Sunday, 22 July 2012

Absorption Vs Variable Costing (Critical Review)

By Jackie, Researcher
Topic: Education
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 stocks
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.

Income Comparison of Variable and Absorption Costing

Advantages and Disadvantages of Absorption Costing System

Management Accounting: Variable Vs Absorption Costing

Marginal Costing Vs Absorption Costing Homework Help, Tutoring

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