VARIABLE COSTING

Variable Costing (Direct Costing) is a method of recording and reporting costs

which regards only the variable manufacturing costs as product costs. Fixed
manufacturing costs are written off as period costs. Variable costing is a concept used in
managerial and cost accounting in which the fixed manufacturing overhead is excluded
from the product-cost of production. The method contrasts with absorption costing, in
which the fixed manufacturing overhead is allocated to products produced. In accounting
frameworks such as GAAP and IFRS, variable costing cannot be used in financial
reporting. A managerial accounting cost concept. Under this method, manufacturing
overhead is incurred in the period that a product is produced. This addresses the issue
of absorption costing that allows income to rise as production rises.

UNDERLYING CONCEPT OF VARIABLE

COSTING
Proponents of this product costing method maintain that the fixed part of factory
overhead is more closely related to the capacity to produce than to the production of
specific units and therefore should be charged off as in the period incurred.
Furthermore, the use of this system will permit construction of an income statement
which highlights the contribution margin of the product and therefore facilitates
managerial decision-making process. The use of variable costing for external reporting
is, however, still the center of considerable controversy. It is contended that under this
method, assets (inventory) are being understated and that it is not an accepted
accounting practice.

Until variable costing becomes a generally accepted accounting practice,

companies who wish to use it must convert inventory and cost of goods sold figures to
an absorption costing basis for external reporting. This conversion is a relatively simple
process in most cases and is no deter-rent to the use of variable costing for internal
management purpose.

ARGUMENTS FOR THE USE OF VARIABLE COSTING

The proponents of variable costing cite the following arguments for the use of this
method:

1. Variable costing reports are simpler and more understandable. Reports prepared
under the variable costing method are more easily understood by most managers
because the reports follow the managers' decision-making processes more closely
than do absorption cost reports. For instance, fixed overhead costs, treated as
period costs under variable costing, are presented at actual costs on income
statements prepared using this method, thereby eliminating the need to show
volume or capacity variances! which usually prove confusing to most managers,
particularly those who are not well versed in accounting.

2. Data needed for break-even and cost-volume profit analyses are readily available.
Income statements prepared under variable costing present costs segregated into
variable and fixed. Moreover, the statements highlight the contribution margin
 figure. These data, as discussed in Chapter 5, are important factors in studying cost-
volume-profit relationships and break-even analysis.

3. The problems involved in allocating fixed costs are eliminated. In most cases,
allocation of fixed costs among the products necessitates the use of certain bases, the
selection of which usually involves estimates and personal judgment. With direct
costing,
this problem is eliminated because fixed costs are not assigned to the products but
instead treated totally as expense during the period. As a result, product costs
computation becomes simpler and more reliable. Aside from this, non allocation of fixed
costs permits a more objective appraisal of income contributions by products, types of
customers, sales areas, etc.

ARGUMENTS AGAINST VARIABLE COSTING

The arguments against the use of variable costing are as follows:

1. Problem in segregating costs into fixed and variable. Separation of costs into fixed
and variable might be difficult, particularly in the case of mixed costs.

2. Importance of allocating fixed cost. There are times when management has to make
long- range policy decisions, like product pricing, which require a knowledge of the
total manufacturing costs, including fixed factory overhead. Under variable costing,
fixed overhead is not a product cost. Hence, there will be a need for additional or
separate computations to determine the full cost of the product.

3. Violation of the matching principle. One of the generally accepted accounting

principles is matching of costs with revenues. This principle is violated by using variable
costing which excludes fixed overhead from product costs and charges the same to
period costs, regardless of production and sales.

4. Inventory costs and other related accounts are understated. With variable costing, the
cost of inventory and the amount of current assets are understated because of the
exclusion of fixed overhead in the computation of product cost. This results into a
decrease in the company's working capital, current ratio and acid test ratio.This weakens
the company's financial position which may adversely affect its relations with creditors,
suppliers, customers and potential investors.
Advantages of Using Disadvantages of
Variable Change Using Variable Change

1. Cost-volume-profit relationship Disadvantages of

data needed for profit planning Using Variable Change
purposes is readily obtained from the
regular accounting statements. 1.Variable costing may encourage
a shortsighted approach to profit
2. Reported net income moves in the planning at the expense of the
same direction as sales. long-run situation.

3. Appraisal of performance of 2. Variable costing tends to give

product line or other segments of the the impression that variable costs
business can be facilitated without the are recovered first, that fixed costs
need for arbitrary allocations of fixed are recovered later and that finally
cost. profits are realized.

4. Analysis of costs relevant to pricing 3. Variable costing is not

is simplified and enhanced. acceptable for external reporting
and tax purpose.
5. Variable costing ties in with
effective plans for costs control as

standard costs and flexible budget.

6. Statements are easier to

understand. There is no over or under
absorbed overhead to be concerned
about.
 ABSORPTION COSTING

Absorption costing (also known as full, traditional, conventional and normal

costing) is a method of product costing in which all manufacturing costs, fixed and
variable, are treated as product or inventoriable costs. This method is generally accepted
for external reporting purposes. Sometimes called “full costing,” is a managerial
accounting method for capturing all costs associated with manufacturing a particular
product. The direct and indirect costs, such as direct materials, direct labor, rent, and
insurance, are accounted for by using this method.

EXPLANATION OF THE TABLE ABOVE

It will be noted that it is only in the treatment of Fixed Factory Overhead that the two
costing methods differ. Under variable costing, it is considered as period cost while
under absorption costing, it is treated as product cost.

Variable and Absorption Costing Compared

Both are methods of costing inventories or, stated in another way, both are
methods of determining the cost of the products manufactured. The basic difference
between these two methods is on the treatment of fixed factory overhead. Under
absorption costing, fixed overhead is treated as product cost, while under direct costing,
fixed overhead is treated as period cost.
EXPLANATION

a. When production volume equals sales volume, net income reported under absorption
costing and variable costing are the same. The reason is that the amount of fixed
overhead charged off to operations is the same under each method and also because
there is no change in the amount of fixed overhead in the absorption inventory.

b. When production exceeds sales volume, net income reported under absorption
costing will be greater than that under variable costing. This result occurs because part
of the period's production would go to increase in inventory, and under absorption
costing, part of the period's fixed overhead would be deferred along with it.

c. When sales exceed production volume net income reported under absorption costing
will be lesser than that under variable costing. The reason is that part of the period's
sales would come from the beginning inventory, which, under absorption costing, carried
with it a portion of the prior period's fixed overhead.

3. As to amount of inventory

Inventory under absorption costing would be bigger in amount than that under
variable costing because it would carry a portion of fixed overhead incurred during the
period.
Required

1. Prepare Income Statements for each month and two-months combined under

a. Variable Costing

b. Absorption Costing

2. Reconcile the net income under absorption costing with net income under variable costing.
Illustrative Problem 12-3.
An Income Statement for the manufacturing operations of Luzon Industries, Inc. for
19X1 is given below. The company operated at 75% of normal capacity during 19_1 and
applied the fixed manufacturing costs to the products at a standard rate per unit of
product. The inventory at the beginning of the year consisted of 40,000 units of product
and the inventory at the end of the year consisted of 30,000 units. The company sold
88,000 units of product during the year. Inventories and production are stated on a
standard cost basis.