Variable Costing: A Tool for

Management
Inventory valuation is a major component in the calculation of
the cost of goods sold and can be used as collateral for loans. It
can be defined as the cost associated with the inventory in an
entity at the end of the reporting period. Inventory valuation is
based on the costs incurred by an entity to acquire the
inventory.
Inventory
Valuation

Absorption Variable
Costing Costing
Importance of Inventory Valuation

It impacts reported profit levels whereby if an entity records a higher valuation in

ending inventory, fewer expenses are charged to the cost of goods sold. On the
other hand, if an entity records a lower valuation in ending inventory, more
expenses are charged to the cost of goods sold.

In cases whereby an entity has undertaken a loan amount from the lender, there
may be an agreement which restricts the set allowed amount of current assets to
current liabilities. The inventory valuation is critical since inventory is the largest
part of the current ratio.

Income taxes- Inventory valuation affects income tax, whereby the chosen method
of handling cost flow can either reduce or increase the total amount of income
taxes paid.
Absorption Costing

Also referred to as full costing, it is a costing system whereby all manufacturing

costs, including variable and fixed costs, are assumed to be product costs. The
period costs, in this case, include administrative, selling and general costs which do
not go into the cost of the product but are expensed at the period incurred.

Advantages:
a) It is GAAP (Generally Accepted Accounting Principles) compliant
b) Takes into account all production costs
c) It helps in the estimation of job costs and profits on jobs by absorbing overheads
into the costs of products.

Disadvantages:
a) It provides a poor analysis of the costs of products
b) It can negatively affect a company’s profit level because all fixed costs are not
subtracted from revenue unless the products are sold
c) It is complex to operate
Variable Costing
Variable costing is a costing technique whereby the variable cost is charged to units
of costs while the fixed cost is completely written off against the contribution. In
variable costing;
a) The prices are determined on the basis of marginal cost and contribution
b) Costs involved are variable and fixed costs and are classified based on
variability
c) The profitability of a product is based on the contribution margin
d) Only variable costs are taken into account when valuing inventory
Advantages:
a) Fixed costs are classified as a period cost and are charged in full to the period in
mention
b) It is helpful in the decision-making process
c) It prevents under or over-absorption of overheads
d) Contribution per unit is constant and does not change in change volumes
e) It is simple to operate
Disadvantages:
a) The closing inventory is not valued according to accounting standards
b) Fixed production costs are not spread out between units of production
Difference between Absorption and Variable Costing
Features Absorption Costing Variable Costing
Definition Is a costing system whereby all Is a costing technique whereby the
the manufacturing costs, variable costs is charged to units of
including variable costs and costs while the fixed cost is
fixed costs, are classified as completely written off against the
part of product costs contribution
Costs Both variable and fixed costs Only variable costs are considered
involved are considered in the cost of as product cost and fixed costs are
the product classified as period costs
Contribution Net profit per unit is Contribution per unit is considered
per unit considered
Costs per Major consideration on the Major consideration on the cost of
unit cost of each unit is given producing the next unit is given
priority priority
Overheads Emphasizes overheads Emphasizes the calculation of the
recovery recovery contribution of each unit
CVP analysis Not suitable for CVP analysis Suitable for CVP analysis
Difference between Absorption and Variable Costing
Features Absorption Costing Variable Costing
Classification Overheads are classified into Overheads are classified into
of overheads production, administrative and fixed and variable category
selling & distribution categories
Ease of Is not easy to operate Is easy to operate
operation
Effect on cost The cost per unit is affected by The cost per unit is not affected
per unit variances in the opening and by variances in the opening and
closing stock closing stock
GAAP Is GAAP compliant Is not GAAP compliant
compliance
Reporting Is used for external reporting to Is used for internal reporting
government, tax authorities, particularly to the management
shareholders etc. for decision making
Decision Is not very helpful in making Is helpful in decision making due
making managerial decisions to the fact that it considers
additional costs involved
Product vs. Period Costs in Absorption and Variable Costing

Variable Absorption
Costing Costing
Elements of Costs

Direct Materials

Product
Direct Labor
Costs Product
Costs
Variable Manufacturing Overhead

Fixed Manufacturing Overhead

Period
Variable Selling and Administrative Expenses
Costs Period
Costs
Fixed Selling and Administrative Expenses
Profit/Loss Scenarios in Absorption and Variable Costing

Status of NOI in
Scenarios Inventory Levels Absorption and
Variable Costing

Increases
1 Production > Sales
Ending > Beginning
NOI of AC > NOI of VC

Decreases
2 Production < Sales
Ending < Beginning
NOI of AC < NOI of VC

Same
3 Production = Sales
Ending = Beginning
NOI of AC = NOI of VC
Reconciliation: Explaining the Gaps in NOI between Methods

Reconciliation from Variable Costing NOI to Absorption Costing NOI

Particulars Year 1 Year 2
Net Operating Income under Variable Costing ** **
Add: Fixed Manufacturing Overhead deferred in ending inventory (1) **
Less: Fixed Manufacturing Overhead released from beginning inventory (2) **
Net Operating Income under Absorption Costing ** **

Reconciliation from Absorption Costing NOI to Variable Costing NOI

Particulars Year 1 Year 2
Net Operating Income under Absorption Costing ** **
Less: Fixed Manufacturing Overhead deferred in ending inventory (1) **
Add: Fixed Manufacturing Overhead released from beginning inventory (2) **
Net Operating Income under Variable Costing ** **

(1) When production > sales – ending inventory is higher than the beginning inventory
(2) When production < sales – ending inventory is lower than the beginning inventory
Income Statement Format: Absorption Costing

Income Statement
Traditional Absorption Costing Format

Particulars Amount ($) Amount ($)

Sales
Less: Cost of Goods Sold
Beginning Inventory
(+) Cost of Goods Manufactured
Cost of Goods Available for Sale
(-) Ending Inventory
Cost of Goods Sold
Gross Profit / Margin
Less: Selling and Administrative Expenses
Net Operating Income (Loss)
Income Statement Format: Variable Costing
Variable Costing Contribution Format Income Statement
Particulars Amount ($) Amount ($)
Sales
Less: Variable Expenses
(a) Variable Cost of Goods Sold
Beginning Inventory
(+) Variable Cost of Goods Manufactured
Variable Cost of Goods Available for Sale
(-) Ending Inventory
Variable Cost of Goods Sold
(b) Variable Selling & Administrative Expenses
Total Variable Expenses
Contribution Margin
Less: Fixed Expenses
Fixed Manufacturing Overhead
Fixed Selling and Administrative Expenses
Net Operating Income (Loss)
Exercise 6-6 Page 264
Lynch Company manufactures and sells a single product. The following costs were incurred
during the company’s first year of operations:
Variable costs per unit:
Manufacturing:
Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . $6
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $9
Variable manufacturing overhead . . . . . . . . . . . . . $3
Variable selling and administrative . . . . . . . . . . . . . . . . . . . . .$4
Fixed costs per year:
Fixed manufacturing overhead . . . . . . . . . . . . . . . . . $300,000
Fixed selling and administrative . . . . . . . . . . . . . . . . $190,000
During the year, the company produced 25,000 units and sold 20,000 units. The selling price
of the company’s product is $50 per unit.
Required:
Assume that the company uses absorption costing:
a. Compute the unit product cost.
b. Prepare an income statement for the year.
Assume that the company uses variable costing:
a. Compute the unit product cost.
b. Prepare an income statement for the year.
Solution

Computing cost per unit under variable and absorption costing

Elements of Cost Absorption Variable

Costing Costing
Direct Material 6 6
Direct Labor 9 9
Variable Manufacturing Overhead 3 3
Fixed Manufacturing Overhead (a) 12 -
Total cost per unit 30 18

(a) Fixed Manufacturing Overhead is computed by dividing total fixed

manufacturing overhead by units produced which is shown below:

$300,000 ÷ 25,000 units = $12

Cost per unit under adsorption costing is higher than cost per unit under
variable costing by fixed manufacturing overhead per unit
Solution - continued
Lynch Company
Income Statement (Traditional Format)

Particulars Amount ($) Amount ($)

Sales (20,000 units @ $50 per unit) 1,000,000
Less: Cost of Goods Sold
Beginning Inventory 0
(+) Cost of Goods Manufactured (25,000 ×30) 750,000
Cost of Goods Available for Sale 750,000
(-) Ending Inventory (5,000×30) 150,000
Cost of Goods Sold 600,000
Gross Profit / Margin 400,000
Less: Selling and Administrative Expenses
Variable (20,000 × $4) 80,000
Fixed 190,000 270,000
Net Operating Income (Loss) 130,000
 Lynch Company
Income Statement (Contribution Format)

Particulars Amount ($) Amount ($)

Sales (20,000 units @ $50 per unit) 1,000,000
Less: Variable Expenses
(a) Variable Cost of Goods Sold
Beginning Inventory 0
(+) Variable Cost of Goods Manufactured (25,000×18) 450,000
Variable Cost of Goods Available for Sale 450,000
(-) Ending Inventory (5,000×18) 90,000
Variable Cost of Goods Sold 360,000
(b) Variable Selling & Administrative Expenses 80,000
Total Variable Expenses 440,000
Contribution Margin 560,000
Less: Fixed Expenses
Fixed Manufacturing Overhead 300,000
Fixed Selling and Administrative Expenses 190,000 490,000
Net Operating Income (Loss) 70,000
Reconciliation: Explaining the Gaps in NOI between Methods

Reconciliation from Variable Costing NOI to Absorption Costing NOI

Particulars Amount ($)
Net Operating Income under Variable Costing 70,000
Add: Fixed Manufacturing Overhead deferred in ending inventory (5,000×12) 60,000
Less: Fixed Manufacturing Overhead released from beginning inventory -
Net Operating Income under Absorption Costing 130,000

Reconciliation from Absorption Costing NOI to Variable Costing NOI

Particulars Amount ($)

Net Operating Income under Absorption Costing 130,000
Less: Fixed Manufacturing Overhead deferred in ending inventory 60,000
Add: Fixed Manufacturing Overhead released from beginning inventory -
Net Operating Income under Variable Costing 70,000
CVP Analysis, Decision Making and Absorption costing

Absorption costing does not dovetail with CVP analysis, nor does it
support decision making. It treats fixed manufacturing overhead as a
variable cost. It assigns per unit fixed manufacturing overhead costs
to production.

Treating fixed manufacturing overhead as a variable cost can:

• Lead to faulty pricing decisions and faulty keep-or-drop decisions.

Assigning per unit fixed manufacturing overhead costs to production

can:
• Potentially produce positive net operating income even when the
number of units sold is less than the breakeven point.
External Reporting and Income Taxes: Absorption Costing

To conform to BAS/BFRS
requirements, absorption costing
must be used for external financial
reports in Bangladesh.

Since top executives are typically

evaluated based on earnings reported
to shareholders in external reports,
they may feel that decisions should be
based on absorption costing data.

Under the Income Tax Ordinance

1984, absorption costing must be used
when filling out income tax returns.
Advantages of Variable Costing and the Contribution Approach
Management finds
it more useful.
Consistent with
CVP analysis.

Net operating income

Advantages

is closer to net cash flow.

Consistent with standard

costs and flexible budgeting

Easier to estimate profitability

of products and segments.

Profit is not affected by

changes in inventories.

Impact of fixed costs on

profits emphasized.
Variable Costing and the Theory of Constraints (TOC)

Companies involved in TOC use a form of variable costing.

However, one difference of the TOC approach is that it treats
direct labor as a fixed cost for three reasons:
 Many companies have a commitment to guarantee
workers a minimum number of paid hours.
 Direct labor is usually not the constraint.
 TOC emphasizes the role direct laborers play in driving
continuous improvement. Since layoffs often devastate
morale, managers involved in TOC are extremely reluctant
to lay off employees.
Lean Production and JIT

When companies use Lean Production . . .

Production
tends to equal
sales . . .

So, the difference between variable and absorption income

tends to disappear.