Question

which method do you think allows for the greatest manipulation of net income; variable or absorption costing and why? discuss any ethical concerns associated with your answer.

Answer 1

Solution:

First of all we need to understand the product costing under Absorption and Variable Costing System.

Under Variable Costing, the cost of manufacturing a product includes all variable costs of making a product which includes direct material cost, direct labor cost and variable manufacturing overhead costs. Under this method, the net profit can be shown lower than what the actual profit is due to the exclusion of fixed manufacturing cost portion of ending inventory in the income statement.

Ethical Issue --- The Matching Concept of Accounting says, all income and revenues of the period should be followed by related expenditure during the period in the income statement to determine true and fair or correct net income or loss of the period. Variable Costing method does not follow this concept since it does not considered Fixed Manufacturing Overhead in valuation of ending inventory or in calculation of Product Cost.

This is the reason we follow absorption costing for statutory reporting.

Under Absorption Costing the cost of manufacturing a product includes all fixed and variable costs for making a product including materials, labor and overhead costs.

Under Absorption Costing the income statement may show a higher asset value than the company actually has. When this form of costing is used on an income statement, it is open to unethical practice through the manipulation of the costs, asset and inventory values, and can be used to make the company’s performance seem better than it actually is.

Hence, Variable Costing Method allows for the greatest manipulation of net income.

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