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UNIT 4: VARIABLE AND ABSORPTION COSTING

II SEM BBA LLB

UNIT 4

VARIABLE AND ABSORPTION COSTING


Variable Costing System

The direct costing or variable costing method applies all direct costs as well as variable manufacturing
overhead costs to the end product. These costs move with the product through the inventory accounts
until the product is sold, at which point they are expensed on the income statement as costs of goods
sold. Fixed manufacturing overhead costs are expensed during the period in which they are incurred.

Advantages and Limitations of Variable Costing

The following are the advantages of variable costing:

1. Planning and Control:

Financial planning requires managers to estimates future sales, future production levels, future costs
etc. Sales forecasts determine production plans, which in turn determine the level of expenditures
required for raw materials, direct labour and variable manufacturing overhead. In order to determine
the level of expenditure at different production levels, knowledge of cost behavior and distinguishing
between fixed and variable costs is essential for making accurate cost estimates at the different levels of
production and sales.

Thus a financial plan will highlight expected production level and related expected costs. This financial
plan can be used to monitor the actual performance as it is done. In case actual performance is different
from the budgeted activity level, corrective action can be taken by management.

2. Managerial Decision- Making:

Management requires knowledge of cost behavior under various operating conditions and business
decisions. The identification and classification of costs as either fixed or variable, with semi-variable
expenses properly subdivided into these fixed and variable components, provide useful framework for
the accumulation and analysis of costs and further for making decisions.

Relevant costs are required for a variety of short-term decision such as changes in production levels,
make or buy, entry into new markets, product mix, plant expansion or contraction or special
promotional activities. These decisions require that costs be split into their fixed and variable
components and this is possible only under variable costing.

Therefore, projection of future costs and revenues for different activity levels and the use of relevant
cost decision-making techniques are facilitated and highlighted in variable costing and not in absorption
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Asst.Prof, ASL 1
UNIT 4: VARIABLE AND ABSORPTION COSTING
II SEM BBA LLB
costing. The utility of variable costing rests upon the fact that, within a limited volume range, fixed costs
tend to remain constant in total when activity level changes, under such conditions, only variable costs
are relevant in ascertaining costs of additional output and sales or in other short-term decisions.

Another benefit of variable costing is that the favorable margin between selling prices and variable cost
should provide a constant reminder of income forgone because of lack of sales volume. A favorable
margin justifies a higher production level.

3. Product Pricing Decisions:

Variable costing provides more useful information to management for pricing decisions than absorption
costing. It is rightly contented that the best or optimum price is that which produces the maximum
excess of total sales revenue over total cost. The optimum production volume is that at which increase
in total cost due to the addition of one more unit of volume is just equal to the increase in total revenue
or a zero increase in total profit.

The price at which this volume can be achieved is the optimum product price. A higher price will
decrease the sales revenue; a lower price tends to increase the sales volume and leads to abnormal
production costs due to overtime, produc-tion inefficiencies, etc. Variable costing serves as the basis of
product pricing in many cases.

Under variable costing, management has the data to determine when it is advisable to accept orders if
other than normal conditions exist. In some cases, a sales order can be accepted even if it contributes
partly to fixed costs. New short-term businesses or orders should be accepted as long as the variable
cost of making and selling are recovered—variable costs represent the minimum sales price under these
conditions. Knowledge of the contribution margin provides guidelines for the most profitable pricing
policies.

However, the full cost and not only the variable cost should be the basis of product pricing in the long-
run. The full cost is the cost which includes variable manufacturing cost and fixed manufacturing cost
incurred in the production process.

4. Cost Control:

For the purpose of cost control, costs should be pooled into separate variable and fixed totals.
Separation of variable and fixed costs supports the use of standards, budgets and responsibility
report-ing to help management in controlling costs. All costs are controllable in the long run by someone
within a business enterprise. But they are not all controllable at the same level of management.

For example, supervisors in production department are responsible for controlling the use of direct
materials in their departments. They have no control, however, over insurance costs related to the
production department building. For a specific level of management, controllable costs are costs that it
controls directly and non-controllable costs are costs that another level of management controls. This

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Asst.Prof, ASL 2
UNIT 4: VARIABLE AND ABSORPTION COSTING
II SEM BBA LLB
distinction, as applied to specific levels of management, is useful in fixing the responsibility for
incurrence of costs and then for reporting cost data to those responsible for cost control.

The variable costing includes only variable manufacturing costs, which varies with change in the volume
of production, in the cost of product and thus makes variable manufacturing costs controllable at cost
center level by operating management. Fixed production costs may not be con-trollable at departmental
level and therefore should not be included in the production costs at costs center level, as it is important
to match control with responsibility.

The fixed manufacturing costs are reported as separate item in the variable costing income statement,
they are easier to identify and control (by a higher level of management) than when they are spread
among units of product as in absorption costing. Similarly, under variable costing, each other variable
and fixed operating expenses (e.g., variable and fixed selling and administrative expenses) are reported
separately and thus become easier to identify and control than in absorption costing where they are not
reported separately but combined together.

5. Inventory Changes do not Affect Profit:

In variable costing, profit is a function of sales volume only. But under absorption costing sales and
production (production creates inventory) both influence profit of a period. Profit in variable costing is
not affected by changes in inventory as it is in absorption costing. In absorption costing, profit may
decline although sales have increased. When inventory levels fluctuate greatly, profits calculated under
absorption costing may be distorted since inventory changes will influence the amount of fixed
manufacturing overheads charged to an accounting period.

6. Avoiding the Impact of Fixed Costs:

Variable costing avoids the arbitrary apportionment of fixed factory overheads and also avoids problem
of determining a suitable absorption basis which is needed for a predetermined overhead absorption
rate. Fixed production costs are charged to the period in which they are incurred and are not carried
forward in stock which may be un-saleable, resulting in earlier profits being overstated. It is argued that
managerial decisions can be easily made if fixed production costs are separated and are not mixed in
inventory or cost of sales.

Since most fixed costs are committed and can-not be avoided, these costs should not be part of
inventory. In addition, the presentation of the total amount of fixed costs on variable costing income
statement emphasizes their full impact on net income, an effect partially hidden in inventory values
under absorption costing.

Another benefit of variable costing is that production managers cannot manipulate income by producing
more or fewer products than needed during a period. Under absorption costing, however, a production
manager could increase income simply by producing more units than are currently needed for sales.

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Asst.Prof, ASL 3
UNIT 4: VARIABLE AND ABSORPTION COSTING
II SEM BBA LLB
Morse, Davis and Haitgraves observe: “when considering the financial accounting principle of matching,
variable costing has advantage over absorption costing because it matches revenue with the direct cost
of producing those revenues. This results in net income varying only with sales and not with both sales
and production, as is often found in absorption costing. In absorption costing, over production especially
distorts net income during a period because the excess inventory is assigned fixed costs that would
otherwise be assigned to the units produced and sold.”

7. Performance Evaluation of Managers:

The evaluation of managers is often linked with the profitability of units they manage and control. The
changes in income from one period to another and difference between the actual income and budgeted
income are used to judge managerial performance and efficiency. For example, if a manager has worked
hard and has increased sales while controlling costs simultaneously, income will increase indicating the
success and better performance of manager.

The variable costing income statement highlights the relationship between sales and income whereas
the absorption costing income statement does not generally show any association between sales and
income. For example, under absorption costing income may decrease although sales have increased or
sales may decrease but income reported may be higher due to large inventory being created due to
higher production. Vari-able costing always produces an increase in income corresponding to the
improved sales performance.

Furthermore, the variable costing can be used to evaluate the profit contributions of plants, product
lines and sales territories. The separation of fixed and variable costs which are basic to vari-able costing
is critical for making accurate evaluations. Thus, variable costing can make a significant contribution to
management decision- making in such and similar areas.

8. Segmental Reporting:

Segmented reporting provides information about the contribution of organizational subunits.


Segmented income statements differ from other income statements because they display amounts for
direct (traceable) fixed costs (costs avoidable if the segment is eliminated) and for common or allocated
fixed costs (costs that will continue to be incurred even if the segment is eliminated).

Presenting segmented income statements on a variable-costing rather than on absorption-costing basis


is preferable because it results in more accurate studies of relative profitability of divisions, plants,
products, territories, activities, and other segments of an organization. It concentrates on the
contribution (the segment margin) that each segment makes to the recovery of common fixed costs.
Marginal income data facilitate appraisal of segments without the bias (cross-subsidies) introduced by
allocated common fixed costs.

Mrs. Rachana
Asst.Prof, ASL 4
UNIT 4: VARIABLE AND ABSORPTION COSTING
II SEM BBA LLB
9. Customer Profitability Analysis:

Customer profitability analysis is an application of segmented reporting in which a customer group is


treated as a segment. This analysis may be done using variable costing to determine a customer
contribution margin or absorption costing to determine a customer gross margin based on full-cost cost
of sales. It is especially helpful when combined with an activity-based costing approach that determines
which activities are performed for each group and assigns costs based on appropriate drivers.

Activities include those required to gain new customers and to maintain relationships with current
customers as well as ordering, packaging, handling, customer service, etc. Furthermore, assignment of
costs for a customer profitability analysis is based on cost-hierarchy concepts similar to those used in
product profitability analysis.

For example, activities, their drivers, and their costs may be classified as order level, customer level,
channel level, market level, or enterprise level. Assignment of revenues is also a critical concern in
customer profitability analysis. Thus, sales returns and allow-ances, the effects of coupon offers, price
discounts, etc., should be traced to specific customer groups.

Limitations of Variable Costing:

The following are the limitations of variable costing:

(i) Separation of Costs into Fixed and Variable:

The variable costing method requires that all costs should be divided into fixed and variable elements.
Also variable costing assumes that the relation between the sales and the variable costs is direct,
proportionate, and linear. It cannot be true under all circumstances. Examples of factors that might
affect this assumption include quantity discounts on materials, and labour efficiency variance.

(ii) Product Costs Not without Fixed Costs:

Complete product cost does not depend only on variable costs. Fixed costs should be considered in
determining the product cost and for long-range pricing and other long-run policy decisions. The
product is not complete until it is in a form and place and at a time desired by the customer, and this
product completion involves distribution just as essentially as it does manufacturing.

(iii) Temptation to Cut-Prices:

It is also argued that if managers are given only variable cost (as is done in variable costing) they will be
tempted to cut prices to the degree that company profits will suffer. Despite the many, other
advantages of the method for internal purposes, variable costing generates product figures providing
little basis for long range pricing policies.

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Asst.Prof, ASL 5
UNIT 4: VARIABLE AND ABSORPTION COSTING
II SEM BBA LLB

(iv) Use of Net Income Figure:

Income figures obtained under variable costing have to be use a carefully if management decides to
expand business or drop a product line. Management has to consider other factors also before deciding
to drop a product line such as customer goodwill. .The loss in customer goodwill which might result from
dropping a product with a low contribution margin could easily offset any gain from products with
higher contribution ratios. Thus the variable costing although useful is not a perfect managerial tool.

(v) Unwise Decisions:

Sometimes variable costing may be unnecessarily given a broader significance than it deserves. For
instance, when sales are higher than production, variable costing net income will be more than
absorption costing net income. In this case, sometimes, management may take unwise actions due to
‘increased profits’ reported by variable costing.

It may prompt the marketing managers to go for lower selling prices, may inspire the managers and
employees to demand higher salary or bonus. But, in fact, there can be no justification for such actions.
At the other extremes, variable costing results may mislead management during a business recession
during which variable costing profit will be minimized due to sales being extremely lower than
production.

Absorption Costing Method

The Absorption costing method applies all direct costs and both fixed and variable manufacturing
overhead costs to the end product. These entire costs move with the product through the inventory
accounts until the product is sold, at which point they are expensed on the income statement as costs of
goods sold.

In other words, Absorption costing means that all of the manufacturing costs are absorbed by the units
produced. Absorption cost is the cost of a finished unit in inventory will include direct materials, direct
labor, and both variable and fixed manufacturing overhead. As a result, absorption costing is also
referred to as full costing or the full absorption method.

Advantages of Absorption Costing:

Following are the main advantages of absorption costing:

1. It suitably recognizes the importance of including fixed manufacturing costs in product cost
determination and framing a suitable pricing policy. In fact all costs (fixed and variable) related to
production should be charged to units manufactured. Price based on absorption costing ensures that all
costs are covered. Prices are well regulated where full cost is the basis.

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Asst.Prof, ASL 6
UNIT 4: VARIABLE AND ABSORPTION COSTING
II SEM BBA LLB
2. It will show correct profit calculation in case where production is done to have sales in future (e.g.,
seasonal sales) as compared to variable costing.

3. It helps to conform to accrual and matching concepts which require matching cost with revenue for a
particular period.

4. It has been recognized by various bodies as FASB (USA), ASG (UK), ASB (India) for the purpose of
preparing external reports and for valuation of inventory.

5. It avoids the separation of costs into fixed and variable elements which cannot be done easily and
accurately.

6. It discloses inefficient or efficient utilization of production resources by indicating under-absorption or


over-absorption of factory overheads.

7. It helps to make the managers more responsible for the costs and services provided to their
centers/departments due to correct allocation and apportionment of fixed factory overheads.

8. It helps to calculate gross profit and net profit separately in income statement.

Disadvantages of Absorption Costing:

Following are the main limitations of absorption costing:

1. Difficulty in Comparison and Control of Cost:

Absorption costing is dependent on level of output; so different unit costs are obtained for different
levels of output. An increase in the volume of output normally results in reduced unit cost and a
reduction in output results in an increased cost per unit due to the existence of fixed expenses. This
makes comparison and control of cost difficult.

2. Not Helpful in Managerial Decisions:

Absorption costing is not very helpful in taking managerial decisions such as selection of suitable
product mix, whether to buy or manufacture, whether to accept the export order or not, choice of
alternatives, the minimum price to be fixed during the depression, number of units to be sold to earn a
desired profit etc.

3. Cost Vitiated because of Fixed Cost included in Inventory Valuation:

In absorption costing, a portion of fixed cost is carried forward to the next period because closing stock
is valued at cost of production which is inclusive of fixed cost.

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Asst.Prof, ASL 7
UNIT 4: VARIABLE AND ABSORPTION COSTING
II SEM BBA LLB
4. Fixed Cost Inclusion in Cost not justified:

Many accountants argue that fixed manufacturing, administration and selling and distribution overheads
are period costs and do not produce future benefits and, therefore, should not be included in the cost of
product.

5. Apportionment of Fixed Overheads by Arbitrary Methods:

The validity of product costs under this technique depends on correct apportionment of overhead costs.
But in practice many overhead costs are apportioned by using arbitrary methods which ultimately make
the product costs inaccurate and unreliable.

6. Not Helpful for Preparation of Flexible Budget:

In absorption costing no distinction is made between fixed and variable costs. It is not possible to
prepare a flexible budget without making this distinction.

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Mrs. Rachana
Asst.Prof, ASL 8