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CHAPTER 7

Variable Costing
Vs
Absorption Costing

• Two systems are used to

produce ISs:
–Absorption Costing
–Variable Costing

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• Absorption Costing
– All we have used so far
– Cost of units
• All factory costs
– Factory costs expensed when
inventory sold
• COGS

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• Absorption Costing
– Inventory costs:
• DL
• DM
• MO/H
– Both FO/H & VO/H
• Required by GAAP

• Variable Costing
– Alternative to Absorption
Costing
– Not GAAP
– Separates VCs & FCs

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• Variable Costing
– Problem with COGS
• Both FC & VC
– Need to change Inventory cost:
• DL
• DM
• VO/H
– Not FO/H

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• FO/H (Variable Costing)
– Not inventory cost
• “product cost”
– Expensed
• “period cost”
– COGS is now a VC

Different IS Formats

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• Different IS formats:

ABSORPTION VARIABLE
Sales Sales
-COGS -VC
GM CM
-SG&A -FC
OP OP

• Assume: 11
Units Produced: 10K
Units Sold: 10K
Price Per Unit: $25
DM: $50K
DL: $30K
VO/H: $20K
FO/H: $50K
Variable SG&A: $30K
Fixed SG&A: $30K

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• With These Problems:

– 1st calculate cost of 1 unit
• ALWAYS!!!!!!!!!!

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13 • Absorption Costing:
• 1st
Calculate cost of 1 unit

DM: $50K
DL: $30K
VO/H: $20K
FO/H: $50K
Total Costs $150K
÷ Units Produced ÷10K
Cost Per Unit $15

14 • Variable Costing
• 1st
Calculate Cost of 1 unit:

DM: $50K
DL: $30K
VO/H: $20K
Total Costs $100K
÷ Units Produced ÷10K
Cost Per Unit $10

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• Difference in cost
– Absorption Costing ($15)
– Variable Costing Method ($10)
•
FO/H per unit
– $50K/10K units =$5

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Absorption Costing IS
Sales: $250K (25x10K)
COGS: -150K ((10+5)x10K)
GM: $100K
-SG&A: -60K (30K+30K)
OP: $40K

17 Variable Costing IS
Sales: $250K (25x10K)
Less VC:
V COGS: -100K (10x10K)
V SG&A: -30K
CM: $120K
Less FC:
FO/H: -50K
F SG&A: -30K
OP: $40K

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• OP was same for both methods
– # units sold = # units produced
• OP will be different if:
– # units sold ≠ # units produced
• Same e.g. but assume:
– 5K units sold
– ½ of production

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Absorption Costing IS
Sales: $125K (25x5K)
COGS: -75K ((10+5)x5K)
GM: $50K
- SG&A: -45K (30K+ ½ 30K)
OP: $5K

20 Variable Costing IS
Sales: $125K (25x5K)
Less VC:
V COGS: -50K (10x5K)
V SG&A: -15K ½ (30K)
CM: $60K
Less FC:
FO/H: -50K
F SG&A: -30K
OP: -$20K

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Reason For Different OP

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• Difference due to FO/H
–Variable Costing

• FO/H Cost expensed ($50K)
–Absorption Costing

• FO/H divided into per unit cost ($5)
• Part of cost of each unit
• Expensed when unit sold
• ½ of units sold

– ½ of FO/H expensed ($25K)

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• Difference in OP
– [$5K – (-$20K) = $25K]
– Due to difference in treatment
of FO/H of unsold units:
FO/H Per Unit x Unsold Units
$5 x 5K = $25K

• Absorption Costing 24
–Inventory Cost = $15 per unit
–Cost of 5K unsold units is $75K
• Variable Costing
–Inventory Cost = $10 per unit
–Cost of the 5K unsold units is
$50K
• Cost not expensed
added to Inv
– Nothing disappears

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Cooking The Books

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• Let’s Review Cost Behavior

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• VC per unit doesn’t change as

production increases
–V=Vx↑/x↑
• Total VC go up
• Total units go up
• VC per unit (V) stays the same

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• FC per unit drops as you produce

more units
– (FC per unit)↓=F/(x↑)
• Total FC stays the same
• Total units goes up
• FC per unit drops
– Spreading FC over greater # of
units

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• Because of these relationships

– You can artificially inflate GAAP
OP

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• With Absorption Costing

If you produce more units:
• FC per unit drops
• Cost of each unit drops
• You end up with
• Lower COGS
• Higher OP
• You can artificially inflate OP

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• Assume
– TC = $5K + $1/unit produced
– Sales Price = $1.90

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• Production: 10K units

– TC = $15K = [$5K + ($1x10K)]
– Unit cost = $1.50
– Profit: 40¢/unit ($1.90 - $1.50)

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• Production: 50K units

– TC = $55K = [$5K + ($1x50K)]
– Unit cost = $1.10
– Profit: 80¢/unit ($1.90 - $1.10)
• Co. doubled its OP
– without selling more units

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Produce & Sell 10K Units
Sales: $19K ($1.90x10K)
COGS: -15K ($1.50x10K)
GM: $4K

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Produce 50K Units & Sell 10K Units
Sales: $19K ($1.90x10K)
COGS: -11K ($1.10x10K)
GM: $8K

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• Co made 40¢ of cost disappear

– 10K units
FC per unit 50¢ ($5K/10K units)
– 50K units
FC per unit 10¢ ($5K/50K units)
40¢

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• The $5K FC is still there
• But only $1K was expensed (with
10K units sold)
• $4K is part of cost of unsold units
– It is part of the cost of the unsold Inventory
• It is an asset
• Not an expense

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• Manipulation of OP is not
possible with Variable Costing
– All FO/H is expensed
currently
– Cost of inventory
solely
VCs
– Can’t shift FO/H cost to Inv

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• Production: 10K units
–TC = $10K = ($1 x 10K)
–Unit cost = $1
• Production: 50K units
–TC = $50K = ($1 x 50K)
–Unit cost = $1

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• With Variable Costing

– Co has $4K of OP regardless
of # of units produced

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Produce & Sell 10K Units
Sales: $19K ($1.90x10K)
VCOGS: -10K ($1x10K)
CM: $9K
FO/H: -5K
OP: $4K

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Produce 50K Units & Sell 10K Units

Sales: $19K ($1.90x10K)
VCOGS: -10K ($1x10K)
CM: $9K
FO/H: -5K
OP: $4K

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• Both Methods give same OP

when:
– Units produced = Units sold

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• That is why we like Variable
Costing OP
– Tells you what Absorption
Costing OP would have been if
no over-production
– It exposes OP manipulation by
making unneeded units

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• Over-production may improve

Absorption OP
• But it is detrimental to Co

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• If units sold > units produced

Variable Costing OP > Absorption Costing OP

47 • Continue with same E.g.:

Units: Produced Sold

1st Year 50K 10K
2nd Year 10K 50K

Cost Fn: $5,000 + $1/unit

Produced Absorption Variable

1stYear 50K $1.10/unit $1/unit
2nd Year 10K $1.50/unit $1/unit

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• 1st Year:

Absorption Costing
Sales: $19K (1.90x10K)
COGS: -11K ($1.10x10K)
OP: $8K (80¢x10K)

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• 1st Year:

Variable Costing
Revenue: $19K (1.90x10K)
VCOGS: -10K ($1x10K)
CM: $9K
FO/H: -5K
OP: $4K

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• Difference in OP

FO/H/Unit X Unsold Units = Difference

10¢ X 40,000 = $4,000

• FO/H / unit = 10¢

•($5,000/50,000)

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• 2nd Year

Absorption Costing
Sales: $95K (1.9x50K)
COGS: -59K ($1.10x40K)+($1.5 x 10K)

OP: $36K

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• 2nd Year

Variable Costing
Sales: $95K (1.90x50K)
VCOGS: -50K ($1x50K)
CM: $45K
FO/H: -5K
OP: $40K

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• What happened?
– 1st Year
Shifted $4K of FC into
inventory
– 2nd Year

• Sold all the units produced in 2nd Year
–This included all of FC for 2nd Year
• Sold unsold units from 1st Year
–This included $4K of FC from 1st Year
– There is an extra $4K of FC in COGS
in 2nd Year

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• 1st Year
– Units produced > Units sold
– Absorption OP > Variable OP
– $4K of FC put into Inv
• 2nd Year
– Units produced < Units sold
– Absorption OP < Variable OP
– Extra $4K of FC in COGS

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• In 2nd year
Difference in Methods

FO/H/Unit X Unsold Units = Difference

10¢ X -40,000 = -$4,000

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Another Example

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Price: $15
VC: DL: $1/ unit produced
DM: $2/ unit produced
VO/H: $1/ unit produced
V SGA: $2/ unit sold
FC: FO/H: $60,000
F SGA: $40,000
10K Units Made & Sold

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• Absorption Costing COGM/unit
DM: $ 20K (2x10K)
DL: 10K (1x10K)
VO/H: 10K (1x10K)
FO/H: 60K
Total Cost: $100K
÷ Units Produced: ÷10K
Cost Per Unit: $10

59 • Variable Costing COGM:

DM: $ 20K (2x10K)
DL: 10K (1x10K)
VO/H: 10K (1x10K)
Total Cost: $40K
÷ Units Produced: ÷10K
Cost Per Unit: $4
• FO/H per unit is $6 ($60,000/10,000 units)
– ($10 - $4 = $6)

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• # of units made = # of units sold

ABSORPTION COSTING
Sales: $150K (15x10K)
COGS: -100K (10x10K)
GM: $50K
SGA: -$60K [40K+(2x10K)]
OP: -$10K

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VARIABLE COSTING
Sales: $150K (15x10K)
VCOGS: -40K (4x10K)
VSGA: -20K (2x10K)
CM: $90K
FO/H: -60K
FSGA: -40K
OP: -10K

62 • Make 20K units & sell 10K units

• COGM - Absorption Costing
DM: $ 40K (2x20K)
DL: 20K (1x20K)
VO/H: 20K (1x20K)
FO/H: 60K
Total Cost: $140K
÷ Units Produced: ÷20K
Cost Per Unit: $7
• Was $10
… now $7
• FO/H
Changed from $6 to $3

63 • COGM Variable Costing:

DM: $ 40K (2x20K)

DL: 20K (1x20K)
VO/H: 20K (1x20K)
Total Cost: $80K
÷ Units Produced: ÷20K
Cost Per Unit: $4

• The cost of unit did not change

• There is no FO/H in COGM

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ABSORPTION COSTING
Sales: $150K (15x10K)
COGS: -70K (7x10K)
GM: $80K
SGA: -$60K [40K+(2x10K)]
OP: $20K

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VARIABLE COSTING
Sales: $150K (15x10K)
VCOGS: -40K (4x10K)
VSGA: -20K (2x10K)
CM: $90K
FO/H: -60K
FSGA: -40K
OP: -10K

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• Difference in Methods:
FMO/H Per Unit x Unsold Units
$3 x 10K = $30K
• Variable Costing Tells Us

–If Co had only produced 10K
units
• Instead of 20K
–Co would have lost $10K

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