Chapter 5

Cost Behavior:
Analysis and Use

McGraw-Hill /Irwin Copyright2008byTheMcGrawHillCompanies,Inc.Allrightsreserved.

5-2

Learning Objective 1

Understand how fixed and

variable costs behave and how
to use them to predict costs.
5-3

Types of Cost Behavior Patterns

Recall the summary of our cost

behavior discussion from Chapter 1.
5-4

The Activity Base

Units
Units Machine
Machine
produced
produced hours
hours

A
Ameasure
measure ofof what
what
causes
causes the
the
incurrence
incurrence ofof aa
variable
variable cost.
cost.

Miles
Miles Labor
Labor
driven
driven hours
hours
5-5

True Variable Cost Example

A variable cost is a cost whose total dollar

amount varies in direct proportion to
changes in the activity level.
Total Long Distance

Your total long

Telephone Bill

distance telephone bill

is based on how many
minutes you talk.

Minutes Talked
5-6

Types of Cost Behavior Patterns

Recall the summary of our cost

behavior discussion from Chapter 1.
5-7

Variable Cost Per Unit Example

A variable cost remains constant if

expressed on a per unit basis.

Telephone Charge
The per minute cost

Per Minute
of long distance calls
is constant, for
example, 10 per
minute.
Minutes Talked
5-8

Extent of Variable Costs

The proportion of variable costs differs across

organizations. For example . . .
A public utility with
large investments in A manufacturing company
equipment will tend will often have many
to have fewer variable costs.
variable costs.

A merchandising company
A service company
usually will have a high
will normally have a high
proportion of variable costs
proportion of variable costs.
like cost of sales.
5-9

Examples of Variable Costs

1.
1. Merchandising
Merchandising companies
companies cost
cost of
of goods
goods sold.
sold.
2.
2. Manufacturing
Manufacturing companies
companies direct
direct materials,
materials,
direct
direct labor,
labor, and
and variable
variable overhead.
overhead.
3.
3. Merchandising
Merchandising and
and manufacturing
manufacturing companies
companies
commissions,
commissions, shipping
shipping costs,
costs, and
and clerical
clerical costs
costs
such
such as
as invoicing.
invoicing.
4.
4. Service
Service companies
companies supplies,
supplies, travel,
travel, and
and
clerical.
clerical.
5-10

True Variable Cost

Direct materials is a true or proportionately

variable cost because the amount used during
a period will vary in direct proportion to the
level of production activity.
Cost

Volume
5-11

Step-Variable Costs

AA resource
resource that
that is
is obtainable
obtainable only
only in
in large
large
chunks
chunks (such
(such as
as maintenance
maintenance workers)
workers) and and
whose
whose costs
costs increase
increase or
or decrease
decrease only
only inin
response
response to
to fairly
fairly wide
wide changes
changes in
in activity.
activity.
Cost

Volume
5-12

Step-Variable Costs

Small changes in the level of production are

not likely to have any effect on the number
of maintenance workers employed.
Cost

Volume
5-13

Step-Variable Costs

Only fairly wide changes in the activity

level will cause a change in the number
of maintenance workers employed.
Cost

Volume
5-14
The Linearity Assumption and the
Relevant Range

A
A straight
straight line
line
Economists
closely
closely
Curvilinear Cost approximates
approximates aa
Function curvilinear
curvilinear
variable
variable cost
cost
line
line within
within the
the
Relevant
relevant
relevant range.
Total Cost

range.
Range
Accountants Straight-Line
Approximation (constant
unit variable cost)

Activity
5-15

Types of Cost Behavior Patterns

Lets turn our attention to fixed cost behavior.

5-16

Total Fixed Cost Example

A fixed cost is a cost whose total dollar amount

remains constant as the activity level changes.

Your monthly basic

telephone bill is
Monthly Basic
Telephone Bill

probably fixed and does

not change when you
make more local calls.

Number of Local Calls

5-17

Types of Cost Behavior Patterns

Recall the summary of our cost

behavior discussion from Chapter 1.
5-18

Fixed Cost Per Unit Example

Average fixed costs per unit decrease

as the activity level increases.

Monthly Basic Telephone

The fixed cost per

Bill per Local Call

local call decreases
as more local calls
are made.

Number of Local Calls

5-19

Types of Fixed Costs

Committed
Committed Discretionary
Discretionary
Long-term,
Long-term, cannot
cannot bebe May
May be
be altered
altered in
in the
the
significantly
significantly reduced
reduced short-term
short-term byby current
current
in
in the
the short-term.
short-term. managerial
managerial decisions
decisions

Examples
Examples Examples
Examples
Depreciation
Depreciation on
on Advertising
Advertising and
and
Buildings
Buildings and
and Research
Research and
and
Equipment
Equipment and
and Development
Development
Real
Real Estate
Estate Taxes
Taxes
5-20

The Trend Toward Fixed Costs

The trend in many industries is toward

greater fixed costs relative to variable costs.
As
As machines
machines taketake over
over Knowledge
Knowledge workers
workers
many
many mundane
mundane tasks
tasks tend
tend toto be
be salaried,
salaried,
previously
previously performed
performed highly-trained
highly-trained andand
by
by humans,
humans, difficult
difficult to
to replace.
replace. The
The
knowledge
knowledge workers
workers cost
cost toto compensate
compensate
are
are demanded
demanded for for these
these valued
valued employees
employees
their
their minds
minds rather
rather is
is relatively
relatively fixed
fixed
than
than their
their muscles.
muscles. rather
rather than
than variable.
variable.
5-21

Is Labor a Variable or a Fixed Cost?

The behavior of wage and salary costs can

differ across countries, depending on labor
regulations, labor contracts, and custom.
In France, Germany, China, and Japan,
management has little flexibility in adjusting
the size of the labor force.
Labor costs are more fixed in nature.

Most companies in the United States continue

to view direct labor as a variable cost.
5-22

Fixed Costs and Relevant Range

90
Thousands of Dollars

Total
Total cost
cost doesnt
doesnt
Relevant
Rent Cost in

change
change forfor aa wide
wide
60 Range range
range ofof activity,
activity, and
and
then
then jumps
jumps to to aa new
new
higher
higher cost
cost for
for the
the
30 next
next higher
higher range
range ofof
activity.
activity.
0
0 1,000 2,000 3,000
Rented Area (Square Feet)
5-23

Fixed Costs and Relevant Range

The relevant range of activity for a fixed

cost is the range of activity over which
the graph of the cost is flat.
Example: Office space is
available at a rental rate of
$30,000 per year in
increments of 1,000 square
feet. As the business grows,
more space is rented,
increasing the total cost.
5-24

Fixed Costs and Relevant Range

Step-variable costs
can be adjusted
How does this type more quickly and . . .
of fixed cost differ The width of the
from a step-variable activity steps is
cost? much wider for the
fixed cost.
5-25

Quick Check

Which
Which of
of the
the following
following statements
statements about
about cost
cost
behavior
behavior are
are true?
true?
1.
1. Fixed
Fixed costs
costs per
per unit
unit vary
vary with
with the
the level
level of
of
activity.
activity.
2.
2. Variable
Variable costs
costs per
per unit
unit are
are constant
constant within
within the
the
relevant
relevant range.
range.
3.
3. Total
Total fixed
fixed costs
costs are
are constant
constant within
within the
the
relevant
relevant range.
range.
4.
4. Total
Total variable
variable costs
costs are
are constant
constant within
within the
the
relevant
relevant range.
range.
5-26

Quick Check

Which
Which of
of the
the following
following statements
statements about
about cost
cost
behavior
behavior are
are true?
true?
1.
1. Fixed
Fixed costs
costs per
per unit
unit vary
vary with
with the
the level
level of
of
activity.
activity.
2.
2. Variable
Variable costs
costs per
per unit
unit are
are constant
constant within
within the
the
relevant
relevant range.
range.
3.
3. Total
Total fixed
fixed costs
costs are
are constant
constant within
within the
the
relevant
relevant range.
range.
4.
4. Total
Total variable
variable costs
costs are
are constant
constant within
within the
the
relevant
relevant range.
range.
5-27

Mixed Costs

A mixed cost has both fixed and variable

components. Consider your utility costs.
Y
Total Utility Cost

s t
o
dc
ixe
ta lm
To Variable
Cost per KW

X Fixed Monthly
Activity (Kilowatt Hours) Utility Charge
5-28

Mixed Costs

Y
Total Utility Cost

s t
o
dc
ixe
ta lm
To Variable
Cost per KW

X Fixed Monthly
Activity (Kilowatt Hours) Utility Charge
5-29

Mixed Costs Example

IfIf your
your fixed
fixed monthly
monthly utility
utility charge
charge is is $40,
$40, your
your
variable
variable cost
cost is
is $0.03
$0.03 per
per kilowatt
kilowatt hour,
hour, andand your
your
monthly
monthly activity
activity level
level is
is 2,000
2,000 kilowatt
kilowatt hours,
hours, the
the
amount
amount of of your
your utility
utility bill
bill is:
is:

Y = a + bX
Y = $40 + ($0.03 2,000)
Y = $100
5-30

Analysis of Mixed Costs

Account
Account analysis
analysis
Each
Each account
account isis classified
classified as
as either
either
variable
variable or
or fixed
fixed based
based on
on the
the analysts
analysts
knowledge
knowledge of of how
how the
the account
account behaves.
behaves.

Engineering
Engineering Approach
Approach
Cost
Cost estimates
estimates areare based
based on
on an
an
evaluation
evaluation of
of production
production methods,
methods,
and
and material,
material, labor
labor and
and overhead
overhead
requirements.
requirements.
5-31

Learning Objective 2

Use a scattergraph plot

to diagnose cost behavior.
5-32

The Scattergraph Method

Plot
Plot the
the data
data points
points on
on aa graph
graph
Y (total
(total cost
cost vs.
vs. activity).
activity).
20
Maintenance Cost

* ** *
1,000s of Dollars

* *
**
10 * *

0 X
0 1 2 3 4
Patient-days in 1,000s
5-33

The Scattergraph Method

Draw
Draw aa line
line
through
through thethe
Y
data
data points
points
20
Maintenance Cost

* ** *
1,000s of Dollars

with
with about
about
* * an
an equal
equal
** number
number of
10 * * points
points above
of
above
and
and below
below
the
the line.
line.
0 X
0 1 2 3 4
Patient-days in 1,000s
5-34

The Scattergraph Method

Use
Use oneone
Y Total maintenance cost = $11,000 data
data point
point
20 to
to estimate
estimate
Maintenance Cost

* ** *
1,000s of Dollars

the
the total
total
* *
** level
level of
of
10 * * activity
activity
Intercept = Fixed cost: $10,000 and
and the
the
0 X
total
total cost.
cost.
0 1 2 3 4
Patient-days in 1,000s
Patient days = 800
5-35

The Scattergraph Method

Make
Make aa quick
quick estimate
estimate of
of variable
variable cost
cost per
per
unit
unit and
and determine
determine the
the cost
cost equation.
equation.

$1,000
Variable cost per unit = = $1.25/patient-day
800

Y = $10,000 + $1.25X

Total maintenance cost Number of patient days

5-36

Learning Objective 3

Analyze a mixed cost

using the high-low method.
5-37

The High-Low Method

Assume the following hours of maintenance work
and the total maintenance costs for six months.
5-38

The High-Low Method

The variable cost
per hour of
maintenance is
equal to the change
in cost divided by
the change in hours.
Hours Total Cost
High 800 $ 9,800
Low 500 7,400
Change 300 $ 2,400

$2,400
= $8.00/hour
300
5-39

The High-Low Method

Total Fixed Cost = Total Cost Total Variable Cost

Total Fixed Cost = $9,800 ($8/hour 800 hours)
Total Fixed Cost = $9,800 $6,400
Total Fixed Cost = $3,400
5-40

The High-Low Method

The Cost Equation for Maintenance

Y = $3,400 + $8.00X
5-41

Quick Check

Sales
Sales salaries
salaries and
and commissions
commissions are
are $10,000
$10,000
when
when 80,000
80,000 units
units are
are sold,
sold, and
and $14,000
$14,000 when
when
120,000
120,000 units
units are
are sold.
sold. Using
Using the
the high-low
high-low
method,
method, what
what is
is the
the variable
variable portion
portion of
of sales
sales
salaries
salaries and
and commission?
commission?
a.
a. $0.08
$0.08 per
per unit
unit
b.
b. $0.10
$0.10 per
per unit
unit
c.
c. $0.12
$0.12 per
per unit
unit
d.
d. $0.125
$0.125 per
per unit
unit
5-42

Quick Check

Sales
Sales salaries
salaries and
and commissions
commissions are
are $10,000
$10,000
when
when 80,000
80,000 units
units are
are sold,
sold, and
and $14,000
$14,000 when
when
120,000
120,000 units
units are
are sold.
sold. Using
Using the
the high-low
high-low
method,
method, what
what is
is the
the variable
variable portion
portion of
of sales
sales
salaries
salaries and
and commission?
commission?
a.
a. $0.08
$0.08 per
per unit
unit
Units Cost
b.
b. $0.10
$0.10 per
per unit
unit High level 120,000 $ 14,000
c.
c. $0.12
$0.12 per
per unit
unit Low level 80,000 10,000
Change 40,000 $ 4,000
d. $0.125 per unit
d. $0.125 per unit
$4,000 40,000 units
= $0.10 per unit
5-43

Quick Check

Sales
Sales salaries
salaries and
and commissions
commissions are are $10,000
$10,000
when
when 80,000
80,000 units
units are
are sold,
sold, and
and $14,000
$14,000 when
when
120,000
120,000 units
units are
are sold.
sold. Using
Using the
the high-low
high-low
method,
method, what
what is
is the
the fixed
fixed portion
portion of
of sales
sales
salaries
salaries and
and commissions?
commissions?
a.
a. $$ 2,000
2,000
b.
b. $$ 4,000
4,000
c.
c. $10,000
$10,000
d.
d. $12,000
$12,000
5-44

Quick Check

Sales
Sales salaries
salaries and
and commissions
commissions are are $10,000
$10,000
when
when 80,000
80,000 units
units are
are sold,
sold, and
and $14,000
$14,000 when
when
120,000
120,000 units
units are
are sold.
sold. Using
Using the
the high-low
high-low
method,
method, what
what is
is the
the fixed
fixed portion
portion of
of sales
sales
salaries
salaries and
and commissions?
commissions?
a.
a. $$ 2,000
2,000
b.
b. $$ 4,000
4,000
c.
c. $10,000
$10,000
d.
d. $12,000
$12,000
5-45

Least-Squares Regression Method

AA method
method used
used toto analyze
analyze mixed
mixed costs
costs ifif aa
scattergraph
scattergraph plot
plot reveals
reveals an
an approximately
approximately linear
linear
relationship
relationship between the X and Y variables.

This method uses all of the

data points to estimate
the fixed and variable
cost components of a The goal of this method is
mixed cost. to fit a straight line to the
data that minimizes the
sum of the squared errors.
5-46

Least-Squares Regression Method

Software can be used to

fit a regression line
through the data points.
The cost analysis
objective is the same:
Y = a + bX

The
The output
output from
from the
the regression
regression analysis
analysis can
can be
be
used
used to
to create
create an
an equation
equation that
that enables
enables you
you to
to
estimate
estimate total
total costs
costs at
at any
any activity
activity level.
level.
5-47

Comparing Results From the Three Methods

The
The three
three methods
methods just
just discussed
discussed provide
provide
slightly
slightly different
different estimates
estimates ofof the
the fixed
fixed and
and
variable
variable cost
cost components
components of of the
the mixed
mixed cost.
cost.
This
This is
is to
to be
be expected
expected because
because each
each method
method
uses
uses different
different amounts
amounts of
of the
the data
data points
points to
to
provide
provide estimates.
estimates.
Least-squares
Least-squares regression
regression provides
provides the
the most
most
accurate
accurate estimate
estimate because
because itit uses
uses all
all of
of the
the
data
data points.
points.
5-48

Learning Objective 4

Prepare an income statement

using the contribution format.
5-49

The Contribution Format Income Statement

Lets put our

knowledge of cost
behavior to work by
preparing a
contribution format
income statement.
5-50

The Contribution Format

The
The contribution
contribution margin
margin format
format emphasizes
emphasizes
cost
cost behavior,
behavior, by
by separating
separating costs
costs into
into fixed
fixed and
and
variable
variable categories.
categories. Contribution
Contribution margin
margin covers
covers
fixed
fixed costs
costs and
and provides
provides for
for income.
income.
5-51

Uses of the Contribution Format

The
The contribution
contribution income
income statement
statement format
format is
is used
used
as
as an
an internal
internal planning
planning and
and decision
decision making
making tool.
tool.
We
We will
will use
use this
this approach
approach for:
for:
1.
1. Cost-volume-profit
Cost-volume-profit analysis
analysis (chapter
(chapter 6).
6).
2.
2. Budgeting
Budgeting (chapter
(chapter 7).
7).
3.
3. Special
Special decisions
decisions such
such as
as pricing
pricing and
and make-or-
make-or-
buy
buy analysis
analysis (chapter
(chapter 11).
11).
5-52

The Contribution Format

Used primarily for Used primarily by

external reporting. management.
 Appendix 5A

Variable Costing

McGraw-Hill /Irwin Copyright2008byTheMcGrawHillCompanies,Inc.Allrightsreserved.

5-54

Learning Objective 5

Use variable costing to prepare a

contribution format income statement
and contrast absorption costing and
variable costing.
(Appendix 5A)
5-55
Overview of Absorption
and Variable Costing

Absorption Variable
Costing Costing
Direct Materials
Product
Product Direct Labor
Costs
Costs Variable Manufacturing Overhead

Fixed Manufacturing Overhead

Period
Period Variable Selling and Administrative Expenses
Costs
Costs Fixed Selling and Administrative Expenses
5-56

Quick Check

Which method will produce the highest values

for work in process and finished goods
inventories?
a. Absorption costing.
b. Variable costing.
c. They produce the same values for these
inventories.
d. It depends.
5-57

Quick Check

Which method will produce the highest values

for work in process and finished goods
inventories?
a. Absorption costing.
b. Variable costing.
c. They produce the same values for these
inventories.
d. It depends.
5-58

Unit Cost Computations

Harvey Company produces a single product

with the following information available:
Number
Number ofof units
units produced
produced annually
annually 25,000
25,000
Variable
Variable costs
costs per
per unit:
unit:
Direct
Direct materials,
materials, direct
direct labor,
labor,
and
and variable
variable mfg.
mfg. overhead
overhead $$ 10
10
Selling
Selling &
& administrative
administrative expenses
expenses $$ 33

Fixed
Fixed costs
costs per
per year:
year:
Manufacturing
Manufacturing overhead
overhead $$150,000
150,000
Selling
Selling &
& administrative
administrative expenses
expenses $$100,000
100,000
5-59

Unit Cost Computations

Unit product cost is determined as follows:

Absorption
Absorption Variable
Variable
Costing
Costing Costing
Costing
Direct
Direct materials,
materials, direct
direct labor,
labor,
and
and variable
variable mfg.
mfg. overhead
overhead $$ 10
10 $$ 10
10
Fixed
Fixed mfg.
mfg. overhead
overhead
($150,000
($150,000 25,000
25,000 units)
units) 66 --
Unit
Unit product
product cost
cost $$ 16
16 $$ 10
10

Selling and administrative expenses are

always treated as period expenses and deducted
from revenue as incurred.
5-60
Income Comparison of
Absorption and Variable Costing

Lets assume the following additional information

for Harvey Company.
20,000 units were sold during the year at a price of
$30 each.
There is no beginning inventory.

Now,
Now, lets
lets compute
compute net
net operating
operating
income
income using
using both
both absorption
absorption
and
and variable
variable costing.
costing.
5-61

Absorption Costing

Absorption
Absorption Costing
Costing
Sales
Sales(20,000
(20,000 $30)
$30) $$600,000
600,000
Less
Lesscost
cost of
of goods
goodssold:
sold:
Beginning
Beginning inventory
inventory $$ --
Add
Add COGM
COGM (25,000
(25,000 $16)
$16) 400,000
400,000
Goods
Goodsavailable
available for
for sale
sale 400,000
400,000
Ending
Ending inventory
inventory (5,000
(5,000 $16)
$16) 80,000
80,000 320,000
320,000
Gross
Grossmargin
margin 280,000
280,000
Less
Lessselling
selling && admin.
admin. exp.
exp.
Variable
Variable (20,000
(20,000 $3)
$3) $$ 60,000
60,000
Fixed
Fixed 100,000
100,000 160,000
160,000
Net
Net operating
operating income
income $$120,000
120,000
5-62

Variable Costing
Variable
manufacturing
Variable
Variable Costing
Costing
costs only.
Sales
Sales(20,000
(20,000 $30)
$30) $$600,000
600,000
Less
Lessvariable
variable expenses:
expenses:
Beginning
Beginning inventory
inventory $$ --
Add
All fixed
Add COGM
COGM (25,000
(25,000 $10)
$10) 250,000
250,000
Goods manufacturing
Goodsavailable
available forfor sale
sale 250,000
250,000
Less overhead is
Lessending
ending inventory
inventory (5,000
(5,000 $10)
$10) 50,000
50,000
Variable expensed.
Variable cost
cost ofof goods
goodssold
sold 200,000
200,000
Variable
Variable selling
selling && administrative
administrative
expenses
expenses(20,000
(20,000 $3)
$3) 60,000
60,000 260,000
260,000
Contribution
Contribution margin
margin 340,000
340,000
Less
Lessfixed
fixed expenses:
expenses:
Manufacturing
Manufacturing overhead
overhead $$150,000
150,000
Selling
Selling && administrative
administrative expenses
expenses 100,000100,000 250,000
250,000
Net
Net operating
operating income
income $$ 90,000
90,000
5-63
Comparing Absorption and
Variable Costing
Lets compare the methods.
Cost
Costof
of
Goods
Goods Ending
Ending Period
Period
Sold
Sold Inventory
Inventory Expense
Expense Total
Total
Absorption
Absorptioncosting
costing
Variable
Variable mfg.
mfg.costs
costs $$200,000
200,000 $$ 50,000
50,000 $$ -- $$250,000
250,000
Fixed
Fixedmfg.
mfg.costs
costs 120,000
120,000 30,000
30,000 -- 150,000
150,000
$$320,000
320,000 $$ 80,000
80,000 $$ -- $$400,000
400,000

Variable
Variable costing
costing
Variable
Variable mfg.
mfg.costs
costs $$200,000
200,000 $$ 50,000
50,000 $$ -- $$250,000
250,000
Fixed
Fixedmfg.
mfg.costs
costs -- -- 150,000
150,000 150,000
150,000
$$200,000
200,000 $$ 50,000
50,000 $$150,000
150,000 $$400,000
400,000
5-64
Comparing Absorption and
Variable Costing

We can reconcile the difference between absorption

and variable net operating income as follows:

Variable
Variable costing
costing net
net operating
operating income
income $$ 90,000
90,000
Add:
Add: Fixed
Fixed mfg.
mfg. overhead
overhead costs
costs
deferred
deferred in
in inventory
inventory
(5,000
(5,000 units
units $6
$6 per
per unit)
unit) 30,000
30,000
Absorption
Absorption costing
costing net
net operating
operating income
income $$ 120,000
120,000

Fixed mfg. overhead $150,000

= = $6.00 per unit
Units produced 25,000 units
5-65

Extended Comparison of Income Data

Here is information about the operation

of Harvey Company for the second year.
Number
Number of of units
unitsproduced
produced 25,000
25,000
Number
Number of of units
unitssold
sold 30,000
30,000
Units
Unitsinin beginning
beginning inventory
inventory 5,000
5,000
Unit
Unit sales
salesprice
price $$ 30
30
Variable
Variable costs
costsper
per unit:
unit:
Direct
Direct materials,
materials, direct
direct labor
labor
variable
variable mfg.
mfg. overhead
overhead $$ 10
10
Selling
Selling & & administrative
administrative
expenses
expenses $$ 33
Fixed
Fixed costs
costsper
per year:
year:
Manufacturing
Manufacturing overhead
overhead $$150,000
150,000
Selling
Selling & & administrative
administrative
expenses
expenses $$100,000
100,000
5-66

Unit Cost Computations

Absorption
Absorption Variable
Variable
Costing
Costing Costing
Costing
Direct
Direct materials,
materials, direct
direct labor,
labor,
and
and variable
variable mfg.
mfg. overhead
overhead $$ 10
10 $$ 10
10
Fixed
Fixed mfg.
mfg. overhead
overhead
($150,000
($150,000 25,000
25,000 units)
units) 66 --
Unit
Unit product
product cost
cost $$ 16
16 $$ 10
10

Since
Since there
there was
was nono change
change inin the
the variable
variable costs
costs
per
per unit,
unit, total
total fixed
fixed costs,
costs, or
or the
the number
number ofof
units
units produced,
produced, thethe unit
unit costs
costs remain
remain unchanged.
unchanged.
5-67

Absorption Costing

Absorption
Absorption Costing
Costing
Sales
Sales(30,000
(30,000 $30)
$30) $$900,000
900,000
Less
Lesscost
cost of
of goods
goodssold:
sold:
Beg.
Beg. inventory
inventory (5,000
(5,000 $16)
$16) $$ 80,000
80,000
Add
Add COGM
COGM (25,000
(25,000 $16)
$16) 400,000
400,000
Goods
Goodsavailable
available for
for sale
sale 480,000
480,000
Less
Lessending
ending inventory
inventory -- 480,000
480,000
Gross
Grossmargin
margin 420,000
420,000
Less
Lessselling
selling && admin.
admin. exp.
exp.
Variable
Variable (30,000
(30,000 $3)
$3) $$ 90,000
90,000
Fixed
Fixed 100,000
100,000 190,000
190,000
Net
Net operating
operating income
income $$230,000
230,000

These are the 25,000 units

produced in the current period.
5-68

Variable Costing Variable

manufacturing
costs only.
Variable
Variable Costing
Costing
Sales
Sales(30,000
(30,000 $30)
$30) $$900,000
900,000
Less
Lessvariable
variable expenses:
expenses:
Beg.
Beg. inventory
inventory (5,000
(5,000 $10)
$10) $$ 50,000
50,000
Add
Add COGM
COGM (25,000
(25,000 $10)
$10) 250,000
250,000 All fixed
Goods
Goodsavailable
available forfor sale
sale 300,000
300,000 manufacturing
Less
Lessending
ending inventory
inventory --
overhead is
Variable
Variable cost
cost ofof goods
goodssold
sold 300,000
300,000 expensed.
Variable
Variable selling
selling & & administrative
administrative
expenses
expenses(30,000
(30,000 $3)
$3) 90,000
90,000 390,000
390,000
Contribution
Contribution margin
margin 510,000
510,000
Less
Lessfixed
fixed expenses:
expenses:
Manufacturing
Manufacturing overhead
overhead $$150,000
150,000
Selling
Selling & & administrative
administrative expenses
expenses 100,000
100,000 250,000
250,000
Net
Net operating
operating income
income $$260,000
260,000
5-69
Comparing Absorption and
Variable Costing

We can reconcile the difference between absorption

and variable net operating income as follows:

Variable costing net operating income $ 260,000

Deduct: Fixed manufacturing overhead
costs released from inventory
(5,000 units $6 per unit) 30,000
Absorption costing net operating income $ 230,000

Fixed mfg. overhead $150,000

= = $6.00 per unit
Units produced 25,000 units
5-70
Comparing Absorption and
Variable Costing

Costing Method 1st Period 2nd Period Total

Absorption $ 120,000 $ 230,000 $ 350,000
Variable 90,000 260,000 350,000
5-71

Summary of Key Insights

Relation
Relation between
between Effect
Effect Relation
Relation between
between
production
production on
on variable
variable and
and
and
and sales
sales iniventory
iniventory absorption
absorption NOI
NOI
Inventory
Inventory Absorption
Absorption
Production
Production >> Sales
Sales increases
increases >>
Variable
Variable
Inventory
Inventory Absorption
Absorption
Production
Production << Sales
Sales decreases
decreases <<
Variable
Variable
Absorption
Absorption
Production
Production == Sales
Sales No
No change
change ==
Variable
Variable

NOI = net operating income

5-72

End of Chapter 5