Question

1. What makes Ford, GM, and Chrysler "look" more profitable when they use "absorption costing"?

2. What are the major differences between absorption costing and variable costing?

3. Under what condition (or for which purpose) a company need to consider using variable costing?

Answer 1

1. Under absorption costing, inventory absorbs both variable and fixed manufacturing costs. These costs are absorbed in direct relation to the number of units produced. These costs remain as asset under inventory until the inventory is sold. So these costs will not be charged as expense (Cost of goods sold) unless the same is sold. Ford, GM, Chrysler had huge fixed manufacturing costs like labor contracts, leases for factories, third party patents etc.. So they over-produced cars in order to absorb more fixed costs there by bringing down the per unit cost. Since production was higher than the demand, these companies had huge closing inventory yet no expense was charged as, under absorption costing expense gets charged only when the inventory is sold. So the cost of unsold inventory reflected under closing stock rather than profit and loss statement. This obviously projects higher profit. This is how Ford, MG, Chrysler looked more profitable using absorption costing.

2. Differences

a.Absorption costing includes fixed costs where as Variable costing does not.

b.Absorption costing is usually generally used for external reporting (in line with GAAP) whereas Variable costing is generally used for internal decision making.

c.Contribution is calculated under Variable costing whereas Net profit is calculated under absorption costing.

d.Profit is directly related to number of sales under Variable costing whereas it is difficult to directly trace change in number of sales to profit under absorption costing.

3.Variable costing is best suitable for Internal decision making reports. Managers can determine which products to expand in and which products to discontinue. It is easier to determine the impact on discontinuing a product under Variable costing. Since fixed costs are not included in variable costing, managers tend to focus on efficiency and cost control for making higher profits as they are directly related under this method.