6.5 Compare and Contrast Variable and Absorption Costing
3 min read•june 18, 2024
Variable and are two key methods for calculating and preparing income statements. These approaches differ in how they treat , impacting reported profits and inventory valuation.
Understanding these costing methods is crucial for managers making pricing and production decisions. The choice between variable and can significantly affect financial reporting, break-even analysis, and performance evaluation in manufacturing companies.
Variable and Absorption Costing
Variable vs absorption costing methods
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- includes only variable manufacturing costs in the product cost
- (raw materials used in production)
- (wages of workers directly involved in production)
- (indirect costs that vary with production volume, such as utilities)
- Fixed manufacturing overhead costs are treated as and expensed in the period incurred (rent, depreciation)
- Also known as or
- Absorption costing includes all manufacturing costs (variable and fixed) in the product cost
- (raw materials used in production)
- (wages of workers directly involved in production)
- Variable manufacturing overhead (indirect costs that vary with production volume, such as utilities)
- Fixed manufacturing overhead costs are allocated to products based on a (rent, depreciation)
- Also known as
Product costs and income statements
-
- Sales revenue
- Less: Variable (includes only variable manufacturing costs)
- Less: Fixed manufacturing overhead
- Less:
- Absorption costing income statement
- Sales revenue
- Less: (includes all manufacturing costs)
- Less: Selling and administrative expenses
- Net operating income
-
- Variable costing:
- Absorption costing:
Production changes and net income
- When production exceeds sales
- Variable costing: Net income is lower because fixed manufacturing overhead is expensed in the period incurred (no deferral of costs)
- Absorption costing: Net income is higher because fixed manufacturing overhead is deferred in inventory (costs spread over more units)
- When sales exceed production
- Variable costing: Net income is higher because fixed manufacturing overhead has already been expensed in previous periods (no additional costs)
- Absorption costing: Net income is lower because fixed manufacturing overhead is released from inventory and expensed in the current period (costs from previous production)
- Over the long run, assuming no change in inventory levels
- Variable and absorption costing will result in the same net income (differences even out)
- Differences in net income are temporary and will reverse over time (no permanent effect)
Cost Analysis and Decision-Making
- : Understanding how costs change in relation to activity levels
- : Examines the relationships between costs, volume, and profit
- : The level of sales at which total revenues equal total costs
- : The range of activity within which cost behavior patterns are valid
- : Measures the extent to which a company uses fixed costs in its operations
Key Terms to Review (38)
Absorption costing: Absorption costing is a method of inventory costing where all manufacturing costs, both fixed and variable, are included in the cost of a product. This approach spreads these costs over all units produced, regardless of their sales status.
Absorption Costing: Absorption costing, also known as full costing, is an accounting method that includes all direct and indirect costs associated with the production of a product or service. It is a comprehensive approach to cost accounting that allocates both variable and fixed costs to the final product, providing a more complete picture of the total cost of production.
Break-even point: The break-even point is the level of sales at which total revenues equal total costs, resulting in zero profit. It can be calculated in both units and dollars to determine the required sales volume or revenue needed to cover all fixed and variable costs.
Break-Even Point: The break-even point is the level of sales or production at which a company's total revenue exactly equals its total costs, resulting in neither a profit nor a loss. It is the point where a company's fixed and variable costs are covered by its sales revenue.
Contribution margin: Contribution margin is the amount remaining from sales revenue after variable expenses have been deducted. It is used to cover fixed expenses and contribute to profits.
Contribution Margin: Contribution margin is the amount of revenue that remains after deducting the variable costs associated with producing a product or service. It represents the portion of sales revenue that contributes to covering fixed costs and generating profit. This concept is crucial in understanding the financial performance and decision-making processes of organizations, whether they are merchandising, manufacturing, or service-based entities.
Cost Behavior: Cost behavior refers to the relationship between a company's costs and its level of business activity or output. It describes how different types of costs, such as variable costs and fixed costs, respond to changes in the volume of production or sales.
Cost behaviors: Cost behaviors describe how costs change in relation to changes in a company's level of activity. These behaviors are essential for budgeting, forecasting, and decision-making processes.
Cost of goods sold: Cost of Goods Sold (COGS) represents the direct costs attributable to the production of goods sold by a company. This amount includes the cost of materials and labor directly used to create the product.
Cost of Goods Sold: Cost of Goods Sold (COGS) represents the direct costs associated with the production or acquisition of the goods or services sold by a business during a specific accounting period. It is a fundamental concept in managerial accounting that helps organizations track and manage their inventory and profitability.
Cost-Volume-Profit Analysis: Cost-Volume-Profit (CVP) analysis is a managerial accounting technique that examines the relationship between a company's costs, volume of output, and profitability. It provides insights into how changes in these factors can impact a business's overall financial performance, helping managers make informed decisions.
Direct Costing: Direct costing, also known as variable costing, is an inventory valuation and product costing method that only includes the variable costs associated with the production of a good or service. It excludes fixed costs, which are treated as period costs and expensed in the current accounting period.
Direct labor: Direct labor refers to the wages and salaries of employees who are directly involved in the production of goods or services. This cost is directly traceable to specific products or jobs within a manufacturing environment.
Direct Labor: Direct labor refers to the cost of the workforce directly involved in the production of goods or the provision of services. It encompasses the wages and salaries paid to employees who physically transform raw materials into finished products or perform tasks that are essential to the completion of a service.
Direct materials: Direct materials are raw materials that can be directly traced to the production of a specific product. These materials are essential components in manufacturing and are included in the cost of goods sold.
Direct Materials: Direct materials are the raw materials that can be directly traced to the production of a specific product. They are a key component of product costs, along with direct labor and manufacturing overhead, and are a crucial element in understanding the differences between merchandising, manufacturing, and service organizations, as well as the various costing methods used in managerial accounting.
Ending Inventory Valuation: Ending inventory valuation is the process of determining the monetary value of the goods or materials remaining in a company's inventory at the end of an accounting period. This value is crucial in calculating the cost of goods sold and the overall financial performance of the business, especially in the context of comparing variable and absorption costing methods.
Expense recognition principle: Expense recognition principle dictates that expenses should be recorded in the period in which they contribute to revenue. This principle ensures that financial statements accurately reflect the company’s financial performance.
Fixed Manufacturing Overhead: Fixed manufacturing overhead refers to the indirect costs associated with the manufacturing process that do not vary with changes in production volume. These costs remain constant regardless of the number of units produced, and they must be incurred to maintain the manufacturing facility and support the overall production operations.
Full Costing: Full costing, also known as absorption costing, is an accounting method that assigns all direct and indirect costs associated with the production of a product or service to the final cost of that product or service. This contrasts with variable costing, which only includes direct and variable indirect costs in the product cost.
GAAP: GAAP, or Generally Accepted Accounting Principles, is a set of standardized guidelines and rules that govern the recording and reporting of financial information. GAAP provides a consistent framework for financial reporting, ensuring comparability and transparency across different organizations and industries.
Gross Profit: Gross profit is the difference between a company's net sales and the cost of goods sold. It represents the amount of revenue a business retains after accounting for the direct costs associated with producing or acquiring the goods or services it sells. This metric is crucial in understanding a company's profitability and financial performance across different business models, including merchandising, manufacturing, and service organizations.
Income Statement: An income statement is a financial report that summarizes a company's revenues, expenses, and profits or losses over a specific period. It provides insight into a company's operational performance and is crucial for assessing profitability. The income statement varies based on the type of organization, including merchandising, manufacturing, and service organizations, as each has different revenue recognition and expense reporting methods.
Marginal Costing: Marginal costing is an accounting approach that focuses on the variable costs associated with producing a product or providing a service. It contrasts with absorption costing, which includes both variable and fixed costs. Marginal costing is particularly relevant in the context of decision-making, such as evaluating the profitability of special orders.
Net Operating Income: Net operating income (NOI) is a financial metric that measures the profitability of a business's core operations, excluding the effects of financing and accounting decisions. It represents the revenue generated from a company's primary business activities, minus the direct costs of operating that business.
Operating leverage: Operating leverage measures how a company's operating income changes with respect to sales volume changes. It indicates the proportion of fixed costs in a company's cost structure, impacting profitability.
Operating Leverage: Operating leverage refers to the degree to which a company's costs are composed of fixed costs versus variable costs. It measures the sensitivity of a company's operating income to changes in its sales volume. Operating leverage is a critical concept in understanding a company's profitability, break-even point, and ability to withstand fluctuations in demand.
Period Costs: Period costs are expenses that are not directly related to the production of a specific product or service, but rather are incurred during a specific accounting period. These costs are typically expensed on the income statement as they are incurred, rather than being capitalized and allocated to inventory or other assets.
Predetermined Rate: A predetermined rate is a fixed or estimated rate used to allocate indirect costs to cost objects, such as products or services, in a costing system. It is a key concept in the comparison of variable and absorption costing methods.
Product Cost per Unit: Product cost per unit refers to the total cost incurred to produce a single unit of a product, including both direct and indirect costs associated with its manufacturing. This metric is crucial in understanding the profitability and pricing decisions for a product within the context of variable and absorption costing methods.
Product costs: Product costs are the costs incurred to create a product, which include direct materials, direct labor, and manufacturing overhead. These costs are capitalized as inventory until the product is sold, at which point they become part of the cost of goods sold.
Product Costs: Product costs refer to the direct and indirect expenses incurred in the production of a good or service. These costs are crucial in determining the total cost of a product and are essential for decision-making and financial reporting purposes.
Relevant range: The relevant range is the span of activity levels within which specific cost behaviors are valid. Outside this range, fixed and variable cost estimates may not hold true.
Relevant Range: The relevant range is a concept in managerial accounting that refers to the range of activity levels over which certain assumptions about cost behavior can be considered valid. It is a critical factor in understanding and predicting cost behavior patterns, estimating variable and fixed cost equations, comparing costing methods, and preparing flexible budgets.
Selling and Administrative Expenses: Selling and administrative expenses are the costs associated with the overall operations and management of a business, excluding the direct costs of manufacturing or producing a product. These expenses include costs related to sales, marketing, and general administration that are necessary for the business to function effectively, but are not directly tied to the production process.
Variable costing: Variable costing is a managerial accounting method where only variable production costs are included in product costs. Fixed manufacturing overhead is treated as a period expense.
Variable Costing: Variable costing is a cost accounting method that assigns only variable costs, such as direct materials and direct labor, to the cost of a product or service. This contrasts with absorption costing, which includes both variable and fixed costs in the product cost. Variable costing is used to analyze the relationship between costs, volume, and profit.
Variable Manufacturing Overhead: Variable manufacturing overhead refers to the indirect production costs that fluctuate in proportion to changes in the level of production activity. These costs vary with the volume of goods produced and include items such as indirect materials, indirect labor, and variable factory utilities.