Deducting the variable cost of goods sold from sales in the variable costing income statement yields the manufacturing margin. Deducting the variable selling and administrative expenses from the manufacturing margin yields the contribution margin. Deducting the fixed costs from the contribution margin yields the income from operations. Show
The difference in the income reported under variable costing and absorption costing is summarized in the following table: Describe and
illustrate income analysis under variable costing and absorption costing. Variable costing is especially useful at the operating level of management because the amount of variable manufacturing costs are controllable at this level. The fixed factory overhead costs are ordinarily controllable by a higher level of management. In the short run, variable costing may be useful in establishing the selling price of a product. This price should be at least equal to the variable costs of making and selling the product. In the long run, however, absorption costing is useful in establishing selling prices because all costs must be covered and a reasonable amount of operating income must be earned. Variable costing can make a significant contribution to management decision making in analyzing and evaluating market segments, such as territories, products, salespersons, and customers. The revenues and variable costs can be allocated to the market segments. Segment contribution margin can be used by managers to support price decisions, evaluate cost changes, and plan volume changes. Contribution margin analysis is the systematic examination of differences between planned and actual contribution margins. These differences can be caused by (1) an increase or decrease in the amount of sales or (2) an increase or decrease in the amount of variable costs. An increase or decrease in either element may in turn be due to (1) an increase or decrease in the number of units sold or (2) an increase or decrease in the unit sales price or unit cost. The effect of these two factors on either sales or variable costs may be stated as follows:
Service firms will not have inventories, manufacturing margin, cost of goods sold, or differences in income from operations between variable and absorption costing. Service firms can report contribution margin as the difference between revenues and variable costs. Service firms can report contribution margin for market segments. In addition, service firms can use contribution margin analysis to plan and control operations. Absorption Costing vs. Variable Costing: An OverviewAbsorption costing and variable costing are methods used to value companies' work in progress and inventory, for accounting purposes. Absorption costing includes all the costs associated with the manufacturing of a product. Variable costing includes the variable costs directly incurred in production and none of the fixed costs. For reporting purposes, absorption costing is required under the Financial Accounting Standards Board’s Generally Accepted Accounting Principles (GAAP). Absorption vs. variable costing will only be a factor for companies that expense costs of goods sold (COGS) on their income statement. Although any company can use both methods for different reasons, public companies are required to use absorption costing due to their GAAP accounting obligations. Key Takeaways
Direct and Indirect CostsBefore looking at absorption versus variable costing, it's important to understand the difference between direct and indirect costs on the income statement. Direct costs are usually associated with COGS, which affects a company’s gross profit and gross profit margin. Indirect costs are associated with the operating expenses of a company. These costs heavily influence operating profit and the operating profit margin. Some of the direct costs associated with manufacturing a product include wages for workers physically manufacturing a product, the raw materials used in producing a product, and direct overhead costs involved in manufacturing a product. Indirect expenses are not directly associated with manufacturing. These can include:
Absorption CostingAbsorption costing is also known as full costing. Public companies are required to use the absorption costing method in cost accounting management for their COGS. Many private companies also use this method because it is GAAP-compliant whereas variable costing isn't. Absorption costing involves allocating all of the direct costs associated with manufacturing a product to COGS. This includes any variable costs directly associated with manufacturing, such as:
This also includes any direct fixed costs, such as:
Depending on a company’s level of transparency, an income statement using absorption costing may break out variable direct costs and fixed direct costs into two line items or combine them together to report a comprehensive COGS. In any case, the variable direct costs and fixed direct costs are subtracted from revenue to arrive at the gross profit. Using the absorption costing method will increase COGS and thus decrease gross profit per unit produced. This means companies will have a higher breakeven price on production per unit. It also means that customers will pay a slightly higher retail price. Furthermore, it means that companies will likely show a lower gross profit margin. The impact of absorption costing will depend on the business. For example, a company has to pay its manufacturing property mortgage payments every month regardless of whether it produces 1,000 products or no products at all. A company may see an increase in gross profit after paying off a mortgage or finishing the depreciation schedule on a piece of manufacturing equipment. These are considerations cost accountants must closely manage when using absorption costing. The absorption costing method is typically the standard for most companies with COGS. It is required for compliance with GAAP. Auditors and financial stakeholders will require it for external reporting. Depending on the type of business structure, small businesses may also be required to use absorption costing for their tax reporting. A main advantage of absorption costing is that it is GAAP-compliant. That means that's the only method needed if it's what a company prefers to use. If a company prefers the variable costing method for management decision-making purposes, it may also be required to use the absorption costing method for reporting purposes. Variable CostingSome companies may choose to use the variable costing method. With variable costing, all of the variable direct costs are included in COGS. The fixed direct costs are allocated to operating expenses rather than COGS. The types of fixed direct costs are the same whether a company uses absorption or variable costing:
Variable costing will result in a lower breakeven price per unit using COGS. This can make it somewhat more difficult to determine the ideal pricing for a product. Variable costing results in gross profit that will be slightly higher. In turn, that results in a slightly higher gross profit margin compared to absorption costing. Keep in mind, companies using the cash method may not need to recognize some of their expenses as immediately with variable costing since they are not tied to revenue recognition. This can be an advantage. The reason variable costing isn't allowed for external reporting is because it doesn't follow the GAAP matching principle. It fails to recognize certain inventory costs in the same period in which revenue is generated by the expenses, like fixed overhead. Key DifferencesBoth costing methods can be used by management to make manufacturing decisions. For internal accounting purposes, both can also be used to value work in progress and finished inventory. The overall difference between absorption costing and variable costing concerns how each accounts for fixed manufacturing overhead costs. Here's a summary of their differences.
Absorption Costing vs. Variable Costing ExampleLet's say that ABC company manufactures and sells 20,000 units of its product yearly. A single product includes these costs:
Under the absorption costing method, the per unit cost of product would be: $3 + $5 + $2 + $1.75 = $11.75 Under the variable costing method, the per unit cost of product would be: $3 + $5 + $2 = $10 Is Variable Costing More Useful Than Absorption Costing?It can be, especially for management decision-making concerning break-even analysis to derive the number of product units needed to be sold to reach profitability. What Are the Advantages of Variable Costing?Unlike absorption costing, variable costing doesn't add fixed overhead costs into the price of a product and therefore can give a clearer picture of costs. By assigning these fixed costs to cost of production as absorption costing does, they're hidden in inventory and don't appear on the income statement. What Are the Disadvantages of Variable Costing?While it's a valuable management tool, it isn't GAAP-compliant and can't be used for external reporting by public companies. Therefore, if a company uses variable costing, it may also have to use absorption costing (which is GAAP-compliant). The Bottom LineMost companies will use the absorption costing method if they have COGS. What's more, for external reporting purposes, it may be required because it's the only method that complies with GAAP. Companies may decide that absorption costing alone is more efficient to use. Depending on a company’s business model and reporting requirements, it may be beneficial to use the variable costing method, or at least calculate it in dashboard reporting. Managers should be aware that both absorption costing and variable costing are options when reviewing their company’s COGS cost accounting process. If a company has high direct, fixed overhead costs it can make a big impact on the per unit price. Companies that use variable costing may be able to allocate high monthly direct, fixed costs to operating expenses. This could result in a more reasonable per unit price in some cases. However, most companies may need to transition to absorption costing at some point, which can be important to factor into short-term and long-term decision making. Which is better absorption or variable costing?Variable costing is more useful than absorption costing if a company wishes to compare different product lines' potential profitability. It is easier to discern the differences in profits from producing one item over another by looking solely at the variable costs directly related to production.
Which of the following will cause income determined with absorption costing to be higher than income determined with direct costing?Which of the following will cause income determined with absorption costing to be higher than income determined with direct costing? units produced are greater than units sold.
What do you mean by absorption costing?Absorption costing, sometimes called “full costing,” is a managerial accounting method for capturing all costs associated with manufacturing a particular product. The direct and indirect costs, such as direct materials, direct labor, rent, and insurance, are accounted for by using this method.
What is the difference between full absorption costing and variable costing?Absorption costing entails allocating fixed overhead costs to all units produced for an accounting period. Variable costing includes all of the variable direct costs in COGS but excludes direct, fixed overhead costs.
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