Absorption Costing and Variable

Absorption costing and variable
costing
Learning objectives:====================
After studying this chapter, you should be able to:
• explain the differences between an absorption costing and a variable costing system;
• prepare profit statements based on a variable costing and absorption costing system;
• account for the difference in profits between variable and absorption costing profit calculations;
• explain the arguments for and against variable and absorption costing;
• distinguish between relevant costing and variable and absorption costing.
'In the previous chapters we looked at the manufacturing costs are assigned to products
procedures necessary to ascertain product or job and included in the stock valuation. Fixed
costs for stock valuation to meet the requirements manufacturing costs are not allocated to the
of external reporting. The approach that we product, but are considered os period costs and
adopted was to allocate all manufacturing costs charged directly to the profit statement. Both
to products, and to value unsold stocks at their absorption costing and variable costing systems
total cost of manufacture. Nonmonufocturing are in complete agreement regarding the
costs were not allocated to the products but were treatment of non-manufacturing costs as period
charged directly to the profit statement and costs. The disagreement between the proponents
excluded from the stock valuation. A costing of absorption costing and the proponents of
system based on these principles is known as on variable costing is concerned with whether or not
absorption or full costing system. manufacturing fixed overhead should be
In this chapter we ore going to look at an regarded as a period cost or a product cost. An
alternative costing system known as variable illustration of the different treatment of fixed
costing, marginal costing or direct costing. Under manufacturing overhead for both absorption and
this alternative system, only variable variable costing systems is shown in Exhibit 8.1.
Absorption costing is sometimes referred to as full costing. You can avoid be-
Problem of coming confused by this if you simply remember that absorption costing and full
costing are used to refer to a system in which all the fixed manufacturing overheads
terminology are allocated to products. The alternative system, which assigns only variable
manufacturing costs to products, should correctly be referred to as variable costing,
although the terms direct costing and marginal w~ting are also frequently used.
This is unfortunate, since neither direct costs nor marginal costs are quite the same
as variable costs. Direct costs are those that can be specifically ide ntified with a
product; they include direct labour and materials but in many situations direct
labour may not vary in the short-term with changes in output. So to use the term
direct costing when it specifically includes a non-variable item (that is, direct
labour) is not at all appropriate. The term marginal costing is also inappropriate,
since economists use this term to describe the cost of producing one additional unit.
Applying this definition may lead to fixed costs being included in a situation where
the production of an additional unit will result in an increase in fixed costs, for
182 - - - - - - - - - - - - - - - - - - - - - - - - - - - ABSORPTION COSTING AND VARIABLE COSTING

C. Drury, Management and Cost Accounting
© J.C. Drury 1992
Exhibit 8.1 Absorption and variable costing systems cost
Absorption costing
Finished goods Profit and loss

stock account
Variable costing
Work in progress Finished goods Profit and loss

stock stock account
0 1n this exhibit it is assumed that dired labour is o variable cost.
example the appointment of an additional supervisor, or an increase in capacity due

to the purchase of an additional machine. Many accountants use the term 'marginal
cost' to mean average variable cost. Because marginal cost may be interpreted in
different ways by accountants and economists, it is better not to use the term when
referring to stock valuation. For all these reasons, we shall be using the term
'variable costing' throughout this book to describe a system of costing where only
the variable manufacturing costs are allocated to the product.
Many writers have argued the cases for and against variable costing for stock
valuation for external reporting (for a summary of the arguments see Fremgen,
1977). One important requirement for external reporting is consistency. It would be
unacceptable if companies changed their methods of stock valuation from year to
year. In addition, inter-company comparison would be difficult if some companies
valued their stocks on an absorption cost basis while others did so on a variable cost
basis. Furthermore, the users of external accounting reports need reassurance that
the published financial statements have been prepared in accordance with generally
accepted standards of good accounting practice. Therefore there is a strong case for
the acceptance of one method of stock valuation for external reporting. In the UK a
Statement of Standard Accounting Practice on Stocks and Work in Progress was
publish ed by the Accounting Standards Committee (SSAP 9). This states:
In order to match costs and revenue, cost of stocks and work in progress
should comprise that expenditure which ha s been incurred in the normal
course of business in bringing the product or service to its present location and
EXTERNAL AND INTERNAL REPORTING -----------------------------183

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182 - - - - - - - - - - - - - - - - - - - - - - - - - - - ABSORPTION COSTING AND VARIABLE COSTING

Finished goods Profit and loss

Work in progress Finished goods Profit and loss

example the appointment of an additional supervisor, or an increase in capacity due

EXTERNAL AND INTERNAL REPORTING -----------------------------183

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