By Shevata Singhal

Absorption Costing
Treats all manufacturing costs as product costs, and non-manufacturing costs as period costs Unit costs consist of direct material and direct labor and both variable and fixed manufacturing overhead. Fixed manufacturing overhead is allocated to each unit of production GAAP

Variable Costing
Only those costs of manufacturing that vary with output (variable costs) are treated as product costs This would include direct material, direct labor and variable manufacturing overhead Fixed manufacturing overhead is expensed during the current period Variable costing is used for internal planning and control only; its not GAAP!

Overview of Absorption and Variable(Marginal) Costing

The only cost of driving my car on a 200 mile trip today is $12 for gasoline.

Variable Costing

Overview of Absorption and Variable Costing

No! You must consider these costs too!
Cost Car payment Insurance Per month $ 300.00 60.00 Per day $ 10.00 2.00

Absorption Costing

Overview of Absorption and Variable (Marginal) Costing

You are wrong. I have the car payment and the insurance payment even if I do not make the trip.

Variable Costing

Overview of Absorption and Variable Costing

Whos right? How should we treat the car payment and the insurance?

Marginal Costing
Provides a useful tool for evaluating marginal business propositions Example, WTT exhibit Marginal costs versus fixed costs

Overview of Absorption and Variable Costing

Absorption Costing
Direct Materials

Variable Costing Product Costs

Product Costs

Direct Labor Variable Manufacturing Overhead Fixed Manufacturing Overhead

Period Costs

Variable Selling and Administrative Expenses Fixed Selling and Administrative Expenses

Period Costs

Comparative Income Effects

Exhibit 7-4 Production = Sales No change in inventory; income the same for both absorption and variable costing Production > Sales Inventories increase; Absorption Income higher than Variable Cost income due to more fixed cost retained in inventory Production < Sales Inventories decrease; Absorption Income lower than Variable Cost income as more fixed costs are released from inventory

Advantages of the Variable Cost Approach

Management finds it easy to understand. Consistent with CVP analysis. Can be used for marginal Cost analysis.

Advantages
Easier to estimate profitability of products and segments. Impact of fixed costs on profits emphasized. Profit is not affected by changes in inventories.

Variable versus Absorption Costing

All manufacturing costs must be assigned to products to properly match revenues and costs.

Fixed costs are not really the costs of any particular product.

Absorption Costing

Variable Costing

Variable versus Absorption Costing

Depreciation, taxes, insurance and salaries are just as essential to products as variable costs.

These are capacity costs and will be incurred even if nothing is produced.

Absorption Costing

Variable Costing

Variable versus Absorption costing

Absorption costing product costs are misleading for decision making. They are the numbers that appear on our external reports.

Variable Costing

Absorption Costing