Ch. 8 Variable Costing and the Costs of Quality and Sustainability

Variable Costing

A costing approach in which only variable manufacturing costs are product costs, and fixed manufacturing costs are period costs (expenses).

For external reporting purposes, generally accepted accounting principles require that income reporting be based on...

absorption costing. Federal tax laws also require the use of absorption costing in reporting income for tax purposes.

Absorption costing is required for...

external financial reporting and income tax reporting

variable costing (or direct costing)

only variable manufacturing overhead is applied to Work-in-Process Inventory as a product cost.

quality of conformance

the extent to which a product meets the specifications of its design

Controversy about absorption and variable costing hinges on the definition of an asset.

An asset is a thing of value owned by the organization with future service potential. By accounting convention, assets are valued at their cost. Since fixed costs comprise part of the cost of production, advocates of absorption costing argue that inventory (an asset) should be valued at its full (absorption) cost of production. Moreover, they argue that these costs have future service potential since the inventory can be sold in the future to generate sales revenue. Proponents of variable costing argue that the fixed-cost component of a product's absorption-costing value has no future service potential. Their reasoning is that the fixed manufacturing-overhead costs during the current period will not prevent these costs from having to be incurred again next period. Fixed-overhead costs will be incurred every period, regardless of production levels. In contrast, variable costs incurred to manufacture a product will not be repeated.

Variable Costing Income Statement

An income statement which reports variable costs and fixed costs separately; also called a contribution margin income statement.

No Change in Inventory - Absorption and Variable Costing

Beginning and ending inventory are the same, because actual production and sales are the same. variable-costing statement, the of fixed manufacturing overhead incurred during 20x0 is an expense in 20x0. Under absorption costing, however, fixed manufacturing overhead was applied to production at the predetermined rate per unit. Since all of the units produced in 20x0 also were sold in 20x0, all of the fixed manufacturing-overhead cost flowed through into Cost of Goods Sold. Thus, all of fixed manufacturing overhead was expensed in 20x0 under absorption costing also.

Cost-Volume-Profit Analysis

Break-even point = (Fixed costs) / (Unit contribution margin)

When inventory increases or decreases during the year, reported income differs under absorption and variable costing. This results from the fixed overhead that is inventoried under absorption costing but expensed immediately under variable costing. A Shortcut to Reconciling Income Fromula:

Difference in fixed overhead expensed under absorption and variable costing = (Change in inventory, in units) * (Predetermined fixed overhead rate per unit)

COGS under absorption costing

Goods Sold*Total Product Costs Total Product Cost = VC + FC If FC per unit is not given, find it by (fixed manufacturing overhead) / (planned annual production)

When inventories decrease, net income under variable costing will be ______ under absorption.

Greater than. Under absorption when decreased inventories, costs from prior periods as well as the current period are expensed.

Decrease in Inventory absorption vs variable

In 20x2, inventory decreased from 15,000 units to zero. Sales during the year exceeded production. As in 20x0 and 20x1, under variable costing, the $600,000 of fixed manufacturing overhead incurred in 20x2 is expensed in 20x2. Under absorption costing, however, more than $600,000 of fixed overhead is expensed in 20x2. Why? Because some of the fixed overhead incurred during the prior year, which was inventoried then, is now expensed in 20x2 as the goods are sold.

Pricing Decisions: most companies that use cost-based pricing base their prices on absorption-costing data. Why?

Many managers argue that fixed manufacturing overhead is a necessary cost incurred in the production process. To exclude this fixed cost from the inventoried cost of a product, as is done under variable costing, is to understate the cost of the product.

Increase in Inventory under absorption costing

Net Income under absorption > variable b/c some of the Fixed MOH remain in Inventory. Since the fixed overhead is inventoried under absorption costing, some of this cost remains in inventory at the end of 20x1.

n 1987, ISO, the International Organization for Standardization, based in Geneva, Switzerland, issued a set of quality control standards for companies selling products in Europe. How do these apply to present day?

Now widely adopted in the United States and other countries, the ISO 9000 standards, as they have come to be collectively known, focus on the processes a company uses to match the quality of design and quality of conformance that its products and services offer with the expectations of its customers. The ISO 9000 standards basically require that a company have a well-defined quality control system in place, and that the target level of product quality be maintained consistently. Moreover, the ISO 9000 standards require a company to prepare extensive documentation of all aspects of the quality control system.

Pricing Decisions: Proponents of variable costing argue...

Proponents of variable costing argue that a product's variable cost provides a better basis for the pricing decision. They point out that any price above a product's variable cost makes a positive contribution to covering fixed cost and profit.

Absorption Costing Income Statement

Sales Revenue -COGS (DM, DL, VOH, FOH) =Gross PRoofit -Selling and administrative expenses (including variable and fixed selling admin. expenses =NOI included in total MOH cost per unit usng a predetermined fixed OH rate

when internal operational analysis require a differentiation of cost behavior, what meets managers' needs?

Some managers find the inconsistency between absorption costing and CVP analysis troubling enough to warrant using variable costing for internal income reporting. Variable costing dovetails much more closely than absorption costing with any operational analyses that require a separation between fixed and variable costs.

Observable versus Hidden Quality Costs

The quality costs discussed in the preceding section are observable. They can be measured and reported, often on the basis of information in the accounting records. In addition to these observable quality costs, however, companies incur hidden quality costs. When products of inferior quality make it to market, customers are dissatisfied. Their dissatisfaction can result in decreased sales and a tarnished reputation for the company. Not only does the company experience lost sales for the inferior products but it will also likely experience lost sales in its other product lines. The opportunity cost of these lost sales and decreased market share can represent a significant hidden cost. Such hidden costs are difficult to estimate or report.

The distinction between absorption and variable costing involves the timing with which fixed manufacturing overhead becomes an expense. Explain the difference:

Under variable costing, fixed overhead is expensed immediately, as it is incurred (Fixed OH is period cost and Vary OH is a product). Under absorption costing, fixed overhead is inventoried until the accounting period during which the manufactured goods are sold. But under both approaches, fixed overhead is eventually expensed.

Explain the implications of absorption and variable costing for cost-volume-profit analysis.

Variable costing highlights the separation between fixed and variable costs, as do cost-volume-profit analysis and break-even calculations. Both of these techniques account for fixed manufacturing overhead as a lump sum. In contrast, absorption costing is inconsistent with CVP analysis, because fixed overhead is applied to goods as a product cost on a per-unit basis.

Six Sigma program

an analytical method that aims at achieving near-perfect results in a production process.

product's quality of design

how well it is conceived or designed for its intended use. For example, a color laser printer intended for business use that has to be refilled three times a day because its paper tray is too small is a low-quality color laser printer with respect to its quality of design.

the variable-costing statements, the contribution format

is used to highlight the separation of variable and fixed costs. First, the manufacturing expenses subtracted from sales revenue each year include only the variable manufacturing costs, which amount to $24 per unit. Second, fixed manufacturing overhead is subtracted as a lump-sum period expense at the bottom of each year's income statement.

The traditional view of quality costs holds that finding the optimal level of product quality is a balancing act between incurring costs of

prevention and appraisal on one hand and incurring costs of failure on the other. As the percentage of defective products decreases, the costs of prevention and appraisal increase. However, the costs of internal and external failure decrease. Adding the costs of prevention, appraisal, and internal and external failure yields total quality costs. The optimal product quality level is the point that minimizes total quality costs.

Due to the increasing importance of maintaining high product quality, many companies routinely measure and report the costs of ensuring high quality. Four types of costs are monitored:

prevention costs, the costs of preventing defects (ex: quality training); appraisal costs, the costs of determining whether defects exist (ex: inspection); internal failure costs, the costs of repairing defects found prior to product delivery; and external failure costs, costs incurred after defective products have been delivered.

Pareto diagram

shows graphically the frequency with which various quality control problems are observed. The Pareto diagram helps the TQM team visualize and communicate to others what the most serious types of defects are. Steps can be taken then to attack the most serious and most frequent problems first.

total quality management, or TQM

the broad set of management and control processes designed to focus the entire organization and all of its employees on providing products or services that do the best possible job of satisfying the customer.

product's grade

the extent of its capabilities in performing an intended purpose, in relation to other products with the same functional use. For example, a laser printer that prints in color is of a higher grade than a laser printer that only prints in black-and-white.

The contemporary view is that if both observable and hidden costs of quality are considered, any deviation from a product's target specifications results in increased quality costs.

the optimal level of product quality occurs at the zero defect level.

absorption costing (or full costing)

variable and fixed manufacturing overhead in the product costs that flow through the manufacturing accounts. This approach to product costing is called absorption costing (or full costing), because all manufacturing-overhead costs are applied to (or absorbed by) manufactured goods. Fixed OH is expensed when products are sold.