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Absorption Vs. Variable Costing
I. Overview
The treatment of the fixed portion of manufacturing overhead.
Absorption costing.
Variable costing.
Note: Also known as contribution margin reporting.
Super-variable costing.
Super-absorption costing.
- Usefulness for managerial purposes.
- Contribution margin indicates how much sales contribute to cover fixed costs and provide a profit.
- Provides a better measure than absorption costing of the relative profitability of individual products, product lines, territories, or customers.
- Provides information about cost-volume-profit (CVP) relationships.
II. Variable costing
Variable costing treats fixed manufacturing costs as period costs, but absorption costing accumulates them as product costs.
Internal reporting for cost behavior analysis is more useful if it concentrates on the production of units because fixed manufacturing overhead is more closely related to the capacity to produce than to the production of individual units.
Because period costs will occur whether or not production occurs, it is improper to allocate these costs to production and defer a current cost of doing business.
Expensed as period cost and used in the computation of the contribution margin in an income statement prepared for internal reporting.
Direct material, direct labor, and variable overhead.
Because unit-of-production depreciation is included in variable overhead and decrease in the remaining useful life of machinery increases unit product cost.
The fixed overhead, selling, and administrative costs are subtracted from the contribution margin to determine operating income.
The variable selling and administrative costs are subtracted from the revenues or sales to determine the contribution margin.
Because changes in the relationship between production and sales do not cause changes in the amount of fixed manufacturing costs, that is, expenses, and profits more directly follow the trends in sales.
III. Absorption vs Variable Costing
Backflush costing.
- Produce the products requiring the most direct labor.
- Defer expenses such as maintenance to a future period.
- Increase production schedules independent of customer demands.
By producing more products than are sold, because more fixed overhead costs are allocated to the ending inventories.
An excess of sales volume over production volume.
The change in the number of units in inventory times the relevant fixed costs per unit.
The operating profit is a function of sales under variable costing, and the operating profit is a function of sales and production.
Because all fixed costs associated with production are expenses of the period under variable costing, an increase in production does not improve a manager’s evaluation based on variable costing operating profit.