Mastery Problem: Variable Costing for Management Analysis

Absorption vs. Variable

Operating income is one of the most important items reported by a company. Depending on the decision-making needs of management, operating income can be determined using absorption costing or variable costing.

Select whether the following characteristics are most often associated with absorption costing or variable costing.

Required under generally accepted accounting principles (GAAP)Absorption Costing

Often used for internal use in decision makingVariable Costing

Cost of goods manufactured includes only variable manufacturing costsVariable Costing

Used in reports prepared for external usersAbsorption Costing

Fixed factory overhead costs are not part of cost of goods manufacturedVariable Costing

Both fixed and variable factory costs are included in cost of goods sold and inventoryAbsorption Costing

Feedback

Review the differences between absorption and variable costing, and how each type of costing is used in the organization and for management processes.

Absorption Statement

Absorption costing does not distinguish between variable and fixed costs. All manufacturing costs are included in the cost of goods sold.

Saxon, Inc. Absorption Costing Income Statement For the Year Ended December 31

Sales$1,200,000

Cost of goods sold:

Cost of goods manufactured$800,000

Ending inventory(200,000)

Total cost of goods sold(600,000)

Gross profit$600,000

Selling and administrative expenses(275,000)

Operating income$325,000

Variable Statement

Under variable costing, the cost of goods manufactured includes only variable manufacturing costs. This type of income statement includes a computation of manufacturing margin.

Saxon, Inc. Variable Costing Income Statement For the Year Ended December 31

Sales$1,200,000

Variable cost of goods sold:

Variable cost of goods manufactured$560,000

Ending inventory(140,000)

Total variable cost of goods sold(420,000)

Manufacturing margin$780,000

Variable selling and administrative expenses(210,000)

Contribution margin$570,000

Fixed costs:

Fixed manufacturing costs$240,000

Fixed selling and administrative expenses65,000

Total fixed costs(305,000)

Operating income$265,000

Method Comparison

Review the income statements on the Absorption Statement and Variable Statement, then complete the following table. The companys sales price per unit is $80, and the number of units in ending inventory is 5,000. There was no beginning inventory.

ItemAmount

Number of units sold

Variable sales and administrative cost per unit$

Number of units manufactured

Variable cost of goods manufactured per unit$

Fixed manufacturing cost per unit$

Feedback

Review the definitions of the items in the table, and think backwards from one of the income statements to get the desired values.

Manufacturing Decisions

Whenever the units manufactured differ from the units sold, finished goods inventory is affected. In analyzing operating income, such increases and decreases could be misinterpreted as operating efficiencies or inefficiencies. Each decision-making situation should be carefully analyzed in deciding whether absorption or variable costing reporting would be more useful.

All costs are controllable in the long run by someone within a business. For a given level of management, costs may be controllable costs or noncontrollable costs.

The production manager for Saxon, Inc. is worried because the company is not showing a high enough profit. Looking at the income statements on the Absorption Statement and the Variable Statement, he notices that the operating income is higher on the absorption cost income statement. He is considering manufacturing another 10,000 units, up to the companys capacity for manufacturing, in the coming year. He reasons that this will boost operating income and satisfy the companys owner that the company is sufficiently profitable. Although the total units manufactured changes, assume that total fixed costs, unit variable costs, unit sales price, and the sales levels are the same. Complete questions (1)-(4) that follow. If the answer is zero, enter "0".

1. Use the income statements on the Absorption Statement and Variable Statement to complete the following table for the original production level. Then prepare similar income statements at a production level 10,000 units higher and add that information to the table. Assume that total fixed costs, unit variable costs, unit sales price, and the sales levels are the same at both production levels.

Operating Income

Original Production Level-AbsorptionOriginal Production Level-VariableAdditional 10,000 Units-AbsorptionAdditional 10,000 Units-Variable

$$$$

2. What is the change in operating income from producing 10,000 additional units under absorption costing?

$

3. What is the change in operating income from producing 10,000 additional units under variable costing?

$

4. What would be your recommendation to the production manager?

a. Do not produce the extra 10,000 units. The increase in operating income under absorption costing is due to fixed manufacturing costs being held in inventory, and the additional inventory will lead to higher handling, storage, financing, and obsolescence costs.

b. Produce the extra 10,000 units. Operating income will be increased, and the production manager will receive praise for creating higher profits.

c. Do not produce the extra 10,000 units. Operating income does not change under absorption costing when the additional units are produced.

d. Produce the extra 10,000 units. It's always a good idea to have extra units on hand and keep the factory operating at capacity, even if all the units are not sold.

a

Feedback

1. Following the examples on the Absorption Statement and Variable Statement panels, recompute operating income under the absorption and variable cost methods, given that the additional units are manufactured. Dont forget that fixed costs will remain the same at any production level within the relevant range.

2. Review your chart and determine the change in operating income, focusing only on the change in absorption costing amounts.

3. Review your chart and determine the change in operating income, focusing only on the change in variable costing amounts.

4. What is the best decision the production manager can make when putting the company's needs ahead of his own?

Feedback

Partially correct

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