Question

Allpro clubs is a startup company that manufactures golf clubs. The owner of the company is upset because allpro has reported losses for the last three quarters, despite increased productio and acquisition of new customers. The owner is worried about his ability to obtain additional financing. In reciewing the operating performance of allpro, you notice that the company's income statement has been prepared using variable costing. You know that although the company is not required to use GAAP, the absorption costing method maybe a better method for Allpro to use for financial reporting purposes. As the senior accountant, draft a memo to the owner explaining the differences between variable and absorption costing and how a change in methodology could impact the company's profitability.

Answer 1

Variable and absorption are two different costing methods. Almost all successful companies in the world use both the methods. Variable costing and absorption costing cannot be substituted for one another because both the systems have their own benefits and limitations.

These costing approaches are known by various names. For example, variable costing is also known as direct costing or marginal costing and absorption costing is also known as full costing or traditional costing.

The information provided by variable costing method is mostly used by internal management for decision making purposes. Absorption costing provides information that is used by internal management as well as by external parties like creditors, government agencies and auditors etc.

Example 1

A company manufactures and sells 5000 units of product X per year . Suppose one unit of product X requires the following costs:

Direct materials: $5 per unit
Direct labor: $4 per unit
Variable manufacturing overhead: $1 per unit
Fixed manufacturing overhead: $20,000 per year

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

Absorption Costing: $5 + $4 + $1 + $4* = $14

Variable Costing: $5 + $4 + $1 = $10

* $20,000 / 5,000

Notice that the fixed manufacturing overhead cost has not been included in the unit cost under variable costing system but it has been included in the unit cost under absorption costing system. This is the primary difference between variable and absorption costing.