What is Absorption and variable costing?
Introduction
An organization prepares income statements to assess the profitability. Incomes statements are also used for decision making by the internal parties like various levels of management and external parties like investors, creditor, government etc. before the preparation of income statements, the costs of producing the goods or providing the services are collated, classified and analyzed. There are two methods of preparing income statement namely variable costing and absorption costing method. The objectives of preparing these statements are different. The variable costing method is used for internal reporting as well as decision making whereas the absorption costing is used for external reporting.
For the purpose of preparing the incomes statements under profit planning, the costs are divided into two types namely product costs and period costs.
Product cost
The term 'product cost' refers to the all cost, which will be incurred in regarding the production of goods. It is also known as inventory cost. Product cost is used in the valuation of inventory. In absorption costing direct material, direct labour, variable manufacturing overhead and fixed manufacturing overhead are considered as product cost and they are used in the valuation of inventory, but in variable costing direct material, direct labour and variable manufacturing overhead are considered as product cost. All the product cost should be in unit and total product cost is calculated on the basis of production unit.
Note: fixed manufacturing overhead is treated as product cost under absorption costing whereas it is treated as periods cost under variable costing.
Period cost
The costs, which are not used in the valuation of inventory is known as period cost. These are expenses in the same financial period. These costs are incurred either for sales activity or with the passage of time. Period cost may be fixed and variable both. Variable period cost should be in per unit and total is calculated on the basis of sales unit but fixed period cost should be in total amount and used on the basis of time. Under absorption costing, fixed period and variable selling and administrative overheads are consider as period cost but in variable costing, fixed manufacturing overhead, fixed and variable selling and administrative overheads are considered as period cost.
Note: (a) direct overhead indicates factory overheads whereas indirect overhead indicated office & administrative overawed and selling & distribution overheads therefore.
(b) Direct overheads = overheads = production/manufacturing overheads= work/factory overheads= standard overheads
The product costs are a part of finished goods. Such costs are also called inventory costs since they are incurred in the value of inventories. The expenses incurred for the administrative and selling and distribution are called period's costs. These costs are not involved in the value of inventories.
The following figure shows the ways of preparing income statement under variable and absorption costing.
Absorption costing or full costing or conventional costing
Concept of absorption costing
Absorption costing included all types of manufacturing cost in product cost. In other words, it included both variables as well s fixed manufacturing overheads in product costs. The variable manufacturing costs includes direct material, direct labour and direct expenses. Therefore, it is also known as full costing it assumes that fixed along with the variable manufacturing constitutes the product cost. It absorbs all costs necessary for production. This method is mostly used for external reporting purpose abortion costing is also known as conventional or traditional costing. The selling and administrative expenses are only considered as period cost under it.
Importance of absorption costing
The importance of absorption costing is mentioned below.
a. This method of costing is more suitable if the income statement is to be reported to the extended parties.
b. It is a suitable method of calculating profit if productions are done for future sales.
c. It is not necessary to classify the cost into variable and fixed costs under for future sales.
d. This method makes the department managers more responsible for their cost centers due to proper allocation of fixed factory overhead on the respective center.
e. This method indicates the over or under absorption of fixed factory overhead that disclosed the profitable and unprofitable or resources.
f. This method enables the calculation of gross profit and net profit separately in income statement.
Limitations of absorption costing
This limitation of absorption costing are given below
• Under absorption costing, the per unit cost changes with the change in output which makes it difficult to computer and control cost.
• Since the absorption costing includes the fixed costs in the product costs, it is not helpful in managerial decisions in the pretext that most of the managerial decisions are made on the basis of marginal costing.
• Under it, the closing stock includes the fixed costs. In this way, a portion of fixed cost is carried forward to next period along with the inventory which is against the accounting principle.
• Since, this method does not classify the cost into variable and fixed, it is difficult to prepare flexible budget under it.
• The accounts are in the view that fixed costs should not be included in product cost. However, that is done in absorption costing.
Concept of absorption costing
Absorption costing included all types of manufacturing cost in product cost. In other words, it included both variables as well s fixed manufacturing overheads in product costs. The variable manufacturing costs includes direct material, direct labour and direct expenses. Therefore, it is also known as full costing it assumes that fixed along with the variable manufacturing constitutes the product cost. It absorbs all costs necessary for production. This method is mostly used for external reporting purpose abortion costing is also known as conventional or traditional costing. The selling and administrative expenses are only considered as period cost under it.
Importance of absorption costing
The importance of absorption costing is mentioned below.
a. This method of costing is more suitable if the income statement is to be reported to the extended parties.
b. It is a suitable method of calculating profit if productions are done for future sales.
c. It is not necessary to classify the cost into variable and fixed costs under for future sales.
d. This method makes the department managers more responsible for their cost centers due to proper allocation of fixed factory overhead on the respective center.
e. This method indicates the over or under absorption of fixed factory overhead that disclosed the profitable and unprofitable or resources.
f. This method enables the calculation of gross profit and net profit separately in income statement.
Limitations of absorption costing
This limitation of absorption costing are given below
• Under absorption costing, the per unit cost changes with the change in output which makes it difficult to computer and control cost.
• Since the absorption costing includes the fixed costs in the product costs, it is not helpful in managerial decisions in the pretext that most of the managerial decisions are made on the basis of marginal costing.
• Under it, the closing stock includes the fixed costs. In this way, a portion of fixed cost is carried forward to next period along with the inventory which is against the accounting principle.
• Since, this method does not classify the cost into variable and fixed, it is difficult to prepare flexible budget under it.
• The accounts are in the view that fixed costs should not be included in product cost. However, that is done in absorption costing.
The format of the income statement prepared under absorption costing is given below.
Under absorption costing the rate of fixed manufacturing overhead I calculated as under.
a. If normal capacity is given, fixed manufacturing overhead per unit = total fixed manufacturing overhead/ normal capacity
b. If normal capacity is not given, the production unit should be assumed as normal capacity.
Fixed manufacturing overhead per unit = total fixed manufacturing overhead/ production unit = total fixed manufacturing overhead / normal capacity
a. If actual production unit is greater than normal capacity that refers to the excess capacity utilization and there will be over absorption of fixed manufacturing overhead. Over absorption of fixed manufacturing is also known as favorable capacity variance. Over absorption of fixed manufacturing is also known as favorable capacity variance. Overhead absorption of fixed manufacturing overhead either can be deducted from the cost of goods sold or can be added to the gross margin.
: Overhead absorption of fixed manufacturing overhead
= (production unit – normal capacity units) x normal manufacturing overhead per unit
b. If actual production is lower than the normal capacity that refer to the under capacity utilization and there will be under absorption of fixed manufacturing overhead. Under absorption of fixed manufacturing overhead either can be added to cost of goods sold or deducting form gross margin.
Under absorption of fixed overhead
= (normal capacity – production unit) x fixed manufacturing overhead unit
c. If actual production is equal to normal capacity neither there will be over nor under absorption fixed manufacturing overhead.
Variable costing is also known as direct costing or marginal costing. Under this costing, direct material, direct labour and variable manufacturing overheads are considered as product cost. In other words, the fixed manufacturing overheads are excluded from the product cost and they are considered as period cost. In this costing, fixed manufacturing overhead and variable selling and administrative costs are considered as period costs. In conclusion, variable costing is a method of recording and reporting costs, which regarded as product costs only those manufacturing costs, which tend to vary directly with the volume of activity. So this costing is very helpful in decision-making process.
This method of costing is adopted to prepare income statement that is used for preparing income statement for internal purpose. CIMA defines "marginal costing is the ascertainment of marginal cost and of the effect on profit of changes in volume or type of output by differentiating between fixed cost and variable cost."
Feature of variable costing
The following of the variable costing are mentioned below:
• The costs of the organization are separated into fixed and variable.
• All fixed costs of the organizations are considered as period cost.
• Only the variable manufacturing costs are used in the valuation of inventory.
• If sales unit is higher than production unit or beginning inventory is higher than ending inventory the profit of variable costing will be higher than absorption costing.
• CVP analysis is one of the integral parts of the variable costing.
• Only the variable manufacturing costs are changes to production and all fixed cost are recovered from contribution.
• Profit is determined by deducting variable cost and fixed cost from sales.
Importance of variable costing
Following are the importance of variable costing:
• It is simple to understand and easy to apply.
• It is very useful tool of profit planning and control.
• It is an appropriate technique for managerial decision making regarding alternate choice like special offer, make or buy, drop or continue etc.
• Cost-volume-profit analysis or break-even point analysis totally based upon variable costing.
• It helps to evaluate costs by avoiding arbitrary apportionment or allocation if fixed cost.
• It helps to evaluate the performance of different department, divisions and salesman.
• There is no problem of over or under absorption of fixed manufacturing overhead because fixed manufactory overhead is considered as period cost.
• The value of closing stock does not include fixed manufactory overhead therefore it prevents the illogical carry forward of fixed manufacturing overhead of one period to next period as part of value of closing stock.
• For standard costing and budgeting, variable costing is the valuable adjunct.
Limitations of variable costing
The following are the limitations of variable costing:
• In variable costing all costs of the organizations are separated into fixed and variable as per the behavioral classification of costs. In fact, no variable cost is completely variable and no fixed cost is completely fixed. Actually most of the costs are semi variable and it difficult it is difficult to segregate them into fixed and variable.
• If work in progress and finished goods inventory are valued on the basis of variable costing, the value of them papering in the balance sheet will be understated and in case of loss by accidents, full loss on account of inventory destroyed by accident. Cannot be recovered from insurance company because variable costing does not include fixed manufacturing overhead in the valued of inventory.
• It is difficult to use contract or shipbuilding industry where the value of work in progress is high in relation to turnover. If fixed manufactories overhead are not included in the valuation work in progress, losses may occur every year, while on the completion of contract. There may be huge profit.
• Sometimes the offer can be accepted at lower price in the argument that if variable cost is little less than price of the offer, it will give some positive contribution. Therefore, it can reduce the selling price and suffer from loss.
• It cannot be successfully used in cost plus contract unless a high percentage over the variable cost is changes from the contracted to cover the fixed cost and profit.
a. If normal capacity is given, fixed manufacturing overhead per unit = total fixed manufacturing overhead/ normal capacity
b. If normal capacity is not given, the production unit should be assumed as normal capacity.
Fixed manufacturing overhead per unit = total fixed manufacturing overhead/ production unit = total fixed manufacturing overhead / normal capacity
Over and under absorption of fixed cost
In absorption costing, fixed manufacturing overhead is considered as product cost and it should be in per unit and multiplied with the production units. There, there may be over or under absorption of fixed manufacturing overhead in absorption costing:a. If actual production unit is greater than normal capacity that refers to the excess capacity utilization and there will be over absorption of fixed manufacturing overhead. Over absorption of fixed manufacturing is also known as favorable capacity variance. Over absorption of fixed manufacturing is also known as favorable capacity variance. Overhead absorption of fixed manufacturing overhead either can be deducted from the cost of goods sold or can be added to the gross margin.
: Overhead absorption of fixed manufacturing overhead
= (production unit – normal capacity units) x normal manufacturing overhead per unit
b. If actual production is lower than the normal capacity that refer to the under capacity utilization and there will be under absorption of fixed manufacturing overhead. Under absorption of fixed manufacturing overhead either can be added to cost of goods sold or deducting form gross margin.
Under absorption of fixed overhead
= (normal capacity – production unit) x fixed manufacturing overhead unit
c. If actual production is equal to normal capacity neither there will be over nor under absorption fixed manufacturing overhead.
Variable costing or marginal costing
Concept of variable costingVariable costing is also known as direct costing or marginal costing. Under this costing, direct material, direct labour and variable manufacturing overheads are considered as product cost. In other words, the fixed manufacturing overheads are excluded from the product cost and they are considered as period cost. In this costing, fixed manufacturing overhead and variable selling and administrative costs are considered as period costs. In conclusion, variable costing is a method of recording and reporting costs, which regarded as product costs only those manufacturing costs, which tend to vary directly with the volume of activity. So this costing is very helpful in decision-making process.
This method of costing is adopted to prepare income statement that is used for preparing income statement for internal purpose. CIMA defines "marginal costing is the ascertainment of marginal cost and of the effect on profit of changes in volume or type of output by differentiating between fixed cost and variable cost."
Feature of variable costing
The following of the variable costing are mentioned below:
• The costs of the organization are separated into fixed and variable.
• All fixed costs of the organizations are considered as period cost.
• Only the variable manufacturing costs are used in the valuation of inventory.
• If sales unit is higher than production unit or beginning inventory is higher than ending inventory the profit of variable costing will be higher than absorption costing.
• CVP analysis is one of the integral parts of the variable costing.
• Only the variable manufacturing costs are changes to production and all fixed cost are recovered from contribution.
• Profit is determined by deducting variable cost and fixed cost from sales.
Importance of variable costing
Following are the importance of variable costing:
• It is simple to understand and easy to apply.
• It is very useful tool of profit planning and control.
• It is an appropriate technique for managerial decision making regarding alternate choice like special offer, make or buy, drop or continue etc.
• Cost-volume-profit analysis or break-even point analysis totally based upon variable costing.
• It helps to evaluate costs by avoiding arbitrary apportionment or allocation if fixed cost.
• It helps to evaluate the performance of different department, divisions and salesman.
• There is no problem of over or under absorption of fixed manufacturing overhead because fixed manufactory overhead is considered as period cost.
• The value of closing stock does not include fixed manufactory overhead therefore it prevents the illogical carry forward of fixed manufacturing overhead of one period to next period as part of value of closing stock.
• For standard costing and budgeting, variable costing is the valuable adjunct.
Limitations of variable costing
The following are the limitations of variable costing:
• In variable costing all costs of the organizations are separated into fixed and variable as per the behavioral classification of costs. In fact, no variable cost is completely variable and no fixed cost is completely fixed. Actually most of the costs are semi variable and it difficult it is difficult to segregate them into fixed and variable.
• If work in progress and finished goods inventory are valued on the basis of variable costing, the value of them papering in the balance sheet will be understated and in case of loss by accidents, full loss on account of inventory destroyed by accident. Cannot be recovered from insurance company because variable costing does not include fixed manufacturing overhead in the valued of inventory.
• It is difficult to use contract or shipbuilding industry where the value of work in progress is high in relation to turnover. If fixed manufactories overhead are not included in the valuation work in progress, losses may occur every year, while on the completion of contract. There may be huge profit.
• Sometimes the offer can be accepted at lower price in the argument that if variable cost is little less than price of the offer, it will give some positive contribution. Therefore, it can reduce the selling price and suffer from loss.
• It cannot be successfully used in cost plus contract unless a high percentage over the variable cost is changes from the contracted to cover the fixed cost and profit.
Income statement under variable costing
The following is the format of income statement under variable costing. 
Application of absorption costing and variable costing
Absorption costing is more widely used than variable costing. However, the growing use of the contribution approach in performance measurement and cost analysis has led to an increasing use of variable costing for internal reporting purpose. Generally, all firms use absorption costing for their report to shareholders and tax authorities. In short, we can say that, variable costing is used for internal reporting purpose and absorption is used of external reporting purpose.
Concept of capacity level
The word capacity is related with constraint or limit or production of the organization in which management combines the variety of scare human and non-human resources which posses the capacity to make and sell goods and to maintain the firm as a going concern.
The human resources include all members within the organization. The non human resources include the factory and office buildings, machinery and equipment. Inventory of productive materials, factory, engineering, office suppliers and cash.
Among these resources available to the firm, variable costs are not regarded as cost of the capacity, the cost of everything else is. While the firm's basis capacity remains stable, its cost tends to remain t=stable in total. When capacity is expanded or contracted in line with changes in the firm's longer-range objectives. The cost of that capacity or decreases accordingly. If there is excess capacity in the organization, there will be idle resources and idle resources earn nothing but in case the cost. In the same way, if there is low capacity, that couldn't meet the demand of the customer and customer divert to another supplier and they never return. Therefore, every organization should determine appropriate level of capacity. It will be the challenging task for the manager. Therefore, it is equally important to understand the concept and the impact of appropriate capacity level. Generally, there are four types of capacity levels which are given below:
a. Theoretical capacity: theoretical capacity is also known as installed capacity. It is the maximum production of which the plant is capable running full time, no interruptions. It is attainable only in that condition when the production activity is operating a full efficiency in all the time, it does, however, serve as a measuring point from which to establish other capacity levels.
b. Practical capacity: this notion of capacity simply applies the facts of factory life to the measure of theoretical capacity. Practical capacity is theoretical capacity less the ordinary and expected interruption, delays, machine and tool breakdowns, variability in worker productivity, holidays, vacation, inventory shutdowns etc. the limit on practical are determined by internal constructs within the factory itself. Practical capacity is based on expected and operational performances; therefore, it is also known as operational and attainable capacity. Capacity is more realistic than theoretical capacity.
c. Normal capacity: normal capacity is the level at which management sets the prices that are expected to recover all costs and realizing a real profit. Theoretical capacity and practical capacity measure what a plant can supply. Normal capacity is a concept based on the level of capacity utilization that specifies average customer demand over a period of time, (say 3-5 years) which includes seasonal and cyclical of time and tread factors. In regarding the estimation of capacity level all realities should be taken into consideration includes the plant break downs, holidays, inventory shutdown, variability in workers' productivity etc. the limit of the normal capacity is established by the external constraints. Normal capacity is used to compute the predetermined fixed overheads rate.
d. Master budget capacity or estimated annual volume: more useful than either theoretical or practical capacity but less widely used than normal capacity is the estimated annual volume or master budget capacity. Its essential meaning is in the name the capacity is determined each year in the light of forecast volume.
Difference between absorption and variable costing
The differences between absorption and variable costing are given below.
Difference between absorption and variable costing
The differences between absorption and variable costing are given below.
Reconciliation of profit
The profit shown by an absorption costing and variable costing might differ. Such difference does not exist if the production units are equal with sales units. In other words, when the production units are not equal with the sales units, the net profit reported by these costing systems will defer.
The reason of such difference is the inclusion of fixed manufacturing overhead. Under absorption costing, the value of inventories includes the fixed cost which is not done under variable costing.
A reconciliation statement is prepared to reconcile the profit as shown by absorption costing and variable costing.
The reason of such difference is the inclusion of fixed manufacturing overhead. Under absorption costing, the value of inventories includes the fixed cost which is not done under variable costing.
A reconciliation statement is prepared to reconcile the profit as shown by absorption costing and variable costing.
Inventory valuation under changing price
Generally, the cost of raw material, labour and overhead may not remain constant over a period, if such price change takes place; the company applies actual costing for inventory valuation. In regarding the valuation of inventory, FIFO and LIFO systems are commonly used. If question is silent in the valuation of inventory in that case FIFO method is used.
Format reconciliation statement under FIFO method
1. Write in brief about the product cost and period cost.
Product cost: the term 'product cost' refers to the all cost which will be incurred in regarding the production of goods. It is also known as inventory cost. Product cost is used in the valuation of inventory. In absorption costing direct material, direct labour, variable manufacturing overhead and fixed manufacturing overhead are considered as product cost and they are used in the valuation of inventory, but in variable costing direct material, direct labour and variable manufacturing overhead are considered as product cost. All the product cost should be in per unit and total product cost is calculated on the basis of production unit.
Period cost: the costs, which are not used in the valuation of inventory is known as period cost. These costs are expended in the same financial period. These costs are incurred either for sales activity or with the passage of time. Period cost may be fixed and variable both. Variable period cost should be in per unit and total is calculated on the basis of sales unit but fixed period cost should be in total amount and used on the basis of time. Under absorption costing, fixed and variable selling and administrative overheads are considered as period cost but in variable costing. Fixed manufacturing overhead, fixed and variable selling and administrative overheads are considered as period cost.
2. Write the limitations of absorption costing.
The limitations of absorption costing are mentioned below:
• Under absorption costing, the per unit cost changes with the changes in output which makes it difficult to compare and control cost.
• Since the absorption costing includes the fixed costs in the product costs. It is not helpful in managerial decisions are made on the basis of marginal costing.
• Under it, the closing stock includes the fixed costs, in this way; a potion of fixed cost is carried forward to next period along with the inventory which is against the accounting principle.
• Since, this method does not classify the costs into variable and fixed, it is difficult to prepare flexible budget under it.
• The accountants are in the view that flex costs should not be included in period are in the view that fixed costs should not be included in product cost. Hewer, this is done in absorption costing.
3. State the advantages of variable costing.
Following are the importance of variable costing.
a. It is simple to understand and easy to apply.
b. It is a very useful tool of profit planning and control.
c. It is an appropriate technique for managerial decision making regarding alternate choice like special offer, make or buy, drop or continue etc.
d. Cost-volume-profit analysis or break-even point analysis artistry based upon variable costing.
e. It helps to control variable costs by available attar apportionment or allocation of fixed cost.
f. It helps to evaluate the performance of different departments, divisions and salesman.
Nice detailed of inventory cost.
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