Question

Variable Costing: Compare and contrast variable costing with absorption costing, highlighting the differences between operating income. Discuss the use of variable costing for decision making in a manufacturing company and a service company.

Answer 1

Difference:

These are the two basic approaches followed all over the world to compute unit product cost. The basic difference between the two is the treatment of items in period cost and product cost. In variable costing, fixed manufacturing cost is considered as period cost and only direct materials, direct labor and variable factory overhead (FOH) is added for product cost.

This reflects in operating income also as in absorpton cost, cost of a product per unit is much higher than in variable costing.

For example:

A company manufactures and sells 10000 units of product ABC. Suppose one unit of product ABC incures

Direct materials: $10 per unit
Direct labor: $8 per unit
Variable manufacturing overhead: $2 per unit
Fixed manufacturing overhead: $40,000 per year

The unit product cost of the company is computed as follows:

Absorption Costing: $10 + $8 + $2 + $4* = $24

Variable Costing: $10 + $8 + $2 = $ 20

* $40,000 / 10,000 = $ 4

Since the cost per unit in absorption costing would be more it would show lower operating income for the product per unit than variable costing

• Advantages of variable costing in decision making:-

  • It provides valuable information for decision making.

  • It enables to identify CM Ratio, BEP in units and dollar, target profit points and in sensitivity analysis.

  • It also advises in buy or make decisions.

  • It also helps in gathering various other infomraiton