Question

What are the benefits of using variable costing when striving to control costs? Are these benefits available under absorption costing?

How can the use of absorption costing result in overproduction?

How will net income under variable costing compare to net income under absorption costing when units produced exceed units sold situation?

Answer 1

Let us first under Absorption Costing and Variable Costing in general terms

ABSORPTION COSTING

Absorption in general, means that everything is to be absorbed into it.

Hence understanding in simple words keeping in mind the term meaning, Absorption Costing is the method of deriving cost of production (cost per unit) in which all costs – direct and indirect shall be incorporated.

Say for example if

Units produced = 1000 units

Raw Material – $ 10/unit

Labour – $ 2/unit

Other variable overheads (OVOH) – $ 3/unit

Fixed Overheads (FOH) - $ 5000

Under absorption costing cost of product shall be

Total Production Cost = Raw Material + Labour + OVOH + FOH = $(10+2+3)*1000+ $ 5000 = $ 20000

Per unit cost

Total Cost / Units Produced = $20000/1000

= $20 per unit

VARIABLE COSTING

Variable in general, means that varies with any change.

Hence understanding in simple words keeping in mind the term meaning, Variable Costing is the method of deriving cost of production (cost per unit) in which costs that varies with change in units produced, meaning with every increase in unit produced the total cost will increase. Fixed overheads do not form part of Cost of production.

Say for example if

Units produced = 1000 units

Raw Material – $ 10/unit

Labour – $ 2/unit

Other variable overheads (OVOH) – $ 3/unit

Fixed Overheads (FOH) - $ 5000

Under variable costing cost of product shall be

Total Production Cost = Raw Material + Labour + OVOH = $(10+2+3)*1000 = $ 15000

Per unit cost

Total Cost / Units Produced = $15000/1000

= $15 per unit

Here fixed over head are charge against the profit generated from sales

So the main aspect in which variable costing differ from absorption costing is that, unlike Absorption costing it classifies COSTS into FIXED & VARIABLE

Benefits of using variable costing when striving to control costs:

We need to understand in production, there are certain costs, which are fixed in nature and are beyond control of production process, such as Rent of Warehouse, Insurance of Factory, etc.

Under cost control, the managers are focussed on controlling the cost per unit of the production, and hence when the costs of the fixed nature cannot be controlled, then they are not in position to derive the exact cost for production.

Under variable costing, these manager gets the opportunity to see if the cost of production per unit can be reduced without changing the units of production, as if all costs were taken then the cost per unit would have reduced just by increasing units of production. This is because if the fixed costs are same for say 1000 units and 1200 units then automatically the costs per unit will reduce, but this can account for overproduction and thus increase supply and hence it may either reduce price or pile up inventory and in turn will increase the maintenance cost of inventory.

Hence under variable costing it is just on the optimum utilisation of resources, the cost per unit can be reduced. Either the manger needs to procure raw material at competitive price, and motivate labours to work more efficiently, only then the cost per unit may reduce.

These benefits are there in absorption costing also, but they are less effective unless proper identification of benefits in relation to Variable and Fixed can be done.

Use of Absorption Costing result in overproduction

As under absorption costing as the fixed costs is included in cost of production hence the cost per unit with increased production will reduce. Thus it may lead to overproduction.

Say for example if

Particulars	Cost	Production	Production	Production
	Per unit	1000	2000	3000
Raw Material	10	10,000.00	20,000.00	30,000.00
Labour	2	2,000.00	4,000.00	6,000.00
Variable Overhead	3	3,000.00	6,000.00	9,000.00
Variable Cost		15,000.00	30,000.00	45,000.00
Fixed Overhead		5,000.00	5,000.00	5,000.00
Total Cost		20,000.00	35,000.00	50,000.00
Under Absorption Costing	Cost per unit	20.00	17.50	16.67
Under Variable Costing	Cost per unit	15.00	15.00	15.00

It is seen that Cost of production per unit is reduced, similarly for 4000 units COP / unit will be ($65000 / 4000) = $16.25 per unit, and hence this will lead to overproduction.

How will net income under variable costing compare to net income under absorption costing when units produced exceed units sold situation?

Under absorption costing the total income shall always be more if the units produced exceeds units sold situation as the closing stock valuation is incorporates the fixed overheads element and is valued higher then variable costing which includes only variable cost in valuation of Closing stock.

Following Profit and Loss Statement can be taken as example

Absorption Costing - Production 1000 Units
Particulars		Amount ($)	Particulars		Amount ($)
To	Opening Stock	-	By	Sales 800 units @ 25	20,000.00
"	Raw Material	10,000.00
"	Labour	2,000.00
"	Variable Overhead	3,000.00	"	Closing Stock	4,000.00
				(Total Cost / Unit Produced
				* Units in hand, i.e 200)
"	Fixed Overhead	5,000.00
"	Profit on Production	4,000.00
		24,000.00			24,000.00
Variable Costing - Production 1000 Units
Particulars		Amount ($)	Particulars		Amount ($)
To	Opening Stock	-	By	Sales 800 units @ 25	20,000.00
"	Raw Material	10,000.00
"	Labour	2,000.00
"	Variable Overhead	3,000.00	"	Closing Stock	3,000.00
				(variable Cost / Unit Produced
				* Units in hand, i.e 200)
"	Fixed Overhead	5,000.00
"	Profit on Production	3,000.00
		23,000.00			23,000.00