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Variable and Absorption Costing

(Two general approaches are used for valuing inventories and cost of goods sold. One approach is called variable Costing and other is called absorption costing.)

Absorption Costing:

Absorption costing treats all costs of production as product costs, regardless weather they are variable or fixed. The cost of a unit of product under absorption costing method therefore consists of direct materials, direct labor and both variable and fixed overhead.

Absorption costing allocates a portion of fixed manufacturing overhead cost to each unit of product, along with the variable manufacturing cost. Because absorption costing includes all costs of production as product costs, it is frequently referred to as full cost method.

Variable Costing:

Under variable costing those costs of production that vary with output are treated as product costs. This would usually include direct materials, direct labor and variable portion of manufacturing overhead. Fixed manufacturing cost is not treated as a product cost under variable costing. Rather, fixed manufacturing cost is treated as a period cost and, like selling and administrative expenses, it is charged off in its entirety against revenue each period. Consequently the cost of a unit of product in inventory or cost of goods sold under this method does not contain any fixed overhead cost. Variable costing is some time referred to as direct costing or marginal costing.

The concepts discussed so for in this section are illustrated below by classification of costs under both costing approaches

Unit Cost Computation:

To illustrate the computation of unit product costs under both absorption and variable costing consider Boley Company, a small company that produces a single product and has the following cost structure.

Required:
1.Compute the unit product cost under absorption costing.
2.Compute the unit product cost under variable costing.

Solution:

Absorption Costing:

Variable Costing:

Under the absorption costing, notice that all production costs, variable and fixed, are included when determining the unit product cost. Thus if the company sells a unit of product and absorption costing is being used, then $12 (consisting of $7 variable cost and $5 fixed cost) will be deducted on the income statement as cost of goods sold. Similarly, any unsold units will be carried as inventory on the balance sheet at $12 each.

Under variable costing, notice that all variable costs of production are included in product costs. Thus if the company sells a unit of product, only $7 will be deducted as cost of goods sold, and unsold units will be carried in the balance sheet inventory account at only$7.

Income Comparison of  Variable and Absorption Costing

Income statements prepared under absorption and variable costing approaches are shown below. We use the data for Boley Company presented earlier along with other information about the company given below

1.  Under absorption costing if inventories increase then some of the fixed manufacturing costs of the current period will not appear on the income statement as part of cost of goods sold. Instead, these costs are deferred to a future period and are carried on the balance sheet as part of the inventory account. such a deferral of cost is known as fixed manufacturing overhead deferred in inventory. When units produced in current period are sold in future periods a portion of the current fixed overhead cost is also released. Thus a cost incurred in current period becomes a cost of the future period and is shown on the income statement as a portion of cost of goods sold in future period. It is called fixed manufacturing overhead released from inventory.
2. Under variable costing method the entire fixed manufacturing overhead is treated as an expense of the current period.
3. The ending inventory figure under variable costing method is usually lower than it is under absorption costing method. The reason is that under variable costing only the variable manufacturing costs are assigned to products and therefore included in inventory.

Advantages of Variable Costing:

The advantages of variable costing can be summarized as follows.

1. The data that are required for CVP analysis can be taken directly from a variable costing format income statement. These data are not available on a convent ail income statement based on absorption costing.
2. Under variable costing, the profit for a period is not affected by changes in inventories. Other things remaining the same (i.e. selling prices, costs, sales mix, etc,), profits move in the same direction as sales when variable costing is in use.
3. Managers often assume that unit product costs are variable costs. This is a problem under absorption costing, since unit product costs are a combination of both fixed and variable costs. Under variable costing, unit product costs do not contain fixed costs.
4. The impact of fixed costs on profits is emphasized under the variable costing and contribution approach. The total amount of fixed costs appears explicitly on the income statement. Under absorption, the fixed costs are mingled together with the variable costs and are buried in cost of goods sold and in ending inventories.
5. variable costing data make it easier to estimate the profitability of product, customers, and other segments of the business. With absorption costing, profitability is obscured by arbitrary allocations of fixed costs.
6. Variable costing ties in with cost control methods such as standard costs and flexible budgets.
7. Variable costing net operating income is closer to net cash flow than absorption costing net operating income. This is particularly important for companies having cash flow problems.