CHAPTER 13 VARIABLE COSTING

Definition
Variable costing (Direct Costing) is a method of recording and reporting costs
which regards only the variable manufacturing costs as product costs. Fixed
manufacturing costs are written off as period costs.
Underlying Concept
Proponents of this product costing method maintain that the fixed part of
factory overhead is more closely related to the capacity to produce than to the
production of specific units and therefore should be charged off as expense in the
period incurred. Furthermore, the use of this system will permit construction of an
income statement which highlights the contribution margin of the product and
therefore facilitates managerial decision-making process. The use of variable costing
for external reporting is, however, still the center of considerable controversy. It is
contended that under this method, assets (inventory) are being understated and that
it is not an accepted accounting practice.
Until variable costing becomes a generally accepted accounting practice,
companies who wish to use it must convert inventory and cost of goods sold figures
to an absorption costing basis for external reporting. This conversion is a relatively
simple process in most cases and is no deterrent to the use of variable costing for
internal management purpose.
Advantages of Using Variable Costing
On advantage of variable costing is that it meets the three objectives of management
control systems by showing separately those costs that can be traced to, and
controlled by each strategic business unit (SBU). Also, net income using variable
costing is not affected by changes in inventory levels because all fixed costs are
deducted from income in the period in which they occur. For this reason, appraisal of
performance of product line or other segments of the business can be facilitated
without the need for arbitrary allocations of fixed cost.
Furthermore, cost-volume-profit relationship data needed for profit planning
purposes is readily obtained from the regular accounting statements. Analysis of
costs relevant to pricing is likewise simplified and enhanced. Variable costing ties in
with effective plans for cost control as standard costs and flexible budget.
Disadvantages of Using Variable Costing
1. Variable costing may encourage a shortsighted approach to profit planning at the
expense of the long-run situation.
2. Variable costing tends to give the impression that variable costs are recovered
first, that fixed costs are recovered later and that finally profits are realized.
3. Variable costing is not acceptable for external reporting and tax purpose.
Absorption Costing
Absorption costing (also known as full, traditional, conventional and normal costing)
is a method of product costing in which all manufacturing costs, fixed and variable,
are treated as product or inventoriable costs. generally accepted for external
reporting purposes.
Comparison between Variable Costing and Absorption Costing
1. As to treatment of the various operating costs:
It will be noted that it is only in the treatment of Fixed Factory overhead that the two
costing methods differ. Under variable costing, it is considered as period cost while
under absorption costing, it is treated as product cost.
2. As to net operating income
Net income is not affected by changes in production under variable costing. Net
income, however is affected by changes in production when absorption costing is in
use. Net income goes up under the absorption approach in response to the increase
in production for a particular year and goes down when production goes down. The
reason for this effect can be traced to the shifting of fixed manufacturing cost
between periods under the absorption costing method as explained below:

Relationship between Production (P) and Sales (S) Net Income

a) P=S AC=VC
b) P>S AC>VC
c) P<S AC<VC

a. When production volume equals sales volume, net income reported under
absorption costing and variable costing are the same. The reason is that the amount
of fixed overhead charged off to operations is the same under each method and also
because there is no change in the amount of fixed overhead in the absorption
inventory.
b. When production exceeds sales volume, net income reported under absorption
costing will be greater than that under variable costing. This result occurs because
part of the period's production would go to increase in inventory, and under
absorption costing, part of the period's fixed overhead would be deferred along with
it.
C. When sales exceed production volume, net income reported under absorption
costing will be lesser than that under variable costing. The reason is that part of the
period's sales would come from the beginning inventory, which, under absorption
costing, carries with it a portion of the prior period's fixed overhead.
3. As to amount of inventory
Inventory value under absorption costing would be higher in amount than that under
variable costing. The inventory amount would carry a portion of fixed overhead
incurred during the period under absorption costing.

Why Managers Prefer Direct Costing to Absorption Costing

In variable costing, only variable manufacturing costs are included in a unit's product
costs, and thus in the value of inventory and cost of goods sold. Fixed overhead is
excluded. Fixed manufacturing overhead is excluded It is reported as a separate
expense and deducted from the contribution margin along with fixed selling and
administrative expense in determining operating income.
Managers generally prefer variable costing because it separates fixed from variable
costs as in cost-volume-profit analysis. As a result, it is easier to compare actual
operating income to planned operating income. With absorption costing, actual
operating income corresponds well with planned operating income only when
inventory levels remain unchanged. With variable costing, income is more closely
associated with sales while absorption costing is influenced by units produced and
units sold.