Chapter 8 – Variable Costing and the Costs of Quality and Sustainability
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CHAPTER 8
VARIABLE COSTING AND THE COSTS OF QUALITY
AND SUSTAINABILITY
Learning Objectives
1. Explain the accounting treatment of fixed manufacturing overhead under
absorption and variable costing.
2. Prepare an income statement under absorption costing.
4. Reconcile reported income under absorption and variable costing.
5. Explain the implications of absorption and variable costing for cost-volume-
profit analysis.
6. Evaluate absorption and variable costing.
8. Discuss two contrasting views of the optimal level of product quality.
Chapter 8 – Variable Costing and the Costs of Quality and Sustainability
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Chapter Overview
I. Absorption and Variable Costing
A Fixed manufacturing overhead
B. Illustration of absorption and variable costing
C. Absorption-costing income statements
D. Variable-costing income statements
E. Reconciling income under absorption and variable costing
F. CVP analysis
G. Evaluation of absorption and variable costing
II. Costs of Assuring Quality
A. Measuring and reporting quality costs
B. Changing views of optimal product quality
C. ISO 9000 standards
III. Costs of Environmental Sustainability
A. Classifying environmental costs
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Key Lecture Concepts
I. Absorption and Variable Costing
• Product, or manufacturing, costs are comprised of direct materials, direct
labor, variable manufacturing overhead, and fixed manufacturing
overhead. The basic difference between absorption and variable costing is
the treatment of fixed manufacturing overhead.
➢ With absorption (full) costing, all costs related to the manufacture
of a good are product costs. Therefore, fixed manufacturing
overhead attaches to the units being made and is carried in
inventory until the product is sold.
➢ Under variable costing, product cost is comprised solely of
variable manufacturing costs. Fixed manufacturing overhead is
viewed as a cost of being ready to produce, not an actual production
cost (i.e., the cost will remain constant no matter how many units
are manufactured).
▪ Fixed manufacturing overhead is treated as a period cost
and expensed immediately.
• Reconciliation of absorption and variable-costing income.
➢ The difference between the two approaches is the timing of when
fixed manufacturing overhead is shown on the income statement:
when the product is sold under absorption costing and when
incurred under variable costing.
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➢ The two methods will usually produce different income figures.
▪ No change in inventory: production = sales
o Under variable costing, all fixed manufacturing
▪ Increase in inventory: production > sales
o Under variable costing, all fixed manufacturing
overhead is expensed. With absorption costing, a
portion of the period’s fixed overhead flows through
▪ Decrease in inventory: sales > production
o Under variable costing, all fixed manufacturing
overhead is expensed. With absorption costing, as
units manufactured in a prior period are sold, an
amount greater than the current period’s fixed
overhead flows through to cost of goods sold.
o Absorption-costing net income is less than variable-
costing net income.
▪ The difference between absorption- and variable-costing
income figures can be reconciled as follows:
o Income difference = Inventory change in units x Fixed
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• CVP analysis
• Evaluation of absorption and variable costing
➢ Absorption-cost proponents argue that fixed manufacturing
overhead is a necessary production cost. Excluding this element
from the inventoried cost of a product will understate the good’s
cost, which is troublesome for companies that use cost-based
pricing techniques.
➢ Variable-cost proponents argue that variable cost is better for
pricing decisions. Any price above a good’s variable cost results in
a positive contribution margin for the company.
➢ Many firms use variable costing for internal-reporting purposes.
Given that absorption costing must be employed for external
financial reporting, companies can use both methods by making
several simple end-of-period adjustments.
➢ If a company operates in a just-in-time environment, inventories
are kept very low and there will be little change in inventory from
period to period. Thus, the income differences between absorption
and variable costing will normally be insignificant.
II. Costs of Assuring Quality
• Don’t confuse a product’s grade with its quality. Grade refers to the extent
of its capabilities in performing an intended purpose, in relation to other
products with the same functional use. Quality of design refers to how
well it is conceived or designed for its intended use. Quality of
conformance refers to the extent to which a product meets the
specification of its design.
• There are four types of quality costs.
➢ Prevention costs are the costs of preventing defects.
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to product delivery.
➢ External failure costs are those costs incurred after product
delivery.
• The optimal level of product quality is a balancing act between the costs of
prevention and appraisal and the costs of failure (internal and external).
• Total quality management (TQM) programs monitor product quality
with measuring and reporting quality costs.
• ISO 9000 standards require that a company have a well-defined quality
control system in place and that the target level of product quality is
consistently maintained.
III. Costs of Environmental Sustainability
• Sustainable development includes business activity that produces the
goods and services needed in the present without limiting the ability of
future generations to meet their needs.
• Environmental costs are the costs of dealing with environmental issues,
• Environmental costs may be categorized in several ways.
➢ Private environmental costs are those borne by a company or
individual. Social environmental costs are those borne by the public
at large.
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➢ Visible environmental costs are those that are known and clearly
identified as tied to environmental issues. Hidden social
environmental costs cannot be clearly tied to environmental issues.
➢ Visible and hidden environmental costs may be further classified
into one of three types.
▪ Monitoring costs include the costs of monitoring the
regulatory environment as well as monitoring the
production process to determine if pollution is being
generated.
• The International Organization for Standardization (ISO) created
standards for environmental sustainability and management known as
ISO 14000 standards.
➢ ISO 14000 is not as widely implemented as ISO 9000 standards.
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Teaching Overview
Students sometimes have difficulty recognizing that the only difference between
absorption costing and variable costing is the treatment of fixed manufacturing
overhead. After they grasp the mechanics, students should be urged to think about the
underlying theoretical and practical differences between the two approaches.
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Links to the Text
Homework Grid – CHAPTER 8
Item No.
Learning
Objectives
Completion
Time (min.)
Special
Features*
Exercises:
8-20
1, 4
15
8-21
5
20
W
8-22
1, 4
15
8-23
1, 4
15
8-24
1
10
8-25
1
30
C
8-26
1, 4
25
8-27
1
10
8-28
7
10
8-29
7
5
I
8-30
7
20
8-31
9
45
C
Problems:
8-32
2, 3, 4
45
8-33
4, 5, 6
45
8-34
2, 3, 4, 6
45
S
8-35
1, 4
25
I
8-36
1, 2, 3
35
8-37
4
45
8-38
2, 3, 4, 6
40
8-39
7
35
8-40
7
40
W
8-41
9
60-180
G, W
Cases:
8-42
2, 3, 4
45
S
8-43
1, 4
30
8-44
1, 4
40