Question

After you have watched the video, Absorption and Variable Costing, enter this forum to compare and contrast Absorption Costing and Variable Costing. Identify the strengths and weaknesses of each approach and discuss how to mathematically reconcile the differences between the two approaches

Answer 1

Comparison : Absorption and Variable Costing

Absorption Costing: Under this fixed cost are treated as product costs. All manufacturing cost are treated as product cost. Stocks are valued at total cost. Non-manufacturing costs are treated as period cost i.e. charged to profit and loss account.

Income statement under Absorption costing

	Sales (A)	****
	Production Cost
	Material	***
	Labour	***
	Overhead: Vriable	***
	Overhead: Fixed	***
Add:	Opening Stock of finished goodsd	***
Less:	Closing stock of finished goods	***
Add/less:	under/over absorption of fixed manufacturing o/h	***
Add:	non-manufacturing cost	***
	Total Cost (B)	****
	Profit (A-B)	***

1. Advantage of Absorption costing: i. Consideration of Fixed cost: Fixed costs are used in production of goods and services. So treated as product cost. ii. Efficient pricing policy: The pricing policy based on Absorption costing ensures that all costs are covered. iii. Conformity with Accrual and Matching concept: Which requires matching costs with revenue for a particular accounting period. iv. External Reporting and Income taxes: absorption costing has been recognized for the purpose of preparing external reports and stock valuation. FASB, ASB recommended this system. v. No need to separate costs as Fixed and Variable cost. vi. Relevance of under/ over costing: It disclosed inefficient or efficient utilization of production resources.
2. Disadvantages of Absorption Costing System: (i) Absorption costing is not useful for decision making: It consider fixed manufacturing overhead as product cost which increase the cost of output. Managerial problems, such as optimum capacity utilization, selection of product-mix, whether to buy or manufacture, evaluation of performance, choice of alternatives can be solved only with the help of variable costing analysis. (ii) Absorption costing is not helpful in control of cost: It is not useful in fixing the responsibility for incurrence of costs. It is not practical to hold a manager accountable for costs over which he/she has not control. (iii) Fixed Costs are Period Costs: Many accountants argue that fixed costs, whether related to manufacturing or to non-manufacturing, are period costs which produce no future benefits and therefore, should not be included in the cost of the product and inventory. (iv) Costs Hide in Inventory : Since the company allocates fixed overhead to the finished unit level in absorption costing, until the company sells a unit, the cost does not show up as an expense, or Cost of Goods Sold.

Variable costing:  “The system in which variable costs are charged to cost units and fixed costs of the period are written off in full against the aggregate contribution.  The variable manufacturing costs as product costs. The fixed costs are regarded as period cost.  Contribution is difference between sales and variable cost of sales.

Income statement under Variable costing :

	Sales (A)	****
	Production Cost
	Material	***
	Labour	***
	Overhead: Vriable	***
Add:	Opening Stock of finished good (Variable cost of previous production)	***
Less:	Closing stock of finished goods	***
Add:	non-manufacturing cost	***
	Total Cost (B)	****
	Contribution(sales – variable cost)	***
	Profit (Contribution- Fixed cost )	***

1. Advantage of variable costing: i. Planning and control: Variable costing emphasis on cost behaviours which provides necessary information to understand how different costs will change in reaction to changes in activity level. ii. Managerial decision making: Information regarding variable cost and contribution facilitates making policy decisions like fixing selling price below cost, make or buy, introduction of new product line, utilization of spare plant capacity etc. iii. Cost control: The management can concentrate more on the control of variable cost which are generally controllable and pay less attention to fixed cost. iv. No under and over absorption of overheads v. Realistic valuation of stock: No fictitious profit can arise due to fixed cost being absorbed in unsold stock. This is because variable costing prevents the carry forward in stock valuation of some portion of current year’s fixed cost.
2. Limitation of Variable costing: i. Improper basis of pricing: Pricing policies can be fully based on marginal costing system(few exceptions) ii. Product costs not without fixed cost: Complete product cost does not depend only variable production cost. iii. Ignore time factor: By ignoring fixed costs, time factor is also ignored. iv. Difficulty in application: It is difficult to apply variable costing system in industries where large stocks of work in progress are locked up v. Separation of costs into fixed and variable component

Reconciliation:

Whenever there is a difference between the production and sales volumes, absorption costing and variable costing result in different net operating income amounts. When the unit costs in beginning inventory and those produced during the period do not change from one period to the next, you can reconcile the net operating income difference as:

Difference in net operating income

=

[Change in ending inventory units]

x

[Fixed manufacturing overhead cost per unit]

While amounts reported in the short run differ when units produced do not equal units sold, the revenue and expense amounts on the income statements will be the same under both methods in the long run. The difference is solely due to timing of when the fixed manufacturing cost is expensed.

A formal reconciliation of variable costing income to absorption costing income begins with variable costing net operating income determined on the variable costing income statement. The change in the inventory cost is added if the number of finished goods inventory units increase during the period. The change is subtracted if finished goods inventory units decrease. The reconciliation appears in the following format if inventory levels increase:

Net operating income under variable costing	$     xxx
Add Increase/Less decrease in inventory value	xx/(xx)
Net operating income under absorption costing	$     xxx