Variable Costing—A Tool for Management
1. Explain how variable costing differs from absorption costing and compute unit product costs under each method.
2. Prepare income statements using both variable and absorption costing.
3. Reconcile variable costing and absorption costing net operating incomes and explain why the two amounts differ.
4. Understand the advantages and disadvantages of both variable and absorption costing.
A. Overview of Variable and Absorption Costing. At least two methods can be used in manufacturing companies to value units of product for accounting purposes—absorption costing and variable costing. These methods differ only in how they treat fixed manufacturing overhead costs.
1. Variable Costing. Variable costing includes only variable production costs in product costs. Direct materials, direct labor and variable manufacturing overhead costs would ordinarily be included in product costs under variable costing. Fixed manufacturing overhead is not treated as a product cost under this method. Rather, fixed manufacturing overhead is treated as a period cost and is charged against income each period.
2. Absorption Costing. Absorption costing treats all production costs as product costs, regardless of whether they are variable or fixed. Under absorption costing, a portion of fixed manufacturing overhead is allocated to each unit of product.
B. Comparison of Absorption and Variable Costing. When comparing absorption costing and variable costing income statements, a number of points should be noted:
1. Deferral of fixed manufacturing costs under absorption costing. Under absorption costing, if inventories increase then a portion of the fixed manufacturing overhead costs of the current period is deferred to future periods in the inventory account. When the units are later taken out of inventory and sold, the deferred fixed costs flow through to the income statement as part of cost of goods sold.
2. Differences in inventories under the two methods. The ending inventory figures under the variable costing and absorption costing methods are different. Under variable costing, only the variable manufacturing costs are included in inventory. Under absorption costing, both variable and fixed manufacturing costs are included in inventory.
3.Suitability for CVP analysis. An absorption costing income statement is not well suited for providing data for CVP computations since it makes no distinction between fixed and variable costs. In contrast, the variable costing method classifies costs by behavior and is very useful in setting-up CVP computations.
C. Extended Comparison of Income Data. Exhibit 7-3 in the text presents a comparison of absorption costing and variable costing income statements over three years in which production is constant but sales vary. Exhibit 7-6 in the text also presents comparative income statements over three years but holds annual sales constant and varies annual production. From these Exhibits, several generalizations can be drawn. (All of these generalizations assume the LIFO inventory flow assumption is being used. The generalizations may not hold in some rare cases if a company uses an inventory flow assumption other than LIFO.)
1. Production equals sales (no change in inventories). When production equals sales, inventories do not change. If inventories do not change, then there is no change in the fixed manufacturing overhead costs in inventories under absorption costing. Therefore, under both costing methods all of the current fixed manufacturing overhead will flow through to the income statement as an expense. In the case of absorption costing it will be part of cost of goods sold. In the case of variable costing, it will be a period expense.
2. Production exceeds sales (inventories increase). When production exceeds sales, inventories grow. If inventories grow, then some of the current fixed manufacturing overhead costs will be deferred in inventories under absorption costing. Since all of the current fixed manufacturing overhead costs are expensed under variable costing, the net operating income reported under absorption costing will be greater than the net operating income reported under variable costing.
3. Sales exceed production (inventories decrease). When sales exceed production, inventories shrink. If inventories decrease, then some of the fixed manufacturing overhead costs that had been deferred in inventories in previous periods will be released to the income statement as part of cost of goods sold as well as all of the current fixed manufacturing overhead costs. Since only the current fixed manufacturing overhead costs are expensed under variable costing, the net operating income reported under absorption costing will be less than the net operating income reported under variable costing.
4. Long-term differences in income. Over an extended period of time, the cumulative net operating income figures reported under absorption costing and variable costing will be about the same; they will differ only by the amount of fixed manufacturing overhead cost in ending inventories under absorption costing. Cumulative net operating income figures will be identical whenever ending inventories are reduced to zero.
5. Changes in production volume. Variable costing net operating income is not affected by changes in production volume. On the other hand, absorption costing net operating income is affected by changes in production volume. For any given level of sales, net operating income under absorption costing will increase as the level of output increases and hence inventories increase.
D. The Matching Principle. Accountants and managers have been arguing for decades concerning the relative merits of absorption and variable costing. In practice, absorption costing is used far more than variable costing even for internal reports. The reasons for this are not entirely clear, although the perception that absorption costing is required for external reporting undoubtedly plays a key role. The argument for using absorption costing in external reports seems to be based on the matching principle.
1. Argument for absorption costing. Advocates of absorption costing argue that all manufacturing costs must be assigned to units of product so as to properly match costs with revenues. They argue that fixed manufacturing overhead costs are essential to the production process and must be included when costing units of product, regardless of how the cost behaves.
2. Argument for variable costing. Advocates of variable costing argue that fixed manufacturing overhead costs are incurred in order to have the capacity to produce. Moreover, they will be incurred regardless of whether anything is actually produced. Since these costs are not caused by any particular unit of product and are incurred to provide capacity for a particular period, the matching principle would dictate that fixed manufacturing overhead costs must be expensed in the current period.
E. Advantages of the Contribution Approach. There are a number of advantages to using variable costing (and the contribution approach) in internal reports and analysis.
1. More useful for CVP analysis. Variable costing statements provide data that are immediately useful for CVP analysis since they categorize costs on the basis of their behavior. In contrast, it is often difficult to rework absorption costing data so that they can be used in CVP analysis and in decisions.
2. Income is not affected by changes in production volume. Under absorption costing, reported net operating income is affected by changes in production since fixed costs are spread across more or fewer units. This can distort income and may even result in income moving in an opposite direction from sales. This does not occur under variable costing.
3. Avoids misunderstandings concerning unit product costs. Absorption costing unit product costs can be easily misinterpreted as variable costs since they are stated on a per unit basis. Such a misperception can lead to serious errors in making decisions. Variable costing avoids this problem since unit costs include only variable costs.
4. Fixed costs are more visible. The impact of fixed costs on profits is emphasized because the total amount of such costs for the period appears separately and is highlighted in the income statement rather than being buried in cost of goods sold and ending inventory.
5. Understandability. Managers should find it easier to understand variable costing reports because data are organized by behavior and because variable costing is much closer to cash flow.
6. Control is facilitated. Variable costing ties in with cost control methods such as flexible budgets.
7. Incremental analysis is more straight-forward. Variable cost corresponds closely with the current out-of-pocket expenditure necessary to produce and sell products and services and can therefore be used more readily in incremental analysis than absorption costing data. And since variable costing net operating income is closer to net cash flow than absorption costing net operating income, it is likely to be more useful to companies that have cash flow problems.
However, variable costing is not generally accepted by auditors for external financial reports and is not permitted by the IRS in the United States and by tax authorities in many other countries for income tax calculations. There is some question about whether variable costing is actually prohibited in the United States by official pronouncements and some companies do use some form of variable costing in their external reports, but absorption costing must be considered the most generally accepted practice.
F. Impact of JIT Inventory Methods. When companies use JIT methods for controlling their operations, the distortions of income that can occur under absorption costing largely (or completely) disappear.
1. The cause of distortions in net operating income. Erratic movements in net operating income under absorption costing and the differences in net operating income between absorption and variable costing can be traced to changing levels of inventory. When inventory levels are constant or negligible, absorption costing and variable costing methods yield the essentially same net operating income.
2. The JIT solution. Under an ideally functioning JIT system, goods are produced strictly to customers’ orders. Finished goods inventories almost disappear and work in process inventories are kept to a minimum. With little or no inventories, fixed manufacturing overhead costs cannot be shifted between periods under absorption costing. As a result, both variable and absorption costing will show essentially the same net operating income figure, and the net operating income under absorption costing will move in the same direction as movements in sales.