Variable costing is more compatible with cost volume profit analysis than is absorption costing

Q: Why is variable costing more useful than absorption costing?

Variable costing is more useful than absorption costing if a company wishes to compare different product lines potential profitability. It is easier to discern the differences in profits from producing one item over another by looking solely at the variable costs directly related to production.

Q: Which costing method is best absorption or variable?

Because absorption costing includes fixed overhead costs in the cost of its products, it is unfavorable compared with variable costing when management is making internal incremental pricing decisions. This is because variable costing will only include the extra costs of producing the next incremental unit of a product.

Q: What is the difference in profit between absorption and variable costing?

Difference Between Variable and Absorption Costing. Variable cost is the accounting method in which all the variable production costs are only included in product cost. In contrast, Absorption costing is where all the absorbed costs are taken into account.

Variable Versus Full Absorption Costing

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Why is variable costing more useful than absorption costing?
Which costing method is best absorption or variable?
What is the difference in profit between absorption and variable costing?

· Generally Accepted Accounting Principles (GAAP) requires that all manufacturing costs be treated as part of the cost of the product and counted as inventory until the product is sold. This approach is known as full absorption costing because the product must “fully absorb” all costs incurred to produce it. Variable costing is based on the distinction between variable costs and fixed costs. Variable costing is used only for internal decision making and dies not meet GAAP external reporting requirements.

Full absorption costing is based on the distinction between manufacturing and non-manufacturing costs. Gross margin is the difference between sale revenue and the cost of goods sold. For external reporting (GAAP), cost of goods sold reflects the full manufacturing cost of the units sold. The full manufacturing cost of units manufactured but not sold is counted as inventory on the balance sheet. Non-manufacturing costs are expensed immediately and subtracted after gross margin to arrive at net operating income. Variable costing captures the distinction between variable and fixed costs and ignores whether the costs are related to manufacturing or non-manufacturing activities. The difference between sales revenue and variable costs is called contribution margin. Fixed costs are deducted after the contribution margin to arrive net profit.

In terms of bottom line profitability, the two methods will provide the same results as long as production and sales are equal. The two methods can give different results, however, for any company that builds or depletes inventory.

o Reconciling Variable and Full Absorption Costing – These are three general rules of thumb regarding reconciling income under full absorption costing and variable costing:
- § If production > sales in the period, there will be an increase in inventory and absorption costing profit will be > than variable costing profit.
- § If production = sales in the period, there will be no change in inventory and absorption costing profit is = to variable costing profit.
- § If production is < sales, then inventory will decrease and absorption costing profit < than variable costing profit.

A key note is that in the end, all costs will reconcile and be equal. These changes denote how a firm will report profit in a period under both costing methods. One costing method is not superior to the other, but they do have different purposes for management.

Chapter 7 Variable Costing: A Tool for Management

Garrison, Managerial Accounting, 12th Edition 313

True/False Questions

1. The inventory value shown on the balance sheet is generally higher under absorption

costing than under variable costing.

Answer: True Level: Medium LO: 1

2. Under variable costing, inventoriable product costs consist of direct materials, direct

labor, variable manufacturing overhead and variable selling and administration

expenses.

Answer: False Level: Medium LO: 1

3. Under variable costing, an increase in the fixed factory overhead will have no effect

on the unit product cost.

Answer: True Level: Medium LO: 1

4. Under the absorption costing method, a portion of fixed manufacturing overhead cost

is allocated to each unit of product.

Answer: True Level: Easy LO: 1

5. Under variable costing, it is possible to defer a portion of the fixed manufacturing

overhead costs of the current period to future periods through the inventory account.

Answer: False Level: Medium LO: 2

6. Under absorption costing, a portion of fixed manufacturing overhead cost is released

from inventory when sales volume exceeds production volume.

Answer: True Level: Medium LO: 2

7. Contribution margin and gross margin mean the same thing.

Answer: False Level: Easy LO: 2

8. When reconciling variable costing and absorption costing net operating income, fixed

manufacturing overhead costs deferred in inventory under absorption costing should

be deducted from variable costing net operating income to arrive at the absorption

costing net operating income.

Answer: False Level: Medium LO: 3