Management Accounting
Chapter 7:
Variable costing (also direct costing): is a method of stock costing in which all variable
manufacturing costs are included as inventoriable costs. All fixed manufacturing costs are excluded
from inventoriable costs, they are costs of the period in which they are incurred
→ Management accountants most frequently use variable costing for decision making and
performance evaluation purposes
Absorption costing: is a method of stock costing in which all variable manufacturing costs and all
fixed manufacturing costs are included as inventoriable costs
→ Absorption costing is the required method under generally accepted accounting principles for
external reporting in most countries
These two methods differ in only one conceptual respect: wether fixed manufacturing costs (both
direct and indirect) are 'inventoriable' costs.
Direct Indirect
Same under both
methods
Variable Direct manufacturing
costs
Indirect manufacturing
Differs under both
methods
Fixed Direct manufacturing
costs
Indirect manufacturing
For stock valuation under both methods, all variable manufacturing costs (both direct and indirect)
are costs which remain unexpired until the stock is sold.
Under variable costing, fixed manufacturing costs (both direct and indirect) are deducted as a
period cost in the period in which they are incurred.
Under absorption costing, fixed manufacturing costs are initially treated as stock-based costs.
The variable-costing income statement differentiates between fixed and variable costs. It entails the
determination of a 'contribution margin' which represents sales less variable costs (contribution
format).
The absorption-costing income statement calculates a 'gross margin' which represents sales less
cost of goods sold.
If the stock level increases during an accounting period, variable costing will generally report less
operating profit than absorption costing. → differences are due solely to moving fixed
manufacturing costs into stock as stock increase and out of stock as they decrease.
Difference between operating profit:
(Absorption-costing operating profit)-(Variable-costing operating profit)=(Fixed manufacturing
costs in closing stock)-(Fixed manufacturing costs in opening stock)
The period-to-period change in operating profit under variable costing is driven solely by changes
in the unit level of sales, given a constant contribution margin per unit.
Under absorption costing, period-to-period change in operating profit is driven by variations in
both the unit level of sales and the unit level of production.
Capsule comparison of stock-costing methods:
Variable costing or absorption costing may be combined with actual, normal or standard costing.
