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VARIABLE COSTING :A TOOL FOR MANAGEMENT

PRESENTED BY: ARSHIYA TARIQ DOHA NOVAL FARHAN LAKHANI HADIQA HANIF SYED DURAK VISHAL SAHITIA ZUHAIB HASSAN

CASE I
CHAINSAW AL DULAPS LEGACY AT SUNBEAM

ABOUT J.DUNLAP
Albert John Dunlap (born July 26, 1937) is a retired corporate executive. He was best known as a turnaround specialist and downsizer. The nicknames "Chainsaw Al" and "Rambo in Pinstripes". However, his reputation was ruined after he engineered a massive accounting scandal at Sunbeam-Oster

What depress the company


Excess inventory profits

Absorption and Variable Costing


Absorption Costing Variable Costing

Direct Materials
Product Costs

Direct Labor Variable Manufacturing Overhead Fixed Manufacturing Overhead

Product Costs

Period Costs

Variable Selling and Administrative Expenses Fixed Selling and Administrative Expenses

Period Costs

Absorption and Variable Costing


Mellon Co. produces a single product with the following information available:
Number of units produced annually Variable costs per unit: Direct materials, direct labor and variable mfg. overhead Selling & administrative expenses Fixed costs per year: Mfg. overhead Selling & administrative expenses 25,000

$ $

10 3

$ 150,000 $ 100,000

Absorption and Variable Costing


Unit product cost is determined as follows:
Absorption Costing Direct materials, direct labor, and variable mfg. overhead Fixed mfg. overhead ($150,000 25,000 units) Unit product cost $ 10 6 16 Variable Costing $ 10 10

Selling and administrative expenses are always treated as period expenses and deducted from revenue.

EMERALD ISLE KNITTERS


INTRODUCTION OF CASE STUDY

ABOUT CASE
Mary OMeara is the owner and manager of Emerald Isle Knitters, Ltd., located in the Republic of Ireland. Mary started the company three years ago with cash loaned to her by a local bank. Like most apparel, manufacturers, Emerald Isle Knitters sells its product to department stores and clothing store chains rather than to retail customers.
The sweater was an immediate success, and the company sold all of its first years production. However, in the second year of operations, one of the companys major customers canceled its order due to bankruptcy, and the company ended the year with a large inventory of unsold sweaters. The third year of operations was a great year in contrast to the disastrous second year.

Sales rebounded dramatically, and all of the unsold production carried over from the second year was sold by the end of the third year.
Shortly after the close of the third year, Mary met with her accountant Sean MacLafferty to discuss the results for the year.

BASIC DATA Selling price per unit sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 Variable manufacturing cost per unit produced . . . . . . . . . . . . . . . . . . . 7 Fixed manufacturing overhead costs per year . . . . . . . . . . . . . . . . . . . . 150,000 Variable selling and administrative expenses per unit sold . . . . . . . . . 1 Fixed selling and administrative expenses per year . . . . . . . . . . . . . . . 90,000
Three Years Together 0 75,000 75,000 0

Year 1 Year 2 Units in beginning inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 0 Units produced. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 25,000 25,000 Units sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 25,000 20,000 Units in ending inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . 0 5,000

Year 3 5,000 25,000 30,000 0

Unit Product Costs Year 1 Year 2 Year 3 Under variable costing (variable manufacturing costs only) 7 7 7 Under absorption costing: Variable manufacturing costs 7 7 7 Fixed manufacturing overhead costs (150,000 spread over the number of units produced in each year) 6 6 6 Total absorption cost per unit 13 13 13

Year 1 Year 2

Year 3 Three Years

Together Absorption Costing Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500,000 400,000 600,000 1,500,000 Cost of goods sold: Beginning inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 0 65,000 0 Add cost of goods manufactured (25,000 units 13 per unit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 325,000 3 25,000 325,000 9 75,000 Goods available for sale . . . . . . . . . . . . . . . . . . . . . 325,000 325,000 390,000 975,000 Less ending inventory (5,000 units 13 per unit) . . . 0 6 5,000 0 0 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . .325,000 260,000 390,000 9 75,000 Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175,000 140,000 210,000 525,000 selling and administrative expenses . . . . . . . . . . . 115,000 * 110,000 * 120,000 * 345,000 Net operating income . . . . . . . . . . . . . . . . . . . . . . . . 60,000 30,000 90,000 180,000 *The selling and administrative expenses are computed as follows: Year 1: 25,000 units 1 per unit variable 90,000 fixed 115,000. Year 2: 20,000 units 1 per unit variable 90,000 fixed 110,000. Year 3: 30,000 units 1 per unit variable 90,000 fixed 120,000.

Variable Costing Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500,000 400,000 600,000 1,500,000 Variable expenses: Variable cost of goods sold: Beginning inventory . . . . . . . . . . . . . . . . . . . . . . . . . 0 0 35,000 0 Add variable manufacturing costs (25,000 units 7 per unit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175,000 1 75,000 175,000 5 25,000 Goods available for sale . . . . . . . . . . . . . . . . . . . . . . 175,000 175,000 210,000 525,000 Less ending inventory (5,000 units 7 per unit) . . 0 3 5,000 0 0 Variable cost of goods sold . . . . . . . . . . . . . . . . . . . . . . 175,000 * 140,000 * 210,000 * 525,000 Variable selling and administrative expenses (1 per unit sold ) . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000 2 00,000 2 0,000 1 60,000 3 0,000 2 40,000 7 5,000 6 00,000 Contribution margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000 240,000 3 60,000 900,000 Fixed expenses: Fixed manufacturing overhead . . . . . . . . . . . . . . . . . . . 1 50,000 150,000 150,000 450,000 Fixed selling and administrative expenses . . . . . . . . . . 90,000 2 40,000 9 0,000 2 40,000 9 0,000 2 40,000 2 70,000 7 20,000 Net operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000 0 120,000 180,000 *The variable cost of goods sold could have been computed more simply as follows: Year 1: 25,000 units sold 7 per unit 175,000. Year 2: 20,000 units sold 7 per unit 140,000.

Year 1 Year 2 Year 3 Variable costing net operating income . . . . . . . . . . . 60,000 0 120,000 Add fixed manufacturing overhead costs deferred in inventory under absorption costing (5,000 units 6 per unit) . . . . . . . . . . . . 0 30,000 0 Deduct fixed manufacturing overhead costs released from inventory under absorption costing (5,000 units 6 per unit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 0 (30,000) Absorption costing net operating income . . . . . . . . . 60,000 30,000 90,000

Absorption Costing Income Statements


Mellon Co. had no beginning inventory, produced 25,000 units and sold 20,000 units this year at $30 each.
Absorption Costing
Sales (20,000 $30) Less cost of goods sold: Beginning inventory $ Add COGM (25,000 $16) 400,000 Goods available for sale $ 400,000 Ending inventory (5,000 $16) 80,000 Gross margin Less selling & admin. exp. Variable (20,000 $3) $ 60,000 Fixed 100,000 Net income $ 600,000

320,000 $ 280,000

160,000 $ 120,000

Variable Costing Income Statements


Now lets look at variable costing by Mellon Co.
Variable Costing
Sales (20,000 $30) Less variable expenses: Beginning inventory Add COGM (25,000 $10) Goods available for sale Ending inventory (5,000 $10) Variable cost of goods sold Variable selling & administrative expenses (20,000 $3) Contribution margin Less fixed expenses: Manufacturing overhead Selling & administrative expenses Net income $ 600,000 $ 250,000 $ 250,000 50,000 $ 200,000 60,000 260,000 $ 340,000

$ 150,000 100,000

250,000 $ 90,000

Comparing Absorption and Variable Costing


Lets compare the methods.
Cost of Goods Sold Absorption costing Variable mfg. costs $ 200,000 Fixed mfg. costs 120,000 $ 320,000 Variable costing Variable mfg. costs $ 200,000 Fixed mfg. costs $ 200,000 Ending Inventory $ 50,000 30,000 $ 80,000 Period Expense $ $ Total $ 250,000 150,000 $ 400,000

$ 50,000 $ 50,000

150,000 $ 150,000

$ 250,000 150,000 $ 400,000

Reconciling Income Under Absorption and Variable Costing


We can reconcile the difference between absorption and variable net income as follows:
Variable costing net income Add: Fixed mfg. overhead costs deferred in inventory (5,000 units $6 per unit) Absorption costing net income $ 90,000

30,000 120,000

Fixed mfg. overhead Units produced

$150,000 = 25,000

$6.00 per unit

Extending the Example

Lets look at the second year of operations for Mellon Company.

Mellon Co. Year 2


In its second year of operations, Mellon Co. started with an inventory of 5,000 units, produced 25,000 units and sold 30,000 units at $30 each.
Number of units produced annually Variable costs per unit: Direct materials, direct labor and variable mfg. overhead Selling & administrative expenses Fixed costs per year: Mfg. overhead Selling & administrative expenses 25,000

$ $

10 3

$ 150,000 $ 100,000

Mellon Co. Year 2


Unit product cost is determined as follows:
Absorption Costing Direct materials, direct labor, and variable mfg. overhead Fixed mfg. overhead ($150,000 25,000 units) Unit product cost
There has been no change in Mellons cost structure.

Variable Costing $ 10 10

10 6 16

Mellon Co. Year 2


Units in ending inventory from the previous period.
Absorption Costing
Sales (30,000 $30) Less cost of goods sold: Beg. inventory (5,000 x $16) Add COGM (25,000 $16) Goods available for sale Ending inventory Gross margin Less selling & admin. exp. Variable (30,000 $3) Fixed Net income $ 900,000 $ 80,000 400,000 $ 480,000 -

480,000 $ 420,000

$ 90,000 100,000

190,000 $ 230,000

Mellon Co. Year 2


Absorption Costing
Sales (30,000 $30) Less cost of goods sold: Beg. inventory (5,000 x $16) Add COGM (25,000 $16) Goods available for sale Ending inventory Gross margin Less selling & admin. exp. Variable (30,000 $3) Fixed Net income $ 900,000 $ 80,000 400,000 $ 480,000 -

480,000 $ 420,000

$ 90,000 100,000

190,000 $ 230,000

25,000 units produced in the current period.

Summary
Income Comparison
Costing Method Absorption Variable 1st Period $ 120,000 90,000 2nd Period $ 230,000 260,000 Total $ 350,000 350,000

In the first period, production (25,000 units) was greater than sales (20,000).

In the second period, production (25,000 units) was less than sales (30,000).

Summary
Income Comparison
Costing Method Absorption Variable 1st Period $ 120,000 90,000 2nd Period $ 230,000 260,000 Total $ 350,000 350,000

For the two-year period, total absorption income and total variable income are the same.

COMPARATIVE EFFECT OF COSTING

IMPACT ON MANAGERS
Opponents of absorption costing argue that shifting fixed manufacturing overhead costs between periods can lead to faulty decisions.
These opponents argue that variable costing income statements are easier to understand because net operating income is only affected by changes in unit sales. This produces net operating income figures that are consistent with managers expectations.

External Reporting and Income Taxes


To conform to GAAP requirements, absorption costing must be used for external financial reports .

Since top executives are typically evaluated based on earnings reported to shareholders in external reports, they may feel that decisions should be based on absorption costing data.

Under the Tax Reform Act of 1986, absorption costing must be used when filling out income tax returns.

Variable costing and theory of constraints


Managing the constraints in company for profits In this direct labor is considered to be fixed cost Two reasons to consider TOC Hiring of more workers without increase in prices Continous improvement

Variable versus Absorption Costing


Fixed manufacturing costs must be assigned to products to properly match revenues and costs. Fixed manufacturing costs are capacity costs and will be incurred even if nothing is produced.

Absorption Costing

Variable Costing

Impact of JIT Inventory Methods


In a JIT inventory system . . .

Production tends to equal sales . . .

So, the difference between variable and absorption income tends to disappear.

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