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An overview of variable costing and absorption costing, two methods used in management accounting for stock costing. Variable costing includes only variable manufacturing costs as inventoriable costs, while absorption costing includes both variable and fixed manufacturing costs. The differences between these methods, their impact on income statements, and their relationship to capacity and budgeting.
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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.
Absorption costing enables managers to increase operating profit in the short run by increasing the production schedule independent of customer demand for products. The term capacity means constraint, an upper limit. Theoretical capacity: is the denominator-level concept that is based on the production of output at full efficiency for all of the time (does not allow for any plant maintenance, any interruptions etc, it can represent a goal Practical capacity: is the denominator-level concept that reduces theoretical capacity for unavoidable operating interruptions such as scheduled maintenance time etc In many cases budgeted demand is well below the supply available (productive capacity) Normal utilization: is the denominator-level concept based on the level of capacity utilization that satisfies average customer demand over a period that includes seasonal, cyclical or other trend factors Master-budget utilization: is the denominator-level concept based on the anticipated level of capacity utilization for the next budget period These two denominator levels can differ, e.g. when an industry has cyclical periods of high and low demand or when management believes that the budgeted production for the coming period is unrepresentative of 'long-term' demand. A major reason for choosing master-budget utilization over normal is the difficulty of forecasting normal utilization in many industries with long-run cyclical patterns.