Absorbtion Costing VS Variable Costing

Topics: Variable cost, Costs, Marginal cost Pages: 10 (3138 words) Published: March 11, 2015
Chapter 7 Notes

Page 1

Variable Costing

Absorption

As we have seen in previous chapters, when you
manufacture your own inventory, the cost of that
inventory includes all of the costs associated with
running the factory that produces the inventory.
Generally, no part of the factory cost is expensed.
Instead, it is capitalized as the cost of the inventory
produced. It is only expensed when the inventory is
sold. At that point the cost of the inventory becomes
Cost of Goods Sold. This system is referred to as
Absorption Costing. It is also know as “Full Costing” and “Full-Absorption Costing”.
The thought is that the
inventory absorbs all of the factory costs fully.

As we have seen, inventory costs are made up of the following under Absorption Costing:




Direct Labor;
Direct Materials; and
Manufacturing Overhead (regardless of whether it is fixed or variable).

GAAP requires that a firm must use Absorption Costing for all of its financial statements that are released to outside parties.
An alternative system to Absorption Costing is Variable Costing. Although GAAP does not permit Variable Costing, Variable Costing is still widely used by companies for internal purposes (e.g., in order to evaluate the performance of a manager, a product or a division).

With Variable Costing, the cost of the inventory produced includes only: •



Direct Labor;
Direct Material; and
Variable Manufacturing Overhead.

Under Variable Costing, Fixed Manufacturing Overhead is not treated as part of the cost of the inventory produced. Instead, Fixed Manufacturing Overhead is expensed in the current period. Currently expensing a cost is often referred to as treating it as a “period cost”. Capitalizing a cost as part of the cost of inventory is often referred to as treating it as a “product cost”.

The exclusion of Fixed Manufacturing Overhead from the cost of inventory makes Cost of Goods Sold a purely Variable Cost.

Please send comments and corrections to me at mconstas@csulb.edu

Chapter 7 Notes

Page 2

Variable Costing vs. Absorption Costing
In addition to having a different definition of inventory cost, Variable Costing uses a different Income Statement format. With a Variable Costing Income Statement, we group expenses into Variable Costs and Fixed Costs. The Variable Costing Income Statement first reports a company's Sales Revenue reduced by its Variable Costs. This difference is referred to as the "Contribution Margin." The Contribution Margin represents the dollar amount that a company’s operations “contribute” to help pay its Fixed Costs. The Variable Costing Income Statement then reduces the company’s Contribution Margin by its Fixed Costs.

This Contribution Margin Format used by Variable Costing is different from the traditional Multi-Step Income Statement associated with Absorption Costing. A comparison of the two formats appears below:

ABSORPTION COSTING
Sales Revenue
-Cost of Goods Sold
Gross Margin or Gross Profit
-Selling, General and Administrative Expenses
Operating Profits

VARIABLE COSTING
Sales Revenue
-Variable Costs and Expenses
Contribution Margin
-Fixed Costs and Expenses
Operating Profits

Assume that Lucy’s Chocolate Factory, Inc. has the following costs, sales and production:
Units Produced:
Units Sold:
Price Per Unit:
Direct Materials:
Direct Labor:
Variable Manufacturing Overhead:
Fixed Manufacturing Overhead:
Variable Sell., Gen. & Adm. Exps.:
Fixed Sell., Gen. & Adm. Exps.:
Using Absorption Costing, each unit would cost the following: Direct Materials:
Direct Labor:
Variable Manufacturing Overhead:
Fixed Manufacturing Overhead:
Total Costs
Divide By Number of Units Produced
Cost Per Unit

$50,000
$30,000
$20,000
$50,000
$150,000
÷10,000
$15

Please send comments and corrections to me at mconstas@csulb.edu

10,000
10,000
$25
$50,000
$30,000
$20,000
$40,000
$30,000
$30,000

Chapter 7 Notes

Page 3

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