Variable Costing For Management Analysis: Managerial Accounting 14e

6
Variable Costing for

Chapter
Management Analysis
Managerial
Accounting
14e
Warren
Reeve
Duchac
www.freebookslide.com
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Absorption Costing
(slide 1 of 2)
• Absorption costing is required under generally

accepted accounting principles for financial statements
distributed to external users.
• Under absorption costing, the cost of goods
manufactured consists of the following:
• Direct materials
• Direct labor
• Fixed and variable factory overhead
• In the financial statements, these costs are included in

the cost of goods sold (income statement) and inventory
(balance sheet).
Absorption Costing
(slide 2 of 2)
• The reporting of income from operations under

absorption costing is as follows:
Variable Costing
(slide 1 of 2)
• For internal use in decision making, managers often use

variable costing.
• Under variable costing, sometimes called direct costing,
the cost of goods manufactured consists of the following:
• Direct materials
• Direct labor
• Variable factory overhead
• Under variable costing, fixed factory overhead costs are
not a part of the cost of goods manufactured.
• Instead, fixed factory overhead costs are treated as a period
expense.
Absorption Costing Versus Variable Costing
Variable Costing
(slide 2 of 2)
• The reporting of income from operations under variable costing is as follows:
• Manufacturing margin is the excess of sales over variable cost of goods sold:
• Variable cost of goods sold consists of direct materials, direct labor, and variable factory
overhead for the units sold.
• Contribution margin is the excess of manufacturing margin over variable selling and
administrative expenses:
• Subtracting fixed costs from contribution margin yields income from operations:
Units Manufactured Equal Units Sold
• When the number of units manufactured equals

the number of units sold, income from
operations will be the same under both methods.
Units Manufactured Exceed Units Sold
• When units manufactured exceed the units sold,

the variable costing income from operations will
be less than it is for absorption costing.
Units Manufactured Less Than Units Sold
• When units manufactured are less than the

number of units sold, the variable costing
income from operations will be greater than that
of absorption costing.
Effects on Income from Operations under
Absorption and Variable Costing (slide 1 of 3)
Analyzing Income Using Absorption
and Variable Costing
• When the units manufactured are greater than
the units sold, finished goods inventory
increases.
• Under absorption costing, a portion of this increase is
related to the allocation of fixed manufacturing
overhead to ending inventory.
• As a result, increases or decreases in income from
operations can be due to changes in inventory levels.
• In analyzing income from operations, such increases or
decreases in could be misinterpreted as operating efficiencies
or inefficiencies.
Using Absorption and Variable Costing
• The use of absorption and variable costing in the

following decision-making situations is described
on the following slides:
• Controlling costs
• Pricing products
• Planning production
• Analyzing contribution margins
• Analyzing market segments
• Accounting reports play a role in these decision-
making situations.
Accounting Reports and Management Decisions
Controlling Costs
(slide 1 of 3)
• All costs are controllable in the long run by

someone within a business.
• However, not all costs are controllable at the
same level of management.
• For example, plant supervisors control the use of
direct materials in their departments. They have no
control, though, over insurance costs related to the
property, plant, and equipment.
Controlling Costs
(slide 2 of 3)
• For a level of management, controllable costs

are costs that can be influenced (increased or
decreased) by management at that level.
• Noncontrollable costs are costs that another
level of management controls.
Controlling Costs
(slide 3 of 3)
• Variable manufacturing costs are controlled by

operating management.
• In contrast, fixed manufacturing overhead costs
such as the salaries of production supervisors
are normally controlled at a higher level of
management.
• Since fixed costs and expenses are reported
separately under variable costing, variable
costing reports are normally more useful than
absorption costing reports for controlling costs.
Pricing Products
(slide 1 of 3)
• Many factors enter into determining the selling

price of a product.
• However, the cost of making the product is
significant in all pricing decisions.
Pricing Products
(slide 2 of 3)
• In the short run, fixed costs cannot be avoided.

Thus, the selling price of a product should at
least be equal to the variable costs of making
and selling it.
• Any price above this minimum selling price
contributes to covering fixed costs and generating
income.
• Since variable costing reports variable and fixed
costs and expenses separately, it is often more
useful than absorption costing for setting short-
run prices.
Pricing Products
(slide 3 of 3)
• In the long run, a company must set its selling

price high enough to cover all costs and
expenses (variable and fixed) and generate
income.
• Since absorption costing includes fixed and
variable costs in the cost of manufacturing a
product, absorption costing is often more useful
than variable costing for setting long-term prices.
Planning Production
(slide 1 of 2)
• In the short run, planning production is limited to existing

capacity.
• In many cases, operating decisions must be made quickly
before opportunities are lost.
• For example, a company with seasonal demand for its products
may have an opportunity to obtain an off-season order that will
not interfere with its current production schedule.
• The relevant factors for such a short-run decision are the additional
revenues and the additional variable costs associated with the order.
• If the revenues from the order exceed the related variable costs, the
order will increase contribution margin and, thus, increase the
company’s income from operations.
• Since variable costing reports contribution margin, it is

often more useful than absorption costing in such cases.
Planning Production
(slide 2 of 2)
• In the long run, planning production can include

expanding existing capacity.
• Thus, when analyzing and evaluating long-run sales and
operating decisions, absorption costing, which considers
fixed and variable costs, is often more useful.
Analyzing Contribution Margins
• For planning and control purposes, managers

often compare planned and actual contribution
margins.
• Variable costing is often used as a basis for such
analyses.
Analyzing Market Segments
(slide 1 of 2)
• A market segment is a portion of a company

that can be analyzed using sales, costs, and
expenses to determine its profitability.
• Examples of market segments include sales
territories, products, salespersons, and customers.
• Absorption costing is often used for long-term
analysis of market segments, while variable
costing is often used for short-term analysis of
market segments.
Analyzing Market Segments
(slide 2 of 2)
• Most companies prepare variable costing reports

for each product.
• These reports are often used for product pricing and
deciding whether to discontinue a product.
• In addition, variable costing reports may be prepared
for geographic areas, customers, distribution
channels, or salespersons.
• A distribution channel is the method for selling a product to a
customer.
Sales Territory Profitability Analysis
• Sales territory profitability analysis may lead

management to do the following:
• Reduce costs in lower-profit sales territories
• Increase sales efforts in higher-profit territories
• The contribution margin ratio is computed as
follows:
Product Profitability Analysis
• A company should focus its sales efforts on

products that will provide the maximum total
contribution margin.
• Product profitability analysis is often used by
management in making decisions regarding
product sales and promotional efforts.
Salesperson Profitability Analysis
• A salesperson profitability report is useful in

evaluating sales performance.
• Such a report normally includes total sales, variable
cost of goods sold, variable selling expenses,
contribution margin, and contribution margin ratio for
each salesperson.
• Other factors should also be considered in
evaluating salespersons’ performance.
• For example, sales growth rates, years of experience,
customer service, territory size, and actual
performance compared to budgeted performance may
also be important.
Contribution Margin Analysis
(slide 1 of 3)
• Contribution margin analysis focuses on explaining the

differences between planned and actual contribution
margins.
• A difference between the planned and actual contribution
margin may be caused by an increase or a decrease in:
• Sales
• Variable costs
• An increase or a decrease in sales or variable costs may
in turn be due to an increase or a decrease in the:
• Number of units sold
• Unit sales price or unit cost
(slide 2 of 3)
• Quantity factor is the effect of a difference in the

number of units sold, assuming no change in unit sales
price or unit cost.
• The sales quantity factor and the variable quantity factor
are computed as follows:
• The preceding factors are computed so that a positive

amount increases contribution margin and a negative
amount decreases contribution margin.
(slide 3 of 3)
• Unit price factor, or unit cost factor, is the effect of a

difference in unit sales price or unit cost on the number
of units sold.
• The unit price factor and unit cost factor are computed
as follows:
• The preceding factors are computed so that a positive

amount increases contribution margin and a negative
amount decreases contribution margin.
Reporting Income Using Variable Costing for
Service Businesses (slide 1 of 2)
• Unlike a manufacturing company, a service
company does not make or sell a product. Thus,
service companies do not have inventory.
• Since service companies have no inventory, they do
not use absorption costing to allocate fixed costs.
• In addition, variable costing reports of service
companies do not report a manufacturing margin.
Reporting Income Using Variable Costing for
Service Businesses (slide 2 of 2)
• A cost is classified as a fixed or variable cost
according to how it changes relative to an
activity base.
• A common activity for a manufacturing firm is the
number of units produced.
• In contrast, most service companies use several
activity bases.
Analyzing Segments Using Variable Costing for
Service Businesses
• A contribution margin report for service
companies can be used to analyze and evaluate
market segments.
Service Industry Market Segments

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6

Variable Costing for

• Absorption costing is required under generally

• In the financial statements, these costs are included in

• The reporting of income from operations under

• For internal use in decision making, managers often use

• The reporting of income from operations under variable costing is as follows:

• When the number of units manufactured equals

• When units manufactured exceed the units sold,

• When units manufactured are less than the

• The use of absorption and variable costing in the

• All costs are controllable in the long run by

• For a level of management, controllable costs

• Variable manufacturing costs are controlled by

• Many factors enter into determining the selling

• In the short run, fixed costs cannot be avoided.

• In the long run, a company must set its selling

• In the short run, planning production is limited to existing

• Since variable costing reports contribution margin, it is

• In the long run, planning production can include

• For planning and control purposes, managers

• A market segment is a portion of a company

• Most companies prepare variable costing reports

• Sales territory profitability analysis may lead

• A company should focus its sales efforts on

• A salesperson profitability report is useful in

• Contribution margin analysis focuses on explaining the

• Quantity factor is the effect of a difference in the

• The preceding factors are computed so that a positive

• Unit price factor, or unit cost factor, is the effect of a

• The preceding factors are computed so that a positive

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