Chapter 8: Variable Costing: A Tool for Management
Published 3 years ago
Published 3 years ago
Objective 1 - Identify how variable costing differs from absorption costing and compute unit product costs under each method.
- Absorption costing assigns both variable costs and fixed costs to products.
- Consisting of Direct Materials, Direct Labour, and both fixed and variable manufacturing overhead.
- Known as full costing.
- A costing method that includes only variable manufacturing costs – direct materials, direct labour, and variable manufacturing overhead – in a product.
- Fixed MOH is treated as a period cost like selling & administrative costs.
- Known as direct costing or marginal costing.
Selling and Administrative Expenses
- S&A costs are treated as period costs regardless of costing method.
Unit Cost Computations
- For absorption: all manufacturing costs are included (variable and fixed), giving a unit product cost with DM, DL, and variable/fixed MOH.
- For variable costing - only variable manufacturing costs are included in product costs, with DM, DL, and variable MOH.
Objective 2: Prepare income statements using both variable and absorption costing.
- Fixed Manufacturing Overhead Cost Deferred in Inventory - Under absorption costing, fixed manufacturing costs associated with ending inventory is carried forward.
- Under the variable costing method, the entire fixed manufacturing overhead costs in the period is treated as an expense of the current period.
- Ending inventory under variable costing is less than absorption because only variable MOH costs are assigned to variable costing.
- Absorption costing makes no distinction between fixed and variable costs – so it is not well suited for CVP analysis.
- Variable costing blends well with contribution approach to the income statement – both concepts are based on classifying cost by behaviour.
- Difference between absorption costing and variable costing centres on timing of the fixed manufacturing costs.
Objective 3 – Reconcile variable costing and absorption costing operating incomes and explain why the two amounts differ.
Extended Comparison of Income Data
- Change in inventories during the year is the key to understanding the difference.
- Fixed MOH is deferred in inventory or released from inventory depending on how inventory moves.
- Productions > Sales - Defer in inventory (don’t charge) as inventories increase.
- Productions < Sales - Release from inventory (Charge for the cost) as inventories decrease.
- Over an extended period of time, cumulative operating income figures tend to be the same under both methods.
Effect of Changes in Production
- Variable Costing – Changes in production does not affect operating income.
- Absorption Costing – Changes in production do affect operating income.
- This is because fixed MOH is shifted between periods as a result of changes in inventory.
- Reconciliation – Traces the differences in operating income to the effects of changes in inventories on absorption costing operating income.
Choosing a Costing Method
Impact on the Manager
Clarity - Absorption costing may provide confusing MOH costs between periods.
- Variable costing income statements are clear and easy to understand – sales are constant, so CM and operating income remain constant.
Drivers - Absorption costing has revenue and production drive operating income which may be confusing.
- Variable costing is driven by revenue.
Cost-Volume-Profit Analysis and Absorption Costing
- Absorption costing is widely used for both internal and external reports – it focuses on full costing of units of product.
- AC doesn’t do well with CVP analysis because inventory is deferred or released, distorting expenses caused by fixed MOH costs.
- If fixed MOH is deferred, they will not appear as expenses and income is overstated.
- In other areas of CVP analysis, it runs into trouble because variable costing is assumed to be used.
- Break-even point may be created by various possible sales and production levels because a single equation does not provide a result for absorption costing – there are two drivers (sales and drivers).
- Misperception that fixed MOH costs are variable with number of units sold, but they are not.
- Managers may decide to drop actually profitable products.
External Reporting, Income Taxes, and Management Performance Evaluation
- Absorption costing is required for external reports for the US and is predominant in Canada.
- Management can use variable costing statements for internal reports – as the adjustment is simple, often both are used. (variable for internal and absorption for external)
- Top executives are usually evaluated on external reports – so there may be a problem for these individuals who favour using variable costing for internal reports.
Advantages of Variable Costing and the Contribution Approach
- Data for CVP analysis can be taken directly from a contribution format income statement. (data is not available on a conventional absorption cost statement)
- Under variable costing, profit is not affected by changes in inventories, and profits move in the same direction as sales.
- Managers often assume unit product costs are variable costs – under absorption this is problematic because they combine fixed and variable costs.
- Under variable costing, impact of fixed costs on profits is emphasized – it is explicitly said on the income statement.
- Variable costing data makes it easier to estimate the profitability of products, customers, and other segments. (in absorption, profitability is obscured by arbitrary allocations of fixed costs)
- Variable costing ties in with cost control methods such as standard costs and flexible budgets.
- Variable costing operating income is closer to net cash flow than absorption costing.
- Absorption costing continues to be used predominantly due to tradition, and because it better matches costs with revenues.
- Arguments for
- Some argue that all manufacturing costs must be assigned to products.
- Expensive to maintain two cost systems.
- Managers may not pay enough attention to fixed manufacturing costs and focus too much on contribution margin. (Focus too much on Short Run Profit)
- Arguments against
- Fixed manufacturing costs are not really the costs of any particular product – they have to do with the capacity to make products.
- Whether a unit is made or not, the fixed MOH costs are incurred.
Impact of Lean Production
- Lean production methods – Allows production in response to customer orders, so number of units produced usually equals number of units sold.
- Reduces the ability of an unethical manager to manage reported earnings by building inventory.
- Cost of a unit of product will be different between variable and absorption costing – but the differences in operating income will mostly disappear.