Managerial Accounting

2011

First semester

Takayuki Asada

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Chapter5. Variable Costing

After reading this chapter, you will be able to:

Explain the difference between full and variable costing

Prepare an income statement using variable costing

Discuss the effect of production on full and variable costing income.

Explain the impact of JIT(just-in-time) on the difference between full and variable costing income.

Discuss the benefits of variable costing for internal reporting purposes

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1. IntroductionIn 2006,the all of tube amplifier produced by Clausen Tube

received rave reviews and company was able to see all 5,000 units it produced and the company profit is $3,500,000.

In 2007 the company increased production to 6,000 units but was only able to see 4,800 Units.

In early January of 2008,Robert Cluasen ,company president and founder, reviewed financial performance for 2007. Profit had actually increased slightly to $3,528,000.

The reason of this good performance must be discussed under less sales volume in 2007 in comparison with the performance of 2007.

It is due to the fact that our financial performance statements are prepared using what’s called full, or absorption costing.

There are a method called variable costing that we could use for internal reporting purposes which wouldn’t produce such puzzling.

In this chapter, we will discuss the differences between full costing and variable costing and gain an understanding of why profit is up at Clausen Tube even though sales are down.3

2. Full and Variable Costing

1)Income statement of manufacturing firms prepared for external purposes use full costing(absorption costing). In full costing,inventory costs include direct material ,direct labor ,and all manufacturing overhead.In this costing methods,variable costs and fixed costs are commingled ,or combined,and it is very difficult to untangle the costs to perform what if analysis that requires separating ficed and variable costs.

2) In variable costing,only variable production costs are included in inventory costs. All fixed production costs are treated as period costs and expensed in the period incurred. Under the variable costing method,the total amount of depreciation(fixed cost component) is treated as an expense of the period.

See Illustration 5-1

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Illustration 5-1 comparison of full and variable costing

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2-1 Variable costing income statementIf variable costing us used , an income statement can be prepared that classifies all expenses in terms of their cost behavior –either fixed or variable. With the variable expenses separated from the fixed expenses ,a contribution margin can be presented.

A contribution margin information will allows readers of the income statement to make estimates of how much profit will change with change in sales.

The account analysis methid is subjective in that different managers viewing the same set of facts may reach different conclusions regarding which costs are fixed and which costs are variable.

Illustration 5-2 Comparison of income statement prepared using full and variables csoting

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3 . Effects of Production on income for full versus variable costing:The Clausen Tube Example

3-1 Quantity produced equals quantity sold

In 2006,there is no beginning inventory of finishhed goods , 5000 units are produced, and 5000 units ar sold. Illustration 5-3 provides a combination of full costing and variable costing income statement for this situation.

As we have just seen ,when the quantity produced equals the quantity sold,there is no difference between net income calculated using full,versus variable,costing. Since all units produced are sold,no fixed costs ends up in ending inventory.

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3. Effects of Production on income for full versus variable costing;The Clausen Tube Example

Illustation 5-3

3-2 Quatity produced is greater than quantity sold

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3-3 Quantity produced is less than quntity sold

Now,what is the case if the quantity produced is less than the quantity sold? To sell more than produced,a company must have some beginning inventory.The recorded value of that beginning inventory will be greater with full costing since full costing includes fixed manufacturing overhead and variable costing does not. Thus, When the beginning inventory is charged to cost of goods sold,the charge will be higher under full costing.

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3-4 Explaining what happened at Clausen Tube

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In 2007, the company produced a lot more units than it sold. The high level ofProduction reduced cost per unit because fixed manufacturign overhead was spread out over more units.

3-5 Impact of JIT on the income effects of full versus variable costing

A company that use JIT may have very low inventory levels since they don’t produce until they are ready to sell their products.

The result is that the units they produce are approximately equal to the units they sell and thus, the differece between variable costing income and Full income is likey to be very small for companies that use JIT.

4. Benefits of varible costing for internal reporting.

There are two primary benefits associated with using variable costing for internal reporting purposes.

4-1 Variable costing facilitates C-V-P analysis

manager simply can’t estimate accurately the impact of changes in volume on cost and profit unless they know which costs are fixed and which cost are variable.

4-2 Variable costing limits management of earnings with production volume

Another reason why variable costing may be preferred for internal purposes is that it does not allow managers to artificially inflate profit by producing more units than they can sell. 13

5. Making Business Decisions

Since many decisions affect sales,being able to estimate the impact of changes in sales on profit greatly facilitate decisions making.

------------------------------------------------------------Thus,we try to explain the contribution margin methods by

simple example of Takashima Retails company.

(1)A product contribution margin:sales of “A”– variable mfc.costs of “A” product -- “A” product sales variable expenses=contribution margin of “A” sales.

(2)B product contribution margin:Sales of “B” – variable mfc.costs of “B” product -- “B” product sales variable expenses= contribution margin of “B” sales 14

Under this example,we can see the contribution margin ratio of two products,however,this analysis say the margin comparison based on the assumption about traceable on each sales variable costs of “A and B” products.

This contribution margin or margin ratios is one methods for manager to analyze each product or product group profitability.

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Summary1.Explain the difference between full and varible

costing.

2.Prepare an income statement using variable costing.

3.Discuss the effect of production on full and variable costing income.

4.Explain the impact of JIT on the difference between full and variable costing income.

5.Discuss the benefits of variable costing for internal reporting purposes.

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