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Chapter 8 Variable Costing and the Costs of Quality and Sustainability Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Absorption and Variable Costing Absorption Costing Product costs Variable Costing Direct materials Direct labor Variable mfg. overhead Product costs Fixed mfg. overhead Period costs Period costs Selling & Admin. exp. 8-2 Absorption and Variable Costing Absorption Costing Product costs Variable Costing Direct materials Direct labor Variable mfg. overhead Product costs Fixed mfg. overhead Period costs Period costs Selling & Admin. exp. The difference between absorption and variable costing is the treatment of fixed manufacturing overhead. 8-3 Absorption and Variable Costing Mellon Co. produces a single product with the following information available: Number of units produced annually Variable costs per unit: Direct materials, direct labor and variable mfg. overhead Selling & administrative expenses Fixed costs per year: Mfg. overhead Selling & administrative expenses 25,000 $ 10 $ 3 $ 150,000 $ 100,000 8-4 Absorption and Variable Costing Unit product cost is determined as follows: Direct materials, direct labor, and variable mfg. overhead Fixed mfg. overhead ($150,000 ÷ 25,000 units) Unit product cost Absorption Costing Variable Costing $ 10 $ 10 $ 6 16 $ 10 Selling and administrative expenses are always treated as period expenses and deducted from revenue. 8-5 Absorption Costing Income Statements Mellon Co. had no beginning inventory, produced 25,000 units, and sold 20,000 units this year at $30 each. Absorption Costing Sales (20,000 × $30) Less cost of goods sold: Beginning inventory Add COGM Goods available for sale Ending inventory Gross margin Less selling & admin. exp. Variable Fixed Net income $ 600,000 8-6 Absorption Costing Income Statements Mellon Co. had no beginning inventory, produced 25,000 units, and sold 20,000 units this year at $30 each. Absorption Costing Sales (20,000 × $30) Less cost of goods sold: Beginning inventory $ Add COGM (25,000 × $16) 400,000 Goods available for sale $ 400,000 Ending inventory (5,000 × $16) 80,000 Gross margin Less selling & admin. exp. Variable Fixed Net income $ 600,000 320,000 $ 280,000 8-7 Absorption Costing Income Statements Mellon Co. had no beginning inventory, produced 25,000 units, and sold 20,000 units this year at $30 each. Absorption Costing Sales (20,000 × $30) Less cost of goods sold: Beginning inventory $ Add COGM (25,000 × $16) 400,000 Goods available for sale $ 400,000 Ending inventory (5,000 × $16) 80,000 Gross margin Less selling & admin. exp. Variable (20,000 × $3) $ 60,000 Fixed 100,000 Net income $ 600,000 320,000 $ 280,000 160,000 $ 120,000 8-8 Variable Costing Income Statements Now let’s look at variable costing by Mellon Co. Variable Costing Sales (20,000 × $30) Less variable expenses: Beginning inventory $ Add COGM Goods available for sale Ending inventory Variable cost of goods sold Variable selling & administrative expenses Contribution margin Less fixed expenses: Manufacturing overhead Selling & administrative expenses Net income $ 600,000 - 8-9 Variable Costing Income Statements Now let’s look at variable costing by Mellon Co. We exclude the Variable Costing fixed manufacturing $ 600,000 overhead. Sales (20,000 × $30) Less variable expenses: Beginning inventory $ Add COGM (25,000 × $10) 250,000 Goods available for sale $ 250,000 Ending inventory (5,000 × $10) 50,000 Variable cost of goods sold $ 200,000 Variable selling & administrative expenses Contribution margin Less fixed expenses: Manufacturing overhead Selling & administrative expenses Net income 8-10 Variable Costing Income Statements Now let’s look at variable costing by Mellon Co. Variable Costing Sales (20,000 × $30) Less variable expenses: Beginning inventory Add COGM (25,000 × $10) Goods available for sale Ending inventory (5,000 × $10) Variable cost of goods sold Variable selling & administrative expenses (20,000 × $3) Contribution margin Less fixed expenses: Manufacturing overhead Selling & administrative expenses Net income $ 600,000 $ 250,000 $ 250,000 50,000 $ 200,000 60,000 $ 150,000 100,000 260,000 $ 340,000 250,000 $ 90,000 8-11 Reconciling Income Under Absorption and Variable Costing We can reconcile the difference between absorption and variable net income as follows: Variable costing net income Add: Fixed mfg. overhead costs deferred in inventory (5,000 units × $6 per unit) Absorption costing net income Fixed mfg. overhead Units produced = $150,000 25,000 $ 90,000 $ 30,000 120,000 = $6.00 per unit 8-12 Cost-Volume-Profit Analysis CVP includes all fixed costs to compute breakeven. Variable costing and CVP are consistent as both treat fixed costs as a lump sum. Absorption costing defers fixed costs into inventory. Absorption costing is inconsistent with CVP because absorption costing treats fixed costs on a per unit basis. 8-13 Mellon Co. Year 2 In its second year of operations, Mellon Co. started with an inventory of 5,000 units, produced 25,000 units, and sold 30,000 units at $30 each. Number of units produced annually Variable costs per unit: Direct materials, direct labor and variable mfg. overhead Selling & administrative expenses Fixed costs per year: Mfg. overhead Selling & administrative expenses 25,000 $ 10 $ 3 $ 150,000 $ 100,000 8-14 Mellon Co. Year 2 Unit product cost is determined as follows: Direct materials, direct labor, and variable mfg. overhead Fixed mfg. overhead ($150,000 ÷ 25,000 units) Unit product cost Absorption Costing Variable Costing $ 10 $ 10 $ 6 16 $ 10 There has been no change in Mellon’s cost structure. 8-15 Mellon Co. Year 2 Units in ending inventory from the previous period. Absorption Costing Sales (30,000 × $30) Less cost of goods sold: Beg. inventory (5,000 x $16) Add COGM (25,000 × $16) Goods available for sale Ending inventory Gross margin Less selling & admin. exp. Variable (30,000 × $3) Fixed Net income $ 900,000 $ 80,000 400,000 $ 480,000 - $ 90,000 100,000 480,000 $ 420,000 190,000 $ 230,000 8-16 Mellon Co. Year 2 Absorption Costing Sales (30,000 × $30) Less cost of goods sold: Beg. inventory (5,000 x $16) Add COGM (25,000 × $16) Goods available for sale Ending inventory Gross margin Less selling & admin. exp. Variable (30,000 × $3) Fixed Net income $ 900,000 $ 80,000 400,000 $ 480,000 - $ 90,000 100,000 480,000 $ 420,000 190,000 $ 230,000 25,000 units produced in the current period. 8-17 Mellon Co. Year 2 Variable Costing Sales (30,000 × $30) Less variable expenses: Beg. inventory (5,000 × $10) Add COGM (25,000 × $10) Goods available for sale Ending inventory Variable cost of goods sold Variable selling & administrative expenses (30,000 × $3) Contribution margin Less fixed expenses: Manufacturing overhead Selling & administrative expenses Net income $ 900,000 $ 50,000 250,000 $ 300,000 $ 300,000 90,000 $ 150,000 100,000 390,000 $ 510,000 250,000 $ 260,000 Excludes fixed manufacturing overhead. 8-18 Summary Income Comparison Costing Method Absorption Variable 1st Period $ 120,000 90,000 2nd Period $ 230,000 260,000 Total $ 350,000 350,000 In the first period, production (25,000 units) was greater than sales (20,000). In the second period, production (25,000 units) was less than sales (30,000). 8-19 Summary Income Comparison Costing Method Absorption Variable 1st Period $ 120,000 90,000 2nd Period $ 230,000 260,000 Total $ 350,000 350,000 For the two-year period, total absorption income and total variable income are the same. 8-20 Evaluation of Variable Costing Management finds it easy to understand. Advantages Impact of fixed costs on profits emphasized. Consistent with CVP analysis. Emphasizes contribution in short-run pricing decisions. Profit for period not affected by changes in fixed mfg. overhead. 8-21 Evaluation of Absorption Costing Fixed manufacturing overhead is treated the same as the other product costs, direct material and direct labor. Advantages Consistent with long-run pricing decisions that must cover full cost. External reporting and income tax law require absorption costing. 8-22 Costs of Assuring Quality Grade Grade refers to the extent of its capabilities in performing an intended purpose, in relation to other products with the same functional use. Quality Quality of design refers to how well it is conceived or designed for its intended use. Quality of conformance refers to the extent to which a product meets the specification of its design. 8-23 There are four types of quality costs. Prevention costs are the costs of preventing defects. Appraisal costs are the costs of determining whether defects exist. Internal failure costs are the costs of repairing defects found prior to product delivery. External failure costs are those costs incurred after product delivery. 8-24 What is the Optimal Level of Product Quality? The optimal level of product quality is reached when: Prevention costs + Appraisal costs = Internal failure costs + External failure costs 8-25 Costs of Environmental Sustainability Sustainable development includes business activity that produces the goods and services needed in the present without limiting the ability of future generations to meet their meets. Environmental costs are the costs of dealing with environmental issues, such as BP’s costs in cleaning up the company’s spill in the Gulf of Mexico. Environmental cost management is the strategic implantation of systems for identifying, measuring, controlling, and reducing the private environmental costs borne by a company or other organization. 8-26 Environmental costs may be categorized in several ways: Private environmental costs are those borne by a company or individual. Social environmental costs are those borne by the public at large. Visible environmental costs are those that are known and clearly identified as tied to environmental issues. Hidden social environmental costs cannot be clearly tied to environmental issues. 8-27 Visible and hidden environmental costs may be further classified into one of three types..  Monitoring costs include the costs of monitoring the regulatory environmental as well as monitoring the production process to determine if pollution is being generated.  Abatement costs include costs to reduce or eliminate pollution.  Remediation costs include on-site and off-site remediation costs. On-site remediation includes costs of reducing or preventing the discharge into the environment of pollutants that have been generated in the production process. Off-site remediation includes the costs of reducing or eliminating pollutants from the environment after they have been discharged. 8-28