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# Variable cost and net operating income

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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 withrespectto 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.

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