Chapter 7 Notes Page 1. As we have seen, inventory costs are made up of the following under Absorption Costing:

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1 Chapter 7 Notes Page 1 Variable Costing Absorption As we have seen in previous chapters, when you manufacture your own inventory, the cost of that inventory includes all of the costs associated with running the factory that produces the inventory. Generally, no part of the factory cost is expensed. Instead, it is capitalized as the cost of the inventory produced. It is only expensed when the inventory is sold. At that point the cost of the inventory becomes Cost of Goods Sold. This system is referred to as Absorption Costing. It is also know as Full Costing and Full-Absorption Costing. The thought is that the inventory absorbs all of the factory costs fully. As we have seen, inventory costs are made up of the following under Absorption Costing: Direct Labor; Direct Materials; and Manufacturing Overhead (regardless of whether it is fixed or variable). GAAP requires that a firm must use Absorption Costing for all of its financial statements that are released to outside parties. An alternative system to Absorption Costing is Variable Costing. Although GAAP does not permit Variable Costing, Variable Costing is still widely used by companies for internal purposes (e.g., in order to evaluate the performance of a manager, a product or a division). With Variable Costing, the cost of the inventory produced includes only: Direct Labor; Direct Material; and Variable Manufacturing Overhead. Under Variable Costing, Fixed Manufacturing Overhead is not treated as part of the cost of the inventory produced. Instead, Fixed Manufacturing Overhead is expensed in the current period. Currently expensing a cost is often referred to as treating it as a period cost. Capitalizing a cost as part of the cost of inventory is often referred to as treating it as a product cost. The exclusion of Fixed Manufacturing Overhead from the cost of inventory makes Cost of Goods Sold a purely Variable Cost.

2 Chapter 7 Notes Page 2 Variable Costing vs. Absorption Costing In addition to having a different definition of inventory cost, Variable Costing uses a different Income Statement format. With a Variable Costing Income Statement, we group expenses into Variable Costs and Fixed Costs. The Variable Costing Income Statement first reports a company's Sales Revenue reduced by its Variable Costs. This difference is referred to as the "Contribution Margin." The Contribution Margin represents the dollar amount that a company s operations contribute to help pay its Fixed Costs. The Variable Costing Income Statement then reduces the company s Contribution Margin by its Fixed Costs. This Contribution Margin Format used by Variable Costing is different from the traditional Multi-Step Income Statement associated with Absorption Costing. A comparison of the two formats appears below: ABSORPTION COSTING Sales Revenue -Cost of Goods Sold Gross Margin or Gross Profit -Selling, General and Administrative Expenses Operating Profits VARIABLE COSTING Sales Revenue -Variable Costs and Expenses Contribution Margin -Fixed Costs and Expenses Operating Profits Assume that Lucy s Chocolate Factory, Inc. has the following costs, sales and production: Using Absorption Costing, each unit would cost the following: Units Produced: 10,000 Units Sold: 10,000 Price Per Unit: $25 Direct Materials: $50,000 Direct Labor: $30,000 Variable Manufacturing Overhead: $20,000 Fixed Manufacturing Overhead: $40,000 Variable Sell., Gen. & Adm. Exps.: $30,000 Fixed Sell., Gen. & Adm. Exps.: $30,000 Direct Materials: $50,000 Direct Labor: $30,000 Variable Manufacturing Overhead: $20,000 Fixed Manufacturing Overhead: $50,000 Total Costs $150,000 Divide By Number of Units Produced 10,000 Cost Per Unit $15

3 Chapter 7 Notes Page 3 Using Variable Costing, each unit would cost the following: Direct Materials: $50,000 Direct Labor: $30,000 Variable Manufacturing Overhead: $20,000 Total Costs $100,000 Divide By Number of Units Produced 10,000 Cost Per Unit $10 The difference in cost of the units under the Absorption Costing Method ($15) and the Variable Costing Method ($10) is equal to the Fixed Manufacturing Overhead per unit ($5), which is included in inventory cost under Absorption Costing and is excluded from inventory cost under Variable Costing. Assuming that Lucy sold all of the units that it produced, you would have the following Income Statements produced by the two methods: Absorption Costing Income Statement Variable Costing Income Statement Sales Revenue: $250,000 (25x10K) Sales Revenue: $250,000 (25x10K) COGS: -150,000 (15x10K) Less VC: VCOGS: -100,000 (10x10K) VSG&Adm: -30,000 Gross Margin: $100,000 Contrib.Marg: $120,000 Less: SG&Adm: -60,000 (30K+30K) Less FC: F MO/H: -50,000 F SG&Adm: -30,000 Oper. Profits: $40,000 Oper. Profits: $40,000 As you can see, both methods produce the same Operating Profits. (This statement assumes that either: (i) your manufacturing costs are the same in the current period and prior periods, or (ii) you are using LIFO). On the other hand, if the number of units that you sell differs from the number of units produced in this period, then the Operating Profits reported using the two methods will differ.

4 Chapter 7 Notes Page 4 Assume that Lucy sold only one-half of its production. Because the number of units sold are one-half of the units that were sold previously then Lucy s Variable Costs and Sales Revenue would be one-half of the figures reported above. Absorption Costing Income Statement Variable Costing Income Statement Sales Revenue: $125,000 ½ (25x10K) Sales Revenue: $125,000 ½ (25x10K) COGS: -75,000 ½ (15x10K) Less VC: VCOGS: -50,000 ½ (10x10K) VSG&Adm: -15,000 ½ (30K) Gross Margin: $50,000 Contrib.Marg: $60,000 Less: SG&Adm: -45,000 (30K+ ½ 30K) Less FC: F MO/H: -50,000 F SG&Adm: -30,000 Oper. Profits: $5000 Oper. Profits: -$20,000 The difference in the Operating Profits reported by the two methods is attributable to the different treatment of Fixed Manufacturing Overhead allocated to the unsold units under Absorption Costing. With Variable Costing, the entire Fixed Manufacturing Overhead Cost ($50,000) is expensed in the current period. With Absorption Costing, the Fixed Manufacturing Overhead is divided into a per unit cost ($5) and added to the Variable Cost of each unit ($10) to produce the total cost of each unit manufactured ($15). When only half of the units are sold, then only half of the Fixed Manufacturing Overhead is expensed. The difference between the Operating Profits reported using the two methods [$5,000 (-$20,000) = $25,000] is equal to the amount of Fixed Manufacturing Overhead that is added to the cost of the unsold units: Fixed Manufacturing Overhead Per Unit x Unsold Units $5 x 5,000 = $25,000 Because the Fixed Manufacturing Overhead that is not expensed is added to the cost of the inventory, the inventory cost is $25,000 higher using Absorption Costing than it is using Variable Costing. With Absorption Costing the inventory cost is $15 per unit and the cost of the 5,000 unsold units is $75,000. On the other hand, with Variable Costing, the inventory cost is $10 per unit, and the cost of the 5,000 unsold units is $50,000. Potential Abuse of Absorption Costing As you will recall from our discussion of Cost Behavior, with a linear cost function, the Variable Cost per unit does not change as production increases (V=Vx /x ) because the total Variable Costs (numerator) go up proportionately as you produce more units (denominator). On the other hand, the Fixed Cost per unit drops as you produce more units [(FC per unit) =F/(x )] because you are dividing the same amount of Fixed Costs by a larger denominator as you increase your production. As noted above, Fixed Manufacturing Costs are part of the cost of inventory with Absorption Costing. The total cost of each unit (both fixed and variable) will drop as you

5 Chapter 7 Notes Page 5 produce more units because of the fact that you are reducing the fixed portion of that cost. By increasing the number of units that it produces, a firm can lower its inventory cost per unit and thereby lower its Cost of Goods Sold and increase its profits. The freedom to produce inventory solely to generate higher profits is a license to print your own money. For example, assume that Ye Old Mint Co. prints commemorative coins. Its cost function is $5,000 + $1 per unit produced, and each coin can be sold for $1.90. If Ye Old Mint produces 10,000 units, the total cost to produce 10,000 units is $15,000 [$5,000 + ($1x10,000)], and the cost of each unit is $1.50. Mint will make 40 cents on each unit sold ($ $1.50) at this production level. On the other hand, if it produces 50,000 units, then the total cost to produce 50,000 units is $55,000 [$5,000 + ($1x50,000)], and the cost of each unit is $1.10. Mint will make 80 cents on each unit that it sells at this production level ($ $1.10). As you can see, Mint doubled its First U.S. Mint profits under Absorption Costing without selling any more units merely by producing more inventory. Produce & Sell 10,000 units Produce 50,000 Units & Sell 10,000 Units Sales Revenue: $19,000 (1.90x10K) Sales Revenue: $19,000 (1.9x10K) COGS: -15,000 ($1.5x10K) COGS: -11,000 ($1.10x10K) Oper. Profits: $4,000 (40 x10k) Oper. Profits: $8,000 (80 x10k) A number of managers and companies have discovered that they can increase profits through overproduction of units, and they have produced more inventory than they need solely for the purpose of boosting their Operating Profits. This manipulation of profits is not possible with Variable Costing. With Variable Costing, all Fixed Costs (including Fixed Manufacturing Overhead) are expensed in the year incurred. The cost of your inventory is made up solely of Variable Costs. Regardless of the number of units that you produce, the inventory cost (Variable Cost) stays the same. If Mint produces 10,000 units, the total cost to produce the units is $10,000 ($1 x 10,000), and each unit costs $1. If Mint produces 50,000 units, the total cost to produce the units is $50,000 ($1 x 50,000), which is still $1 per unit.

6 Chapter 7 Notes Page 6 With Variable Costing, Mint would report $4,000 of Operating Profits regardless of the number of units produced: Produce & Sell 10,000 units Produce 50,000 Units & Sell 10,000 Units Sales Revenue: $19,000 (1.90x10K) Sales Revenue: $19,000 (1.90x10K) VCOGS: -10,000 ($1x10K) VCOGS: -10,000 ($1x10K) Contrib. Marg: $9,000 Contrib. Marg: $9,000 F MO/H: -5,000 F MO/H: -5,000 Oper. Profits: $4,000 Oper. Profits: $4,000 Variable Costing always produces the same amount of Operating Profits as that generated using Absorption Costing when 10,000 units were produced and sold ($4,000). For this reason, the Operating Profits reported using Variable Costing are compared to the Operating Profits reported using Absorption Costing. The Operating Profits produced by Variable Costing tells you the amount of Operating Profits that would have been reported using Absorption Costing if the manager (or firm) had only produced enough units to meet sales demands. It exposes the manipulation of Operating Profits produced by making unsold units. Although, producing unneeded units improves Operating Profits, this overproduction is actually detrimental to the firm. The unsold units are not free. The firm expended the Variable Costs needed to produce the units. Thus, you are tying up valuable resources in the cost of the unsold inventory (as well as the cost to store the unsold inventory) that could be used elsewhere. The current trend in inventory management is to try to reduce inventory levels and thereby reduce such inventory and storage costs (e.g., the growing popularity of the Just In Time Inventory System). Moreover, once you produce this excess inventory, you cannot sell it without hurting your Operating Profits in the year of sale. If you ever sell more units than you produce, then Variable Costing will have higher Operating Profits than those produced using Absorption Costing. Assume that Ye Old Mint Co. has the following production and sales levels: Units Produced Units Sold First Year 50,000 10,000 Second Year 10,000 50,000 As noted previously, the following inventory costs is produced at the following production levels using Absorption Costing and Variable Costing: Units Produced Absorption Costing Variable Costing First Year 50,000 $1.10 per unit $1 per unit Second Year 10,000 $1.50 per unit $1 per unit

7 Chapter 7 Notes Page 7 In the first year, Absorption Costing will report Operating Profits that are $4,000 higher than those reported using Variable Costing: Absorption Costing Variable Costing Sales Revenue: $19,000 (1.90x10K) Sales Revenue: $19,000 (1.90x10K) COGS: -11,000 ($1.10x10K) VCOGS: -10,000 ($1x10K) Oper. Profits: $8,000 (80 x10k) Contrib. Marg: $9,000 F MO/H: -5,000 Oper. Profits: $4,000 The difference in Operating Profits is due to transferring $4,000 of Fixed Manufacturing Overhead away from Cost of Goods Sold to the cost of the unsold inventory, which is an asset on the Balance Sheet. Note that when Mint produces 50,000 units, the Fixed Manufacturing Overhead ($5,000) is spread over all of those units and produces a per unit cost of 10 ($5,000/50,000): F MO/H per Unit X Unsold Units = Absorption Costing Profits exceed Variable Costing Profits by: 10 X 40,000 = $4,000 As you can see, when you produce more units than you sell, then your Operating Profits are higher using Absorption Costing than those produced using Variable Costing. In the second year, however, Mint sells more units than it produces, and the opposite is true: Absorption Costing Variable Costing Sales Revenue: $95,000 (1.9x50K) Sales Revenue: $95,000 (1.90x50K) COGS: -59,000 ($1.10x40K)+ VCOGS: -50,000 ($1x50K) ($1.5 x 10K) Oper. Profits: $36,000 (80 x10k) Contrib. Marg: $45,000 F MO/H: -5,000 Oper. Profits: $40,000 Now, all of the Fixed Manufacturing Overhead that was not expensed (and was placed in inventory) during the first year under Absorption Costing now moves to Cost of Goods Sold. This makes Mint s expenses $4,000 higher than they are using Variable Costing. Recall that with Variable Costing all of the Fixed Manufacturing Overhead was expensed in the first year, which is why the Operating Profits reported using Variable Costing were lower in the first year. Variable Costing has no deferred Fixed Manufacturing Overhead Cost that is recaptured upon the sale of the inventory. F MO/H per Unit X Unsold Units = Absorption Costing Profits exceed Variable Costing Profits by: 10 X -40,000 = -$4,000 This time we dipped into inventory levels. Thus, there are negative unsold units. The negative amount of profits indicates that the Variable Costing Method produces

8 Chapter 7 Notes Page 8 Operating Profits that are $4,000 higher than those reported using the Absorption Method. Variable Costing Example The following information relates to Robin Toy Co: Sales Price: $15 Variable Costs and Expenses: Direct Labor: $1/ unit produced Direct Materials: $2/ unit produced Variable Manufacturing Overhead: $1/ unit produced Variable Selling, General & Administrative Expenses: $2/ unit sold Fixed Costs and Expenses: Fixed Manufacturing Overhead: $60,000 Fixed Selling, General & Administrative Expenses: $40,000 What are the Operating Profits of Robin if it manufactures and sells 10,000 units using both Absorption Costing and Variable Costing? The first thing that you should always do with these problems is to calculate the Cost of Goods Manufactured per unit using each method. Absorption Costing: Direct Materials: $ 20,000 (2x10,000) Direct Labor: 10,000 (1x10,000) Variable Manufacturing Overhead: 10,000 (1x10,000) Fixed Manufacturing Overhead: 60,000 Total Manufacturing Cost: $100,000 Divide By The Number of Units Produced: 10,000 Manufacturing Cost Per Unit: $10 Variable Costing: Direct Materials: $ 20,000 (2x10,000) Direct Labor: 10,000 (1x10,000) Variable Manufacturing Overhead: 10,000 (1x10,000) Total Manufacturing Cost: $40,000 Divide By The Number of Units Produced: 10,000 Manufacturing Cost Per Unit: $4

9 Chapter 7 Notes Page 9 Note that the Fixed Manufacturing Overhead per unit is $6 ($60,000/10,000 units), which is the difference between the costs produced by the two methods ($10 - $4 = $6). As we have seen before, because Robin sold exactly the number of units that it manufactured, the two methods produce the same Operating Profits: ABSORPTION COSTING VARIABLE COSTING Sales Revenue: $150,000 (15x10K) Sales Revenue: $150,000 (15x10K) Cost of Goods Sold: -100,000 (10x10K) Var. COGS: -40,000 (4x10K) Gross Margin: $50,000 Var Sell. & Adm: -20,000 (2x10K) Selling & Administrative: -$60,000 (40K+(2x10K)) Contribution Margin: $90,000 Operating Profits: -$10,000 Fxd. Manuf. OH: -60,000 Fxd. Sell. & Adm: -40,000 Operating Profits: -10,000 Now, let us examine what happens when Robin doubles its production to 20,000 units. Assume that it still sells 10,000 units. Again, you must first calculate the Cost of Goods Manufactured per unit for each method. Absorption Costing: Direct Materials: $ 40,000 (2x20,000) Direct Labor: 20,000 (1x20,000) Variable Manufacturing Overhead: 20,000 (1x20,000) Fixed Manufacturing Overhead: 60,000 Total Manufacturing Cost: $140,000 Divide By The Number of Units Produced: 20,000 Manufacturing Cost Per Unit: $7 Note what happened to the cost of one unit under Absorption Costing when we increased production. It decreased from $10 to $7. This difference is due solely to the Fixed Manufacturing Overhead. The Fixed Manufacturing Overhead has now dropped to $3 per unit ($60,000/20,000 units) from the previous $6 per unit. Variable Costing: Direct Materials: $ 40,000 (2x20,000) Direct Labor: 20,000 (1x20,000) Variable Manufacturing Overhead: 20,000 (1x20,000) Total Manufacturing Cost: $80,000 Divide By The Number of Units Produced: 20,000 Manufacturing Cost Per Unit: $4

10 Chapter 7 Notes Page 10 Note that the inventory cost of one unit did not change under Variable Costing. Because Robin sold less units than it manufactured, the two methods produce different Operating Profits figures: ABSORPTION COSTING VARIABLE COSTING Sales Revenue: $150,000 (15x10K) Sales Revenue: $150,000 (15x10K) Cost of Goods Sold: -70,000 (7x10K) Var. COGS: -40,000 (4x10K) Gross Margin: $80,000 Var Sell. & Adm: -20,000 (2x10K) Selling & Administrative: -$60,000 (40K+(2x10K)) Contribution Margin: $90,000 Operating Profits: $20,000 Fxd. Manuf. OH: -60,000 Fxd. Sell. & Adm: -40,000 Operating Profits: -10,000 Note that the Operating Profits produced using Variable Costing did not change. It stayed at a loss of $10,000. The Operating Profits reported using Absorption Costing improved from the original loss of $10,000 to a profit of $20,000. Why? Robin did not produce more revenue than before. This $30,000 increase in the Operating Profits came solely from reducing the cost of Robin s inventory from $10 per unit to $7 per unit. Remember that Variable Costing expenses all of the Fixed Manufacturing Overhead. However, with Absorption Costing, the Fixed Manufacturing Overhead ($3 per unit) that is attributable to the unsold units (10,000 units) was removed from the expenses on the Income Statement and added to the cost of Inventory on the Balance Sheet: Fixed Manufacturing Overhead Per Unit x Unsold Units $3 x 10,000 = $30,000 So, Absorption Costing allowed Robin to reduce its total expenses by $30,000 as a result of its production of unneeded units. Variable Costing did not permit such a reduction in expenses.