Discussion Topic: Variable Costing vs. Absorption Costing
Review Chapter 9, which discusses variable costing and absorption costing.
- How does a variable costing income statement differ from a traditional (using absorption costing) income statement?
- How can the use of absorption costing allow a buildup of inventory?
- What are some of the reasons that management would want cost accountants provide them with both variable costing and absorption costing income statements?
Just do response each posted # 1 to 3 down below only.
Variable costing is when inventoriable costs are included with the variable direct and indirect costs. All fixed costs are not included and are only included as costs when they incur. Absorption costing is when all variable costs and fixed costs are included in the inventory. (Datar, 2018) Absorption costing gives a more accurate number of net profitability. If a company does not sell all of its product within the same period that they are manufactured those numbers would not be reflected in a variable costing income statement. The traditional income statement will include that information whether it is sold or not. (Maverick, 2019) Production leads to higher operating income. Checks and balances can be implemented so that managers are not building up inventory for their personal gain through bonuses and stock value increases. Unfortunately, these checks and balances are not 100% fool proof. (Datar, 2018) Managers will want both variable costing and absorption costing income statements because how inventory is calculated will change the operating income values. Managers can look at how fixed manufacturing costs move between units produced and units sold. Managers are often asked to reduce inventory levels. If you use variable costing operating income compared to the absorption costing operating income you can drastically decrease your ending inventory levels and in turn drastically drop your operating income. When using variable costing, you cannot increase operating income by producing for inventory, because quantity of units sold is related to operating income. (Datar, 2018)
Datar, S. M. & Rajan, M. V. (2018). Horngren’s Cost Accounting: A Managerial Emphasis, Global Edition. Pearson Education Limited: London
Maverick, J. B. (2019, April 18). Absorption Costing vs. Variable Costing: What’s the Difference? Retrieved from https://www.investopedia.com/ask/answers/052515/what-are-differences-between-absorption-costing-and-variable-costing.asp
The net operating income resulted from absorption costing and variable costing method is not the same due to each treats the fixed manufacturing overhead cost differently. “Absorption costing income statements do not need to differentiate between variable and fixed costs” (Datar & Rajan, 2017, p. 333). All costs related to the production, including the fixed overhead cost, are accounted for in the cost of goods sold (COGS) to result in the gross margin. On the other hand, the variable costing income statement only includes the variable costs in the COGS to result in the contribution margin. Besides, absorption costing is required to be in compliance with generally accepted accounting principles (GAAP) and used for calculating taxes while variable-costing is not.
Absorption costing adds the fixed overhead cost to the product cost per unit while variable costing includes the fixed overhead cost in the period cost. This results in the product cost per unit in the absorption costing method higher than the variable costing. In other words, under absorption costing, each unit in inventory includes a part of the fixed manufacturing overhead cost and is valued more than under variable costing. This is the reason why the inventory amount under absorption costing is higher than the variable costing. In order to keep the cost down, the company has to increase its unit production since the fixed cost does not change within the period regardless of how many units are produced. Therefore, the fixed cost per unit would be reduced when the units increased. For example, if the fixed manufacturing cost in the period is $5,000 and the total production units in the same period is 10,000. Each unit cost would include an extra 50 cents while the variable costing has less 50 cents per unit. If the company produces 20,000 units, each unit cost in the absorption costing income statement would be reduced by 25 cents. For variable costing, the fixed manufacturing overhead cost would appear in the variable costing income statement as an expense instead (Datar & Rajan, 2017, p. 338-339).
Variable costing may provide a better picture of the actual direct product cost than absorption costing. However, absorption costing provides an effective cost of a product that includes all costs to finish a product. Also, although the company may use variable costing, it is required to use absorption costing for external reporting, in compliance with GAAP, and for filing taxes. Therefore, both costing methods would help management understand a complete picture of each actual unit cost and provide an accurate product cost to external users.
Datar, S. & Rajan, M. (2017). Horngren’s cost accounting: A managerial emphasis (16thed.). Pearson. Retrieved from https://purdueuniversityglobal.vitalsource.com/#/books/9780134475950/cfi/6/108!/4/2/26/[email protected]:100