In the production stage of a product’s life cycle, companies must allocate costs incurred to determine a product's total production cost. Costs can be allocated to a product using either of the two methods: variable and absorption costing. In variable costing, costs are divided into fixed and variable segments, with the fixed costs being treated as period costs. However, absorption costing assigns all costs to a product as a single lump sum, regardless of whether they are fixed or variable. Show
GAAP ComplianceWhile recording and summarizing financial transactions, accountants follow a set of rules and conventions known as the generally accepted accounting principles (GAAP).These principles don’t recognize variable costing as the technique for reporting costs in financial statements. Variable costs such as direct materials, direct labor and variable manufacturing overhead are added as product costs, while all the total fixed costs are expensed in the year of production as period costs. This is in conflict with the GAAP requirement that all costs of manufacturing a particular product be expensed at once. TaxationVariable costing is not accepted by GAAP because it reports a lower taxable figure as inventory increases. In the eyes of the Internal Revenue Service, lower taxable income means less tax revenue. Hence, to ensure fairness in tax collection, GAAP advocates the use of the absorption costing method in reporting the costs of production, since taxable profits increase proportionately with increase in inventory sales. Matching CostsThe variable costing approach doesn’t provide correct matching of costs because fixed costs incurred in manufacturing the inventory are charged to expenses, irrespective of whether the inventory is sold in the period or not. This fact prevents the variable costing approach from being used for external reporting purposes. However, variable costing is used in managerial decision making through the use of the cost-volume-profit (CVP) analysis technique. CVP analysis is a model used to identify the appropriate operating activity levels required to prevent losses, attain targeted profits and monitor organizational performance. Shareholders’ WealthManagers as agents of shareholders have a duty to protect and generally increase the value of the shareholders’ wealth. One avenue through which shareholders can monitor the progress of the management is through financial statements. Since the variable costing approach doesn’t present accurate income figures, it is not allowed in the preparation of financial statements for external users. This is one of the premises on which the GAAP disallows the use of variable costing in the preparation of financial statements. UnderstatementIn preparing financial statements, the GAAP states that the cost of inventory should include all costs incurred in the production of the inventory. This includes a reasonable portion of fixed manufacturing costs incurred to produce the inventory. The variable costing approach ignores such fixed manufacturing costs, thereby understating the overall cost of the product. ABC costing assigns a proportion of overhead costs on the basis of the activities under the presumption that the activities drive the overhead costs. As such, ABC costing converts the indirect costs into product costs. There are also cost systems with a different approach. Instead of focusing on the overhead costs incurred by the product unit, these methods focus on assigning the fixed overhead costs to inventory. There are two
major methods in manufacturing firms for valuing work in process and finished goods inventory for financial accounting purposes: variable costing and absorption costing. Variable costing, also called direct costing or marginal costing, is a method in which all variable costs (direct material, direct labor, and variable overhead) are assigned to a product and fixed overhead costs are expensed in the
period incurred. Under variable costing, fixed overhead is not included in the value of inventory. In contrast, absorption costing, also called full costing, is a method that applies all direct costs, fixed overhead, and variable manufacturing overhead to the cost of the product. The value of inventory under absorption costing includes direct material, direct labor, and all overhead. The difference in the
methods is that management will prefer one method over the other for internal decision-making purposes. The other main difference is that only the absorption method is in accordance with GAAP. The difference between the absorption and variable costing methods centers on the treatment of fixed manufacturing overhead costs. Absorption costing “absorbs” all of the costs used in manufacturing and includes fixed manufacturing overhead as product costs. Absorption costing is in accordance with GAAP, because the product cost includes fixed overhead. Variable costing considers the variable overhead costs and does not consider fixed overhead as part of a product’s cost. It
is not in accordance with GAAP, because fixed overhead is treated as a period cost and is not included in the cost of the product. CONCEPTS IN PRACTICE While companies use absorption costing for their
financial statements, many also use variable costing for decision-making. The Big Three auto companies made decisions based on absorption costing, and the result was the manufacturing of more vehicles than the market demanded. Why? With absorption costing, the fixed overhead costs, such as marketing, were allocated to inventory, and the larger the inventory, the lower was the unit cost of that overhead. For example, if a fixed cost of $1,000 is allocated to 500 units, the cost is $2 per unit.
But if there are 2,000 units, the per-unit cost is $0.50. While this was not the only reason for manufacturing too many cars, it kept the period costs hidden among the manufacturing costs. Using variable costing would have kept the costs separate and led to different decisions. Absorption costing considers all fixed overhead as part of a product’s cost and assigns it to the product. This treatment means that as inventories increase and are possibly carried over from the year of production to actual sales of the units in the next year, the company allocates a portion of the fixed manufacturing overhead costs from the current period to future periods. Carrying over inventories and overhead costs is reflected in the ending inventory balances at the end of the production period, which become the beginning inventory balances at the start of the next period. It is anticipated that the units that were carried over will be sold in the next period. If the units are not sold, the costs will continue to be included in the costs of producing the units until they are sold. Finally, at the point of sale, whenever it happens, these deferred production costs, such as fixed overhead, become part of the costs of goods sold and flow through to the income statement in the period of the sale. This treatment is based on the expense recognition principle, which is one of the cornerstones of accrual accounting and is why the absorption method follows GAAP. The principle states that expenses should be recognized in the period in which revenues are incurred. Including fixed overhead as a cost of the product ensures the fixed overhead is expensed (as part of cost of goods sold) when the sale is reported. For example, assume a new company has fixed overhead of $12,000 and manufactures 10,000 units. Direct materials cost is $3 per unit, direct labor is $15 per unit, and the variable manufacturing overhead is $7 per unit. Under absorption costing, the amount of fixed overhead in each unit is $1.20 ($12,000/10,000 units); variable costing does not include any fixed overhead as part of the cost of the product. Figure 8.1.1 shows the cost to produce the 10,000 units using absorption and variable costing. Figure \(\PageIndex{1}\): Finished Goods Inventory under Absorption and Variable Costing. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)Assume each unit is sold for $33 each, so sales are $330,000 for the year. If the entire finished goods inventory is sold, the income is the same for both the absorption and variable cost methods. The difference is that the absorption cost method includes fixed overhead as part of the cost of goods sold, while the variable cost method includes it as an administrative cost, as shown in Figure 8.1.2. When the entire inventory is sold, the total fixed cost is expensed as the cost of goods sold under the absorption method or it is expensed as an administrative cost under the variable method; net income is the same under both methods. Now assume that 8,000 units are sold and 2,000 are still in finished goods inventory at the end of the year. The cost of the fixed overhead expensed on the income statement as cost of goods sold is $9,600 ($1.20/unit × 8,000 units), and the fixed overhead cost remaining in finished goods inventory is $2,400 ($1.20/unit × 2,000 units). The amount of the fixed overhead paid by the company is not totally expensed, because the number of units in ending inventory has increased. Eventually, the fixed overhead cost will be expensed when the inventory is sold in the next period. Figure 8.1.3 shows the cost to produce the 8,000 units of inventory that became cost of goods sold and the 2,000 units that remain in ending inventory. Figure \(\PageIndex{3}\): Cost of Goods Sold and Ending Inventory with the Absorption and Variable Costing Methods. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)If the 8,000 units are sold for $33 each, the difference between absorption costing and variable costing is a timing difference. Under absorption costing, the 2,000 units in ending inventory include the $1.20 per unit share, or $2,400 of fixed cost. That cost will be expensed when the inventory is sold and accounts for the difference in net income under absorption and variable costing, as shown in Figure 8.1.4. Figure \(\PageIndex{4}\): Net Income under Absorption and Variable Costing When Ending Inventory Remains. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)Under variable costing, the fixed overhead is not considered a product cost and would not be assigned to ending inventory. The fixed overhead would have been expensed on the income statement as a period cost. Inventory DifferencesBecause absorption costing defers costs, the ending inventory figure differs from that calculated using the variable costing method. As shown in Figure 8.1.3, the inventory figure under absorption costing considers both variable and fixed manufacturing costs, whereas under variable costing, it only includes the variable manufacturing costs. Suitability for Cost-Volume-Profit AnalysisUsing the absorption costing method on the income statement does not easily provide data for cost-volume-profit (CVP) computations. In the previous example, the fixed overhead cost per unit is $1.20 based on an activity of 10,000 units. If the company estimated 12,000 units, the fixed overhead cost per unit would decrease to $1 per unit. This calculation is possible, but it must be done multiple times each time the volume of activity changes in order to provide accurate data, as CVP analysis makes no distinction between variable costing and absorption costing income statements. YOUR TURN Comparing Variable and Absorption MethodsA company expects to manufacture 7,000 units. Its direct material costs are $10 per unit, direct labor is $9 per unit, and variable overhead is $3 per unit. The fixed overhead is estimated at $49,000. How much would each unit cost under both the variable method and the absorption method? AnswerThe variable cost per unit is $22 (the total of direct material, direct labor, and variable overhead). The absorption cost per unit is the variable cost ($22) plus the per-unit cost of $7 ($49,000/7,000 units) for the fixed overhead, for a total of $29. Advantages and Disadvantages of the Variable Costing MethodVariable costing only includes the product costs that vary with output, which typically include direct material, direct labor, and variable manufacturing overhead. Fixed overhead is not considered a product cost under variable costing. Fixed manufacturing overhead is still expensed on the income statement, but it is treated as a period cost charged against revenue for each period. It does not include a portion of fixed overhead costs that remains in inventory and is not expensed, as in absorption costing. If absorption costing is the method acceptable for financial reporting under GAAP, why would management prefer variable costing? Advocates of variable costing argue that the definition of fixed costs holds, and fixed manufacturing overhead costs will be incurred regardless of whether anything is actually produced. They also argue that fixed manufacturing overhead costs are true period expenses and have no future service potential, since incurring them now has no effect on whether these costs will have to be incurred again in the future. Advantages of the variable approach are:
While the variable cost method helps management make decisions, especially when the number of units in ending inventory fluctuates, there are some disadvantages:
Advantages and Disadvantages of the Absorption Costing MethodUnder the absorption costing method, all costs of production, whether fixed or variable, are considered product costs. This means that absorption costing allocates a portion of fixed manufacturing overhead to each product. Advocates of absorption costing argue that fixed manufacturing overhead costs are essential to the production process and are an actual cost of the product. They further argue that costs should be categorized by function rather than by behavior, and these costs must be included as a product cost regardless of whether the cost is fixed or variable. The advantages of absorption costing include:
While financial and tax reporting are the main advantages of absorption costing, there is one distinct disadvantage:
ETHICAL CONSIDERATIONS Cost Accounting for Ethical Business ManagersAn ethical and evenhanded approach to providing clear and informative financial information regarding costing is the goal of the ethical accountant. Ethical business managers understand the benefits of using the appropriate costing systems and methods. The accountant’s entire business organization needs to understand that the costing system is created to provide efficiency in assisting in making business decisions. Determining the appropriate costing system and the type of information to be provided to management goes beyond providing just accounting information. The costing system should provide the organization’s management with factual and true financial information regarding the organization’s operations and the performance of the organization. Unethical business managers can game the costing system by unfairly or unscrupulously influencing the outcome of the costing system’s reports. Comparing the Operating Income Statements for Both Methods Assuming No Ending Inventory in the First Year, and the Existence of Ending Inventory in the Second YearIn order to understand how to prepare income statements using both methods, consider a scenario in which a company has no ending inventory in the first year but does have ending inventory in the second year. Outdoor Nation, a manufacturer of residential, tabletop propane heaters, wants to determine whether absorption costing or variable costing is better for internal decision-making. It manufactures 5,000 units annually and sells them for $15 per unit. The total of direct material, direct labor, and variable overhead is $5 per unit with an additional $1 in variable sales cost paid when the units are sold. Additionally, fixed overhead is $15,000 per year, and fixed sales and administrative expenses are $21,000 per year. Production is estimated to hold steady at 5,000 units per year, while sales estimates are projected to be 5,000 units in year 1; 4,000 units in year 2; and 6,000 in year 3. Under absorption costing, the ending inventory costs include all manufacturing costs, including overhead. If fixed overhead is $15,000 per year and 5,000 units are manufactured each year, the fixed overhead per unit is $3: $15,000 / 5,000 units = $3 per unit The projected income statement using absorption costing is shown in Figure 8.1.5: Figure \(\PageIndex{5}\): Outdoor Nation’s Income Statement Using Absorption Costing. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)In variable costing, the fixed overhead is not included in the cost of goods sold even if it relates to manufacturing. As a result, the net income under variable costing differs from absorption costing by the same amount as inventory differential. The projected income under variable costing is shown in Figure 8.1.6: Figure \(\PageIndex{6}\): Outdoor Nation’s Income Statement Using Variable Costing. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)The difference between the methods is attributable to the fixed overhead. Therefore, the methods can be reconciled with each other, as shown in Figure 8.1.7. Figure \(\PageIndex{7}\): Outdoor Nation’s Reconciliation of Net Incomes. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)Each method results in different amounts for net income when the inventory amounts change. More specifically, the effects on income are:
Can absorption costing be used for external reporting?Under generally accepted accounting principles (GAAP), absorption costing is required for external reporting. Absorption costing is an accounting method that captures all of the costs involved in manufacturing a product when valuing inventory.
Does GAAP use variable or absorption costing?The absorption costing method is typically the standard for most companies with COGS. It is required for compliance with GAAP.
Is variable costing accepted for external reporting?Therefore, variable costing is not permitted for external reporting. It is commonly used in managerial accounting and for internal decision-making purposes.
Is variable costing allowed under GAAP?The variable cost method is not acceptable for financial reporting under GAAP. GAAP requires expenses to be recognized in the same period as the related revenue, and the variable method expenses fixed overhead as a period cost regardless of how much inventory remains.
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