Variable Cost

This paper seeks to write a reply to a friend with answers to her questions whether Claire’s Antiques should work to convert the fixed costs to variable cost and whether the proposal is good or bad. This paper will also identify the types of costs that Claire’s Antiques would incur as fixed costs. Fixed cost are costs that remain fixed regardless of the level of production within a relevant range. Variable costs on the other hand vary with levels of production (Atkinson, 2005 ). Examples of variable costs are the costs of raw material and direct labor, since they have to vary or change with the change of production level.

Fixed costs are normally associated with some portion of factory overhead like the depreciation of the building and the salary of the plant or production manager who must be paid whether or not there is production for a given period (Meigs, Meigs & Meigs, 1995). To argue therefore that fixed cost should be converted into variable cost would sound difficult if not impossible to happen since the nature of cost for defining them is determined whether they could be incurred if the company changes the level of production.

Assuming fixed costs are converted into variable costs, it would be sounding as if the company would not produce for a certain period that it would not be incurring any cost. Such would sound ridiculous because the plant manager may not agree with it since he or she is paid monthly and it could be that he or she is faultless why production could not be done. Similarly assuming production equipments are already purchased and they are used in production, the passage of time to determine their depreciation by obsolescence cannot be stopped (Meigs, Meigs & Meigs, 1995).

I would therefore advise my friend that the suggestion could not be done for Claire’s Antiques. From the list of costs enumerated, it would appear that the other costs allocated on a per unit basis are fixed cost since they are just allocated and implying a group of costs that management would just allocate for each unit produced. As explained earlier said fixed costs do not vary with the production level but even if there are no units produced for the month it does not mean that no fixed costs are incurred for the period (Atkinson, Anthony, et al, 2005).

The cost for various components parts , packaging, etc. , production labor and sales commission are properly falling under variable costs and therefore they could not be classified as fixed cost. Given the difficulty or impossibility of conversion of fixed cost into variable, Claire’s Antiques should be advised to operate at least in any period at break-even point, which is the point at which the company’s contribution margin could equal or at least cover the amount of fixed costs that are inevitably incurred (Atkinson, 2005).

Thus, not to operate without any good reason would amount to incurring fixed costs already and would not be good for the company. The situation of Claire’s Antiques would require the company to classify its costs into variable and fixed cost to be able to plan more effectively. Case facts say that the company cannot always predict the market and producing above or below the actual demand for its products could cause losses for the company.

For the company to avoid selling its products at discount after wards in case of overproduction it should know its breakeven point but before this is possible, it needs to properly classify its fixed costs from variable costs. References: Atkinson, A. , et al (2005), Management Accounting, Person Custom Publishing, New Jersey, USA Case Study – Claire’s Antiques Meigs, R, Meigs, W. , & Meigs, M. (1995) Financial Accounting, McGraw-Hill, New York, USA

Throughout the corporate world, businesses are transforming labor into a more flexible (and variable) cost. Among such companies are Hewlett-Packard, General Electric, DuPont, Sun Microsystems, and British Airways. Discuss whether direct labor is a fixed or a variable cost. What are the pros and cons of management treating direct labor as a variable cost? Are there ethical issues to be considered here? Direct labor can be classified as a fixed cost or a variable cost, depending on how flexible the employer needs to be/can be with the labor force throughout the year.

Direct labor will be classified as a variable cost if the employer employs the practice of hiring/firing (or laying off) permanent employees throughout the year depending on seasonal business. This is a common practice in the US & UK, where management is legally & customarily given much more latitude to fluctuations in the labor force. Where direct labor is classified as a fixed cost, firms typically see laying off personnel during a business down-turn as letting go skilled/trained workers not easily replaced when business picks back up.

These types of firms will also employ the practice of hiring temporary employees in times of upturn, so as to not need to lay-off any permanent employees when business returns to normal. The pros of management treating direct labor as a variable cost is giving management the latitude to keep producing at optimal staffing levels whatever the fluctuations of business. This means a leaner, more competitive business. The cons of management treating direct labor as a variable cost are that valuable employees are often laid off, and are not easily (or inexpensively) replaced, and lay-offs can undermine the morale of those remaining employees.

The ethics of the situation is that management could be toying with a person’s psyche if they’re repeatedly laying off an individual. If you hire an individual knowing of the likelihood of laying him off in the future, you’ve taken away the opportunity for that person to find permanent employment with another firm. (Brewer, P. C, Garrison, R. H & Noreen, E. W. (2011). Managerial Accounting for managers (2nd ed. ). New York, NY: McGraw Hill. )

All business entities’ main goal is to make a profit by offering products or services. Cost plays an integral role when we make a business decision that is geared towards attaining our goal. Costs are generally categorized into two groups, fixed and variable costs. We will define between fixed and variable costs and how each behaved differently with the change in the level of output. Defining Fixed and Variable Costs What is Cost? Before we can differentiate between fixed and variable cost, let us first define what is cost. Baker (2000) said total cost is what it costs to operate at some particular rate of output.

Investor words (“Online Financial Glossary,” n. defines cost as the total money time and resources associated with a purchase or activity. According to the US Chamber of Commerce (“Finance Toolkit”) before you can use cost/volume/profit analysis in evaluating your business you need to get a handle on your fixed costs as compared with your variable costs. What are Variable and Fixed Costs? According to Sollenberger and Schneider (1996), variable cost changes in total indirect proportion to changes in activity or output. A decrease in activity brings a proportional decrease in total variable cost and vice versa.

Fixed cost on the other hand is constant in total amount regardless of changes in activity level. Fixed cost per unit decreases as activity or volume increases and vice versa. (Sollenberger & Schneider, 1996) Scenario. Suppose we are running a restaurant and have identified certain costs along with the number of annual units sold of 1000, annual raw materials costs of 650, and annual rent of 9000. Let us then identify what are our fixed and variable costs and the cost per unit of each.

With 1000 units, the unit cost of raw materials would be . 65 while the building rent is 9 for each unit produced. At this point, both may still be considered fixed cost for the simple reason that there is still no change in the productivity or output. Suppose we increase output to 6000 units then to 8000 units the following year and still within the relevant range. What would now be our total annual cost and unit costs? Would our costs still be fixed or variable?

On a per unit computation, it looks as if raw materials is fixed while rent is variable but we do our cost analysis based on the total costs and not on a per unit cost and as defined above, we know that variable costs changes in direct proportion to productivity or output while fixed costs remains the same regardless of the output. Thus, the total annual cost of raw materials is our variable costs because as we increase the output, so did our total costs while building rent remains the same regardless of the change in our output.

References

1. Baker, S. L. (1985-2000). Cost Concepts. Economics Interactive Tutorials. Retrieved January 5, 2008 from http://hadm. sph. sc. edu/COURSES/ECON/Cost/Cost. html
2. Investorwords. Online Financial Glossary. Retrieved January 05, 2008 from http://www. investorwords. com/5221/variable_cost. html
3. Sollenberger, H. M. & Schneider, A. (1996 Philippine Copyright). Managerial Accounting. Cincinnati, Ohio: Southwestern College Publishing. US Chamber of Commerce. Finance Toolkits.
4. Retrieved January 05, 2008 from the US Chamber of Commerce for Small Business Center online database http://www. uschamber. com/sb/business/P06/P06_7510. asp

Introduction

This paper posits that in making decisions to control variable costs there are trade-offs that are inevitable but a choice must be made if higher profits is desired.  This paper will attempt to prove this thesis in the case of JetSet Travel, Inc. (JTI), a company which develops, manufactures, and sells a wide range of travel-related equipment and products. As a manufacturing company incurs variable costs in the form of direct materials and direct labor and is faced with reality that variable cost increases with production.

Analysis and Discussion

The nature of variable cost. Variable cost normally takes the form of direct materials and direct labor.  This cost normally directly varies with production volume which means that as company increase production, the company also increases variable cost also.  Logically, if the company limits or controls production, it also controls variable cost.  To control production however, is to control sales and to control sales is to control profits.  Sound business decision techniques therefore require that variable cost could not just be arbitrarily controlled since this may affect revenues and eventually profits.

How to control variable cost? Controlling variable cost must need sacrifice increase in revenues.  It could thus be understood that a company is required to incur variable cost if it wants to earn profits but in order to earn profit the variable cost for production of the company’s products must not be too big as to cause the company no profits or losses.  The better question that should be resolve is this:  At what level of production should the company continue producing given a certain percentage of variable cost to revenues that would cause the company to earn profits still?  The theoretical answer to the question is that production level should be at least above the break even point, where total cost equals total revenues.  It should be noted that the answer to the question assumes a certain percentage of total variable cost to sales that is not changing regardless of the level of production.  It could thus be argued that variable cost could still be reduced in relation to revenues but this could increase fixed cost.

 Decreasing variable cost while increasing fixed cost would be a better option if bottom line figures or net profits in relation to revenues would be higher than maintaining present relationships of variable cost to revenues.  To increase fixed cost means increasing cost that would not vary with production and this could take the form on investing in equipments utilizing better technology.  To illustrate, a business could purchase an equipment to replace manual labor in the factory.  Replacing work hours of laborer will definitely reduce the number of laborers in the factory but the cost of depreciation which is fixed cost will increase because equipment takes the nature of long-term asset and depreciation will be incurred regardless if the  factory produces or not.  This set of plans could be integrated in the budget (Businesstown.com, 2007) to enhance control attainment of control of cost. Read about variable costs for pharmaceutical companies

Conclusion

To control variable costs is not easy as deciding not to spend it.  In business, the company is expected to use assets and resources and incur liabilities for the business and corresponding expenses and costs are necessary results.  However, in so spending cost and expenses, the company expects to earn revenue above these cost and expenses.  It is therefore logical that the cost should be used in order to have revenues.  Striking a balance, therefore, between variable and fixed could be resorted to increase profitability.  Assuming that demand for company products will continue, I recommend purchasing equipments using better technology that could reduce direct labor cost.  However, as a word of caution, the risk of my recommendation is that it may increase fixed cost and which could be affect the company’ profitability if demand for company’s products will slow down.

Reference

1. Businesstown.com (2007) Accounting – Purchasing/Cost Control: Using Your Budget to Control Costs, {www document} URL http://www.businesstown.com/accounting/slashing-budget.asp, Accessed June 2, 2007

Fixed Cost and variable cost makes up the total cost of the business.  Fixed Cost is costs that do not change during a specified period.  They are expenses of the company that is not affected by the change in proportion to the activity of a business (Ross et.al, 1995) .  For example, the least payment on the production facility and the company president’s salary  are fixed cost.  But of course, fixed cost are not fixed forever.  They maybe only fixed, maybe let’s say for a quarter or a year.  Beyond that time, lease can be terminated and executives may retire.  More to the point, any fixed cost can be modified or eliminated given enough time, so in the long run all cost are variable.  Thou we should always remember that during the time that the cost is fixed, that cost is effectively a sunk cost because we are going to pay for it no matter what.

On the other hand, a variable cost is a cost that is directly proportional to the activity of the business.  It depends on the amount of good or services produced during a period of time.   Examples of this kind of cost are the labor, transportation and raw materials.

The main costs that a manufacturer faces can be summarized in the following table:

• Cost item
• Cost category
• Justification
• Raw materials to be processed
• Variable (proportionally)

Production recipe:

• any un-proportional change would impact the features of the product
• Semi-manufactured components to be assembled
• Variable (proportionally)
• Production recipe
• Energy
• Variable (less than proportionally)
• Physical properties produce economies of scale
• Personnel (direct labour)
• Variable (proportionally)
• Constant productivity of people directly involved in production
• Particularly flexibility-oriented legal contracts with the labour force
• Personnel (indirect labour)
• Quasi-fixed

The size of necessary administrative personnel (and of other indirect labour) doesn’t change so much if production incrementally changes. Discrete jump will happen when the overall scale of production drastically changes.

• Plant rent
• Fixed
• The typical contract of rent makes no reference to effective production levels
• Amortization of capital goods
• Fixed
• Fiscal and accountancy rules
• Policy costs (advertising, R&D,…)
• Fixed or quasi-fixed
• Discretionary costs

The above-mentioned table is just a rough and conditional description. It is only meant for easy introduction to the problem – often implicitly assuming many specific hypotheses.

References

1. Piana, Valentino (2003) Cost.  Economics Web Institute.  Viewed on: June 9, 2006.  Available at: http://www.economicswebinstitute.org/glossary/costs.htm#cost
2. Ross, S.A., Westerfield, R.W., & Jordan, B.D (1995) Fundamentals of Corporate Accounting (3rd ed.). The Irwin Series in Finance. Chicago; Bogota; Boston; Buenos Aires; Caracas; London; Madrid; Mexico City; Sydney; Toronto.

ASSIGNMENT P 6-16 , P6-17 PROBLEM 6-16 Variable and Absorption Costing Unit Product Costs and Income Statements; Explanation of Difference in Net Operating Income [LO1, LO2, LO3] Wiengot Antennas, Inc. , produces and sells a unique type of TV antenna. The company has just opened a new plant to manufacture the antenna, and the following cost and revenue data have been provided for the first month of the plant’s operation in the form of a worksheet. Because the new antenna is unique in design, management is anxious to see how profitable it will be and has asked that an income statement be prepared for the month.

Required: 1. Assume that the company uses absorption costing. a. Determine the unit product cost. b. Prepare an income statement for the month. 2. Assume that the company uses variable costing. a. Determine the unit product cost. b. Prepare a contribution format income statement for the month. 3. Explain the reason for any difference in the ending inventory balances under the two costing methods and the impact of this difference on reported net operating income. PROBLEM 6-17 Variable and Absorption Costing Unit Product Costs and Income Statements [LO1, LO2] Nickelson Company manufactures and sells one product.

The following information pertains to each of the company’s first three years of operations: p. 262 During its first year of operations Nickelson produced 60,000 units and sold 60,000 units. During its second year of operations it produced 75,000 units and sold 50,000 units. In its third year, Nickelson produced 40,000 units and sold 65,000 units. The selling price of the company’s product is $56 per unit. Required: 1. Compute the company’s break-even point in units sold. 2. Assume the company uses variable costing: a.

Compute the unit product cost for year 1, year 2, and year 3. b. Prepare an income statement for year 1, year 2, and year 3. 3. Assume the company uses absorption costing: a. Compute the unit product cost for year 1, year 2, and year 3. b. Prepare an income statement for year 1, year 2, and year 3. 4. Compare the net operating income figures that you computed in requirements 2 and 3 to the break-even point that you computed in requirement 1. Which net operating income figures seem counterintuitive? Why? LEARNING OBJECTIVES FOR ASSIGNMENT.

LO1, LO2, LO3 OVERVIEW OF VARIABLE AND ABSOPTION COSTING As you begin to read about variable LEARNING OBJECTIVE 1 and absorption costing income Explain how variable costing differs from statements in the coming pages, absorption costing and compute unit focus your attention on three key product costs under each method. concepts. First, both income statement formats include product costs and period costs, although they define these cost classifications differently. Second, variable costing income statements are grounded in the contribution format.

They categorize expenses based on cost behavior—variable costs are reported separately from fixed costs. Absorption costing income statements ignore variable and fixed cost distinctions. Third, as mentioned in the paragraph above, variable and absorption costing net operating income figures often differ from one another. The reason for these differences always relates to the fact the variable costing and absorption costing income statements account for fixed manufacturing overhead differently.

Pay very close attention to the two different ways that variable costing and absorption costing account for fixed manufacturing overhead. Variable Costing Under variable costing, only those manufacturing costs that vary with output are treated as product costs. This would usually include direct materials, direct labor, and the variable portion of manufacturing overhead. Fixed manufacturing overhead is not treated as a product cost under this method. Rather, fixed manufacturing overhead is treated as a period cost and, like selling and administrative expenses, it is expensed in its entirety each period.

Consequently, the cost of a unit of product in inventory or in cost of goods sold under the variable costing method does not contain any fixed manufacturing overhead cost. Variable costing is sometimes referred to as direct costing or marginal costing. Absorption Costing As discussed in Chapter 3, absorption costing treats all manufacturing costs as product costs, regardless of whether they are variable or fixed. The cost of a unit of product under the absorption costing method consists of direct materials, direct labor, nd both variable and fixed manufacturing overhead.

Thus, absorption costing allocates a portion of fixed manufacturing overhead cost to each unit of product, along with the variable manufacturing costs. Because absorption costing includes all manufacturing costs in product costs, it is frequently referred to as the full cost method. p. 231 EXHIBIT 6–1 Variable Costing versus Absorption Costing Selling and Administrative Expenses Selling and administrative expenses are never treated as product costs, regardless of the costing method.

Thus, under absorption and variable costing, variable and fixed selling and administrative expenses are always treated as period costs and are expensed as incurred. Summary of Differences The essential difference between variable costing and absorption costing, as illustrated in Exhibit 6-1, is how each method accounts for fixed manufacturing overhead costs—all other costs are treated the same under the two methods. In absorption costing, fixed manufacturing overhead costs are included as part of the costs of work in process inventories.

When units are completed, these costs are transferred to finished goods and only when the units are sold do these costs flow through to the income statement as part of cost of goods sold. In variable costing, fixed manufacturing overhead costs are considered to be period costs—just like selling and administrative costs—and are taken immediately to the income statement as period expenses. Variable And Absorption Costing—An Example To illustrate the difference between variable costing and absorption costing, consider Weber Light Aircraft, a company that produces light recreational aircraft.

Data concerning the company’s operations appear below: As you review the data above, it is important to realize that for the months of January, February, and March, the selling price per aircraft, variable cost per aircraft, and total monthly fixed expenses never change. The only variables that change in this example are the number of units produced (January =1 unit produced; February = 2 units produced; March = 4 units produced) and the number of units sold (January = 1 unit sold; February = 1 unit sold; March = 5 units sold).

We will first construct the company’s variable costing income statements for January, February, and March. Then we will show how the company’s net operating income would be determined for the same months using absorption costing. Variable Costing Contribution Format Income Statement To prepare the company’s variable costing income statements for January, February, and March we begin by computing the unit product cost. Under variable costing, product costs consist solely of variable production costs.

At Weber Light Aircraft, the variable production cost per unit is $25,000, determined as follows: LEARNING OBJECTIVE 2 Prepare income statements using both variable and absorption costing. Since each month’s variable production cost is $25,000 per aircraft, the variable costing cost of goods sold for all three months can be easily computed as follows: p. 233 And the company’s total selling and administrative expense would be derived as follows: Putting it all together, the variable costing income statements would appear as shown inExhibit 6-2.

Notice, the contribution format has been used in these income statements. Also, the monthly fixed manufacturing overhead costs ($70,000)have been recorded as a period expense in the month incurred. EXHIBIT 6–2 Variable Costing Income Statements A simple method for understanding how Weber Light Aircraft computed its variable costing net operating income figures is to focus on the contribution margin per aircraft sold, which is computed as follows:

The variable costing net operating income for each period can always be computed by multiplying the number of units sold by the contribution margin per unit and then subtracting total fixed costs. For Weber Light Aircraft these computations would appear as follows: Notice, January and February have the same net operating loss. This occurs because one aircraft was sold in each month and, as previously mentioned, the selling price per aircraft, variable cost per aircraft, and total monthly fixed expenses remain constant. . 234 Absorption Costing Income Statement As we begin the absorption costing portion of the example, remember that the only reason absorption costing income differs from variable costing is that the methods account for fixed manufacturing overhead differently. Under absorption costing, fixed manufacturing overhead is included in product costs. In variable costing, fixed manufacturing overhead is not included in product costs and instead is treated as a period expense just like selling and administrative expenses.

The first step in preparing Weber’s absorption costing income statements for January, February, and March, is to determine the company’s unit product costs for each month as follows1: Notice that in each month, Weber’s fixed manufacturing overhead cost of $70,000 is divided by the number of units produced to determine the fixed manufacturing overhead cost per unit. Given these unit product costs, the company’s absorption costing net operating income in each month would be determined as shown in Exhibit 6-3.

The sales for all three months in Exhibit 6-3 are the same as the sales shown in the variable osting income statements. The January cost of goods sold consists of one unit produced during January at a cost of $95,000 according to the absorption costing system. The February cost of goods sold consists of one unit produced during February at a cost of $60,000 according to the absorption costing system. The March cost of goods sold ($230,000) consists of one unit produced during February at an absorption cost of $60,000 plus four units produced in March with a total absorption cost of $170,000 (= 4 units produced × $42,500 per unit).

The selling and administrative expenses equal the amounts reported in the variable costing income statements; however they are reported as one amount rather than being separated into variable and fixed components. EXHIBIT 6–3 Absorption Costing Income Statements p. 235 Note that even though sales were exactly the same in January and February and the cost structure did not change, net operating income was $35,000 higher in February than in January under absorption costing. This occurs because one aircraft produced in February is not sold until March.

This aircraft has $35,000 of fixed manufacturing overhead attached to it that was incurred in February, but will not be recorded as part of cost of goods sold until March. Contrasting the variable costing and absorption costing income statements in Exhibits 62and 6-3, note that net operating income is the same in January under variable costing and absorption costing, but differs in the other two months. We will discuss this in some depth shortly. Also note that the format of the variable costing income statement differs from the absorption costing income statement.

An absorption costing income statement categorizes costs by function—manufacturing versus selling and administrative. All of the manufacturing costs flow through the absorption costing cost of goods sold and all of the selling and administrative costs are listed separately as period expenses. In contrast, in the contribution approach, costs are categorized according to how they behave. All of the variable expenses are listed together and all of the fixed expenses are listed together.

The variable expenses category includes manufacturing costs (i. e. , variable cost of goods sold) as well as selling and administrative expenses. The fixed expenses category also includes both manufacturing costs and selling and administrative expenses. Reconciliation of Variable Costing with Absorption Costing Income As noted earlier, variable costing and absorption costing net operating incomes may not be the same. In the case of Weber Light Aircraft, the net operating incomes are the same in January, but differ in the other two months.

These differences occur because under absorption costing some fixed manufacturing overhead is capitalized in inventories (i. e. , included in product costs) rather than currently expensed on the income statement. If inventories increase during a period, under absorption costing some of the fixed manufacturing overhead of the current period will bedeferred in ending inventories. For example, in February two aircraft were produced and each carried with it $35,000 (= $70,000 ÷ 2 aircraft produced) in fixed manufacturing overhead.

Since only one aircraft was sold, $35,000 of this fixed manufacturing overhead was on February’s absorption costing income statement as part of cost of goods sold, but $35,000 would have been on the balance sheet as part of finished goods inventories. In contrast, under variable costing all of the $70,000 of fixed manufacturing overhead appeared on the February income statement as a period expense. Consequently, net operating income was higher under absorption costing than under variable costing by $35,000 in February. This was reversed in March when four units were produced, but five were sold.

In March, under absorption costing $105,000 of fixed manufacturing overhead was included in cost of goods sold ($35,000 for the unit produced in February and sold in March plus $17,500 for each of the four units produced and sold in March), but only $70,000 was recognized as a period expense under variable costing. Hence, the net operating income in March was $35,000 lower under absorption costing than under variable costing.

LEARNING OBJECTIVE 3 Reconcile variable costing and absorption costing net operating incomes and explain why the two amounts differ. p. 36 In general, when the units produced exceed unit sales and hence inventories increase, net operating income is higher under absorption costing than under variable costing. This occurs because some of the fixed manufacturing overhead of the period is deferred in inventories under absorption costing. In contrast, when unit sales exceed the units produced and hence inventories decrease, net operating income is lower under absorption costing than under variable costing. This occurs because some of the fixed manufacturing overhead of previous periods is released from inventories under absorption costing.

When the units produced and unit sales are equal, no change in inventories occurs and absorption costing and variable costing net operating incomes are the same. 2 Variable costing and absorption costing net operating incomes can be reconciled by determining how much fixed manufacturing overhead was deferred in, or released from, inventories during the period: The reconciliation would then be reported as shown in Exhibit 6-4: EXHIBIT 6–4 Reconciliation of Variable Costing and Absorption Costing Net Operating Incomes

Again note that the difference between variable costing net operating income and absorption costing net operating income is entirely due to the amount of fixed manufacturing overhead that is deferred in, or released from, inventories during the period under absorption costing. Changes in inventories affect absorption costing net operating income—they do not affect variable costing net operating income, providing that variable manufacturing costs per unit are stable. p. 237 EXHIBIT 6–5 Comparative Income Effects—Absorption and Variable Costing

The reasons for differences between variable and absorption costing net operating incomes are summarized in Exhibit 6-5. When the units produced equal the units sold, as in January for Weber Light Aircraft, absorption costing net operating income will equal variable costing net operating income. This occurs because when production equals sales, all of the fixed manufacturing overhead incurred in the current period flows through to the income statement under both methods.

For companies that use Lean Production, the number of units produced tends to equal the number of units sold. This occurs because goods are produced in response to customer orders, thereby eliminating finished goods inventories and reducing work in process inventory to almost nothing. So, when a company uses Lean Production differences in variable costing and absorption costing net operating income will largely disappear. When the units produced exceed the units sold, absorption costing net operating income will exceed variable costing net operating income.

This occurs because inventories have increased; therefore, under absorption costing some of the fixed manufacturing overhead incurred in the current period is deferred in ending inventories on the balance sheet, whereas under variable costing all of the fixed manufacturing overhead incurred in the current period flows through to the income statement. In contrast, when the units produced are less than the units sold, absorption costing net operating income will be less than variable costing net operating income.

This occurs because inventories have decreased; therefore, under absorption costing fixed manufacturing overhead that had been deferred in inventories during a prior period flows through to the current period’s income statement together with all of the fixed manufacturing overhead incurred during the current period. Under variable costing, just the fixed manufacturing overhead of the current period flows through to the income statement. Advantages Of Variable Costing And The Contribution Approach Variable costing, together with the contribution approach, offers appealing advantages for internal reports.

This section discusses four of those advantages. Enabling CVP Analysis CVP analysis requires that we break costs down into their fixed and variable components. Because variable costing income statements categorize costs as fixed and variable, it is much easier to use this income statement format to perform CVP analysis than attempting to use the absorption costing format, which mixes together fixed and variable costs. Moreover, absorption costing net operating income may or may not agree with the results of CVP analysis.

For example, let’s suppose that you are interested in computing the sales that would be necessary to generate a target profit of $235,000 at Weber Light Aircraft. A CVP analysis based on the January variable costing income statement from Exhibit 6-2would proceed as follows: Thus, a CVP analysis based on the January variable costing income statement predicts that the net operating income would be $235,000 when sales are $500,000. And indeed, the net operating income under variable costing is $235,000 when the sales are $500,000 in March.

However, the net operating income under absorption costing is not $235,000 in March, even though the sales are $500,000. Why is this? The reason is that under absorption costing, net operating income can be distorted by changes in inventories. In March, inventories decreased, so some of the fixed manufacturing overhead that had been deferred in February’s ending inventories was released to the March income statement, resulting in a net operating income that is $35,000 lower than the $235,000 predicted by CVP analysis.

If inventories had increased in March, the opposite would have occurred—the absorption costing net operating income would have been higher than the $235,000 predicted by CVP analysis. p. 239 Explaining Changes in Net Operating Income The variable costing income statements in Exhibit 6-2 are clear and easy to understand. All other things the same, when sales go up, net operating income goes up. When sales go down, net operating income goes down. When sales are constant, net operating income is constant. The number of unit produced does not affect net operating income.

Absorption costing income statements can be confusing and are easily misinterpreted. Look again at the absorption costing income statements in Exhibit 6-3; a manager might wonder why net operating income went up from January to February even though sales were exactly the same. Was it a result of lower selling costs, more efficient operations, or was it some other factor? In fact, it was simply because the number of units produced exceeded the number of units sold in February and so some of the fixed manufacturing overhead costs were deferred in inventories in that month.

These costs have not gone away—they will eventually flow through to the income statement in a later period when inventories go down. There is no way to tell this from the absorption costing income statements. To avoid mistakes when absorption costing is used, readers of financial statements should be alert to changes in inventory levels. Under absorption costing, if inventories increase, fixed manufacturing overhead costs are deferred in inventories, which in turn increases net operating income. If inventories decrease, fixed manufacturing overhead costs are released from inventories, which in turn decreases net perating income.

Thus, when absorption costing is used, fluctuations in net operating income can be due to changes in inventories rather than to changes in sales. Supporting Decision Making The variable costing method correctly identifies the additional variable costs that will be incurred to make one more unit. It also emphasizes the impact of fixed costs on profits. The total amount of fixed manufacturing costs appears explicitly on the income statement, highlighting that the whole amount of fixed manufacturing costs must be covered for the company to be truly profitable.

In the Weber Light Aircraft example, the variable costing income statements correctly report that the cost of producing another unit is $25,000 and they explicitly recognize that $70,000 of fixed manufactured overhead must be covered to earn a profit. Under absorption costing, fixed manufacturing overhead costs appear to be variable with respect to the number of units sold, but they are not. For example, in January, the absorption unit product cost at Weber Light Aircraft is $95,000, but the variable portion of this cost is only $25,000.

The fixed overhead costs of $70,000 are commingled with variable production costs, thereby obscuring the impact of fixed overhead costs on profits. Because absorption unit product costs are stated on a per unit basis, managers may mistakenly believe that if another unit is produced, it will cost the company $95,000. But of course it would not. The cost of producing another unit would be only $25,000. Misinterpreting absorption unit product costs as variable can lead to many problems, including inappropriate pricing decisions and decisions to drop products that are in fact profitable. p. 240 Adapting to the Theory of Constraints

The Theory of Constraints (TOC), which was introduced in Chapter 1, suggests that the key to improving a company’s profits is managing its constraints. For reasons that will be discussed in a later chapter, this requires careful identification of each product’s variable costs. Consequently, companies involved in TOC use a form of variable costing. Variable costing income statements require one adjustment to support the TOC approach. Direct labor costs need to be removed from variable production costs and reported as part of the fixed manufacturing costs that are entirely expensed in the period incurred.

The TOC treats direct labor costs as a fixed cost for three reasons. First, even though direct labor workers may be paid on an hourly basis, many companies have a commitment—sometimes enforced by labor contracts or by law—to guarantee workers a minimum number of paid hours. Second, direct labor is not usually the constraint;therefore, there is no reason to increase it. Hiring more direct labor workers would increase costs without increasing the output of saleable products and services. Third, TOC emphasizes continuous improvement to maintain competitiveness.

Without committed and enthusiastic employees, sustained continuous improvement is virtually impossible. Because layoffs often have devastating effects on employee morale, managers involved in TOC are extremely reluctant to lay off employees. For these reasons, most managers in TOC companies regard direct labor as a committed-fixed cost rather than a variable cost. Hence, in the modified form of variable costing used in TOC companies, direct labor is not usually classified as a product cost.

Is the company correct in its decision of not manufacturing standard model compressors on Sundays? Why? Show your calculations. Decision making should be based on change of RELEVANT items ONLY. The company’s calculation is WRONG, as it takes into concern of irrelevant fixed cost. By double-counting depreciation, other Mfg. overheads, SG&A in Sunday’s cost; it distorts the P&L sheet. To correctly show cost structure for decision making, there are two different approaches, yet each should reach same conclusion. Approach 1: Differential Cost Approach

As suggested in case, by producing 4 unites on Sunday, total depreciation, total Mfg. overhead and SG&A will not change. Thus, we should only look into accounts that will change out of producing activities on Sunday. Table below shows the result of Contribution Margin computation. As illustrated in the table, producing on Sunday will bring $ 2,600 contribution margin per unit and thus company should manufacture. Approach 2: Comprehensive Income Approach. Based on P&L sheet we can calculate total fixed cost for one week manufacturing Depreciation=$ 497? 4= $11,928 Mfg. Then we construct weekly income statement of two scenarios As suggested in table, by producing in Sunday, company can realize $ 10,400 profit every week, same as by using Differential Cost Approach. Total Increasing Profit=Contribution Margin? unit=$ 2,600? 4=$ 10,400 Suppose Marge McPhee decides to manufacture 10 light weight compressors each week during weekdays for 8 weeks only and sell them at a price of $8,000.

Compared to only producing standard compressors, do you support this decision? Why? Show your calculations to support your argument. We use differential cost approach to make decision. Since factory is producing at full-capacity and company cannot force the 3rd shift, nor recruit more labor, the direct labor hour is the constrain factor. Light compressor requires 62. 5 DLH and standard compressor requires 100 DLH, in other words, produce 1 light compressor can produce 62. 5/100=0. 25 standard compressor and 10 light compressors => 6. 25 standard compressors. Based on information, we can construct the comparison table between two scenarios. As illustrated by table, producing 10 light compressors instead of 6. 25 standard compressors for ONLT 8 weeks will generate $ 182,000 more contribution margin. However, to realize this amount of margin Catawba need to invest $ 218,000 on additional jigs, sensors and soft wares. Thus, company should NOT produce light compressor.