CHAPTER 10

Variable Costing: A Tool For Evaluating Management Performance

Inventory Costing and Capacity Analysis

Planning decisions typically analysis of how alternative inventory-costing choices would
affect reported income. Reported income is considered crucial in evaluating performance of
managers.

The inventory-costing choices relate to which manufacturing costs are treated as

inventoriable costs. There are three inventory costing

● Absorption Costing
● VAriable Costing, and
● Throughput Costing

Absorption Costing (full, traditional, conventional and normal costing) - is a method of

product costing in which all manufacturing costs, fixed and variable are treated as product
inventoriable costs.

This method is the required method for external reporting in most countries including the
Philippines.

Variable Costing (Direct Costing) - is a method of inventory costing in which all variable
manufacturing costs are inventoriable costs. All fixed manufacturing costs are excluded
from inventoriable costs and treated as costs of the period in which they are incurred.

Underlying Concept of Variable Costing

Fixed part of factory overhead is more closely related to the capacity to produce
than to the production of the specific units and therefore should be charged off as expense in
the period incurred. Until variable costing becomes generally accepted accounting practice,
companies who wish to use it must convert inventory and cost of goods sold figures to an
Absorption Costing basis for external reporting.

Advantages of Using Variable Costing

1. It meets the three objectives of management control systems by showing separately

those costs that can be traced to, and controlled by each Strategic Business Unit (SBU).
2. Net Income using variable costing is not affected by changes in inventory levels because
all fixed costs are deducted from income in the period in which they are incurred. For this
reason, appraisal of performance of product line or other segments of the business can
be facilitated without the need for arbitrary allocations of fixed cost.
Disadvantages of Using Variable Costing

1. Variable costing may encourage a shortsighted approach to profit planning at the

expense of the long-run situation.
2. Variable Costing tends to give the impression that variable costs are recovered first, that
fixed costs are recovered later and that finally profits are realized.
3. Variable costing is not acceptable for external reporting and tax purpose.

Comparison Between Variable Costing and Absorption Costing

1. As to Treatment of the various Operating Costs

Absorption Costing Variable Costing

Direct Materials

Direct Labor Product Cost

Production Cost Variable Manufacturing

overhead

Fixed Manufacturing
overhead

Variable Selling and Period Cost

Administrative Expense
Period Cost
Fixed Selling and
Administrative Expense

Note: It is the treatment of Fixed Factory Overhead that the two costing methods
differ. Under Variable Costing, it is considered as period costs while under absorption
costing, it is treated as product cost.

2. As to Net Operating Income

Net Income is not affected by changes in production under variable costing. Net
Income, however, is affected by changes in production when absorption costing is in use.

Net Income goes up under the Absorption approach in response to the increase in
production for a particular year and goes down when production goes down.

The reason for this can be traced to the shifting of fixed manufacturing cost between
periods under the absorption costing method as explained below:

Relationship between
Production (P) and Sales (S) Net Income
a) P = S AC = VC
b) P > S AC > VC
c) P < S AC < VC

a) When Production volume equals Sales volume, Net Income reported under Absorption
Costing (AC) and Variable Costing (VC) are the same

Reason: The amount of Fixed Overhead charged off to operations is the same under
each method and also because there is no change in the amount of Fixed overhead in
the absorption inventory.

b) Production exceeds Sales Volume, Net Income reported and Absorption costing will be
greater than that under Variable costing.

This result occurs because part of the period’s p[roduction would go to increase in
inventory, and under absorption costing, part of the period’s fixed overhead would be
deferred along with it.

3. As to amount of inventory
Inventory value under absorption costing would be higher in amount than that
under Variable costing. The inventory amount would carry a portion of Fixed overhead incurred
during the period under absorption costing.

Reconciliation of Net Income Under Variable Costing with Net Income Under Absorption
Costing

The reconciliation of Net Income figures under the two product costing methods may be
done as follows:

Net Income, Absorption Costing PXX

Add: Fixed overhead in Beginning Inventory XX
Total PXX
Less: Fixed Overhead in Ending Inventory XX
Net Income, Variable Costing PXX
====

Why Managers Prefer Direct Costing (Variable Costing) to Absorption Costing?

Managers generally prefer variable costing because it separates fixed from variable
costs as in cost-volume-profit analysis As a result, it is easier to compare actual operating
income to planned operating income. With absorption costing, actual operating income
corresponds well with planned operating income only when inventory levels remains
unchanged. With variable costing, income is more closely associated with sales while
absorption costing is influenced by units produced and units sold.

Variable Costing and Performance Evaluation of Managers

The evaluation of managers is often to the profitability of the units they control. How
income changes from one period to the next and how actual income compares to planned
income are frequently used as signals of managerial ability. To be meaningful signals, however,
income should reflect managerial effort.. For example, if managers has worked hard and
increased sales while holding costs in check, income should increase over the prior period,
signalling success. In general term, if income performance is expected to reflect managerial
performance, then managers have the high to expect the following:

1. As sales revenue increases from one period to next, all other things being equal, income
should increase
2. As sales revenue decreases from one period to the next, all other things being equal,
income should decrease
3. As sales revenue remains unchanged from one period to the next, all other things being
equal, income should remain unchanged.

The important point is that variabl costing is not affected by the the change in inventory
because all fixed costs are deducted from income in the period in which they occur; fixed costa
are not included in inventory changes and do not affect net income. For this reason, variable
costing net income can be considered a more reliable measure and is preferable for use in
strategic performance measurement. When full costing is used (as is required for financial
reporting), the management accountant must use special caution in interpreting the amount of
net income and attempt to determine what portion of profit , if any, might be due to inventory
changes. This is specially important as net income is used as a basis for performance
evaluation, as it is in profit Strategic Business Units (SBUs).

Variable Costing for Planning and Control.

Financial Planning requires managers to estimate future sales, future production levels,
future costs, and so on. Because sales forecasts, the basis of the budget, are not certain,
management may wish to look at several different levels of sales to assess the range of
possibilities facing the firm. Knowledge of cost behavior is fundamental to achieving this
outcome. Fixed costs do not vary with volume changes; so, distinguishing between fixed and
variable costs is essential to making an accurate cost assessment at the different possible sales
and production volumes.

Once management has chosen one expected sales and production level for the coming
year, the costs that should occur can also be determined. The financial plan, then, consists of
the expected activity levels and the associated expected costs. This plan can be used to
monitor the actual performance as it unfolds.

If actual performance is different from what was expected, corrective action may be
necessary. By comparing actual outcomes with the expected outcomes and taking corrective
Action when necessary, managers exercise control. For the control process to work, though,
cost behavior must be known.