for All Occasions is a service business that provides musical groups to play at parties, wedding
receptions, etc. Customers can choose between a big swing-style band, a small jazz combo, or a rock
band. The price customers must pay depends on the style of band they choose and the number of hours
they want the band to perform.
Big Band
Jazz Combo
Rock Band
Number of Musicians
15
4
5
Price per Hour
$650
$185
$200
Last year, Music for All Occasions performed the following jobs:
Big Band
Jazz Combo
Rock Band
Number of Jobs
32
97
88
Total Number of Hours for All Jobs
105
410
370
At the beginning of this year, competition forced the owner of Music for All Occasions to change the price
for the Big Band to $575 per hour and reduce the number of musicians in the group to 12. The wage rate
for musicians in the Big Band was also raised to $25 per hour. Based on the former price of $650 per
hour, the owner estimated the Big Band would perform 35 jobs this year totaling 115 hours. However,
with the reduced price, the Big Band actually played 50 jobs for a total of 165 hours.
Perform the following analysis for Music for All Occasions:
1. Determine the cost behavior (fixed or variable) for all of the company’s costs and identify the activity
base for the variable costs.
3. Prepare a variable costing income statement for the entire company for last year. Be sure your
income statement shows both contribution margin and income from operations.
4. Prepare a contribution margin analysis report for only the Big Band for this year comparing planned
performance under the old price structure ($650 per hour with 15 musicians) and the actual
performance under the reduced price structure ($575 per hour with 12 musicians).
Type Item Description LO(s) Difficulty
Time
Est
BUSPROG AICPA ACBSP – APC Bloom’s EE Excel GL SMH FAI Service Real World Writing Ethics Internet Group
DQ 1 1 Easy 5 min. Analytic Measurement Managerial Accounting Features/Costs Knowledge
DQ 2 1 Easy 5 min. Analytic Measurement Managerial Accounting Features/Costs Knowledge
DQ 3 1 Easy 5 min. Analytic Measurement Managerial Accounting Features/Costs Application
DQ 4 1 Easy 5 min. Analytic Reporting Managerial Accounting Features/Costs Knowledge
DQ 5 3 Easy 5 min. Analytic Measurement Managerial Accounting Features/Costs Knowledge
DQ 6 3 Easy 5 min. Analytic Decision Modeling Managerial Accounting Features/Costs Knowledge
DQ 7 4 Easy 5 min. Analytic Measurement Managerial Accounting Features/Costs Knowledge
DQ 8 4 Easy 5 min. Analytic Measurement Managerial Accounting Features/Costs Knowledge
DQ 9 5 Easy 5 min. Analytic Measurement Managerial Accounting Features/Costs Knowledge
DQ 10 5 Easy 5 min. Analytic Measurement Managerial Accounting Features/Costs Knowledge
DQ 11 5 Easy 5 min. Analytic Measurement Managerial Accounting Features/Costs Knowledge x
PE 1A Variable costing 1 Easy 10 min. Analytic Measurement Managerial Accounting Features/Costs Application x
PE 1B Variable costing 1 Easy 10 min. Analytic Measurement Managerial Accounting Features/Costs Application x
PE 2A Variable costing – production exceeds sales 1 Easy 10 min. Analytic Measurement Managerial Accounting Features/Costs Application x
PE 2B Variable costing – production exceeds sales 1 Easy 10 min. Analytic Measurement Managerial Accounting Features/Costs Application x
PE 3A Variable costing – sales exceed production 1 Easy 10 min. Analytic Measurement Managerial Accounting Features/Costs Application x
PE 4A Analyzing income under absorption and variable costing 2 Easy 10 min. Analytic Measurement Managerial Accounting Features/Costs Application x
PE 4B Analyzing income under absorption and variable costing 2 Easy 10 min. Analytic Measurement Managerial Accounting Features/Costs Application x
PE 5A Contribution margin by segment 4 Easy 15 min. Analytic Measurement Managerial Accounting Features/Costs Application x
PE 5B Contribution margin by segment 4 Easy 15 min. Analytic Measurement Managerial Accounting Features/Costs Application x
PE 6A Contribution margin analysis 5 Easy 15 min. Analytic Measurement Managerial Accounting Features/Costs Application x
PE 6B Contribution margin analysis 5 Easy 15 min. Analytic Measurement Managerial Accounting Features/Costs Application x
EX 1 Inventory valuation under absorption and variable costing 1 Easy 10 min. Analytic Measurement Managerial Accounting Features/Costs Application
EX 2 Income statements under absorption costing and variable costing 1 Moderate 20 min. Analytic Measurement Managerial Accounting Features/Costs Application x x
EX 3 Income statements under absorption costing and variable costing 1 Moderate 20 min. Analytic Measurement Managerial Accounting Features/Costs Application x x
EX 4 Cost of goods manufactured, using variable costing and absorption costing 1 Moderate 20 min. Analytic Measurement Managerial Accounting Features/Costs Application
EX 6 Absorption costing income statement 1 Easy 20 min. Analytic Measurement Managerial Accounting Features/Costs Application x
EX 7 Variable costing income statement 1 Moderate 20 min. Analytic Measurement Managerial Accounting Features/Costs Application x x
EX 8 Estimated income statements, using absorption and variable costing 1,2 Moderate 20 min. Analytic Measurement Managerial Accounting Features/Costs Application x x
EX 9 Variable and absorption costing 1 Moderate 20 min. Analytic Measurement Managerial Accounting Features/Costs Application x
EX 10 Variable and absorption costing – three products 2,3 Moderate 25 min. Analytic Measurement Managerial Accounting Features/Costs Application x
EX 11 Change in sales mix and contribution margin 4 Moderate 25 min. Analytic Measurement Managerial Accounting Features/Costs Application
EX 12 Product profitability analysis 4 Moderate 25 min. Analytic Measurement Managerial Accounting Features/Costs Application x
EX 13 Territory and product profitability analysis 4 Moderate 20 min. Analytic Measurement Managerial Accounting Features/Costs Application x
EX 15 Segment profitability analysis 4 Moderate 30 min. Analytic Measurement Managerial Accounting Features/Costs Application x x
EX 16 Segment contribution margin analysis 4,6 Moderate 30 min. Analytic Measurement Managerial Accounting Features/Costs Application x x
EX 17 Contribution margin analysis – sales 5 Moderate 25 min. Analytic Measurement Managerial Accounting Features/Costs Application x x
EX 18 Contribution margin analysis – sales 5 Moderate 30 min. Analytic Measurement Managerial Accounting Features/Costs Application x
EX 19 Contribution margin analysis – variable costs 5 Moderate 25 min. Analytic Measurement Managerial Accounting Features/Costs Application x
EX 20 Variable costing income statement for a service company 4,6 Moderate 30 min. Analytic Measurement Managerial Accounting Features/Costs Application x x
EX 21 Contribution margin reporting and analysis for a service company 5,6 Moderate 30 min. Analytic Measurement Managerial Accounting Features/Costs Application x x
EX 22 Variable costing income statement and contribution margin analysis for a service company 5,6 Moderate 30 min. Analytic Measurement Managerial Accounting Features/Costs Application x x
PR 1A Absorption and variable costing income statements 1,2 Moderate 30 min. Analytic Measurement Managerial Accounting Features/Costs Application x x
PR 2A Income statements under absorption costing and variable costing 1,2 Challenging 40 min. Analytic Measurement Managerial Accounting Features/Costs Application x
PR 4A Salespersons’ report and analysis 4 Challenging 40 min. Analytic Measurement Managerial Accounting Features/Costs Application x
PR 5A Segment variable costing income statement and effect on income of change in operations 4 Challenging 40 min. Analytic Measurement Managerial Accounting Features/Costs Application x x
PR 6A Contribution margin analysis 5 Challenging 40 min. Analytic Measurement Managerial Accounting Features/Costs Application x x
PR 1B Absorption and variable costing income statements 1,2 Moderate 30 min. Analytic Measurement Managerial Accounting Features/Costs Application x x
PR 2B Income statements under absorption costing and variable costing 1,2 Challenging 40 min. Analytic Measurement Managerial Accounting Features/Costs Application x
PR 3B Absorption and variable costing income statements for two months and analysis 1,2 Challenging 40 min. Analytic Measurement Managerial Accounting Features/Costs Application x x
PR 4B Salespersons’ report and analysis 4 Challenging 40 min. Analytic Measurement Managerial Accounting Features/Costs Application x
PR 5B Variable costing income statement and effect on income of change in operations 4 Challenging 40 min. Analytic Measurement Managerial Accounting Features/Costs Application x x
PR 6B Contribution margin analysis 5 Challenging 40 min. Analytic Measurement Managerial Accounting Features/Costs Application x x
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