Three key concepts: 1) Both income statement formats (Variable and absorption) include product and period costs, they just define these cost classifications differently. 1) Variable costing income statements are grounded in the contribution format. They categorize expenses based on cost behavior – variable costs are reported separately from fixed costs. Absorption costing income statements ignore variable and fixed cost distinctions. 3) Variable and absorption costing net income figures often differ from one another. This is due to the fact that they account for manufacturing overhead differently.
* Only manufacturing costs that vary with output are treated as product costs. Usually includes DM, DL and the variable portion of manufacturing overhead. Fixed overhead is treated as a period cost and expensed in its entirety each period. Variable costing is sometimes referred to as direct or marginal costing.
*Variable costing unit product cost=DM + DL + Variable Manufacturing Overhead
*Variable cost of goods sold= (Variable production cost) x (Units sold)
*The variable costing net operating income for each period can always be computed by multiplying the number of units sold by the contribution margin per unit and subtracting total fixed costs.
Contribution Margin Per Unit Sold
= Selling price per unit – (Variable production per unit + Variable selling and admin per unit)
* Treats all manufacturing costs as product costs, regardless of whether they are variable or fixed. The cost of a unit consists of DM, DL and BOTH variable and fixed manufacturing overhead. Referred to as the full cost method.
*First step is to determine unit product costs
*Fixed manufacturing overhead cost per unit=fixed manufacturing overhead cost
# of units produced
-Sales are the same as variable costing
**Even though sales are the same, net operating income (loss) can differ due to units being produced and sold in different periods, which determines when it’s counted into Cost of Goods Sold.
-Selling and administration expenses equal the amounts reported in the variable costing income statements; however they are reported as one amount rather than being separated into variable and fixed components
-In general, when the units produced exceed unit sales and hence inventories increase, net operating income is higher under absorption costing than under variable costing. This occurs because some of the fixed MO of the period is deferred in inventories under absorption costing. When sales exceed production (and inventories decrease), net operating income is lower under absorption costing than variable costing. When the units produced and sold are equal, no change in inventories occurs and absorption and variable costing net operating incomes are the same. Relation between Production and Sales for the Period| Effect on Inventories| Relation between Absorption and Variable Costing Net Operating Incomes| Units produced=Units sold| No change in inventories| Abs. NOI=Var. NOI| Units produced>Units sold| Inventories increase| Abs. NOI>Var. NOI| Units produced<Units sold| Inventories decrease| Abs. NOI<Var. NOI|
*Changes in inventories affect absorption costing NOI—they do not affect variable costing NOI, providing that variable manufacturing costs are stable
-Under variable costing, just the fixed manufacturing overhead of the current period flows through to the income statement.
Advantages of Variable Costing and the Contribution Approach
-Enabling CVP Analysis: Much easier to use variable costing income statement during CVP analysis because costs are already broken into fixed/variable.
-Explaining Changes in NOI: Absorption costing income statements can be confusing. In variable costing, when sales increase, so does NOI
-Supporting Decision Making:...