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Initially, this blog was created to share business knowledge, forecast future market and identify potential business activities. All private researches and postings were based on historical data, market survey and analysis for the future market trend in the global world.
Sunday, 22 July 2012
Absorption Vs Variable Costing (Critical Review)
By Jackie, Researcher
Area of discussion: Cost & Management Accounting
Chapter: Income effects of alternative cost accumulation systems
The objectives of this research are to explain the differences between an
absorption costing and a variable costing system, prepare profit statements
based on variable costing and absorption costing system, explain the difference
in profits between variable and absorption costing profit calculations, explain
the arguments for and against variable and absorption costing, and a clear
example was taken from college exam to be used in this discussion followed by
step-by-step guide and answer.
Basically, absorption costing
treats all manufacturing costs as product costs, regardless whether they are
variable or fixed. On the other hand, variable costing only treats those
manufacturing costs that vary with output as product costs. Fixed manufacturing
overhead is not treated as production cost under this method, but rather
treated as period cost. Thus, the cost of a unit of product in inventory or
cost of goods sold under the variable costing method does not contain any fixed
manufacturing overhead cost and therefore, the product cost per unit computed
using variable costing is always lower than the product cost per unit computed
using absorption costing. Their similarity is both of them are in complete
agreement regarding the treatment of non-manufacturing costs as period costs. Please
note that, variable costing is also sometimes referred to as ‘direct costing’
or ‘marginal costing’.
The differences between absorption costing and variable costing
Let’s take a look at this sample question:
Some arguments in support of variable costing
Variable costing provides more useful information for decision making
Data required by CVP (cost-volume-profit) analysis can be taken directly
from contribution format in income statement which is only available in
variable costing. Those data are extremely useful in calculating expected sales
level to break-even, or expected sales level to earn a specific profit, margin
of safety and contribution per unit. Besides, those relevant costs data are
also required for a variety of short-term decisions making. For examples, make
or buy decision as well as product mix decision.
Variable costing avoids fixed overheads being capitalized in unsaleable
When a company produced a large amount of stocks but did not sold all of
them, the fixed production overheads incurred during that particular period
will be included in stock valuation. The stocks will therefore be over-valued.
Profit calculation for that particular period will be misleading, where by
current period’s profits will be over-stated.
Some arguments in support of absorption costing
Fixed overheads are essential for production
Production of goods is not possible if fixed manufacturing overhead costs
are not incurred. Thus, fixed manufacturing overhead costs should be allocated
to units produced and included in inventory valuation.
Consistency with external reporting
External reporting requires all manufacturing costs (including fixed
production overhead) to be included as part of product cost. That is why
external reporting did not recognize variable costing method as they failed to
include fixed manufacturing overhead costs inside their cost of production.
Addition readings, related links and references:
Variable Costing Vs Absorption Costing: Definition, explanation &
unit cost computation.