Variable and Absorption Costing

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1) When will profits reported under variable and absorption costing differ? How can we reconcile the profits reported under the two approaches?

Profits reported under variable and absorption costing will differ when inventory increases or decreases during the year. The difference involves the timing with which fixed manufacturing overhead becomes an expense. Under variable costing, fixed overhead is expensed immediately as it is incurred. Under absorption costing, fixed overhead is inventoried until the manufactured goods are sold. The formula:

Difference in fixedChange inPredetermined
overhead expensed=inventory, in Xfixed overhead
under absorption andunitsrate per unit
variable costing
may be used to calculate the difference in the amount of fixed overhead, expensed in a given time period, under the two product costing methods. This difference in the amount of fixed overhead expensed indicates the difference in profit under absorption and variable costing.

2) Would you recommend variable or absorption costing as a source of information for managers? Explain your answer.

Variable costing can be a valuable tool for managers when they have to make short term decisions to either make or buy a part and the pricing. In making this decision, managers can ignore fixed costs in the short term as these costs will be incurred in any case so the variable costs will provide the manager with a good measure of the differential costs that need to be evaluated. When dealing with variable costing, the grouping of costs as variable or fixed will make is straightforward for the manager to forecast the effects that changes in sales have on profit and thus provide the manager with a valuable tool for decision making.

Variable product costs are particularly useful for short-term decisions, such as whether to make or buy a component, and pricing – especially when variable selling and administrative costs are included. The fixed costs will be incurred...
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