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Financial and Managerial
Accounting
John J. Wild
Third Edition
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 19
Variable Costing and
Performance Reporting
Conceptual Learning
Objectives
C1: Distinguish between absorption
costing and variable costing.
C2: Describe how absorption costing
can result in over-production.
C3: Explain the role of variable costing in
pricing special orders.
19-3
Analytical Learning Objectives
A1: Analyze income reporting for both
absorption and variable costing.
A2: Compute and interpret breakeven
volume in units.
19-4
Procedural Learning
Objectives
P1: Compute unit cost under both
absorption and variable costing.
P2: Prepare an income statement using
absorption costing and using variable
costing.
P3: Prepare a contribution margin report.
P4: Convert income under variable
costing to the absorption cost basis.
19-5
C1
Absorption Costing & Variable
Costing
Absorption costing (also called full
costing), assumes that products
absorb all costs incurred to
produce them.

While widely used for financial reporting (GAAP), this
costing method can result in misleading product cost
information for business decisions.
19-6
C1
Absorption Costing & Variable
Costing
Under variable costing, only
costs that change in total with
changes in production level
are included in product costs.
19-7
C1
Distinguishing Between Absorption
Costing and Variable Costing: Absorption
Costing
Absorption Costing
Direct
Materials
Direct
Labor
Variable
Overhead
Fixed
Overhead
Product Cost
19-8
C1
Distinguishing Between Absorption
Costing and Variable Costing:
Variable Costing
Variable Costing
Direct
Materials
Direct
Labor
Product Cost
Variable
Overhead
Fixed
Overhead
Period Cost
19-9
P1
Difference Between Absorption Costing and Variable
Costing: Computing Unit Cost
Exhibit 19.1 Summary Cost Data
Direct materials cost………………………………………….
$4 per unit
Direct labor cost………………………………………….
$8 per unit
Overhead cost
Variable overhead cost……………………………………..
$180,000
Fixed overhead cost…………………………………………..
600,000
Total overhead cost…………………………………………..
$780,000
Expected units produced…………………………………..
60,000 units
19-10
P1
Difference Between Absorption Costing and Variable
Costing: Computing Unit Cost
Exhibit 19.2 Unit Cost Computation
Absorption Variable
Costing Costing
Direct labor cost per unit……………...
$8
$8
Direct materials cost per unit………….
4
4
Overhead cost
Variable overhead cost per unit…..
3
3
Fixed overhead cost per unit……...
10
Total product cost per unit…………….
$25
$15
19-11
A1
Analysis of Income Reporting for Both
Absorption and Variable Costing
Exhibit 19.3 Summary Cost Information for 2007-2009
Production Costs
Direct materials cost
Direct labor cost
Variable overhead cost
Non-Production Costs
$4 per unit Variable selling and administrative expenses
$2 per unit
$8 per unit Fixed selling and administrative expenses $200,000 per year
$3 per unit
Units Produced Units Sold Units in Ending Inventory
2007
2008
2009
60,000
60,000
60,000
60,000
40,000
80,000
0
20,000
0
19-12
A1
P2
Analysis of Income Reporting for Absorption
Costing: Units Produced Equal Units Sold
Exhibit 19.4 Income for 2007-----Quantity Produced Equals Quantity Sold
IceAge Company
Income Statement (Absorption Costing)
For Year Ended December 31, 2007
Sales (60,000 x $40)…………………………………………………………..
Cost of goods sold (60,000 x $25*)……………………………………………
Gross margin……………………………………………………………………
Selling and administrative expenses [$200,000 + (60,000 x $2)]…………
Net income………………………………………………………………………..
$2,400,000
1,500,000
900,000
320,000
$580,000
Notice that the net income is $580,000
*Units produced equal 60,000; units sold equal 60,000.
† See Exhibit 19.2 for unit cost computation under absorption and variable costing.
19-13
A1
P2
Analysis of Income Reporting for Variable
Costing: Units Produced Equal Units Sold
Exhibit 19.4 Income for 2007-----Quantity Produced Equals Quantity Sold
IceAge Company
Income Statement (Variable Costing)
For Year Ended December 31, 2007
Sales (60,000 x $40)
Variable expenses
Variable production costs
(60,000 x $15*)
$900,000
Variable selling and administrative
expenses (60,000 x $2)
120,000
Contribution margin
Fixed expenses
Fixed overhead
600,000
Fixed selling and
administrative expense
$200,000
Net income
$2,400,000
1,020,000
1,380,000
$800,000
$580,000
19-14
A1
P2
Analysis of Income Reporting for Variable
Costing: Units Produced Equal Units Sold
Exhibit 19.4 Income for 2007-----Quantity Produced Equals Quantity Sold
IceAge Company
Income Statement (Variable Costing)
For Year Ended December 31, 2007
Sales (60,000 x $40)
Variable expenses
Variable production costs
(60,000 x $15*)
$900,000
Variable selling and administrative
expenses (60,000 x $2)
120,000
Contribution margin
Fixed expenses
Fixed overhead
600,000
Fixed selling and
administrative expense
$200,000
Net income
We can see that the income under
variable costing is also $580,000. This
is because the number of units
produced are equal to the number of
units sold.
$2,400,000
1,020,000
1,380,000
$800,000
$580,000
19-15
A1
Analysis of Income Reporting for Both
Absorption and Variable Costing: Units
Produced Equal Units Sold
Exhibit 19.4A Production Cost Assignment for 2007
Cost of Goods Sold
Ending Inventory
(Expense)
(Asset)
Absorption Costing
Direct materials
60,000 x $4
$ 240,000 0 x $4
$ 0
Direct labor
60,000 x $8
480,000 0 x $8
0
Variable overhead
60,000 x $3
180,000 0 x $3
0
Fixed overhead
60,000 x $10
600,000 0 x $10
0
Total costs
$1,500,000
$0
Variable Costing
Direct materials
Direct labor
Variable overhead
Fixed overhead
Total costs
Cost difference
60,000 x $4
60,000 x $8
60,000 x $3
$ 240,000
240,000
180,000
$900,000
0 x $4
0 x $8
0 x $3
Period Cost
(Expense)
$240,000
480,000
180,000
600,000
$1,500,000
$ 0
0
0
$0
2,007
Expense
$600,000
$600,000
240,000
480,000
180,000
600,000
$1,500,000
0
19-16
A1
P2
Analysis of Income Reporting for Absorption
Costing: Units Produced Exceed Units Sold
Exhibit 19.5 Income for 2008----Quantity Produced Exceeds Quantity Sold†
IceAge Company
Income Statement (Absorption Costing)
For Year Ended December 31, 2008
Sales (40,000 x $40)
Cost of goods sold (40,000x$25*)
Gross margin
Selling and administrative expenses [$200,000 + (40,000 x $2)]
Net income
$1,600,000
1,000,000
600,000
280,000
$320,000
*Units produced equal 60,000; units sold equal 40,000.
† See Exhibit 19.2 for unit cost computation under absorption and variable costing.
19-17
A1
P2
Analysis of Income Reporting for Absorption
Costing: Units Produced Exceed Units Sold
Exhibit 19.5 Income for 2008----Quantity Produced Exceeds Quantity Sold†
IceAge Company
Income Statement (Absorption Costing)
For Year Ended December 31, 2008
Sales (40,000 x $40)
Cost of goods sold (40,000x$25*)
Gross margin
Selling and administrative expenses [$200,000 + (40,000 x $2)]
Net income
$1,600,000
1,000,000
600,000
280,000
$320,000
Income for 2008 is $320,000
*Units produced equal 60,000; units sold equal 40,000.
† See Exhibit 19.2 for unit cost computation under absorption and variable costing.
19-18
A1
P2
Analysis of Income Reporting for Variable
Costing: Units Produced Exceed Units Sold
Exhibit 19.5 Income for 2008----Quantity Produced Exceeds Quantity Sold†
IceAge Company
Income Statement (Variable Costing)
For Year Ended December 31, 2008
Sales (40,000 x $40)
Variable expenses
Variable production costs
(40,000 x $15*)
$600,000
Variable selling and administrative
expenses (40,000 x $2)
80,000
Contribution margin
Fixed expenses
Fixed overhead
600,000
Fixed selling and
administrative expense
200,000
Net income
$1,600,000
680,000
920,000
800,000
$120,000
19-19
A1
P2
Analysis of Income Reporting for Variable
Costing: Units Produced Exceed Units Sold
Exhibit 19.5 Income for 2008----Quantity Produced Exceeds Quantity Sold†
IceAge Company
Income Statement (Variable Costing)
For Year Ended December 31, 2008
Sales (40,000 x $40)
$1,600,000
Variable expenses
Variable production costs
(40,000 x $15*)
$600,000
Under variable costing, the
Variable selling and administrative
expenses (40,000 x $2) net 80,000
680,000
income is only $120,000
Contribution margin
920,000
Fixed expenses
Fixed overhead
600,000
Fixed selling and
administrative expense
200,000
800,000
Net income
$120,000
19-20
A1
P2
Analysis of Income Reporting for Variable
Costing: Units Produced Exceed Units Sold
Exhibit 19.5 Income for 2008 ---Quantity Produced Exceeds Quantity Sold†
IceAge Company
Income Statement (Variable Costing)
For Year Ended December 31, 2008
Sales (40,000 x $40)
Variable expenses
Variable production costs
(40,000 x $15*)
$600,000
Variable selling and administrative
expenses (40,000 x $2)
80,000
Contribution margin
Fixed expenses
Fixed overhead
600,000
Fixed selling and
administrative expense
200,000
Net income
$1,600,000
Under absorption
costing,$200,000 of fixed
overhead is allocated to the
20,000 units in ending inventory
and is not expensed until680,000
future
periods. Variable costing920,000
expenses the entire $600,000 of
fixed overhead.
800,000
$120,000
19-21
A1
Analysis of Income Reporting for Both
Absorption and Variable Costing: Units
Produced Exceed Units Sold
Exhibit 19.5A Production Cost Assignment for 2008
Cost of Goods Sold
(Expense)
Absorption Costing
Direct materials
Direct labor
Variable overhead
Fixed overhead
Total costs
Ending Inventory
(Asset)
Period Cost
(Expense)
2008
Expense
40,000 x $4
40,000 x $8
40,000 x $3
40,000 x $10
$ 160,000
320,000
120,000
400,000
$1,000,000
20,000 x $4 $ 80,000
20,000 x $8
160,000
20,000 x $3
60,000
20,000 x $10
200,000
$500,000
$160,000
320,000
120,000
400,000
$1,000,000
40,000 x $4
40,000 x $8
40,000 x $3
$ 160,000
320,000
120,000
________
20,000 x $4 $ 80,000
20,000 x $8
160,000
20,000 x $3
60,000
_______
$600,000
$160,000
320,000
120,000
600,000
$600,000
$300,000
$600,000
$1,200,000
Variable Costing
Direct materials
Direct labor
Variable overhead
Fixed overhead
Total costs
Cost difference
($200,000)
19-22
A1
P2
Analysis of Income Reporting for Absorption
Costing: Units Produced Are Less Than
Units Sold
†
Exhibit 19.6 Income for 2009—Quantity Produced is Less Than Quantity Sold
IceAge Company
Income Statement (Absorption Costing)
For Year Ended December 31, 2009
Sales (80,000 x $40)
Cost of goods sold (80,000x$25*)
Gross margin
Selling and administrative expenses [$200,000 + (80,000 x $2)]
Net income
$3,200,000
2,000,000
1,200,000
360,000
$840,000
Income is now $840,000
*Units produced equal 60,000; units sold equal 80,000.
†
See Exhibit 19.2 for unit cost computation under absorption and variable
19-23
A1
P2
Analysis of Income Reporting for Variable
Costing: Units Produced Are Less Than
Units Sold
Exhibit 19.6 Continued
IceAge Company
Income Statement (Variable Costing)
For Year Ended December 31, 2009
Sales (80,000 x $40)
Variable expenses
Variable production costs (80,000 x $15*)
$1,200,000
Variable selling and administrative expenses ($80,000 x $2)
160,000
Contribution margin
Fixed expenses
Income under variable
Fixed overhead
600,000
costing is $1,040,000
Fixed selling and
administrative expense 200,000
Net income
$3,200,000
1,360,000
1,840,000
800,000
$1,040,000
19-24
A1
Analysis of Income Reporting for Both
Absorption and Variable Costing: Units
Produced Are Less Than Units Sold
Exhibit 19.6A Production Cost Assignment for 2009
Cost of Good Sold
Ending Inventory
(Expense)
(Asset)
Absorption Costing
Direct materials
Direct labor
Variable overhead
Fixed overhead
Total costs
80,000 x $4
80,000 x $8
80,000 x $3
80,000 x $10
Period Cost
(Expense)
2009
Expense
$ 320,000
640,000
240,000
800,000
$2,000,000
0 x $4
0 x $8
0 x $3
0 x $10
$ 0
0
0
0
$0
$320,000
640,000
240,000
800,000
$2,000,000
$ 320,000
640,000
240,000
________
0 x $4
0 x $8
0 x $3
$ 0
0
0
Variable Costing
Direct materials
Direct labor
Variable overhead
Fixed overhead
Total costs
Cost difference
80,000 x $4
80,000 x $8
80,000 x $3
$1,200,000
___
$600,000
$320,000
640,000
240,000
600,000
$0
$600,000
$1,800,000
$200,000
19-25
A1
Income Reporting Summarized
Exhibit 19.7 Summary of Income Statements
Units Produced
Income for
Income for
and Sold
Absorption Costing Variable Costing Difference
2007 Units produced: 60,000
Units sold: 60,000
$580,000
$580,000
$0
2008 Units produced: 60,000
Units sold: 40,000
320,000
120,000
200,000
2009 Units produced: 60,000
Units sold: 80,000
840,000
1,040,000 -200,000
Totals Units produced: 180,000
Units sold: 180,000
$1,740,000
$1,740,000
$0
19-26
C2
Planning Production
Producing too
much inventory
Producing too
little inventory
Excess
inventory
Lost sales
Higher storage
and financing
costs
Customer
dissatisfaction
Greater risk of
obsolescence
19-27
C2
Planning Production
Exhibit 19.8 Unit Cost Under Absorption Costing
When 60,000 Units are Produced
Direct materials cost
$4 per unit
Direct labor cost
8 per unit
Variable overhead
3 per unit
Total variable cost
15 per unit
Fixed overhead ($600,000/60,000 units)
10 per unit
Total production cost
$25 per unit
When 100,000 Units are Produced
Direct materials
$4 per unit
Direct labor
8 per unit
Variable overhead
3 per unit
Total variable cost
15 per unit
Fixed overhead ($600,000/100,000 units) 6 per unit
Total production cost
$21 per unit
19-28
C2
Planning Production: Income Under Absorption
Costing for Different Production Levels
Exhibit 19.9
IceAge Company
Income Statement (Absorption Costing)
For Year Ended December 31, 2007
[60,000 Units Produced; 60,000 Units Sold]
Sales (60,000 x $40)
Cost of goods sold (60,000 x $25*)
Gross margin
Selling and administrative expenses
Variable (60,000 x $2) $120,000
Fixed
200,000
Net income
$2,400,000
1,500,000
900,000
320,000
$580,000
IceAge Company
Income Statement (Absorption Costing)
For Year Ended December 31, 2007
[100,000 Units Produced; 60,000 Units Sold]
Sales (60,000 x $40)
Cost of goods sold (60,000 x $21**)
Gross margin
Selling and administrative expenses
Variable (60,000 x $2) $120,000
Fixed
200,000
Net income
$2,400,000
1,260,000
1,140,000
320,000
$820,000
19-29
C2
Planning Production: Income Under Absorption
Costing for Different Production Levels
Exhibit 19.10
For Year Ended December 31, 2007
[60,000 Units Produced; 60,000 Units Sold]
Sales (60,000 x $40)
Variable expenses
Variable production costs
(60,000 x $15)
$900,000
Variable selling and administrative
expenses (60,000 x $2)
120,000
Contribution margin
Fixed expenses
Fixed overhead
600,000
Fixed selling and
administrative expense
200,000
Net income
$2,400,000
1,020,000
1,380,000
800,000
$580,000
For Year Ended December 31, 2007
[100,000 Units Produced; 60,000 Units Sold]
Sales (60,000 x $40)
Variable expenses
Variable production costs
(60,000 x $15)
$900,000
Variable selling and administrative
expenses (60,000 x $2)
120,000
Contribution margin
Fixed expenses
Fixed overhead
600,000
Fixed selling and
administrative expense
200,000
Net income
$2,400,000
1,020,000
1,380,000
800,000
$580,000
19-30
C2
Planning Production: Income Under Absorption
Costing for Different Production Levels
Why is income under
absorption costing
affected by the
production level
when that for
variable costing is
not?
The answer lies in the different
treatment of fixed overhead
costs for the two method.
19-31
C3
Setting Prices
Over the Long Run:
 Price must be high enough to cover all
costs, including variable costs and
fixed costs, and still provide an
acceptable return to owners
19-32
C3
Setting Prices
Over the Short Run:
 Fixed production costs such as the cost to maintain
plant capacity do not change with changes in
production levels.
 With excess capacity, increases in production level
would increase variable production costs, but not
fixed costs.
 While managers try to maintain the long-run price
on existing orders, which covers all production
costs, managers should accept special orders
provided the special order price exceeds variable
cost.
19-33
C3
Setting Prices
Exhibit 19.11 Computing Incremental Income for a Special Order
Rejecting Special Order
Accepting Special Order
Incremental sales
$ 0 Incremental sales (1,000 x $22)
Incremental costs
0 Incremental costs
Variable production cost (1,000 x $15)
____ Variable selling expense (1,000 x $2)
Incremental income
$ 0 Incremental income
$22,000
15,000
2,000
$ 5,000
19-34
P3
Contribution Margin Report
Precision Tech
Contribution Margin Report
For the year ended December 31, 2009
Sales
$ 18,000
Variable Expenses
Variable production costs $ 3,600
Variable selling expenses
6,800 10,400
Contribution margin
$ 7,600
Contribution margin contributes to
covering fixed costs and earning
income
Contribution
margin is the
excess of
sales over
total variable
expenses
19-35
P3
Contribution Margin Report
Precision Tech
Contribution Margin Report
For the year ended December 31, 2007
Sales
Variable Expenses
Variable production costs $
Variable selling expenses
Contribution margin
%
of sales
$ 18,000 100.0%
3,600
6,800
10,400
$ 7,600
57.8%
42.2%
The
Contribution
Margin Ratio
is contribution
margin
divided by
sales
19-36
P3
Limitations of Reports Using Variable Costing
•Absorption costing is almost exclusively
used for external reporting (GAAP).
•For income tax purposes, absorption
costing is the only acceptable basis for
filings with the Internal Revenue Service
(IRS) under the Tax Reform Act of 1986.
•Absorption costing is the only acceptable
basis for both external reporting and tax
reporting.
19-37
P4
Converting Reports Under Variable
Costing to Absorption Costing
Exhibit 19.15 Converting Variable Costing Income to Absorption Costing Income
2007
Variable costing income
$580,000
Add: Fixed overhead cost deferred in ending inventory (20,000 × $10)
0
Less: Fixed overhead cost recognized from beginning inventory (20,000 × $10)
0
Absorption costing income
$580,000
2008
2009
$120,000 $1,040,000
200,000
0
0 -200,000
$320,000 $840,000
19-38
A2
Calculating Break-Even
We can use the data in the following contribution margin
format for IceAge to help us determine break-even point.
IceAge Company
Contribution Margin Report
For the year ended December 31, 2009
Sales
Variable Expenses
Variable production costs
Variable selling expenses
Contribution margin
Fixed expenses
Net income
$
$
900
120
$
$
2,400
1,020
1,380
800
580
Per
Unit
$
40
$
17
23
19-39
A2
Calculating Break-Even
Break-Even Volume in Units =
Total Fixed Costs
Contribution Margin per Unit
Where:
 Contribution margin per unit =
Sales price per unit – Variable cost per unit

19-40
A2
Calculating Break-Even
Precision Tech’s Break-Even Volume in Units
Total fixed costs
CM per unit
$800,000
=
=
$23 per unit
34,783 units
19-41
End of Chapter 19
19-42