Under the variable costing method, which of the following is always expensed in its entirety

Chapter 6

Variable Costing: A Tool for Management

Two general approaches are used in manufacturing companies for costing products for the purposes of valuing inventories and cost of goods sold. One approach is the absorption costing. Absorption costing is generally used for external financial reports. The other approach, called variable costing, is preferred by some managers for internal decision making and must be used when an income statement is prepared in the contribution format. Ordinarily, absorption costing and variable costing produce different figures for net operating income, and the difference can be quite large. In addition to showing how these two methods differ, we will consider the arguments for and against each costing method and we will show how management decisions can be affected by the costing method chosen.

Overview of Absorption and Variable Costing

The contribution format income statement and cost – volume profit [CVP] analysis are valuable management tools. Both of these tools emphasize cost behavior and require that managers carefully distinguish between variable and fixed costs. Absorption costing assigns both variable and fixed manufacturing costs to products – mingling them in a way that makes it difficult for managers to distinguish between them. In contrast, variable costing focuses on cost behavior – clearly separating fixed from variable costs. One of the strengths of variable costing is that it harmonizes with both the contribution approach and the CVP concepts.

Variable Costing

Under variable costing, only those manufacturing costs that vary with output are treated as product costs. This would usually include direct materials, direct labor, and the variable portion of manufacturing overhead. Fixed manufacturing overhead is not treated as a product cost under this method. Rather, fixed manufacturing overhead is treated as a period cost and, like selling and administrative expenses, it is expensed in its entirety each period. Consequently, the cost of a unit of product in inventory or in cost of goods sold under the variable costing method does not contain any fixed manufacturing overhead cost. Variable costing is sometimes referred to as direct costing or marginal costing.

Selling and Administrative Expense

To complete this summary comparison of absorption and variable costing, we need to briefly consider the handling of selling and administrative expenses. These expenses are never treated as product costs, regardless of the costing method. Thus, under absorption and variable costing, variable and fixed selling and administrative expenses are always treated as period costs and are expensed as incurred.

Exhibit 6 – 1 summarizes the classification of costs under both absorption and variable costing.

Exhibit 6 – 1 Cost Classifications – Absorption versus Variable Costing

Unit Cost Computations

To illustrate the computation of unit product costs under both absorption and variable costing, consider Boley Company, a small company that produces a single product and that has the following cost structure:

Required:

1. Compute the unit product cost under absorption costing.
2. Compute the unit product cost under variable costing.

Solution

Under the absorption costing method, all manufacturing costs, variable and fixed, are included when determining the unit product cost. Thus, if the company sells a unit of product and absorption costing is being used, then $12 [consisting of $7 variable cost and $5 fixed cost] will be deducted on the income statement as cost of goods sold. Similarly, any unsold units will be carried as inventory on the balance sheet at $12 each.

Under the variable costing method, only the variable manufacturing costs are included in product costs. Thus, if the company sells a unit of product, only $7 will be deducted as cost of goods sold, and unsold units will be carried as inventory on the balance sheet at only $7 each.

Income Comparison of Absorption and Variable Costing

Exhibit 6 – 2 displays income statements prepared under the absorption and variable costing approaches. In preparing these statements, we use the data for Boley Company presented earlier, along with other information about the company as given below:

Exhibit 6 – 2 Comparison of Absorption and Variable Costing – Boley Company

*Note the difference in ending inventories. Fixed manufacturing overhead cost at $5 per unit is included under the absorption approach. This explains the difference in ending inventory and in net operating income [1,000 units x $5 per unit = $5,000].

Several observations should be made concerning the income statements in Exhibit 6 – 2. First, the net operating incomes under the two costing methods are not the same. The net operating income under absorption costing is higher than under variable costing by $5,000. Why is this? Under absorption costing, each of the units produced during the period is assigned $5 of fixed manufacturing overhead cost. This is true of the 1,000 units in ending inventory as well as the 5,000 units that were sold. Consequently, the ending inventory under absorption costing contains $5,000 of fixed manufacturing overhead and the cost of goods sold contains $25,000 of fixed manufacturing overhead. In contrast, the entire $30,000 of fixed manufacturing overhead is expensed under variable costing. As a direct result, the net operating income under variable costing is $5,000 higher than under absorption costing. In effect, the $5,000 of fixed manufacturing overhead in ending inventory under absorption costing is deferred to the future period in which these units are sold. This $5,000 of fixed manufacturing overhead cost in the ending inventory is referred to as fixed manufacturing overhead cost deferred in inventory. In general, under absorption costing, when inventories increase, some of the fixed manufacturing costs of the current period are reported on the balance sheet as part of the ending inventories rather than on the income statement as part of cost of goods sold.

Second, the absorption costing income statement makes no distinction between fixed and variable costs – a distinction that is crucial for CVP analysis and for much of the planning and control concepts discussed in later chapters. It is difficult or even impossible to determine from an absorption costing income statement which costs are variable and which are fixed. In contrast, on a variable costing income statement the fixed and variable costs are explicitly identified – making CVP analysis far easier.

The difference between the absorption and variable costing approaches to accounting for fixed manufacturing costs centers on timing. Advocates of variable costing say that fixed manufacturing costs should be expensed immediately in total, whereas advocates of absorption costing say that fixed manufacturing costs should be charged against revenues gradually as units of product are sold. Any units of product not sold under absorption costing result in fixed manufacturing costs being inventoried and carried forward on the balance sheet as assets to the next period.

Exhibit 6 – 5 Comparative Income Effects – Absorption and Variable Costing