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Total variable costs increase proportionally with activity level, while variable cost per unit remains constant. Total fixed costs remain the same as activity level changes, but fixed cost per unit decreases as activity increases. The document provides examples of variable costs like materials and labor, and fixed costs like depreciation and rent. It also discusses how the proportion of fixed to variable costs differs between industries and is trending upward overall.
chapter05-140915010931-phpapp01
- 1. Chapter 5Chapter 5 Cost Behavior: Analysis and Use
- 2. Learning Objective LO1LO1 To understand how fixed and variable costs behave and how to use them to predict costs.
- 3. Summary of Variable and Fixed Cost Behavior Cost In Total Per Unit Variable Total variable cost is Variable cost per unit remains proportional to the activity the same over wide ranges level within the relevant range. of activity. Total fixed cost remains the same even when the activity Fixed cost per unit goes Fixed level changes within the down as activity level goes up. relevant range. Recall the summary of our cost behaviorRecall the summary of our cost behavior discussion from Chapter 1.discussion from Chapter 1. Types of Cost Behavior Patterns
- 4. The Activity Base A measure of what causes the incurrence of a variable cost A measure of what causes the incurrence of a variable cost UnitsUnits producedproduced UnitsUnits producedproduced Miles driven Miles driven Labor hours Labor hours Machine hours Machine hours
- 5. Minutes Talked TotalLongDistance TelephoneBill True Variable Cost Example A variable cost is a cost whose total dollar amount varies in direct proportion to changes in the activity level. Your total long distance telephone bill is based on how many minutes you talk.
- 6. Summary of Variable and Fixed Cost Behavior Cost In Total Per Unit Variable Total variable cost is Variable cost per unit remains proportional to the activity the same over wide ranges level within the relevant range. of activity. Total fixed cost remains the same even when the activity Fixed cost per unit goes Fixed level changes within the down as activity level goes up. relevant range. Recall the summary of our cost behaviorRecall the summary of our cost behavior discussion from Chapter 1.discussion from Chapter 1. Types of Cost Behavior Patterns
- 7. Minutes Talked PerMinute TelephoneCharge Variable Cost Per Unit Example A variable cost remains constant if expressed on a per unit basis. The cost per minute talked is constant. For example, 10¢ per minute.
- 8. Extent of Variable Costs The proportion of variable costs differs across organizations. For example . . . A public utility withA public utility with large investments inlarge investments in equipment will tendequipment will tend to haveto have fewerfewer variable costs.variable costs. A public utility withA public utility with large investments inlarge investments in equipment will tendequipment will tend to haveto have fewerfewer variable costs.variable costs. A manufacturing companyA manufacturing company will often havewill often have manymany variable costs.variable costs. A manufacturing companyA manufacturing company will often havewill often have manymany variable costs.variable costs. A merchandising companyA merchandising company usually will have ausually will have a highhigh proportionproportion of variable costsof variable costs like cost of sales.like cost of sales. A merchandising companyA merchandising company usually will have ausually will have a highhigh proportionproportion of variable costsof variable costs like cost of sales.like cost of sales. A service companyA service company will normally have awill normally have a highhigh proportionproportion of variable costs.of variable costs. A service companyA service company will normally have awill normally have a highhigh proportionproportion of variable costs.of variable costs.
- 9. Examples of Variable Costs 1.1. Merchandising companiesMerchandising companies – cost of goods sold.– cost of goods sold. 2.2. Manufacturing companiesManufacturing companies – direct materials,– direct materials, direct labor, and variable overhead.direct labor, and variable overhead. 3.3. Merchandising and manufacturing companiesMerchandising and manufacturing companies –– commissions, shipping costs, and clerical costscommissions, shipping costs, and clerical costs such as invoicing.such as invoicing. 4.4. Service companiesService companies – supplies, travel, and– supplies, travel, and clerical.clerical. 1.1. Merchandising companiesMerchandising companies – cost of goods sold.– cost of goods sold. 2.2. Manufacturing companiesManufacturing companies – direct materials,– direct materials, direct labor, and variable overhead.direct labor, and variable overhead. 3.3. Merchandising and manufacturing companiesMerchandising and manufacturing companies –– commissions, shipping costs, and clerical costscommissions, shipping costs, and clerical costs such as invoicing.such as invoicing. 4.4. Service companiesService companies – supplies, travel, and– supplies, travel, and clerical.clerical.
- 10. Volume Cost True Variable Cost Direct materials is a true or proportionately variable cost because the amount used during a period will vary in direct proportion to the level of production activity.
- 11. Step-Variable Costs A resource that is obtainable only in large chunks (suchA resource that is obtainable only in large chunks (such as maintenance workers) and whose costs increase oras maintenance workers) and whose costs increase or decrease only in response to fairly wide changes indecrease only in response to fairly wide changes in activity is known as aactivity is known as a step-variable coststep-variable cost.. Volume Cost
- 12. Step-Variable Costs Volume Cost Small changes in the level of production are not likely to have any effect on the number of maintenance workers employed. Small changes in the level of production are not likely to have any effect on the number of maintenance workers employed.
- 13. Step-Variable Costs Only fairly wide changes in the activity level will cause a change in the number of maintenance workers employed Only fairly wide changes in the activity level will cause a change in the number of maintenance workers employed Volume Cost
- 14. Relevant Range A straight line closely approximates a curvilinear variable cost line within the relevant range. A straight line closely approximates a curvilinear variable cost line within the relevant range. Activity TotalCost Economist’sEconomist’s Curvilinear CostCurvilinear Cost FunctionFunction The Linearity Assumption and the Relevant Range Accountant’s Straight-LineAccountant’s Straight-Line Approximation (constantApproximation (constant unit variable cost)unit variable cost)
- 15. Summary of Variable and Fixed Cost Behavior Cost In Total Per Unit Variable Total variable cost is Variable cost per unit remains proportional to the activity the same over wide ranges level within the relevant range. of activity. Total fixed cost remains the same even when the activity Fixed cost per unit goes Fixed level changes within the down as activity level goes up. relevant range. Let’s look at fixed cost behavior on the nextLet’s look at fixed cost behavior on the next screens.screens. Types of Cost Behavior Patterns
- 16. Number of Local Calls MonthlyBasic TelephoneBill Total Fixed Cost Example A fixed cost is a cost whose total dollar amount remainsA fixed cost is a cost whose total dollar amount remains constant as the activity level changes. Your monthlyconstant as the activity level changes. Your monthly basic telephone bill is probably fixed and does notbasic telephone bill is probably fixed and does not change when you make more local calls.change when you make more local calls.
- 17. Summary of Variable and Fixed Cost Behavior Cost In Total Per Unit Variable Total variable cost is Variable cost per unit remains proportional to the activity the same over wide ranges level within the relevant range. of activity. Total fixed cost remains the same even when the activity Fixed cost per unit goes Fixed level changes within the down as activity level goes up. relevant range. Recall the summary of our cost behaviorRecall the summary of our cost behavior discussion from Chapter 1.discussion from Chapter 1. Types of Cost Behavior Patterns
- 18. Number of Local Calls MonthlyBasicTelephone BillperLocalCall Fixed Cost Per Unit Example Average fixed costs per unit decrease as the activity level increases. The fixed cost per local call decreases as more local calls are made.
- 19. Examples Advertising and Research and Development Examples Advertising and Research and Development Examples Depreciation on Buildings and Equipment and Real Estate Taxes Examples Depreciation on Buildings and Equipment and Real Estate Taxes Types of Fixed Costs Discretionary May be altered in the short-term by current managerial decisions Discretionary May be altered in the short-term by current managerial decisions Committed Long-term, cannot be significantly reduced in the short-term. Committed Long-term, cannot be significantly reduced in the short-term.
- 20. The Trend Toward Fixed Costs The trend in many industries is toward greater fixed costs relative to variable costs. As machines take overAs machines take over many mundane tasksmany mundane tasks previously performedpreviously performed by humans,by humans, ““knowledge workersknowledge workers”” are demanded forare demanded for their minds rathertheir minds rather than their muscles.than their muscles. As machines take overAs machines take over many mundane tasksmany mundane tasks previously performedpreviously performed by humans,by humans, ““knowledge workersknowledge workers”” are demanded forare demanded for their minds rathertheir minds rather than their muscles.than their muscles. Knowledge workersKnowledge workers tend to be salaried,tend to be salaried, highly-trained andhighly-trained and difficult to replace. Thedifficult to replace. The cost to compensatecost to compensate these valued employeesthese valued employees isis relatively fixedrelatively fixed rather than variable.rather than variable. Knowledge workersKnowledge workers tend to be salaried,tend to be salaried, highly-trained andhighly-trained and difficult to replace. Thedifficult to replace. The cost to compensatecost to compensate these valued employeesthese valued employees isis relatively fixedrelatively fixed rather than variable.rather than variable.
- 21. Is Labor a Variable or a Fixed Cost? The behavior of wage and salary costs can differ across countries, depending on labor regulations, labor contracts, and custom. In France, Germany, China, and Japan, management has little flexibility in adjusting the size of the labor force. Labor costs are more fixed in nature. In France, Germany, China, and Japan, management has little flexibility in adjusting the size of the labor force. Labor costs are more fixed in nature. In the United States and the United Kingdom, management has greater latitude. Labor costs are more variable in nature. In the United States and the United Kingdom, management has greater latitude. Labor costs are more variable in nature.
- 22. RentCostin ThousandsofDollars 0 1,000 2,000 3,000 Rented Area (Square Feet) 0 30 60 Fixed Costs and Relevant Range 90 Relevant Range Total cost doesn’t change for a wide range of activity, and then jumps to a new higher cost for the next higher range of activity. Total cost doesn’t change for a wide range of activity, and then jumps to a new higher cost for the next higher range of activity.
- 23. Fixed Costs and Relevant Range Example:Example: Office space isOffice space is available at a rental rateavailable at a rental rate of $30,000 per year inof $30,000 per year in increments of 1,000increments of 1,000 square feet. As thesquare feet. As the business grows, morebusiness grows, more space is rented,space is rented, increasing the total cost.increasing the total cost. Example:Example: Office space isOffice space is available at a rental rateavailable at a rental rate of $30,000 per year inof $30,000 per year in increments of 1,000increments of 1,000 square feet. As thesquare feet. As the business grows, morebusiness grows, more space is rented,space is rented, increasing the total cost.increasing the total cost. The relevant range of activity for a fixed cost is the range of activity over which the graph of the cost is flat.
- 24. How does thisHow does this type of fixed costtype of fixed cost differ from a step-differ from a step- variable cost?variable cost? Step-variable costsStep-variable costs can be adjustedcan be adjusted more quickly and . . .more quickly and . . . The width of theThe width of the activity steps isactivity steps is much wider for themuch wider for the fixed cost.fixed cost. Fixed Costs and Relevant Range
- 25. Quick Check Which of the following statements about cost behavior are true? 1. Fixed costs per unit vary with the level of activity. 2. Variable costs per unit are constant within the relevant range. 3. Total fixed costs are constant within the relevant range. 4. Total variable costs are constant within the relevant range. Which of the following statements about cost behavior are true? 1. Fixed costs per unit vary with the level of activity. 2. Variable costs per unit are constant within the relevant range. 3. Total fixed costs are constant within the relevant range. 4. Total variable costs are constant within the relevant range.
- 26. Which of the following statements about cost behavior are true? 1. Fixed costs per unit vary with the level of activity. 2. Variable costs per unit are constant within the relevant range. 3. Total fixed costs are constant within the relevant range. 4. Total variable costs are constant within the relevant range. Which of the following statements about cost behavior are true? 1. Fixed costs per unit vary with the level of activity. 2. Variable costs per unit are constant within the relevant range. 3. Total fixed costs are constant within the relevant range. 4. Total variable costs are constant within the relevant range. Quick Check
- 27. Fixed Monthly Utility Charge Variable Cost per KW Activity (Kilowatt Hours) TotalUtilityCost X Y A mixed cost has both fixed and variable components. Consider your utility costs. A mixed cost has both fixed and variable components. Consider your utility costs. Mixed Costs Total mixed cost
- 28. Fixed Monthly Utility Charge Variable Cost per KW Activity (Kilowatt Hours) TotalUtilityCost X Y Mixed Costs Total mixed cost
- 29. Mixed Costs Example If your fixed monthly utility charge is $40, yourIf your fixed monthly utility charge is $40, your variable cost is $0.03 per kilowatt hour, and yourvariable cost is $0.03 per kilowatt hour, and your monthly activity level is 2,000 kilowatt hours,monthly activity level is 2,000 kilowatt hours, what is the amount of your utility bill?what is the amount of your utility bill? If your fixed monthly utility charge is $40, yourIf your fixed monthly utility charge is $40, your variable cost is $0.03 per kilowatt hour, and yourvariable cost is $0.03 per kilowatt hour, and your monthly activity level is 2,000 kilowatt hours,monthly activity level is 2,000 kilowatt hours, what is the amount of your utility bill?what is the amount of your utility bill? Y = a + bX Y = $40 + ($0.03 × 2,000) Y = $100
- 30. Analysis of Mixed Costs Each account is classified as eitherEach account is classified as either variable or fixed based on the analyst’svariable or fixed based on the analyst’s knowledge of how the account behaves.knowledge of how the account behaves. Each account is classified as eitherEach account is classified as either variable or fixed based on the analyst’svariable or fixed based on the analyst’s knowledge of how the account behaves.knowledge of how the account behaves. Cost estimates are based on anCost estimates are based on an evaluation of production methods, andevaluation of production methods, and material, labor and overheadmaterial, labor and overhead requirements.requirements. Cost estimates are based on anCost estimates are based on an evaluation of production methods, andevaluation of production methods, and material, labor and overheadmaterial, labor and overhead requirements.requirements. Account Analysis and the Engineering ApproachAccount Analysis and the Engineering ApproachAccount Analysis and the Engineering ApproachAccount Analysis and the Engineering Approach
- 31. Learning Objective LO2LO2 To use a scattergraph plot to diagnose cost behavior.
- 32. Plot the data points on a graphPlot the data points on a graph (total cost vs. activity).(total cost vs. activity). Plot the data points on a graphPlot the data points on a graph (total cost vs. activity).(total cost vs. activity). 0 1 2 3 4 * MaintenanceCost 1,000’sofDollars 10 20 0 * ** * * * * * * Patient-days in 1,000’s X Y The Scattergraph Method
- 33. The Scattergraph Method Draw a line through the data points with about anDraw a line through the data points with about an equal numbers of points above and below the line.equal numbers of points above and below the line. Draw a line through the data points with about anDraw a line through the data points with about an equal numbers of points above and below the line.equal numbers of points above and below the line. 0 1 2 3 4 * MaintenanceCost 1,000’sofDollars 10 20 0 * ** * * * * * * Patient-days in 1,000’s X Y
- 34. The Scattergraph Method Use one data point to estimate the total level of activityUse one data point to estimate the total level of activity and the total cost.and the total cost. Use one data point to estimate the total level of activityUse one data point to estimate the total level of activity and the total cost.and the total cost. Intercept = Fixed cost: $10,000 0 1 2 3 4 * MaintenanceCost 1,000’sofDollars 10 20 0 * ** * * * * * * Patient-days in 1,000’s X Y Patient days = 800Patient days = 800 Total maintenance cost = $11,000Total maintenance cost = $11,000
- 35. The Scattergraph Method Make a quick estimate of variable cost per unit andMake a quick estimate of variable cost per unit and determine the cost equation.determine the cost equation. Make a quick estimate of variable cost per unit andMake a quick estimate of variable cost per unit and determine the cost equation.determine the cost equation. Variable cost per unit = $1,000 800 = $1.25/patient-day$1.25/patient-day Y = $10,000 + $1.25XY = $10,000 + $1.25XY = $10,000 + $1.25XY = $10,000 + $1.25X Total maintenance at 800 patients 11,000$ Less: Fixed cost 10,000 Estimated total variable cost for 800 patients 1,000$ Total maintenance costTotal maintenance costTotal maintenance costTotal maintenance cost Number of patient daysNumber of patient daysNumber of patient daysNumber of patient days
- 36. Learning Objective LO3LO3 To analyze a mixed cost using the high-low method.
- 37. The High-Low Method Assume the following hours of maintenance work and the total maintenance costs for six months.
- 38. The High-Low Method TheThe variable costvariable cost per hourper hour ofof maintenance ismaintenance is equal to the changeequal to the change in cost divided byin cost divided by the change in hours.the change in hours. TheThe variable costvariable cost per hourper hour ofof maintenance ismaintenance is equal to the changeequal to the change in cost divided byin cost divided by the change in hours.the change in hours. = $8.00/hour$8.00/hour $2,400 300 Hours Total Cost High 800 9,800$ Low 500 7,400 Change 300 2,400$
- 39. The High-Low Method Total Fixed Cost = Total Cost – Total Variable CostTotal Fixed Cost = Total Cost – Total Variable Cost Total Fixed Cost = $9,800 – ($8/hourTotal Fixed Cost = $9,800 – ($8/hour × 800 hours)× 800 hours) Total Fixed Cost = $9,800 – $6,400Total Fixed Cost = $9,800 – $6,400 Total Fixed Cost =Total Fixed Cost = $3,400$3,400
- 40. The High-Low Method Y = $3,400 + $8.00Y = $3,400 + $8.00XX The Cost Equation for Maintenance
- 41. Quick Check Sales salaries and commissions are $10,000 when 80,000 units are sold, and $14,000 when 120,000 units are sold. Using the high-low method, what is the variable portion of sales salaries and commission? a. $0.08 per unit b. $0.10 per unit c. $0.12 per unit d. $0.125 per unit Sales salaries and commissions are $10,000 when 80,000 units are sold, and $14,000 when 120,000 units are sold. Using the high-low method, what is the variable portion of sales salaries and commission? a. $0.08 per unit b. $0.10 per unit c. $0.12 per unit d. $0.125 per unit
- 42. Sales salaries and commissions are $10,000 when 80,000 units are sold, and $14,000 when 120,000 units are sold. Using the high-low method, what is the variable portion of sales salaries and commission? a. $0.08 per unit b. $0.10 per unit c. $0.12 per unit d. $0.125 per unit Sales salaries and commissions are $10,000 when 80,000 units are sold, and $14,000 when 120,000 units are sold. Using the high-low method, what is the variable portion of sales salaries and commission? a. $0.08 per unit b. $0.10 per unit c. $0.12 per unit d. $0.125 per unit Quick Check $4,000 ÷ 40,000 units = $0.10 per unit Units Cost High level 120,000 14,000$ Low level 80,000 10,000 Change 40,000 4,000$
- 43. Quick Check Sales salaries and commissions are $10,000 when 80,000 units are sold, and $14,000 when 120,000 units are sold. Using the high-low method, what is the fixed portion of sales salaries and commissions? a. $ 2,000 b. $ 4,000 c. $10,000 d. $12,000 Sales salaries and commissions are $10,000 when 80,000 units are sold, and $14,000 when 120,000 units are sold. Using the high-low method, what is the fixed portion of sales salaries and commissions? a. $ 2,000 b. $ 4,000 c. $10,000 d. $12,000
- 44. Sales salaries and commissions are $10,000 when 80,000 units are sold, and $14,000 when 120,000 units are sold. Using the high-low method, what is the fixed portion of sales salaries and commissions? a. $ 2,000 b. $ 4,000 c. $10,000 d. $12,000 Sales salaries and commissions are $10,000 when 80,000 units are sold, and $14,000 when 120,000 units are sold. Using the high-low method, what is the fixed portion of sales salaries and commissions? a. $ 2,000 b. $ 4,000 c. $10,000 d. $12,000 Quick Check
- 45. Least-Squares Regression Method A method used to analyze mixed costs if a scattergraph plot reveals an approximately linear relationship between the X and Y variables. This method usesThis method uses allall of theof the data points to estimatedata points to estimate the fixed and variablethe fixed and variable cost components of acost components of a mixed cost.mixed cost. This method usesThis method uses allall of theof the data points to estimatedata points to estimate the fixed and variablethe fixed and variable cost components of acost components of a mixed cost.mixed cost. The goal of this method isThe goal of this method is to fit a straight line to theto fit a straight line to the data thatdata that minimizes theminimizes the sum of the squared errorssum of the squared errors.. The goal of this method isThe goal of this method is to fit a straight line to theto fit a straight line to the data thatdata that minimizes theminimizes the sum of the squared errorssum of the squared errors..
- 46. Least-Squares Regression Method Software can be usedSoftware can be used to fit a regression lineto fit a regression line through the data points.through the data points. The cost analysisThe cost analysis objective is the same:objective is the same: Y = a + bXY = a + bX The output from the regression analysis can be used to create an equation that enables you to estimate total costs at any activity level. The output from the regression analysis can be used to create an equation that enables you to estimate total costs at any activity level.
- 47. Comparing Results From the Three Methods The three methods just discussed provideThe three methods just discussed provide slightly different estimates of the fixed andslightly different estimates of the fixed and variable cost components of the mixed cost.variable cost components of the mixed cost. This is to be expected because each methodThis is to be expected because each method uses different amounts of the data points touses different amounts of the data points to provide estimates.provide estimates. Least-squares regression provides the mostLeast-squares regression provides the most accurate estimate because it uses all the dataaccurate estimate because it uses all the data points.points. The three methods just discussed provideThe three methods just discussed provide slightly different estimates of the fixed andslightly different estimates of the fixed and variable cost components of the mixed cost.variable cost components of the mixed cost. This is to be expected because each methodThis is to be expected because each method uses different amounts of the data points touses different amounts of the data points to provide estimates.provide estimates. Least-squares regression provides the mostLeast-squares regression provides the most accurate estimate because it uses all the dataaccurate estimate because it uses all the data points.points.
- 48. Learning Objective LO4LO4 To prepare an income statement using the contribution format.
- 49. Let’s put ourLet’s put our knowledge of costknowledge of cost behavior to work bybehavior to work by preparing apreparing a contribution formatcontribution format income statement.income statement. The Contribution Format Income Statement
- 50. The Contribution Format Total Unit Sales Revenue 100,000$ 50$ Less: Variable costs 60,000 30 Contribution margin 40,000$ 20$ Less: Fixed costs 30,000 Net operating income 10,000$ The contribution margin format emphasizesThe contribution margin format emphasizes cost behavior. Contribution margin covers fixedcost behavior. Contribution margin covers fixed costs and provides for income.costs and provides for income. The contribution margin format emphasizesThe contribution margin format emphasizes cost behavior. Contribution margin covers fixedcost behavior. Contribution margin covers fixed costs and provides for income.costs and provides for income.
- 51. Uses of the Contribution Format The contribution income statement format is usedThe contribution income statement format is used as an internal planning and decision making tool.as an internal planning and decision making tool. We will use this approach for:We will use this approach for: 1.1. Cost-volume-profit analysis (Chapter 6).Cost-volume-profit analysis (Chapter 6). 2.2. Budgeting (Chapter 7).Budgeting (Chapter 7). 3.3. Special decisions such as pricing and make-or-Special decisions such as pricing and make-or- buy analysis (Chapter 11).buy analysis (Chapter 11). The contribution income statement format is usedThe contribution income statement format is used as an internal planning and decision making tool.as an internal planning and decision making tool. We will use this approach for:We will use this approach for: 1.1. Cost-volume-profit analysis (Chapter 6).Cost-volume-profit analysis (Chapter 6). 2.2. Budgeting (Chapter 7).Budgeting (Chapter 7). 3.3. Special decisions such as pricing and make-or-Special decisions such as pricing and make-or- buy analysis (Chapter 11).buy analysis (Chapter 11).
- 52. The Contribution Format Comparison of the Contribution Income Statement with the Traditional Income Statement Traditional Approach Contribution Approach (costs organized by function) (costs organized by behavior) Sales 100,000$ Sales 100,000$ Less cost of goods sold 70,000 Less variable expenses 60,000 Gross margin 30,000$ Contribution margin 40,000$ Less operating expenses 20,000 Less fixed expenses 30,000 Net operating income 10,000$ Net operating income 10,000$ Used primarily forUsed primarily for external reporting.external reporting. Used primarily byUsed primarily by management.management.
- 53. Learning Objective LO5LO5 To use variable costing to prepare a contribution format income statement and contrast absorption costing and variable costing. (Appendix 5A)
- 54. Chapter 5Chapter 5 Variable Costing Appendix 5A
- 55. Overview of Absorption and Variable Costing Direct Materials Direct Labor Variable Manufacturing Overhead Fixed Manufacturing Overhead Variable Selling and Administrative Expenses Fixed Selling and Administrative Expenses Variable Costing Absorption Costing Product Costs Period Costs Product Costs Period Costs
- 56. Quick Check Which method will produce the highest values for work in process and finished goods inventories? a. Absorption costing. b. Variable costing. c. They produce the same values for these inventories. d. It depends. Which method will produce the highest values for work in process and finished goods inventories? a. Absorption costing. b. Variable costing. c. They produce the same values for these inventories. d. It depends.
- 57. Which method will produce the highest values for work in process and finished goods inventories? a. Absorption costing. b. Variable costing. c. They produce the same values for these inventories. d. It depends. Which method will produce the highest values for work in process and finished goods inventories? a. Absorption costing. b. Variable costing. c. They produce the same values for these inventories. d. It depends. Quick Check
- 58. Unit Cost Computations Harvey Company produces a single productHarvey Company produces a single product with the following information available:with the following information available: Number of units produced annually 25,000 Variable costs per unit: Direct materials, direct labor, and variable mfg. overhead 10$ Selling & administrative expenses 3$ Fixed costs per year: Manufacturing overhead 150,000$ Selling & administrative expenses 100,000$
- 59. Unit Cost Computations UnitUnit product costproduct cost is determined as follows:is determined as follows: Selling and administrative expenses areSelling and administrative expenses are always treated asalways treated as period expensesperiod expenses and deductedand deducted from revenue as incurred.from revenue as incurred. Absorption Costing Variable Costing Direct materials, direct labor, and variable mfg. overhead 10$ 10$ Fixed mfg. overhead ($150,000 ÷ 25,000 units) 6 - Unit product cost 16$ 10$
- 60. Income Comparison of Absorption and Variable Costing Let’s assume the following additional information for Harvey Company. 20,000 units were sold during the year at a price of $30 each. There were no units in beginning inventory. Now, let’s compute net operating income using both absorption and variable costing.
- 61. Absorption Costing Sales (20,000 × $30) 600,000$ Less cost of goods sold: Beginning inventory -$ Add COGM (25,000 × $16) 400,000 Goods available for sale 400,000 Ending inventory (5,000 × $16) 80,000 320,000 Gross margin 280,000 Less selling & admin. exp. Variable (20,000 × $3) 60,000$ Fixed 100,000 160,000 Net operating income 120,000$ Absorption Costing
- 62. Variable Costing Sales (20,000 × $30) 600,000$ Less variable expenses: Beginning inventory -$ Add COGM (25,000 × $10) 250,000 Goods available for sale 250,000 Less ending inventory (5,000 × $10) 50,000 Variable cost of goods sold 200,000 Variable selling & administrative expenses (20,000 × $3) 60,000 260,000 Contribution margin 340,000 Less fixed expenses: Manufacturing overhead 150,000$ Selling & administrative expenses 100,000 250,000 Net operating income 90,000$ Variable manufacturing costs only. All fixed manufacturing overhead is expensed. Variable Costing
- 63. Cost of Goods Sold Ending Inventory Period Expense Total Absorption costing Variable mfg. costs 200,000$ 50,000$ -$ 250,000$ Fixed mfg. costs 120,000 30,000 - 150,000 320,000$ 80,000$ -$ 400,000$ Variable costing Variable mfg. costs 200,000$ 50,000$ -$ 250,000$ Fixed mfg. costs - - 150,000 150,000 200,000$ 50,000$ 150,000$ 400,000$ Income Comparison of Absorption and Variable Costing Let’s compare the methods.
- 64. Comparing the Two Methods Variable costing net operating income 90,000$ Add: Fixed mfg. overhead costs deferred in inventory (5,000 units × $6 per unit) 30,000 Absorption costing net operating income 120,000$ Fixed mfg. Overhead $150,000 Units produced 25,000 units = = $6.00 per unit We can reconcile the difference between absorption and variable income as follows:
- 65. Extended Comparison of Income Data Number of units produced 25,000 Number of units sold 30,000 Units in beginning inventory 5,000 Unit sales price 30$ Variable costs per unit: Direct materials, direct labor variable mfg. overhead 10$ Selling & administrative expenses 3$ Fixed costs per year: Manufacturing overhead 150,000$ Selling & administrative expenses 100,000$ Here is information about the operation of Harvey Company for the second year.
- 66. Unit Cost Computations Since there was no change in the variable costsSince there was no change in the variable costs per unit, total fixed costs, or the number ofper unit, total fixed costs, or the number of units produced, the unit costs remain unchanged.units produced, the unit costs remain unchanged. Since there was no change in the variable costsSince there was no change in the variable costs per unit, total fixed costs, or the number ofper unit, total fixed costs, or the number of units produced, the unit costs remain unchanged.units produced, the unit costs remain unchanged. Absorption Costing Variable Costing Direct materials, direct labor, and variable mfg. overhead 10$ 10$ Fixed mfg. overhead ($150,000 ÷ 25,000 units) 6 - Unit product cost 16$ 10$
- 67. Absorption Costing Sales (30,000 × $30) 900,000$ Less cost of goods sold: Beg. inventory (5,000 × $16) 80,000$ Add COGM (25,000 × $16) 400,000 Goods available for sale 480,000 Less ending inventory - 480,000 Gross margin 420,000 Less selling & admin. exp. Variable (30,000 × $3) 90,000$ Fixed 100,000 190,000 Net operating income 230,000$ Absorption Costing These are the 25,000 unitsThese are the 25,000 units produced in the current period.produced in the current period. These are the 25,000 unitsThese are the 25,000 units produced in the current period.produced in the current period.
- 68. Variable Costing Sales (30,000 × $30) 900,000$ Less variable expenses: Beg. inventory (5,000 × $10) 50,000$ Add COGM (25,000 × $10) 250,000 Goods available for sale 300,000 Less ending inventory - Variable cost of goods sold 300,000 Variable selling & administrative expenses (30,000 × $3) 90,000 390,000 Contribution margin 510,000 Less fixed expenses: Manufacturing overhead 150,000$ Selling & administrative expenses 100,000 250,000 Net operating income 260,000$ Variable Costing All fixedAll fixed manufacturingmanufacturing overhead isoverhead is expensed.expensed. VariableVariable manufacturingmanufacturing costs only.costs only.
- 69. Comparing the Two Methods Variable costing net operating income 260,000$ Deduct: Fixed manufacturing overhead costs released from inventory (5,000 units × $6 per unit) 30,000 Absorption costing net operating income 230,000$ We can reconcile the difference between absorption and variable income as follows: Fixed mfg. Overhead $150,000 Units produced 25,000 units = = $6.00 per unit
- 70. Income Comparison Costing Method 1st Period 2nd Period Total Absorption 120,000$ 230,000$ 350,000$ Variable 90,000 260,000 350,000
- 71. Summary of Key Insights Relation between Effect Relation between production on variable and and sales iniventory absorption income Inventory Absorption Production > Sales increases > Variable Inventory Absorption Production < Sales decreases < Variable Absorption Production = Sales No change = Variable
- 72. End of Chapter 5
Editor's Notes
- #2: Chapter 5: Cost Behavior: Analysis and Use. Managers who understand how costs behave are better able to predict costs and make decisions under various circumstances. This chapter explores the meaning of fixed, variable and mixed costs (the relative proportions of which define an organization’s cost structure). It also introduces the income statement prepared using the contribution format.
- #3: Learning objective number 1 is to understand how fixed and variable costs behave and how to use them to predict costs.
- #4: We introduced this table in Chapter 1. Let’s concentrate on variable costs in total. Recall that total variable cost is proportional to the activity level within the relevant range. As activity increases total variable cost increases, and as activity decreases total variable cost decreases.
- #5: An activity base (also called a cost driver) is a measure of what causes the incurrence of variable costs. As the level of the activity base increases, the variable cost increases proportionally. Variable costs may be caused by a variety of different activity bases. Gasoline consumption in your car is largely determined by the number of miles driven and the speed at which you travel.
- #6: A true variable cost is one whose total dollar amount varies in direct proportion to changes in the level of activity. On your land-line, your total long distance telephone bill is determined by the number of minutes you talk. An activity base, or cost driver, is a measure of what causes the incurrence of variable costs. As the level of activity base increases, the variable cost increases proportionally.
- #7: On a per unit basis, variable costs remain the same over a wide range of activity.
- #8: A variable cost remains constant if expressed on a per unit basis. For your land-line, the cost per long-distance minute talked may remain the same at 10¢ per minute.
- #9: A public utility like Florida Power and Light, with large investments in equipment, will tend to have fewer variable costs. A manufacturing company like Black and Decker will often have many variable costs associated with the manufacture and distribution of its products to customers. A merchandising company like Wal-Mart will usually have a high proportion of variable costs such as the cost of merchandise purchased for resale. Some service companies, such as restaurants, have a high proportion of variable costs due to their raw material costs. Other service companies, such as an architectural firm, have a high proportion of fixed costs in the form of highly trained salaried employees.
- #10: Here are some examples of variable costs we are likely to find in different types of businesses: 1. Merchandising companies cost of goods sold. 2. Manufacturing companies direct materials, direct labor, and variable overhead. 3. Merchandising and manufacturing companies commissions, shipping costs, and clerical costs such as invoicing. 4. Service companies supplies, travel, and clerical.
- #11: Recall that we talked earlier about how true variable costs vary directly and proportionately with changes in activity. Direct material is an example of a cost that behaves in a true variable pattern. Now let’s look at what are known as step-variable costs.
- #12: A step variable cost remains constant within a narrow range of activity, so it tends to look like a fixed cost. Maintenance workers are often considered to be a variable cost, but this labor cost does not behave as a true variable cost. Fairly wide changes in the level of production will cause a change in the number of maintenance workers employed and the total maintenance cost.
- #13: For a step-variable cost, total cost increases to a new higher level when we reach the next higher range of activity. For example, a maintenance worker is obtainable only as a whole person who is capable of working approximately 2,000 hours per year.
- #14: Only fairly wide changes in the level of activity will cause a change in a step-variable cost. Maintenance workers are obtainable only in large chunks of a whole person who is capable of working approximately 2,000 hours a year.
- #15: Part IEconomists correctly point out that many costs that accountants classify as variable costs actually behave in a curvilinear fashion. Part IIIn many important decisions, accountants tend to treat costs as linear in nature. Part IIIAs long as the company is operating within the relevant range of activity, the accountant’s approximation of the economist’s curvilinear cost function seems to work quite well.The relevant range is the range of activity within which the assumptions made about cost behavior are valid.
- #16: Now let’s look at fixed costs. Total fixed costs remain constant within the relevant range of activity.
- #17: If you have a land-line in your home, you pay a flat connection fee that is the same every month. This fee is fixed because it does not change in total, regardless of the number of calls made.
- #18: Finally, fixed cost per unit decreases as activity level goes up.
- #19: As you make more and more local calls, the connection fee cost per call decreases. If your connection fee is $15 and you make one local call per month, the average connection fee is $15 per call. However, if you make 100 calls per month, the average connection fee drops to 15¢ per call.
- #20: Part IOne type of fixed cost is known as committed fixed costs. These are long-term fixed costs that cannot be significantly reduced in the short-term. Some examples include depreciation on equipment and buildings and real estate taxes. Part IIAnother type of fixed cost is known as discretionary fixed costs. These types of fixed costs may be altered in the short-term by current management decisions. Some examples of discretionary fixed costs include advertising and research and development costs. For example, some construction companies may lay off workers during months with minimal customer demand. However, other construction companies may opt to retain their workers all year. A cost may be discretionary or committed depending on management’s strategy.
- #21: Part I In many industries, we see a trend toward greater fixed costs relative to variable costs. In the past fifteen years, we have seen computers and robotics take over many mundane tasks previously performed by humans. For example, H&R Block employees used to fill out tax returns for customers by hand. Now, computer software is used to complete tax returns. Safeway and Kroger employees used to key-in prices by hand on cash registers. Now, barcode readers enter price and other product information automatically. Part II In today’s world economy, knowledge workers are in demand for their experience and knowledge, rather than for their muscle. Most knowledge workers tend to be salaried, highly trained, and very difficult to replace. The cost of these valued employees tends to be fixed rather than variable.
- #22: In much of Europe, China, and Japan, management has little flexibility in adjusting the size of the labor force. Labor costs tend to be viewed as more fixed than variable. In recent years, we have seen some changes in management’s flexibility. In the U.S. and United Kingdom, management has much greater latitude to adjust the size of the labor force. Labor costs in some industries are still viewed as more variable than fixed.
- #23: Fixed costs only stay constant in total within the relevant range of activity. As we adjust the relevant range of activity upward or downward, we see changes in total fixed costs. These upward or downward adjustments are generally very wide.
- #24: An example of changes in total fixed costs might be rent for office space. A company can rent 1,000 square feet of office space for $30,000 per year. If the company fills its current space and needs additional office space, the next 1,000 square feet will cost an additional $30,000 per year. So when a company needs 1,000 square feet of office space, the fixed office rent is $30,000. If another 1,000 square feet are needed, the fixed office rent will be $60,000.
- #25: The question becomes, how do changes in fixed costs outside the relevant range differ from step-variable costs? Step-variable costs can be adjusted more quickly and the width of the change in activity is much wider for changes in fixed costs. For example, a step-variable cost such as maintenance workers may have steps with a width of 40 hours a week. However, fixed costs may have steps that have a width of thousands or tens-of-thousands of hours of activity.
- #26: See how you do on this question. There can be more than one correct answer. Be careful and take your time.
- #27: Number 4 is not correct because total variable costs increase as activity increases, within the relevant range and decrease as activity decreases, within the relevant range.
- #28: A mixed cost has both a fixed and variable element. When you pay your utility bill, you know that a portion of your total bill is fixed. This is the standard monthly utility charge. The variable portion of your utility costs depends upon the number of kilowatt hours you consume. Your total utility bill has both a fixed and variable element. The graph demonstrates the nature of a normal utility bill.
- #29: The mixed cost line can be expressed with the equation Y equals A plus B times X. This equation should look familiar, from your algebra and statistics classes. Based on this equation, Y is the total mixed cost; A is the total fixed cost (or the vertical intercept of the line); B is the variable cost per unit of activity (or the slope of the line); and X is the actual level of activity. In our utility example, Y is the total mixed cost; A is the total fixed monthly utility charge; B is the cost per kilowatt hour consumed, and X is the number of kilowatt hours consumed.
- #30: Part IRead through this short question to see if you can calculate the total utility bill for the month.Part IIHow did you do? The total bill is $100.
- #31: In account analysis, we can analyze mixed costs by looking at each account and classifying the cost as variable, fixed or mixed based on the cost behavior over time. A more sophisticated way to analyze the nature of costs is to ask our engineers to evaluate each cost in terms of production methods, material requirements, labor usage and overhead.
- #32: Learning objective number 2 is to use a scattergraph plot to diagnose cost behavior.
- #33: A scattergraph plot is a quick and easy way to isolate the fixed and variable components of a mixed cost.The first step is to identify the cost, which is referred to as the dependent variable, and plot it on the Y axis. The activity, referred to as the independent variable, is plotted on the X axis. The second step is to analyze the data points on the scattergraph to see if they are linear, such that a straight line can be drawn that approximates the relation between cost and activity. If the plotted data points do not appear to be linear, do not analyze the data any further. If there does appear to be a linear relationship between the level of activity and cost, we will continue our analysis.
- #34: The third step is to draw a straight line where, roughly speaking, an equal number of points reside above and below the line. Make sure that the straight line goes through at least one data point on the scattergraph.
- #35: Part I The fourth step is to identify the Y intercept. This is where the straight line crosses the Y axis and is equal to the estimate of total fixed costs. In this case, the fixed costs are $10,000. Part IIThe fifth step is to estimate the variable cost per unit of the activity, which in this example is the cost per patient day. In our case, we used the first data point that was on the straight line. From this point, we estimate the total number of patient days and the total maintenance cost. Part IIIOur estimate of the total number of patient days at this data point is 800, and the estimate of the total maintenance cost is $11,000. We will use this information to estimate the variable cost per patient day.
- #36: Part I Now, subtract the fixed cost from the total estimated cost for eight hundred patient days. We arrive at an estimated total variable cost or $1,000 for 800 patients. Part IIDivide the total variable cost by the 800 patients and we have determined that the variable cost per patient day is $1.25. We can use this information to setup of basic cost equation. Part IIOur maintenance cost equation tells us that Y, the total maintenance cost is equal to $10,000, the total fixed cost, plus $1.25 times X, the number of patient days.
- #37: Learning objective number 3 is to analyze a mixed cost using the high-low method.
- #38: The high-low method can be used to analyze mixed costs if a scattergraph plot reveals an approximately linear relationship between the X and Y variables. We will use the data shown in the Excel spreadsheet to determine the fixed and variable portions of maintenance costs. We have collected data about the number of hours of maintenance and total cost incurred.Let’s use the information on this slide and see how the high-low method works.
- #39: Part I The first step in the process is to identify the high level of activity and the low level of activity. You can see that the high level of activity is 800 hours and the low level of activity is 500 hours. The second step is to determine the total costs associated with the two chosen points. The total cost for the high and low levels of activity is $9,800 and $7,400, respectively. Part II The third step is to calculate the change in the cost between the two data points and divide it by the change in activity level between the two data points. In our case, the change in level of activity is 300 hours and the change in total cost is $2,400. Part III The variable cost per unit of activity is determined by dividing the change in total cost by the change in activity. For our maintenance example, we divide $2,400 by 300 hours and determine that the variable cost per hour of maintenance is $8.
- #40: Part IThe fourth step is to take the total cost, at either activity level, and deduct the variable cost component. The residual represents the estimate of total fixed costs. Here is the equation we will use to calculate total fixed cost. Part IIWe can substitute known data to estimate total fixed cost. We know that total costs are $9,800 at the high level of activity. Total variable cost is $6,400, which is computed by multiplying the $8 variable cost per unit by the 800 hours of maintenance. Part III By solving the equation, we see that total fixed cost is equal to $3,400.
- #41: Step five is to construct an equation to estimate total maintenance cost at any level of activity within the relevant range. Our basic equation of Y is equal to $3,400 (our total fixed cost) plus $8 times the actual level of activity. You can verify the equation by calculating total maintenance costs at 500 hours, the low level of activity. It will be worth your time to make the calculation.
- #42: See if you can apply what we have just discussed to determine the variable portion of sales salaries and commissions for this company.
- #43: The correct answer is 10¢ per unit.
- #44: Using the same data, calculate the total fixed cost portion of sales salaries and commissions.
- #45: The calculation for the answer is a bit more complex, but we see that total fixed cost equals $2,000.
- #46: The least-squares regression method is a more sophisticated approach to isolating the fixed and variable portion of a mixed cost. The least-squares method uses all the data points, instead of just a few. The basic goal of this method is to fit a straight line to the data that minimizes the sum of the squared errors. The regression errors are the vertical deviations from the data points to the regression line.
- #47: The formulas that are used for least-squares regression are complex. Fortunately, computer software can perform the calculations quickly. The observed values of the X and Y variables are entered into the computer program and all necessary calculations are made. Output from the regression analysis can be used to create the equation that enables us to estimate total costs at any activity level.
- #48: The three methods we discussed for isolating the fixed and variable portions of a mixed cost yield slightly different results. The most accurate estimate is provided by the least-squared regression method. Less accurate results are usually associated with the scattergraph. The high-low method provides results that fall somewhere in the middle of the other two methods.
- #49: Learning objective number 4 is to prepare an income statement using the contribution format.
- #50: The contribution approach provides an income statement format geared directly to cost behavior, which has been the focus of discussion in this chapter. This statement is used for internal purposes.
- #51: This approach separates costs into fixed and variable. Sales minus variable costs equals contribution margin. The contribution margin minus fixed costs equals net operating income.
- #52: This approach is used as an internal planning and decision-making tool, and will be discussed further in the chapters shown on your screen.
- #53: The contribution approach differs from the traditional approach covered in Chapter 1. The traditional approach organizes costs in a functional format. Costs relating to production, administration and sales are grouped together without regard to their cost behavior. The traditional approach is used primarily for external reporting purposes.
- #54: Learning objective number 5 is to use variable costing to prepare a contribution format income statement and contrast absorption costing and variable costing.
- #55: Appendix 5A: Variable Costing In this appendix, we will show you how to use Microsoft Excel to determine the key variables necessary for least-squares regression. As you have seen, we need three pieces of information: the estimated variable cost per unit (the slope of the line), the estimated fixed cost (the intercept), and R squared. Let’s get started. We think you will find that using Microsoft Excel is quite easy.
- #56: Absorption costing (also called full costing) charges products with all manufacturing costs, regardless of whether the costs are fixed or variable. The cost of a unit of product consists of all four types of manufacturing costs — direct material, direct labor, variable manufacturing overhead, and fixed manufacturing overhead. Since no distinction is made between variable and fixed costs, absorption costing is not well suited for cost-volume-profit analysis. Variable costing (also called direct costing) charges products with only the variable manufacturing costs. The cost of a unit of product consists of the three variable manufacturing costs — direct material, direct labor, and variable manufacturing overhead. Variable costing is consistent with the contribution format income statement, and it supports cost-volume-profit analysis because of its emphasis on separating variable and fixed costs. The only difference in the two approaches is the treatment of fixed manufacturing overhead. With absorption costing, fixed manufacturing overhead is a product cost. With variable costing, fixed manufacturing overhead is a period cost. Note that selling and administrative costs are treated as period costs with both absorption costing and variable costing. Think about the impact of each method on inventory values, and then answer the following question.
- #57: To answer this question correctly, recall which method includes more manufacturing costs in the unit product cost.
- #58: Unit product costs are in both work in process and finished goods inventories. Absorption costing results in the highest inventory values because it treats fixed manufacturing overhead as a product cost. Using variable costing, fixed manufacturing overhead is expensed as incurred and never becomes a part of the product cost.
- #59: Harvey Company makes twenty-five thousand units of a single product. Variable manufacturing costs total $10 per unit. Variable selling and administrative expenses are $3 per unit. Fixed manufacturing overhead for the year is $150,000, and fixed selling and administrative expenses for the year are $100,000.
- #60: With variable costing, only the $10 per unit variable manufacturing costs (direct material, direct labor, and variable manufacturing overhead) are product costs. With absorption costing, we include all production costs, variable and fixed. To compute the per unit amount of fixed manufacturing overhead, we divide $150,000 of fixed manufacturing overhead by the 25,000 units manufactured. Selling and administrative expenses are always treated as period expenses and deducted from revenue as incurred.
- #61: We need some additional information to allow us to prepare income statements for Harvey Company: Twenty thousand units were sold during the year. There were no units in beginning inventory. Now, let’s prepare income statements for Harvey Company. We will start with an absorption income statement.
- #62: Harvey had no beginning inventory and sold only 20,000 of the 25,000 units produced, leaving 5,000 units in ending inventory. The sales price is $30 per unit, so sales revenue for the 20,000 sold is $600,000 The computation of cost of goods sold on your screen starts with beginning inventory, adds cost of goods manufactured and subtracts ending inventory. We could also compute cost of goods sold directly by multiplying 20,000 units sold times the $16 unit cost. We subtract cost of goods sold from sales to get the $280,000 gross margin. We subtract selling and administrative expenses from gross margin to get absorption cost net operating income of $120,000. The $60,000 variable selling and administrative expense is computed by multiplying 20,000 units sold times $3 per unit. The $100,000 fixed administrative expense was given earlier. Net operating income is $120,000.
- #63: Now, let’s examine a variable cost income statement. Notice that this is a contribution format statement. First, we subtract all variable expenses from sales to get contribution margin. The first variable expense is variable cost of goods sold, which is computed using only the $10 per unit variable manufacturing cost. The next variable expense is the variable selling and administrative expense. It is computed as before, 20,000 units sold at $3 per unit. After computing contribution margin, we subtract fixed expenses to get the $90,000 variable cost net operating income. Note that all of the $150,000 of fixed manufacturing overhead is expensed as a lump sum under variable costing.
- #64: The only difference between the two methods is the treatment of fixed manufacturing overhead. Absorption costing treats fixed manufacturing overhead as a product cost using an overhead rate of $6 per unit. As a result, $30,000 of fixed manufacturing overhead is left in inventory as a part of the cost of the 5,000 unsold units. Income computed using variable costing expenses all $150,000 of the fixed manufacturing overhead as a period expense. None of the fixed manufacturing overhead remains in inventory with variable costing. The variable costing inventory of $50,000 is computed by multiplying the $10 per unit variable product cost times the 5,000 unsold units.
- #65: The difference between absorption cost net operating income and variable cost net operating income results from the $30,000 of fixed manufacturing overhead remaining in inventory as part of the cost of the 5,000 unsold units, using absorption costing. Using variable costing, this $30,000 is expensed in the period resulting in a net operating income that is $30,000 less than absorption cost net operating income. The $30,000 can be computed by multiplying the 5,000 unsold units times the $6 fixed manufacturing overhead cost per unit. We can reconcile the difference between the two methods by adding the $30,000 to the $90,000 variable cost income to get the $120,000 absorption cost net operating income.
- #66: In the second year, Harvey Company again makes 25,000 units of the same product, but sells 30,000 units. Last year&apos;s 5,000 unit ending inventory becomes this year&apos;s beginning inventory. The sales price is the same as last year, $30 per unit. Variable manufacturing costs total $10 per unit. Variable selling and administrative expenses are $3 per unit. Fixed manufacturing overhead for the year is $150,000, and fixed selling and administrative expenses for the year are $100,000.
- #67: With variable costing, only the $10 per unit variable manufacturing costs (direct material, direct labor, and variable manufacturing overhead) are product costs. With absorption costing, we include fixed manufacturing overhead in product costs. To compute the per unit amount of fixed manufacturing overhead, we divide $150,000 of fixed manufacturing overhead by the 25,000 units manufactured. Since there was no change in the per unit variable costs, total fixed costs, or the number of units produced, the unit costs remain unchanged.
- #68: Harvey sold 30,000 units in the second year, 25,000 units produced in the second year plus 5,000 units from beginning inventory. The sales price is $30 per unit, so sales revenue for the 30,000 units sold is $900,000. The computation of cost of goods sold on your screen starts with beginning inventory, adds cost of goods manufactured and subtracts ending inventory. We could also compute cost of goods sold directly by multiplying 30,000 units sold times the $16 unit cost. We subtract cost of goods sold from sales to get the $420,000 gross margin. We subtract selling and administrative expenses from gross margin to get absorption cost net operating income of $230,000. The $90,000 variable selling and administrative expense is computed by multiplying 30,000 units sold times $3 per unit. The $100,000 fixed administrative expense was given. Net operating income is $230,000.
- #69: Now, let’s examine a variable cost income statement for the second year. Again, notice that this is a contribution format statement. First, we subtract all variable expenses from sales to get contribution margin. The first variable expense is variable cost of goods sold, which is computed using only the $10 per unit variable manufacturing cost. The next variable expense is the variable selling and administrative expense. It is computed as before, 30,000 units sold at $3 per unit. After computing contribution margin, we subtract fixed expenses to get the $260,000 variable cost net operating income. Note that all of the $150,000 of fixed manufacturing overhead is expensed as a lump sum.
- #70: The difference between absorption cost net operating income and variable cost net operating income results from the $30,000 of fixed manufacturing overhead released from beginning inventory, using absorption costing. Using variable costing, this $30,000 was expensed in the first year, never becoming a part of the inventory value. The $30,000 can be computed by multiplying the 5,000 from inventory times the $6 fixed manufacturing overhead cost per unit. We can reconcile the difference between the two methods by subtracting the $30,000 from the $260,000 variable cost income to get the $230,000 absorption cost net operating income.
- #71: For the two-year time period, both methods report the same total income, $350,000, because for the two-year period total sales of 50,000 units equals total production of 50,000 units. Although sales and production may differ in any given year, over an extended period of time, sales cannot exceed production, nor can production greatly exceed sales. The shorter the time period, the more the net operating income figures will tend to differ.
- #72: On your screen is a summary of what we have observed over the two-year period. When production is greater than sales, as in Harvey’s year 1, absorption income is greater than variable costing income. When production is less than sales, as in Harvey’s year 2, absorption costing income is less than variable costing income. When production equals sales, the two methods report the same net operating income.
- #73: End of Chapter 5.