Question

What is variable costing and how are variable costing and absorption costing used for different purposes? Why is net income different when variable costing is used rather than absorption costing?

Answer 1

Variable Costing

Variable costing is a managerial accounting cost concept. Under this method, manufacturing overhead is incurred in the period that a product is produced. This addresses the issue of absorption costing that allows income to rise as production rises. Under an absorption cost method, management can push forward costs to the next period when products are sold. This artificially inflates profits in the period of production by incurring less cost than would be incurred under a variable costing system. Variable costing is generally not used for external reporting purposes. Under the Tax Reform Act of 1986, income statements must use absorption costing to comply with GAAP.

Variable costing is a costing method that includes only variable manufacturing costs—direct materials, direct labor, and variable manufacturing overhead—in unit product costs.

In other words, Variable costing is a concept used in managerial and cost accounting in which the fixed manufacturing overhead is excluded from the product-cost of production. The method is in contrast with absorption costing, in which the fixed manufacturing overhead is allocated to products produced. In accounting frameworks such as GAAP and IFRS, variable costing is not allowed in financial reporting.

Variable Costing in Financial Reporting

Although accounting frameworks such as GAAP and IFRS prohibit the use of variable costing in financial reporting, this costing method is commonly used by managers to:

• Conduct break-even analysis to determine the number of units needed to be sold to begin earning a profit
• Determine the contribution margin on a product, which helps to understand the relationship between cost, volume, and profit
• Facilitate decision-making by excluding fixed manufacturing overhead costs, which can create problems due to how fixed costs are allocated to each product.

Example of Variable Costing

IFC is a manufacturer of phone cases. Below are excerpts from the company’s income statement for its latest year end (2018):

Manufacturing Costs ($):
Labour	$75,000.00
Materials	$150,000.00
Insurance	$50,000.00
Equipment	$100,000.00
Building	$123,000.00
Utilities (Fixed)	$20,000.00
Utilities (Variable)	$80,000.00

IFC does not report an opening inventory. During 2018, the company manufactured 1,000,000 phone cases and reported total manufacturing costs of $598,000 (around $0.60 per phone case).

The manufacturer recently received a special order for 1,000,000 phone cases at a total price of $400,000. Despite having ample capacity, the manager is reluctant to accept this special order because it is below the cost of $598,000 to manufacture the initial 1,000,000 phone cases as outlined in the company’s income statement. Being the company’s cost accountant, the manager wants you to determine whether the company should accept this order.

First, it is important to know that $598,000 in manufacturing costs to produce 1,000,000 phone cases includes fixed costs such as insurance, equipment, building, and utilities. Therefore, we should use variable costing when determining whether to accept this special order.

Variable costing:

• Direct material of $150,000
• Direct labor of $75,000
• Variable manufacturing overhead of $80,000

Total = $305,000 / 1,000,000 units produced = $0.305 variable cost per case

Cost to produce special order of 1,000,000 phone cases = $0.305 x 1,000,000 = $305,000. Therefore, there is a contribution margin of $400,000 – $305,000 = $95,000.

Based on our variable costing method, the special order should be accepted. The special order will add $95,000 of profits to the company.

It is crucial to understand why the manager was reluctant to accept the order. The manager included fixed costs in the cost calculation, which is incorrect in decision-making. Given ample capacity, the company will not incur additional fixed costs to produce the special order of 1,000,000. As you can see, variable costing plays an important role in decision-making.

Absorption Costing

Absorption costing, also known as full costing, entails allocating fixed overhead costs across all units produced for the period, resulting in a per-unit cost, unlike variable costing, which combines all fixed overhead costs into one expense, reporting them as a single line item on a balance sheet to be taken against net income. In contrast, absorption costing will result in two categories of fixed overhead costs: those attributable to the cost of goods sold and those attributable to inventory.

One of the big advantages of absorption costing is that it is the method required for a company to be in compliance with generally accepted accounting principles (GAAP). Even if a company decides to use variable costing in-house, it is required by law to use absorption costing in any external financial statements it publishes. Absorption costing is also the method that a company is required to use for calculating and filing its taxes.

Absorption costing also provides a more accurate accounting of net profitability, especially when a company doesn't sell all of its products in the same accounting period in which they are manufactured. Every expense is allocated to products manufactured whether or not they are sold.

Variable Costing vs. Absorption Costing

Under variable costing, the following costs go into the product:

• Direct material (DM)
• Direct labor (DL)
• Variable manufacturing overhead (VMOH)

Under absorption costing, the following costs go into the product:

• Direct material (DM)
• Direct labor (DL)
• Variable manufacturing overhead (VMOH)
• Fixed manufacturing overhead (FMOH)

The diagram provided below provides an overview of which costs go into variable costing vs absorption costing methods:

Note that product costs are costs that go into the product while period costs are costs that are expensed in the period incurred.

Summary:

1. Product costs are calculated differently under each method:

	Absorption	Variable
Direct Materials	Include	Include
Direct Labor	Include	Include
Overhead:
Variable Overhead	Include	Include
Fixed Overhead	Include	DO NOT include
Total Product Costs ÷ Total Units Produced =Product Cost per Unit	Sum ÷ Total Units Produced = Cost Per Unit	sum ÷ Total Units Produced = Cost Per Unit

2. Income statement formats are different under each method (both use units sold for variable expenses):

• Absorption uses standard GAAP income statement of Sales – Cost of Goods Sold = Gross Profit – Operating Expenses = Net Operating Income
• Variable uses a contribution margin income statement of Sales – Variable Costs = Contribution Margin – Fixed Expenses = Net Operating Income

3.   Net income on the two reports can be different if units produced do not equal units sold.

Causes of difference in net operating income under variable and absorption costing

Variable costing and absorption costing usually produce different net operating income figures. The reason is that the fixed manufacturing overhead cost is not treated the same way under two costing methods. To understand how the difference in treatment of fixed manufacturing overhead cost changes the net operating income figures of two costing systems, we need to prepare two income statements, one under variable costing and one under absorption costing. For this purpose, consider the following example:

For Example :

A company prepares variable costing income statement for the use of internal management and absorption costing income statement for the use of external parties like creditors, banks, tax authorities etc. The company manufactures a product that is sold for $80. The variable and fixed cost data is given below:

Direct materials: $30.00
Direct labor:$19.00

Factory over head:
Variable cost: $6.00
Fixed cost ($45,000/9000 units): $5.00

Marketing, general and administrative:
Variable cost (per unit sold): $4.00
Fixed cost (per month): $28,000

During the month of June, 9,000 units were produced and 7,500 units were sold. The opening inventory was 2,000 units.

Required:

1. Prepare two income statements, one using variable costing method and one using absorption costing method.
2. Explain the difference in net operating income (if any) under two approaches.

Solution

(1) Income statements

(a). Absorption Costing:

*Computation of units in ending inventory:

(b). Variable Costing:

Reconciliation of net operating income:

(2). Explanation of the difference in net operating income:

Notice that the net operating income under absorption costing is $7,500 ($92,000 – $84,500) higher than the net operating income under variable costing. This difference is because of fixed manufacturing overhead that becomes the part of ending inventory under absorption costing system. The ending inventory absorbs a portion of fixed manufacturing overhead and reduces the burden of the current period. In this way a portion of fixed cost that relates to the current period is transferred to the next period.

Under variable costing, the fixed manufacturing overhead cost is not included in the product cost but charged to the income statement of the relevant period in its entirety. Therefore no portion of fixed cost is absorbed by the ending inventory.

In our example, the net operating income is higher under absorption costing than variable costing because closing inventory is higher than the opening inventory.

Important points to remember:

1. The net operating income under absorption costing systems is always higher than variable costing system when inventory increases.
2. The net operating income under variable costing systems is always higher than absorption costing system when inventory decreases.
3. When inventory increases, the fixed manufacturing overhead cost is deferred to inventory.
4. When inventory decreases, the fixed manufacturing overhead cost is released from inventory.