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Variable Costing
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.
Absorption
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 VARIABLE COSTING Sales Revenue Sales Revenue -Cost of Goods Sold -Variable Costs and Expenses Gross Margin or Gross Profit Contribution Margin -Selling, General and Administrative Expenses -Fixed Costs and Expenses Operating Profits Operating Profits
Assume that Lucy’s Chocolate Factory, Inc. has the following costs, sales and production:
Units Produced: 10, Units Sold: 10, Price Per Unit: $ Direct Materials: $50, Direct Labor: $30, Variable Manufacturing Overhead: $20, Fixed Manufacturing Overhead: $40, Variable Sell., Gen. & Adm. Exps.: $30, Fixed Sell., Gen. & Adm. Exps.: $30,
Using Absorption Costing, each unit would cost the following:
Direct Materials: $50, Direct Labor: $30, Variable Manufacturing Overhead: $20, Fixed Manufacturing Overhead: $50, Total Costs $150, Divide By Number of Units Produced ÷10, Cost Per Unit $
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, Less: SG&Adm: -45,000 (30K+ ½ 30K)^ Less FC: F MO/H: -50, F SG&Adm: -30, Oper. Profits: $5000 Oper. Profits: -$20,
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,
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
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 ($1.90 - $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 ($1.90 - $1.10). As you can see, Mint doubled its profits under Absorption Costing without selling any more units merely by producing more inventory.
Produce & Sell 10,000 units Produce 5 0,000 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.
First U.S. Mint
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, F MO/H: -5, Oper. Profits: $4,
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,
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)+ ($1.5 x 10K)
VCOGS: -50,000 ($1x50K)
Oper. Profits: $36,000 (80¢x10K)^ Contrib. Marg: $45, F MO/H: -5, Oper. Profits: $40,
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,
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
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: $ 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, Fixed Selling, General & Administrative Expenses: $40,
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,
Total Manufacturing Cost: $100, Divide By The Number of Units Produced: ÷10, Manufacturing Cost Per Unit: $
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, Divide By The Number of Units Produced: ÷10, Manufacturing Cost Per Unit: $
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, Var Sell. & Adm: -20,000 (2x10K)
Selling & Administrative: -$60,000 (40K+(2x10K))^ Contribution Margin: $90,
Operating Profits: $20,000 Fxd. Manuf. OH: -60, Fxd. Sell. & Adm: -40, Operating Profits: -10,
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,
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.
