VARIABLE COSTING: A TOOL

FOR MANAGEMENT
Two general approaches are used for valuing inventories and cost of goods sold. One
approach, called absorption costing, is generally used for external reporting purposes. The
other approach, called variable costing, is preferred by some managers for internal decision
making and must be used when an income statement is prepared in the contribution format.

Absorption costing

also called the full cost method

treats all costs of production as product costs, regardless of whether they are
variable or fixed
is not well suited for CVP computations since no distinction is made between variable
and fixed costs, absorption costing
the cost of a unit of product consists of direct materials, direct labor, and both
variable and fixed overhead
Variable and fixed selling and administrative expenses are treated as period costs
and are deducted from revenue as incurred.

Variable costing

also called direct costing or marginal costing

treats only those costs of production that vary with output as product costs.
is in accordance with the contribution approach income statement and supports CVP
analysis because of its emphasis on separating variable and fixed costs.
The cost of a unit of product consists of direct materials, direct labor, and variable
overhead.
Fixed manufacturing overhead, and both variable and fixed selling and administrative
expenses are treated as period costs and deducted from revenue as incurred.

Unit Cost Computations

Mitsubishi Company produces 25,000 units of a single product. Variable manufacturing
costs total $10 per unit. Variable selling and administrative expenses are $3 per unit. Fixed
manufacturing overhead for the year is $150,000 and fixed selling and administrative
expenses for the year are $100,000.
To determine the unit product cost:

VARIABLE COSTING: A TOOL

FOR MANAGEMENT

The unit product costs under absorption and variable costing would be $16 and $10,
respectively. Under absorption costing, all production costs, variable and fixed, are included
when determining unit product cost. Under variable costing, only the variable production
costs are included in product costs.

Income Comparison of Absorption and Variable Costing

We need some additional information to allow us to prepare income statements for
Mitsubushi Company:

20,000 units were sold during the year.

The selling price per unit is $30.

There is no beginning inventory.
To compute for the Absorption costing income statement:

Mitsubishi sold only 20,000 of the 25,000 units produced, leaving 5,000 units in ending
inventory. At a sales price of $30 per unit, sales revenue for the 20,000 units sold is
$600,000. At a unit product cost of $16, cost of goods sold for the 20,000 units sold is
$320,000. Subtracting cost of goods sold from sales, we find the gross margin of $280,000.
After subtracting selling and administrative expenses from the gross margin, we see that net
operating income is $120,000.
Fixed manufacturing overhead deferred in inventory, as a result of the 5,000 unsold units at
$6 of fixed overhead per unit, is $30,000.
To compute for the Variable Costing income statement:

VARIABLE COSTING: A TOOL

FOR MANAGEMENT

In a contribution format income statement, first, we subtract all variable expenses from
sales to get contribution margin. At a product cost of $10 per unit, the variable cost of
goods sold for 20,000 units is $200,000. The next variable expense is the variable selling
and administrative expense. After computing contribution margin, we subtract fixed
expenses to get the $90,000 net operating income. Note that all $150,000 of fixed
manufacturing overhead is expensed in the current period.
Under absorption costing, $120,000 of fixed manufacturing overhead is included in cost of
goods sold and $30,000 is deferred in ending inventory as an asset on the balance sheet.
Under variable costing, the entire $150,000 of fixed manufacturing overhead is treated as a
period expense.
The variable costing ending inventory is $30,000 less than absorption costing, thus
explaining the difference in net operating income between the two methods.
Comparing the two methods:

The difference in net operating income between the two methods ($30,000) can also be
reconciled by multiplying the number of units in ending inventory (5,000 units) by the fixed
manufacturing overhead per unit ($6) that is deferred in ending inventory under absorption
costing.
Practically speaking, absorption costing is required for external reports. Since top executives
are typically evaluated based on earnings reported to shareholders in external reports, they
may feel that decisions should be based on absorption costing data.

Advantages of Variable Costing and the Contribution Approach

The advantages of variable costing and the contribution approach include:
The data required for CVP analysis can be taken directly from a contribution format
income statement.
Profits move in the same direction as sales, assuming other things remain the same.
Managers often assume that unit product costs are variable costs. Under variable
costing, this assumption is true.
Fixed costs appear explicitly on a contribution format income statement; thus, the
impact of fixed costs on profits is emphasized.

VARIABLE COSTING: A TOOL

FOR MANAGEMENT
Variable costing data make it easier to estimate the profitability of products,
customers, and other business segments.
Variable costing ties in with cost control methods, such as standard costs and flexible
budgeting.
Variable costing net operating income is closer to net cash flow than absorption
costing net operating income.