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Variable Costing: A Tool for Management

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  1. Variable Costing:A Tool for Management Chapter 5

  2. Learning Objective 1 Explain how variable costing differs from absorption costing and compute unit product costs under each method.

  3. Overview of Absorption and Variable Costing

  4. 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. . .

  5. 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. . .

  6. Unit Cost Computations Harvey Company produces a single productwith the following information available:

  7. Unit Cost Computations Unit product cost is determined as follows: Under absorption costing, all production costs, variable and fixed, are included when determining unit product cost. Under variable costing, only the variable production costs are included in product costs.

  8. Learning Objective 2 Prepare income statements using both variable and absorption costing.

  9. Income Comparison ofAbsorption and Variable Costing Let’s assume the following additional information for Harvey Company. • 20,000 units were sold during the year at a priceof $30 each. • There is no beginning inventory. Now, let’s compute net operatingincome using both absorptionand variable costing.

  10. Absorption Costing Fixed manufacturing overhead deferred in inventory is 5,000 units × $6 = $30,000.

  11. Variablemanufacturing costs only. All fixedmanufacturingoverhead isexpensed. Variable Costing

  12. Learning Objective 3 Reconcile variable costing and absorption costing net operating incomes and explain why the two amounts differ.

  13. Comparing the Two Methods

  14. Fixed mfg. overhead $150,000 Units produced 25,000 units = = $6 per unit Comparing the Two Methods We can reconcile the difference betweenabsorption and variable income as follows:

  15. Extended Comparisons of Income Data Harvey Company – Year Two

  16. Unit Cost Computations Since the variable costs per unit, total fixed costs, and the number of units produced remained unchanged, the unit cost computations also remain unchanged.

  17. Unit product cost. Absorption Costing Fixed manufacturing overhead released from inventory is 5,000 units × $6 = $30,000.

  18. Variablemanufacturing costs only. All fixedmanufacturingoverhead isexpensed. Variable Costing

  19. Fixed mfg. overhead $150,000 Units produced 25,000 units = = $6 per unit Comparing the Two Methods We can reconcile the difference betweenabsorption and variable income as follows:

  20. Comparing the Two Methods

  21. Summary of Key Insights

  22. Learning Objective 4 Understand the advantages and disadvantages of both variable and absorption costing.

  23. Impact on the Manager Opponents of absorption costing argue thatshifting fixed manufacturing overhead costsbetween periods can lead to faulty decisions. These opponents argue that variable costing incomestatements are easier to understand because net operatingincome is only affected by changes in unit sales. Thisproduces net operating income figures that areconsistent with managers’ expectations.

  24. CVP Analysis, Decision Makingand Absorption costing Absorption costing does not dovetail with CVP analysis, nor does it support decision making. It treats fixed manufacturing overhead as a variable cost. It assigns per unit fixed manufacturing overhead costs to production. • Treating fixed manufacturing overhead as a variable cost can: • Lead to faulty pricing decisions and faulty keep-or-drop decisions. • Assigning per unit fixed manufacturing overhead costs to production can: • Potentially produce positive net operating income even when the number of units sold is less than the breakeven point.

  25. Since top executivesare typically evaluated based on earnings reported to shareholdersin external reports, they may feel that decisions should be based on absorption costing data. External Reporting and Income Taxes To conform toIFRS and US GAAP requirements, absorption costing must be used forexternal financial reports. In many countries, including US,absorption costing must beused when filling out income tax returns.

  26. Consistent with CVP analysis. Management findsit more useful. Net operating income is closer tonet cash flow. Consistent with standardcosts and flexible budgeting. Easier to estimate profitabilityof products and segments. Impact of fixed costs on profits emphasized. Profit is not affected bychanges in inventories. Advantages of Variable Costingand the Contribution Approach Advantages

  27. Variable versus Absorption Costing Fixed manufacturingcosts must be assignedto products to properlymatch revenues andcosts. Fixed manufacturing costs are capacity costsand will be incurredeven if nothing isproduced. VariableCosting AbsorptionCosting

  28. Variable Costing and the Theory of Constraints (TOC) Companies involved in TOC use a form of variable costing. However, one difference of the TOC approach is that it treats direct labor as a fixed cost for three reasons: • Many companies have a commitment to guarantee workers a minimum number of paid hours. • Direct labor is usually not the constraint. • TOC emphasizes the role direct laborers play in driving continuous improvement. Since layoffs often devastate morale, managers involved in TOC are extremely reluctant to lay off employees.

  29. Impact of Lean Production When companies use Lean Production . . . Productiontends to equalsales . . . So, the difference between variable and absorption income tends to disappear.

  30. Learning Objective 5 Compute predetermined overhead rates and explain why estimated overhead costs (rather than actual overhead costs) being used in the costing process.

  31. Why Use an Allocation Base? Manufacturing overhead is applied to products/jobs that are in process. An allocation base, such as direct labor hours, direct labor dollars, or machine hours, is used to assign manufacturing overhead to individual products/jobs. • We use an allocation base because: • It is impossible or difficult to trace overhead costs to particular products/jobs. • Manufacturing overhead consists of many different items ranging from the grease used in machines to production manager’s salary. • Many types of manufacturing overhead costs are fixed even though output fluctuates during the period.

  32. Estimated total manufacturingoverhead cost for the coming period POHR = Estimated total units in theallocation base for the coming period Ideally, the allocation base is a cost driver that causes overhead. Manufacturing Overhead Application The predetermined overhead rate (POHR) used to apply overhead to products/jobs is determined before the period begins.

  33. The Need for a POHR Using a predetermined rate makes itpossible to estimate total product/job costs sooner. Actual overhead for the period is notknown until the end of the period.

  34. Determining Predetermined Overhead Rates Predetermined overhead rates are calculated using a three-step process. Estimate total amount of the allocation base for the period. Estimate total manufacturing overhead costs.  Estimate the level of production for the period. POHR =  ÷ 

  35. Overhead applied = POHR × Actual activity Application of Manufacturing Overhead Based on estimates, and determined before the period begins. Actual amount of allocation is based upon the actual level of activity (normal costing system).

  36. Estimated total manufacturingoverhead cost for the coming period POHR = Estimated total units in theallocation base for the coming period $150,000 POHR = 50,000 direct labor hours (DLH) Overhead Application Rate for the Harvey Example POHR = $3.00 per DLH For each direct labor hour worked on a particular product, $3.00 of factory overhead will be applied to it. For product valuation, it must be valued by unit. In this case, assume each unit requires 2 direct labor hours. Hence, each unit of the product absorbs $6 predetermined overhead. In order to match back with Harvey’s example, we further assume that variable manufacturing overhead = 0. So the predetermined overhead represents only fixed manufacturing overhead cost as shown in slides 14 & 19.

  37. Learning Objective 6 Understand the implications of basing the predetermined overhead rate on activity at capacity rather than on estimated activity for the period.

  38. Predetermined Overhead Rate and Capacity • Calculating predetermined overhead rates using an estimated, or budgeted amount of the allocation base has been criticized because: • Basing the predetermined overhead rate upon budgeted activity results in product costs that fluctuate depending upon the activity level. • Calculating predetermined rates based upon budgeted activity charges products for costs that they do not use.

  39. Capacity-Based Overhead Rates Criticisms can be overcome by using estimated total units in the allocation base at capacity in the denominator of the predetermined overhead rate calculation. Let’s look at the difference!

  40. An Example Equipment is leased for $100,000 per year. Running at full capacity, 50,000 units may be produced. The company estimates that 40,000 units will be produced and sold next year. What is the predetermined overhead rate?

  41. TraditionalMethod $100,000 40,000 = = $2.50 per unit Capacity Method $100,000 50,000 = = $2.00 per unit An Example Equipment is leased for $100,000 per year. Running at full capacity, 50,000 units may be produced. The company estimates that 40,000 units will be produced and sold next year.

  42. Barossa Winery in Barossa Valley, South Australia,leases an automatic corking machine for $100,000 per year. At full capacity, it can cork 50,000 cases of wine per year. The company estimates 40,000 cases of wine will be produced and sold next year. What is the predetermined overhead rate based on the estimated number of cases of wine? a. $2.00 per case. b. $2.50 per case. c. $4.00 per case. Quick Check 

  43. Quick Check  Barossa Winery in Barossa Valley, South Australia, leases an automatic corking machine for $100,000 per year. At full capacity, it can cork 50,000 cases of wine per year. The company estimates 40,000 cases of wine will be produced and sold next year. What is the predetermined overhead rate based on the estimated number of cases of wine? a. $2.00 per case. b. $2.50 per case. c. $4.00 per case.

  44. Barossa Winery in Barossa Valley, South Australia, leases an automatic corking machine for $100,000 per year. At full capacity, it can cork 50,000 cases of wine per year. The company estimates 40,000 cases of wine will be produced and sold next year. What is the predetermined overhead rate based on the number of cases of wineat capacity? a. $2.00 per case. b. $2.50 per case. c. $4.00 per case. Quick Check 

  45. Quick Check  Barossa Winery in Barossa Valley, South Australia, leases an automatic corking machine for $100,000 per year. At full capacity, it can cork 50,000 cases of wine per year. The company estimates 40,000 cases of wine will be produced and sold next year. What is the predetermined overhead rate based on the number of cases of wineat capacity? a. $2.00 per case. b. $2.50 per case. c. $4.00 per case.

  46. When capacity is used in the denominator of the predetermined rate, what happens to the predetermined overhead rate as estimated activity decreases? a. The predetermined overhead rate goes up when activity goes down. b. The predetermined overhead rate stays the same because it is not affected by changes in activity. c. The predetermined overhead rate goes down when activity goes down. Quick Check 

  47. Quick Check  When capacity is used in the denominator of the predetermined rate, what happens to the predetermined overhead rate as estimated activity decreases? a. The predetermined overhead rate goes up when activity goes down. b. The predetermined overhead rate stays the same because it is not affected by changes in activity. c. The predetermined overhead rate goes down when activity goes down.

  48. When estimated activity is used in the denominator of the predetermined rate, what happens to the predetermined overhead rate as estimated activity decreases? a. The predetermined overhead rate goes up when activity goes down. b. The predetermined overhead rate stays the same because it is not affected by changes in activity. c. The predetermined overhead rate goes down when activity goes down. Quick Check 

  49. Quick Check  When estimated activity is used in the denominator of the predetermined rate, what happens to the predetermined overhead rate as estimated activity decreases? a. The predetermined overhead rate goes up when activity goes down. b. The predetermined overhead rate stays the same because it is not affected by changes in activity. c. The predetermined overhead rate goes down when activity goes down.

  50. Income Statement Preparation – Capacity