In order to avoid some of the complexities associated with absorption costing, and especially manufacturing overhead, some organizations use variable costing.1 This note discusses variable costing, a technique that remove fixed manufacturing overhead from the absorption process, treating it as a period cost rather than a product cost. In so doing, it relies on the distinction between fixed and variable costs. While not permitted by GAAP for external reporting purposes, this technique frequently is used internally by managers to help them better understand how manufacturing costs are being incurred. The note compares absorption costing with variable costing, identifies the differences between the approaches, and discusses the advantages and disadvantages of each. The note’s learning objectives are contained in Exhibit 1.
Exhibit 1. LEARNING OBJECTIVES
Upon completing this note, you should know about:
- The distinction between absorption costing and variable costing, and the advantages and disadvantages of each
- The cause of a difference between income under absorption costing and variable costing under the same set of manufacturing and selling circumstances
- The reason why there can be an overhead volume variance under absorption costing, but not under variable costing.
- The impact of just-in-time (JIT) manufacturing operations on the differences between absorption and variable costing.
VARIABLE COSTING VERSUS ABSORPTION COSTING
Both generally accepted accounting principles and tax regulations require manufacturing companies to use an absorption costing system. Under an absorption system, fixed manufacturing costs—both direct and indirect—are treated as product costs. That is, they are assigned (or attached) to products during the manufacturing process, and absorbed into inventory. They remain attached to the products in the work-in-process inventory, and, subsequently, in the finished goods inventory, until the products are sold. At that time they are removed from finished goods inventory, and placed on the income statement as part of cost of goods sold.
A company that treated its fixed manufacturing costs as period costs, i.e., did not assign them to products but expensed them on the income statement in the period when they were incurred, ordinarily would receive a qualified opinion on its audited financial statements. In effect, by not attaching these costs to products, and expensing them when the products are sold, it is violating the matching principle.
Absorption costing therefore must be used to value inventories for financial statements prepared under Generally Accepted Accounting Principles (GAAP), and it must be used for tax computing purposes. This does not mean that it must be used for managerial purposes, however. For internal reporting and control purposes, management can use any kind of information it wishes. There is only one criterion: the information must be useful. Because of the complexities associated with absorption costing, many companies have chosen to use something somewhat more intuitive, and therefore useful, for internal purposes: variable costing.
The difference between the two types of costing lies exclusively in the treatment of the fixed portion of manufacturing overhead. This is illustrated in Exhibit 8. As this exhibit indicates, absorption costing treats fixed manufacturing overhead as a product cost, whereas variable costing treats it as a period cost.
As the following example shows, the difference between these two forms of costing can have a significant impact on an organization’s financial statements.
Example: Two companies are identical in every respect except one: Company A uses absorption costing, while Company V uses variable costing. In Month 1, both companies produce and sell 1,000 units of their product. In Month 2, both companies produce 1,500 units of their product, but sell only 1,000 units. In Month 3, both companies produce 500 units, but sell 1,000 units (obtaining the remaining 500 units from the finished goods inventory left over at the end of Month 2).
To keep things simple, we will use only variable and fixed manufacturing overhead (i.e., no direct manufacturing cost), plus selling, general, and administrative costs. Assume the following. . . .
1 For a discussion of absorption costing, see David W. Young, Note on Absorption Costing, Cambridge, MA, The Crimson Press Curriculum Center