Question

Explain why variable costing and absorption costing can result in different period incomes. Support your argument by an example which spans more than one accounting period.

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.

The reason why absorption costing and variable costing results in different net incomes can be explained as below.

1) Under absorption costing, normal manufacturing costs are considered product costs and included in inventory but in variable costing only variable costs are taken into consideration.

2) In Absorption costing product costs includes Direct materials,Direct Labours,variable manufacturing overheads and fixed manufacturing overheads while in variable costing prodcuts cost will be Direct materials,Direct Labours,variable manufacturing overheads .

ABC company produces and sells only calculators. The company uses variable costing for internal reporting and absorption costing for external reporting. The data for the year 2014 is given below:

Direct materials: $100/unit
Direct labor: $35/unit
Variable manufacturing overhead: $15/unit
Fixed manufacturing overhead: $126,000 per year

Company produced and sold 7,000 calculators during the year 2015.

Required: Compute the unite product cost under variable costing and absorption costing.

Solution:

Particulars Absorption Costing Variable Costing

Material 100 100

Labour 35 35

Variable manufacturing overhead 15 15

Fixed manufactuirng overhead* 18 -

168 150

*Fixed manufactuirng overhead = 126000/7000 = 18

Fixed manufactuirng overhead are not taken into cost in the case of variable costing.In the above example we can see the cost is different in both the mothods.This is the reason why net incomes are different in both the costing methods.