Variable Costing and the Effect of Sales and Production on Operating Income

Given a constant contribution margin per unit and constant fixed costs, the period-to-period change in operating income under variable costing is driven solely by changes in the quantity of units actually sold. Consider the variable-costing operating income of Stassen in 2021 versus 2020. Recall the following:

Contributionmargin per unit=Selling price−Variable manufacturingcost per unit−Variable marketingcost per unit=$1,000 per unit−$200 per unit−$185 per unit=$615 per unit                                                    Change in variable‐costing                                            operating income=Contributionmarginper unit×Change in quantityof units sold2021 vs. 2020: $1,537,500−$1,230,000=$615 per unit×(6,500 unit−6,000 units)$307,500=$307,500

Under variable costing, Stassen managers cannot increase operating income by “producing for inventory.” Why not? Because, as you can see from the preceding computations, when using variable costing, only the quantity of units sold drives operating income. We’ll explain later in this chapter that absorption costing enables managers to increase operating income by increasing both the unit level of sales and the unit level of production. Before you proceed to the next section, make sure that you examine Exhibit 9-3 for a detailed comparison of the differences between variable costing and absorption costing.

Exhibit 9-3

Comparative Income Effects of Variable Costing and Absorption Costing

Table shows the answers to the questions on the basis of variable costing, absorption costing, and comments on the question.

The details of the table are as follows:

1. Question: Are fixed manufacturing costs inventoried?

• Variable costing: No

• Absorption costing: Yes

• Comment: Basic theoretical question of when these costs should be expensed

2. Question: Is there a production-volume variance?

• Variable costing: No

• Absorption costing: Yes

• Comment: Choice of denominator level affects measurement of operating income under absorption costing only

3. Question: Are classifications between variable and fixed costs routinely made?

• Variable costing: Yes

• Absorption costing: Infrequently

• Comment: Absorption costing can be easily modified to obtain subclassifications for variable and fixed costs, if desired (for example, see Exhibit 9-1, Panel B)

4. Question: How do changes in unit inventory levels affect operating income?

(a) When production is equal to sales

• Variable costing: Equal

• Absorption costing: Equal

• Comment: Differences are attributable to the timing of when fixed manufacturing costs are expensed.

(b) When production is greater than sales

• Variable costing: Lower, that is lower operating income than under absorption costing.

• Absorption costing: Higher, higher operating income than under variable costing.

• Comment: Differences are attributable to the timing of when fixed manufacturing costs are expensed.

(c) When production is less than sales

• Variable costing: Higher

• Absorption costing: Lower

• Comment: Differences are attributable to the timing of when fixed manufacturing costs are expensed.

5. What are the effects on cost- volume-profit relationship (for a given level of fixed costs and a given contribution margin per unit)?

• Variable costing: Driven by unit level of sales.

• Absorption costing: Driven by (a) unit level of sales, (b) unit level of production, and (c) chosen denominator level.

• Comment: Management control benefit which Effects of changes in output level on operating income are easier to understand under variable costing.

Note: Assuming that all manufacturing variances are written off as period costs, that no change occurs in work-in-process inventory, and no change occurs in the budgeted fixed manufacturing cost rate between accounting periods.