BULLET NOTES ON PRODUCT COSTING (ABSORPTION VS.
VARIABLE)
Product Versus Period Costs
Product costs are costs that are a necessary and integral part of producing the
finished product.
Product costs do not become expenses until the company sells the finished goods
inventory.
Period costs are costs that are matched with the revenue of a specific time period
rather than included as part of the cost of a salable product.
Period costs include selling and administrative expenses and companies deduct them
from revenues in the period in which they are incurred.
Absorption vs. Variable Costing
Absorption Costing
o Costing method that includes all manufacturing costs (direct materials, direct
labor and both variable and fixed manufacturing overhead) in the cost of a unit
of product.
o Treats fixed manufacturing overhead as a product cost.
o Also called Full Costing and Conventional Costing.
Variable Costing
o Costing method that includes only variable manufacturing costs (direct
materials, direct labor, and variable manufacturing overhead) in the cost of a
unit of product.
o Treats fixed manufacturing overhead as a period cost.
o Also called Direct Costing.
Summary of Differences
Absorption costing Variable costing
Cost Seldom segregates costs into variable Costs are segregated into variable
segregation and fixed costs and fixed
Cost of inventory includes all the Cost of inventory includes only
Cost of manufacturing costs; materials, the variable manufacturing costs;
Inventory labor, variable factory overhead, and materials, labor and variable
fixed factory overhead factory overhead.
Treatment of Fixed factory overhead is treated as Fixed factory overhead is treated
Fixed OH product cost. as period cost.
Income Distinguishes between production Distinguishes between variable
Statement and other costs. and fixed costs.
Note:
Selling and administrative expenses are period costs under both absorption and
variable costing.
Companies use the cost-volume-profit format in preparing a variable costing income
statement.
The one primary difference between variable and absorption costing is that under
variable costing companies charge fixed manufacturing overhead as an expense in
the current period, instead of being deferred to a future period through the ending
inventory as under absorption costing.
Difference in Net Income Under Absorption and Variable Costing:
When units produced exceed units sold, net income under absorption costing will
show a higher net income than variable costing since fixed overhead costs are deferred
to a future period as part of the ending inventory cost.
When units produced are less than units sold, net income under absorption costing
will show lower net income than variable costing because fixed manufacturing
overhead cost in beginning inventory is charged to the current year income under
absorption costing.
When units produced and sold are the same, net income will be equal under the two
costing approaches because there is no increase in ending inventory, and therefore no
deferral of fixed overhead costs to future periods through the ending inventory.
BULLET NOTES – VARIABLE AND ABSORPTION COSTING Compiled by Vhin
Decision-Making Concerns
For external reporting purposes, companies must report financial information using
GAAP, which requires that absorption costing be used for the costing of inventory.
Some companies have recognized that net income calculated using GAAP does not
highlight differences between variable and fixed costs and may lead to poor business
decisions. Therefore, some companies use variable costing for internal reporting
purposes.
Management may be tempted to overproduce in a given period in order to increase
net income, but this decision may not be in the company’s best interest since the
buildup of inventories will lead to additional costs to the company in the long run.
Variable costing avoids the temptation to overproduce because net income under
this approach is not affected by changes in production levels.
Potential Advantages of Variable Costing
Variable costing has several potential advantages relative to absorption costing:
ο Net income computed under variable costing is unaffected by changes in
production levels.
ο The use of variable costing is consistent with cost-volume-profit analysis and
incremental analysis.
ο Net income computed under variable costing is closely tied to changes in sales
and provides a more realistic assessment of the company’s success or failure.
ο The presentation of fixed and variable cost components on the variable costing
income statement makes it easier to identify these costs and understand their effect
on the company’s results.
Reconciliation of Income under Absorption Costing & Variable Costing
Basic Formula:
∆ Income = ∆ Inventory x unit FFOH
Where:
∆ Inventory = Ending Inventory – Beginning Inventory
∆ Inventory = Units Produced – Units Sold
Alternative Formula:
Income, Absorption costing xx
Add: FFOH in beginning inventory xx
Total xx
Less: FFOH in ending inventory xx
Income, Variable costing xx
