Variable Costing

Absorption (full) costing is used for external reporting purposes, the cost of a product
must include all the cost of manufacturing it: direct materials, direct labor, and all
factory overhead (both fixed and variable). Since no distinction is made between variable
and fixed costs, absorption costing is not well suited for Cost-Volume-Profit (CVP)
computations.

Under absorption costing, the fixed portion of manufacturing overhead is “absorbed” into
the cost of each unit of product.
1. Product cost thus includes all manufacturing costs, both fixed and variable.
2. Absorption-basis cost of goods sold is subtracted from sales to arrive at gross
margin.
3. Total selling and administrative (S&A) expenses (i.e., both fixed and variable) are
then subtracted from the gross margin to arrive at operating income.

Variable (Direct) Costing is used for internal purposes, decision making is improved
by treating fixed overhead as a period cost so that only costs that are variable in the
short run are included in the cost of the product. Fixed overhead costs are considered as
period costs and are deducted in the period in which they are incurred.
1. Product cost includes only the variable portion of manufacturing costs.
2. Variable-basis cost of goods sold and the variable portion of S&A expenses are
subtracted from sales to arrive at ​contribution margin​.
a. Contribution margin (sales - total variable costs) is an important element
of the variable costing income statement because it is the amount
available for covering fixed costs (both manufacturing and S&A).
b. For this reason, some accountants call the method ​contribution margin
reporting​.
c. Contribution margin is an important metric internally but is generally
considered irrelevant to outside financial statement users.

This approach dovetails with the contribution approach income statement and supports
CVP analysis because of its emphasis on separating variable and fixed costs.

Variable costs are direct function of production volume. They increase when production
grows and decreases when production shrinks. Raw materials and labor directly involved
with production are common variable costs.
Justifications for Variable Costing

Under variable costing, fixed overhead cost is considered a cost of maintaining capacity,
not a cost of production.
1. To illustrate, a company has a fixed rental expenses of ₱100,000 per month on its
factory building. The cost will be ₱100,000 regardless of whether there is any
production. If the company produces zero units, the cost will be ₱100,000; if the
company produces 10,000 units, the cost will be ₱100,000.
2. Therefore, the ₱100,000 is not viewed as a cost of production and is not added to
the cost of the inventories produced. The ₱100,000 is a cost of maintaining a
certain level of production capacity.

To emphasize, variable costing is used only for internal decision-making purposes: it is

not permitted for external financial reporting or for tax calculation. The main advantage
of the variable costing method is that income cannot be manipulated by management
action, whereas management can manipulate income using the absorption method.

EXAMPLE ​| During its first month in business, a firm produced 100 units and sold 80
while incurring the following costs:

The impact on the financial statements from using one method over the other can be
seen in these calculations:

The ₱600 difference (₱1500 - ₱900) in inventory value represents the fixed overhead that
is charged to the absorption basis inventory. Because 20% of the units produced are still
in inventory, 20% of the 3,000 of fixed costs, or ₱600, is still in inventory. Under the
variable basis, all fixed costs are expended.

The per-unit selling price of the finished goods was ₱100, and the company incurred
₱200 of variable selling and administrative expenses and ₱600 of fixed selling and
administrative expenses.

The following are partial income statements prepared using the two methods:
 1. The ₱600 difference in operating income (₱1,200- ₱600) is the difference between
the two ending inventory values (₱1,500 - ₱900). In essence, the absorption
method carries 20% of the fixed overhead costs (₱3,000 x 20% = ₱600) on the
balance sheet as an asset because 20% of the month’s production (100 available
- 80 sold = 20 on hand) is still in inventory.
2. This calculation is for illustrative purposes only. The differences in operating
income is exactly the differences in ending inventory only when beginning
inventory is ₱0.

Impact on Operating Income

As production and sales levels change, the two methods have varying impacts on
operating income. ​When everything produced during a period is sold that period​,
the two methods report the ​same operating income​. Total fixed costs budgeted for the
period are charged to sales revenue in the period under both methods. When production
and ​sales are not equal for a period​, the two methods report ​different operating
income​.

Income will be higher or lower under variable costing depending upon whether
inventories are increased during the period or liquidated.

If ​inventories increase during a period​, the ​variable costing method will show a
lower income because all fixed costs are being subtracted on the income statement,
while under the absorption method, some fixed costs are being capitalized as
inventories.

Variable costing will show a ​higher income ​in periods ​when inventories decline
because the absorption method forces the subtraction of all of the current period fixed
costs, plus some fixed costs incurred (and capitalized) in prior periods.

Under ​variable costing​, ​profits always move in the same directions as sales
volume​. Profits reported under absorption costing behave erratically and sometimes
move in the opposite direction from sales trends.

In the long run, the two methods will report the same total profits if sales equal
production. The inequalities between production and sales are usually minor over an
extended period.
 Relation Between Variable
Relation Between Production
and Absorption Costing
and Sales
Net Operating Income

Production = Sales Absorption Costing NI =

(No change in inventory) Variable Costing NI

Production > Sales Absorption Costing NI >

(Inventory increases) Variable Costing NI*
Production < Sales Absorption Costing NI <
(Inventory decreases) Variable Costing NI**

*Net operating income will be higher under absorption costing than under variable
costing because fixed manufacturing overhead cost will be deferred in inventory under
absorption costing.

**Net operating income will be lower under absorption costing than under variable
costing because fixed manufacturing overhead cost will be released from inventory under
absorption costing.

A production manager can increase absorption-basis operating income merely by

increasing production, whether there is any customer demand for the additional product
or not. The company must also deal with the increased carrying costs resulting from
swelling inventory levels.

This practice, called ​producing for inventory​, can be effectively discouraged by using
variable costing for performance reporting and consequent bonus calculation.

EXAMPLE | Anteiku Corporation is a small company that produces a single product

called Quinx.

Unit product costs are computed as follows:

Details of its 3-year transactions are as follows:

3-year income statements prepared under the two methods:

During Year 1, both Absorption and Variable costing Net Operating Income are the same
since all inventories produced during the period are sold, no portion of fixed overhead is
capitalized. Absorption costing shows a higher operating income than variable costing in
Year 2 because fixed overhead has been capitalized and does not get expensed until
Year 3. Variable costing net operating income is higher in Year 3 because some fixed
overhead from Year 2 is expensed on Year 3 upon sale to customers.

From an internal point of view, a manager can manipulate absorption income by

changing production levels. But, with variable costing, a manager cannot manipulate
simply by changing production levels. If the manager was being given a bonus for a
higher level of income, (s)he could obtain the bonus by producing more units than could
be sold. As a result, some fixed costs would be added to the balance sheet as
inventories. Thus, the income statement and balance sheet both look good, despite the
fact that the production manager has done a bad thing; (s) he has produced excessive
inventories, which require the company to incur storage and financing costs. Spoilage
may be a result.
Reconciling Net Operating Income

Benefits of Variable Costing

Although the use of variable costing for financial statements is prohibited, the most
agree about its superiority for internal reporting. It is better suited than absorption
costing to the needs of management.
1. Management requires knowledge of cost behavior under various operating
conditions. For planning and control, management is more concerned with
treating fixed and variable costs separately than with calculating full costs.
2. Full costs are usually of dubious value because they contain arbitrary allocations
of fixed costs.
3. First and foremost, under the variable costing method, a production manager
cannot manipulate income levels by overproducing. Given the same cost structure
every year, the income levels will be based on sales, not the level of production.
4. Under variable costing, the cost data for profit planning and decision making are
readily available from accounting records and statements. Reference to auxiliary
records and supplementary analyses is not necessary. For example,
cost-volume-profit relationships and the effects of changes in sales volume on net
income easily be computed from the income statement based on the same data.
5. Profit and losses reported under variable costing have a relationship to sales
revenue and are not affected by inventory or production variations.
6. Absorption cost income statements may show decreasing in profits when sales
are rising and increases in profits when sales are decreasing, which may be
confusing to management. Attempts at explanation by means of volume
variances often compound rather than clarifying the confusion. Production volume
variances not only are unnecessary but also are frustrating and confusing to
management.
7. When variable costing is used, the favorable margin between selling prices and
variable cost should provide a constant reminder of profits forgone because of
lack of sales volume. A favorable margin justifies a higher production level.
8. The full impact of fixed costs on net income, partially hidden in inventory values
under absorption costing, is emphasized by the presentation of costs on an
income statement prepared under variable costing.
9. Proponents of variable costing maintain that fixed factory is more closely
correlated to capacity to produce than to the production of individual units.

Further Aspects of Variable Costing

Variable costing is also preferred over absorption costing for studies of relative
profitability of products, territories, and other segments of a business. It concentrates on
the contribution that each segment makes to the recovery of fixed costs that will not be
altered by decisions to make and sell. Under variable costing procedures,
1. The marginal income concept leads to better pricing decisions, which are a
principal advantage of variable costing.
2. The impact of fixed costs on net income is emphasized by showing the total
amount of such costs separately in financial reports.
3. Out-of-pocket expenditures required to manufacture products conform closely
with the valuation of inventory.
4. The relationship between profit and the major factors of selling price, sales mix,
sales volume, and variable manufacturing and nonmanufacturing costs is
measured in terms of a single index of profitability.
a. The profitability index, as expressed as a positive amount or as a ratio,
facilitates the analysis of cost-volume-profit relationships, compares the
effects of two or more contemplated courses of action, and aids in
answering many questions that arise in profit planning.
5. Inventory changes have no effect on the breakeven computations.
6. Marginal income figures facilitate appraisal of products, territories, and other
business segments without having the results hidden or obscured by allocated
joint fixed costs.
7. Questions regarding whether a particular part should be made or bought can be
more effectively answered if only variable costs are used.
a. Management must consider whether to charge the product being made
with variable costs only or to charge a percentage of fixed costs as well.
b. Management must also consider whether the making of the part will
require additional fixed costs and a decrease in normal production.
8. Disinvestment decisions are facilitated because whether a product or department
is recouping its variable costs can be determined.
a. If the variable costs are being covered, operating a department at an
apparent loss may be profitable.
9. Management is better able to judge the differences between departments if
certain fixed costs are omitted from the statements instead of being allocated
arbitrarily.
10. Cost figures are guided by the sales figures.
a. Under variable costing, cost of goods sold will vary directly with sales
volume, and the influence of production on gross profit is avoided.
b. Variable costing also eliminates the possible difficulties of having to
explain over- or underapplied factory overhead to higher management.

Throughput Costing

Also called as ​Super-Variable costing​, considers ​only direct materials as true

variable cost (product cost). ​All other costs are period costs​.

Lean Production And Absorption Costing

Differences in net operating income between absorption and variable costing occur when
production doesn’t equal sales.

Under lean production, inventories are reduced drastically and changes in inventories are
small. As a consequence, ​the difference between absorption and variable costing
net operating incomes is reduced under lean production​.