Chapter 8: Variable Costing: A Tool for Management

Objective 1 - Identify how variable costing differs from absorption costing and compute unit product costs under each method.

Absorption Costing

  • 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.

Variable 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.

Image result for absorption costing vs variable income statement

  • 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.

Image result for reconciliation variable and absorption

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).

Decision Making

  • 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

  1. Data for CVP analysis can be taken directly from a contribution format income statement. (data is not available on a conventional absorption cost statement)
  2. Under variable costing, profit is not affected by changes in inventories, and profits move in the same direction as sales.
  3. Managers often assume unit product costs are variable costs – under absorption this is problematic because they combine fixed and variable costs.
  4. Under variable costing, impact of fixed costs on profits is emphasized – it is explicitly said on the income statement.
  5. 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)
  6. Variable costing ties in with cost control methods such as standard costs and flexible budgets.
  7. 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.

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