What is the difference between absorption costing income and variable costing income?
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Variable and absorption costing are two allocation methods that companies use to determine product cost. Each has significant differences in how they allocate manufacturing overhead. Variable costing only applies the variable manufacturing overhead costs. Absorption costing applies all manufacturing overhead costs, both fixed and variable. Direct material and direct labor allocation is the same for both methods; differences occur in income reporting, product pricing, and decision making. Show
Both of these costing methods fall under accrual accounting procedures. All costs get recorded as a company incurs them, regardless if cash changes hands or not. Fixed costs do not change in a production system regardless of output. Variable costing requires companies to expense fixed costs in the accounting period when they occur. The absorption method, however, adds fixed costs to the production system, ultimately allocating the costs to manufactured products.  Income reporting is one major difference between these two costing methods. Under the process described earlier, variable costing reports lower net income. This occurs because companies expense fixed costs, while absorption costing does not. Lower profit on the income statement reduces taxes paid by the company. Companies using the absorption method will not incur lower net income until they sell goods, which move the costs from inventory to cost of goods sold. Product cost information is another significant difference. The variable method has a tendency to undercost manufactured goods because a company does not record fixed manufacturing overhead to products. Absorption cost principles seek a more defined product cost. Including all manufacturing overhead — fixed and variable — gives companies a more accurate description of costs needed to produce goods. Another different is in pricing products. Companies that use variable costing may think they can price products lower than those using the absorption method, but this is untrue. Reducing the final selling price will result in lower net income because fixed manufacturing overhead resides as a period cost on the income statement. Companies need to ensure that they price goods appropriately to cover all product costs, whether on the income statement or included as the inventory cost. Managerial decisions may also be different under each method. One issue, for example, is to select which method provides the most accurate product cost and meets accounting guidelines. National accounting standards may not approve of variable costing. Therefore, managers must determine which method their company should use. Another decision is how production output affects fixed costs, which can change on a per-unit basis when manufacturing goods.
Absorption CostingGenerally accepted accounting principles require use of absorption costing (also known as “full costing”) for external reporting. Under absorption costing, normal manufacturing costs are considered product costs and included in inventory. The rationale for absorption costing is that it causes a product to be measured and reported at its complete cost. Because costs like fixed manufacturing overhead are difficult to identify with a particular unit of output does not mean that they were not a cost of that output. As a result, such costs are allocated to products. However valid the claims are in support of absorption costing, the method does suffer from some deficiencies as it relates to enabling sound management decisions. Absorption costing information may not always provide the best signals about how to price a product, reach conclusions about discontinuing a product, and so forth. Variable CostingThis last point can be made clear with a very simple illustration. Assume that a company produces 10,000 units of a product, and per unit costs are $2 for direct material, $3 for direct labor, and $4 for variable factory overhead. In addition, fixed factory overhead amounts to $10,000. The product cost under absorption costing is $10 per unit, consisting of the variable cost components ($2 + $3 + $4 = $9) and $1 of allocated fixed factory overhead ($10,000/10,000 units). Under variable costing, the product cost is limited to the variable production costs of $9. Now consider a “management decision.” Assume the company is approached to sell one additional unit at $9.50. This sale will not result in any added SG&A cost or otherwise impact sales of other units. Variable Costing In ActionDouble-Edged SwordA typical illustration of decision making based on variable costing data looks simple enough. But, such decisions are actually very tricky. Considerable business savvy is necessary, and there are several traps that must be avoided. First, a business must ultimately recover the fixed factory overhead and all other business costs; the total units sold must provide enough margin to accomplish this purpose. It would be easy to use up full manufacturing capacity, one sale at a time, and not build in enough margin to take care of all the other costs. If every transaction were priced to cover only variable cost, the entity would quickly go broke. Second, if a company offers special deals on a selective basis, regular customers may become alienated or hold out for lower prices. The key point here is that variable costing information is useful, but it should not be the sole basis for decision making. Avoiding A Downward SpiralVariable costing data are quite useful in avoiding incorrect decisions about product discontinuation. Many businesses offer multiple products. Some will usually be more successful than others, and a logical business decision may be to focus on the best-performing units, while discontinuing others. Assume that a company offers products A, B, and C. Each is being produced in equal proportion, and the company is fully able to meet customer demand from existing capacity (i.e., producing more will not increase sales). The company is not incurring any variable costs relating to selling, general, and administration efforts. From the absorption costing data in the dark shaded area, it appears that Product A is yielding a negative gross profit. Logically, a manager may target that product for discontinuation. However, if that decision is reached, Products B and C will each have to absorb more fixed factory overhead. The revised cost data (in the light shaded area) show that eliminating Product A will actually reduce overall profitability! The decline in overall profits from discontinuing the “loser” occurs because the “loser” was absorbing some fixed cost of production. The $15 selling price for Product A at least covered its variable cost ($6 + $5 + $3 = $14) and contributed toward coverage of the business’s unavoidable fixed cost burden. The lesson here is that a company must be very careful in eliminating “unprofitable” products. This decision can often result in a series of successive shifts in overhead to other remaining products. This, in turn, can cause other products to also appear unsuccessful. A downward spiral of product discontinuation decisions can ultimately destroy a business that was otherwise successful. This illustration underscores why a good manager will not rely exclusively on absorption costing data. Variable costing techniques that help identify product contribution margins (as more fully described in the following paragraphs) are essential to guiding the decision process. Variable costing is not a panacea, and guiding a business is not easy. Decision making is not as simple as applying a single mathematical algorithm to a single set of accounting data. A good manager must consider business problems from multiple perspectives. In the context of measuring inventory and income, a manager will want to understand both absorption costing and variable costing techniques. This information must be interlaced with knowledge of markets, customer behavior, and the like. The resulting conclusions can set in motion plans of action that bear directly on the overall fate of the organization. Income StatementMuch of the preceding discussion focused on per-unit cost assessments. In addition, the examples assumed that selling, general, and administrative costs were not impacted by specific actions. It is now time to consider aggregated financial data and take into account shifting amounts of SG&A. The following income statements present information about Nepal Company. On the left is the income statement prepared using the absorption costing method, and on the right is the same information using variable costing. For now, assume that Nepal sells all that it produces, resulting in no beginning or ending inventory. With absorption costing, gross profit is derived by subtracting cost of goods sold from sales. Cost of goods sold includes direct materials, direct labor, and variable and allocated fixed manufacturing overhead. From gross profit, variable and fixed selling, general, and administrative costs are subtracted to arrive at net income. This approach should look familiar. It is the presentation that is typical of financial statements generated for general use by shareholders and other persons external to the daily operations of a business. With variable costing, all variable costs are subtracted from sales to arrive at the contribution margin. Nepal’s presentation divides variable costs into two categories. The variable product costs include all variable manufacturing costs (direct materials, direct labor, and variable manufacturing overhead). These costs are subtracted from sales to produce the variable manufacturing margin. Some of Nepal’s SG&A costs also vary with sales. As a result, these amounts must also be subtracted to arrive at the true contribution margin. Management must take into account all variable costs (whether related to manufacturing or SG&A) in making critical decisions. For instance, Nepal may pay sales commissions that are based on sales; to exclude those from consideration in evaluating the “margin” that is to be generated from a particular transaction or event would be quite incorrect. From the contribution margin are subtracted both fixed factory overhead and fixed SG&A costs. Because Nepal does not carry inventory, the income is the same under absorption and variable costing. The difference is only in the manner of presentation. Carefully study the arrows that show how amounts appearing in the absorption costing approach would be repositioned in the variable costing income statement. Since the bottom line is the same under each approach, this may seem like much to do about nothing. But, remember that “gross profit” is not the same thing as “contribution margin,” and decision logic is often driven by consideration of contribution effects. Further, when inventory levels fluctuate, the periodic income will differ between the two methods. Impact Of InventoryThe following income statements are identical to those previously illustrated, except sales and variable expenses are reduced by 10%. Assume that the units relating to the “10% reduction” were nevertheless manufactured. What is the effect of this inventory build-up? Income is higher under absorption costing by $15,000. This is consistent with a general rule of thumb: Increases in inventory cause income to be higher under absorption costing than under variable costing, and vice versa. To further examine the reason income is higher, remember that $450,000 was attributed to total production under absorption costing. Of this amount, 10% ($45,000) is now diverted into inventory. Under variable costing, total product costs were $300,000 and 10% ($30,000) of that amount would be assigned to inventory. As a result, $15,000 more is assigned to inventory under absorption costing. This logically coincides with the degree to which income is higher! Another way to view the impact of the inventory build-up is to examine the following “cups.” The top set of cups initially contains the costs incurred in the manufacturing process. With absorption costing, those cups must be emptied into either cost of goods sold or ending inventory. Compare the drawing above to the variable costing illustration that follows. The ending inventory cup contains less with variable costing because there is no fixed factory overhead in ending inventory! Recognize that a reduction in inventory during a period will cause the opposite effect from that shown. Specifically, a portion of the contents of the beginning inventory cup would be transferred to expense commensurate with the decrease in inventory. Since the inventory cup contains less under variable costing, expect expenses to be lower and income to be higher.
Principlesofaccounting.com ™ Copyright © 2022. All rights reserved. What is the difference between absorption costing operating income and variable costing operating income?Absorption costing assigns per unit fixed manufacturing overhead costs to production. This can potentially produce positive net operating income even when the number of units sold is less than the breakeven point. Variable costing income is only affected by changes in unit sales.
What are the differences between the absorption costing income and the variable costing income for these two years?The only difference between absorption costing and variable costing is in the treatment of fixed manufacturing overhead. Using absorption costing, fixed manufacturing overhead is reported as a product cost. Using variable costing, fixed manufacturing overhead is reported as a period cost.
What is the difference between operating income under absorption costing and variable costing quizlet?* Operating income under absorption costing is higher than operating income under variable costing when production units exceed sales units. A method of inventory costing in which all variable manufacturing costs and all fixed manufacturing costs are "included" as inventoriable costs.
What's the major difference between absorption costing and variable costing What are the advantages of variable costing?Absorption costing and variable costing are two popular methods of accounting that companies use to determine the value of their inventories and analyze their finances. While variable costing only focuses on the variable cost for calculating the cost of a product, absorption costing includes every production cost.
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