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Absorption costing is a costing system which treats all costs of production as product costs, regardless weather they are variable or fixed. The cost of a unit of product under absorption costing method consists of direct materials, direct labor and both variable and fixed overhead. Absorption costing allocates a portion of fixed manufacturing overhead cost to each unit of product, along with the variable manufacturing cost. Because absorption costing includes all costs of production as product costs, it is frequently referred to as full costing method.
Variable, Direct or Marginal Costing
Definition and explanation:
Variable costing is a costing system under which those costs of production that vary with output are treated as product costs. This would usually include direct materials, direct labor and variable portion of manufacturing overhead. Fixed manufacturing cost is not treated as a product costs under variable costing. Rather, fixed manufacturing cost is treated as a period cost and, like selling and administrative expenses, it is charged off in its entirety against revenue each period. Consequently the cost of a unit of product in inventory or cost of goods sold under this method does not contain any fixed overhead cost. Variable costing is some time referred to as direct costing or marginal costing. To complete this summary comparison of absorption and variable costing, we need to consider briefly the handling of selling and administrative expenses. These expenses are never treated as product costs, regardless of the costing method in use. Thus under either absorption or variable costing, both variable and fixed selling and administrative expenses are always treated as period costs and deducted from revenues as incurred.
Unit Cost Computation/Calculation:
To illustrate the computation/calculation of unit product costs under both absorption and variable costing consider the following example.
A small company that produces a single product has the following cost structure.Required:
Compute the unit product cost under absorption costing method.
Compute the unit product cost under variable / marginal costing method.
Under the absorption costing, notice that all production costs, variable and fixed, are included when determining the unit product cost. Thus if the company sells a unit of product and absorption costing is being used, then $12 (consisting of $7 variable cost and $5 fixed cost) will be deducted on the income statement as cost of goods sold. Similarly, any unsold units will be carried as inventory on the balance sheet at $12 each.
Under variable costing, notice that all variable costs of production are included in product costs. Thus if the company sells a unit of product, only $7 will be deducted as cost of goods sold, and unsold units will be carried in the balance sheet inventory account at only $7.
Income Comparison of Variable and Absorption Costing
The income statements prepared under absorption costing and variable costing usually produce different net operating income figures. This difference can be quite large. Here we will explain the basic reason of this difference in income. The explanation for this difference needs two separate income statements one under absorption costing and other under variable costing. We will prepare two income statements that will produce different income figures and then explain the reasons of difference. Consider the following example:
Following data relates to a manufacturing company:
Prepare income statements using:
a. Absorption costing system
b. Variable costing system
Prepare a reconciliation schedule
The income statements prepared above have different net operating income figures. Now we will explain why net operating income is different under both the costing systems.
Several points can be noted from the income statements prepared above:
Under absorption costing if inventories increase then some of the fixed manufacturing costs of the current period will not appear on the income statement as part of cost of goods sold. Instead, these costs are deferred to a future period and are carried on the balance sheet as part of the inventory account. Such a deferral of cost is known as fixed manufacturing overhead deferred in inventory. The process involved can be explained by referring to income statements prepared above. During the current period 6,000 units have been produced but only 5,000 units have been sold leaving 1,000 unsold units in the ending inventory. Under the absorption costing system each unit produced was assigned $5 in fixed overhead cost. Therefore each unit going into inventory at the end of the period has $5 in fixed manufactured overhead cost attached to it, or a total of $5,000 for 1,000 units (1,000 - $5). This fixed manufacturing overhead cost of the current period deferred in inventory to the next period, when hopefully these units will be taken out of inventory and sold. This deferral of $5,000 of fixed manufacturing overhead costs can be clearly seen by analyzing the ending inventory under the absorption costing method:
In summary, under absorption costing, of the $30,000 in fixed manufacturing overhead costs incurred during the period, only $25,000 (5,000 $ per unit) has been included in the cost of goods sold. The remaining $5000 (1000 units not sold $5 per unit) has been deferred in inventory to the next period.
Under variable costing method the entire $30,000 in fixed manufacturing overhead costs has been treated as an expense of the current period (see the bottom portion of the variable costing income statement).
The ending inventory figure under the variable costing method is $5,000 lower than it is under the absorption costing method. The reason is that under variable costing, Only the variable manufacturing costs are assigned to units of product and therefore included in the inventory:
The $5,000 difference in ending inventories explains the difference in net operating income reported between the two costing methods. Net operating is $5,000 higher under absorption costing since, as explained above, $5,000 of fixed manufacturing overhead cost has been deferred in inventory to the next period under that costing method. Hopefully, when the units relating to this $5,000 fixed cost will be sold in the next period the cost attached to these units will be included in the cost of goods sold of the next period. This is called fixed manufacturing overhead cost released from inventory.
The absorption costing system makes no distinction between fixed and variable costs; therefore, it is not well suited for CVP computations, which are important for good planning and control. To generate data for cost volume profit (CVP) analysis, it would be necessary to spend considerable time reworking and reclassifying costs on the absorption statement.
The variable costing approach to costing units of product works very well with the contribution approach to the income statement, since both concepts are based on the idea of classifying costs by behavior. The variable costing data could be immediately used in cost volume profit (CVP) calculations.
Advantages of Variable Costing
Variable costing has the following main advantages:
The data that are required for cost volume profit (CVP) analysis can be taken directly from a variable costing format income statement. These data are not available on a conventional income statement based on absorption costing.
Under variable costing, the profit for a period is not affected by changes in inventories. Other things remaining the same (i.e. selling prices, costs, sales mix, etc.), profits move in the same direction as sales when variable costing is in use.
Managers often assume that unit product costs are variable costs. This is a problem under absorption costing, since unit product costs are a combination of both fixed and variable costs. Under variable costing, unit product costs do not contain fixed costs.
The impact of fixed costs on profits is emphasized under the variable costing and contribution approach. The total amount of fixed costs appears explicitly on the income statement. Under absorption, the fixed costs are mingled together with the variable costs and are buried in cost of goods sold and in ending inventories.
Variable costing data make it easier to estimate the profitability of products, customers, and other segments of the business. With absorption costing, profitability is obscured by arbitrary allocations of fixed costs.
Variable costing ties in with cost control methods such as standard costs and flexible budgets.
Variable costing net operating income is closer to net cash flow than absorption costing net operating income. This is particularly important for companies having cash flow problems.
With all of these advantages one might wonder why absorption costing continues to be used almost exclusively for external reporting purposes and why it is predominant choice for internal reports as well. This is partly due to tradition, but absorption costing is also attractive to many accountants because they believe it better matches costs with revenues. Advocates of absorption costing argue that all manufacturing costs must be assigned to products in order to properly match the costs of producing units of product with the revenues from the units when they are sold. The fixed costs of depreciation, taxes, insurance, supervisory, salaries, and so on, are just as essential to manufacturing products as are the variable costs. Advocates of variable costing argue that fixed manufacturing costs are not really the costs of any particular unit of product. These costs are incurred to have the capacity to make products during a particular period and will be incurred even if nothing is made during the period. Moreover, whether a unit is made or not, the fixed manufacturing cost will be exactly the same. Therefore, variable costing advocates argue that fixed manufacturing costs are not part of the costs of producing a particular unit of product and thus the matching principle dictates that fixed manufacturing costs should be charged to the current period. At any rate, absorption costing is the generally accepted method for preparing mandatory external financial reports and income tax returns. Probably because of the cost and possible confusion of maintaining two separate costing systems-one for external reporting and one for internal reporting-most companies use absorption costing for both external and internal reports.
Limitations of Variable Costing--GAAP and External Reports
Practically speaking, absorption costing is required for external reports in United States and almost all over the world. A company that attempts to use variable costing (also called direct costing and marginal costing) on its external financial reports runs the risk that its auditors may not accepts the financial statements as conforming to generally accepted accounting principles (GAAP). Tax laws almost all over the world require the usage of a form of absorption costing for filling out income tax forms.
Even if a company must use absorption costing for its external reports, a manager can use variable costing statements for internal reports. No particular accounting problems are created by using both costing methods--the variable costing method for internal reports and the absorption costing method for external reports. The adjustment from variable costing net operating income to absorption costing net operating income is a simple one that can be easily made at year-end.
Top executives are typically evaluated based on the earnings reported to shareholders on the external financial reports. This creates a problem for top executives who might otherwise favor using variable costing for internal reports. They may feel that since they are evaluated based on absorption costing reports, decisions should also be based on absorption costing data.
Absorption Costing Around the World:
Absorption costing is norm around the world for external financial reports. After the fall of communism, accounting methods were changed in Russia to bring them into closer agreement with accounting methods used in the west. One result was the adoption of absorption costing
Variable Costing and Theory of Constraints (TOC):
In many companies direct labor is not really a variable cost. Even though direct labor may not be paid on an hourly basis, many companies have a commitment--sometimes enforced in labor contracts or by law--to guarantee workers a minimum number of paid hours. In TOC companies, there are two additional reasons to consider direct labor to be a fixed cost.
First, direct labor is not usually a constraint. In simplest case constraint is a machine. In more complex cases, the constraint is a policy (such as a poorly designed compensation scheme for sales persons) that prevents the company from using its resources more effectively. If direct labor is not the constraint, there is no reason to increase it. Hiring more direct labor would increase costs without increasing the output of salable products and services.
Second, TOC emphasizes continuous improvement to maintain competitiveness. Without committed and enthusiastic employees, sustained continuous improvement virtually impossible. Since layoffs often have devastating effects on employee morale, managers involved in TOC are extremely reluctant to lay off employees.
For these reasons, most managers in TOC companies regard direct labor as a committed fixed cost rather than as a variable cost. Hence, in the modified form of variable costing used in TOC companies, direct labor is not usually included as a part of product costs.
Impact of Just In Time (JIT) Inventory Methods on Variable and Absorption Costing System
Variable costing and absorption costing produce different net operating income figures whenever the number of units produced is different from the number of units sold. In other words, whenever there is a change in the number of units in inventory. Absorption costing net operating income figure can be erratic, sometimes moving in a direction that is opposite from the movement in sales.
When companies use just in time (JIT) methods, these problems are reduced. The erratic movement of net operating income under absorption costing and the difference in net operating income between absorption and variable costing occur because of changes in the number of units in inventory. Under just in time (JIT) goods are produced to customers' orders and the goal is to eliminate finished goods inventory entirely and reduce work in process inventory to almost nothing. If there is very little inventory, the changes in inventories will be very small and both variable costing and absorption costing will show basically the same net operating income figure. In that case, absorption costing net operating income will move in the same direction as movement in sales.
Of course the cost of a unit of product will still be different between variable and absorption costing. But when just in time (JIT) is used, the differences in net operating income will largely disappear.
Advantages and Disadvantages of Absorption Costing System
Advantages of Absorption Costing:
It recognizes the importance of fixed costs in production;
This method is accepted by Inland Revenue as stock is not undervalued;
This method is always used to prepare financial accounts;
When production remains constant but sales fluctuate absorption costing will show less fluctuation in net profit and
Unlike marginal costing where fixed costs are agreed to change into variable cost, it is cost into the stock value hence distorting stock valuation.
Disadvantages of Absorption Costing:
As absorption costing emphasized on total cost namely both variable and fixed, it is not so useful for management to use to make decision, planning and control;
as the manager's emphasis is on total cost, the cost volume profit relationship is ignored. The manager needs to use his intuition to make the decision.