Chapter 16: Variable costing

How much does a product cost? Financial reporting answers with absorption costing: all manufacturing costs, fixed and variable, are product costs. Managers often prefer variable costing: only variable manufacturing costs are product costs, and fixed manufacturing overhead is a period cost. This final chapter explains the difference, why the two methods can report different operating income, and how variable costing and the contribution margin help managers analyse products, segments and service businesses.

Absorption versus variable costing

Variable selling and administrative costs (such as sales commissions) are never product costs; they are expenses in both methods, but in variable costing they are subtracted before the contribution margin.

Under absorption costing the fixed overhead per unit depends on the number of units produced:

Why operating income differs

• Units produced = units sold: operating income is the same under both methods; all fixed overhead of the year is expensed either way.
• Units produced > units sold (inventory rises): absorption costing shows higher operating income, because part of this year's fixed overhead stays in ending inventory and is postponed to a later period.
• Units produced < units sold (inventory falls): absorption costing shows lower operating income, because fixed overhead from earlier years, carried in beginning inventory, is released into cost of goods sold.

(With beginning inventory the general rule is: the difference equals the change in the fixed overhead contained in inventory.) In the textbook example Smart Touch Learning has variable manufacturing costs of $245 per tablet and fixed overhead of $111,000 a year. In year 2 it produces 2,500 and sells 2,000: fixed overhead per unit is 111,000 / 2,500 = $44.40, so 500 units in ending inventory carry 500 × 44.40 = $22,200 of fixed overhead, and absorption income is $22,200 higher. In year 3 it produces 1,500 and sells 2,000 (including those 500): absorption income is $22,200 lower. Over the three years total income is equal.

Variable costing in management decisions

Managers use costing information to set prices, control costs and plan production. Absorption costing creates a dangerous incentive: by producing more than can be sold, a manager can raise reported operating income (fixed overhead disappears into inventory) without selling a single extra unit, while the company is left with costly inventory. Variable costing removes this incentive, because operating income moves only with sales. For short-term decisions, such as the promotion above, the contribution margin is the relevant measure: fixed costs that do not change are not affected by the decision.

Profitability analysis. A business segment is an identifiable part of a company for which financial information is available: a product line, geographic area, customer type or salesperson. A contribution margin income statement per segment shows which segments cover their variable costs best and contribute most to fixed costs; the contribution margin ratio (contribution margin / sales) makes segments of different size comparable. Managers use this for decisions on the sales mix and on which products or regions to emphasise.

Service companies

Service companies have no inventory and no cost of goods sold, but they do have fixed and variable costs, so variable costing works well. JR's Towing separates variable costs (truck operating costs, driver wages) from fixed costs (depreciation of the trucks, rent and utilities of the shop). With towing revenue of $202,500 and a contribution margin of $103,500, the contribution margin ratio is 103,500 / 202,500 = 51.11%. Splitting the statement by segment (for example by type of tow) shows where to focus.

Accounting is magic

The final case class tied the managerial chapters together. Steel production at Tata Steel showed the relevant range (more capacity needs investment, raising fixed costs), CVP analysis and operating leverage (a steel mill has high fixed costs, so profits swing strongly with volume), and the choice between costing systems: job order versus process costing, plantwide rates versus ABC, and absorption versus variable costing. The "magic" is that the same company can show different product costs and different profits depending on the method chosen; a good manager knows which number fits which decision.