Variable Costing For Management Analysis: Financial and Managerial Accounting 13e

CHAPTER
20 Variable Costing for

Management Analysis
Financial and
Managerial
Accounting
13e
Warren
Reeve
Duchac
Absorption Costing
• Absorption costing is required under generally

accepted accounting principles.
• Under absorption costing, the cost of goods
manufactured consists of the following:
o Direct materials
o Direct labor
o 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).
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Variable Costing
(slide 1 of 2)
• Under variable costing, sometimes called direct costing, the

cost of goods manufactured consists of the following:
o Direct materials
o Direct labor
o Variable factory overhead
• Under variable costing, fixed factory overhead costs are treated
as a period expense.
Variable Costing
(slide 2 of 2)
• The reporting of income from operations under variable costing is as follows:
o Manufacturing margin is the excess of sales over variable cost of goods sold:
o Variable cost of goods sold consists of direct materials, direct labor, and variable factory overhead
for the units sold.
o Contribution margin is the excess of manufacturing margin over variable selling and administrative
expenses:
o Subtracting fixed costs from contribution margin yields income from operations:
Units Manufactured versus Units Sold
• When the number of units manufactured equals the

number of units sold, income from operations will be
the same under both methods.
• When units manufactured exceed the units sold, the
variable costing income from operations will be less
than it is for absorption costing.
• 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)
(slide 2 of 3)
(slide 3 of 3)
Income Analysis Under
(slide 1 of 4)
• When the units manufactured are greater than the

units sold, finished goods inventory increases.
o Under absorption costing, a portion of this increase is
related to the allocation of fixed manufacturing overhead to
ending inventory.
(slide 2 of 4)
• Assume that Frand Manufacturing Company has no

beginning inventory and sales are estimated to be
20,000 units at $75 per unit. Also, assume that sales
will not change if more than 20,000 units are
manufactured.
• Frand’s management is evaluating whether to
manufacture 20,000 units (Proposal 1) or 25,000 units
(Proposal 2). The costs and expenses related to each
proposal appear on the following slide.
Absorption Costing Income Statements
for Two Production Levels
(slide 3 of 4)
• The income statements on the previous slide shows

that Frand Manufacturing Company can increase
income from operations by $80,000 ($280,000 –
$200,000) by simply increasing finished goods
inventory by 5,000 units.
• The $80,000 increase in income from operations
under Proposal 2 is caused by the allocation of the
fixed manufacturing costs of $400,000 over a greater
number of units manufactured.
(slide 4 of 4)
• Under variable costing, income from operations is

$200,000, regardless of whether 20,000 units or
25,000 units are manufactured.
o This is because no fixed manufacturing costs are allocated
to the units manufactured.
 Instead, all fixed manufacturing costs are treated as a period
expense.
Controlling Costs
(slide 1 of 2)
• 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 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 2 of 2)
• Variable manufacturing costs are controlled by

operating management.
• In contrast, fixed manufacturing overhead costs 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 2)
• Many factors enter into determining the selling price

of a product. However, the cost of making the
product is significant in all pricing decisions.
• 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.
• 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 2 of 2)
• 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
• In the short run, planning production is limited to existing

capacity. In many cases, operating decisions must be made
quickly before opportunities are lost.
o For example, a company with seasonal demand for its products may
have an opportunity to obtain an off-season order.
 The relevant factors for such a short-run decision are the additional
revenues and the additional variable costs associated with the order.
o Since variable costing reports contribution margin, it is often more
useful than absorption costing in such cases.
• 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 Market Segments
• A market segment is a portion of a company that can

be analyzed using sales, costs, and expenses to
determine its profitability.
o 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.
Sales Territory Profitability Analysis
• Sales territory profitability analysis may lead

management to do the following:
o Reduce costs in lower-profit sales territories
o 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.
o 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.
Contribution Margin Analysis
(slide 1 of 2)
• 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:
o Sales
o 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:
o Number of units sold
o Unit sales price or unit cost
Contribution Margin Analysis
(slide 2 of 2)
• Quantity factor is the effect of a difference in the

number of units sold, assuming no change in unit
sales price or unit cost.
• 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.
Reporting Income from Operations Using
Variable Costing for a Service Company
• Unlike a manufacturing company, a service company

does not make or sell a product.
o Since service companies have no inventory, they do not use
absorption costing to allocate fixed costs.
o In addition, variable costing reports of service companies
do not report a manufacturing margin.
• A cost is classified as a fixed or variable cost
according to how it changes relative to an activity
base.
o A common activity for a manufacturing firm is the number
of units produced.
o Most service firms use several activity bases.
Contribution Margin Analysis Report—
Service Company

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CHAPTER

20 Variable Costing for

• Absorption costing is required under generally

• Under variable costing, sometimes called direct costing, the

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

• When the number of units manufactured equals the

• When the units manufactured are greater than the

• Assume that Frand Manufacturing Company has no

• The income statements on the previous slide shows

• Under variable costing, income from operations is

• All costs are controllable in the long run by someone

• Variable manufacturing costs are controlled by

• Many factors enter into determining the selling price

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

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

• A market segment is a portion of a company that can

• Sales territory profitability analysis may lead

• The contribution margin ratio is computed as follows:

• A company should focus its sales efforts on products

• A salesperson profitability report is useful in

• Contribution margin analysis focuses on explaining the

• Quantity factor is the effect of a difference in the

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

• Unlike a manufacturing company, a service company

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