Question

Inventory is an important part of many companies Balance Sheet. The costing methodology used to value inventory in manufacturing organization can impact the organization’s bottom line. Two important method of inventory costing in manufacturing companies are Variable Costing and Absorption Costing. (a) Describe each method - Variable Costing and Absorption Costing (b) Briefly outline their differences.

Answer 1

(a)

• Variable Costing-

In managerial accounting concepts, Variable costs are expenses which vary in proportion to the amount of good and services produced. It is a cost concept under which only the variable costs are assigned to inventory. This implies that the indirect expenses or overheads are charged in the period in which they are incurred while, direct materials and variable overhead costs are assigned to inventory. Thus, it is also known as direct costing method. Few examples of variable costs are: cost of raw materials, direct labour costs, sales commissions, and other utility costs. Variable cost can be calculated by multiplying the quantity of output with the variable cost per unit of output.

• Absorption Costing:

Absorption costing is a cost concept which absorbs all the costs of manufacturing a product. Under this method, all the fixed as well as variable costs are apportioned to cost centers where they are accounted for. In other words, the cost of a finished product will include direct material expenses, direct labour expenses, variable manufacturing overheads and also the fixed manufacturing overheads. Thus, this method incoprporates any cost that is a direct cost in manufacturing a good as the cost base.

(b) Differences between Variable Costing and Absorption Costing:

1. Under Variable costing fixed manufacturing expenses are treated as period cost unlike product cost in Absorption costing.
2. Variable costing calculates Contribution whereas Absorption Costing calculates Net Profit.
3. Value of closing stock in variable Costing is lower since stock is valued at Variable Costing only, however, under Absorption Costing stock is valued at its total production cost which includes fixed costs also and thus value of closing stock is comparatively higher.
4. Variable Costing is mainly used for internal reporting purposes whereas Absorption Costing is used for External Reposrting.