5.

INVENTORY COSTING FULL VERSUS DIRECT COSTING

Variable and absorption costing comparison:
Variable costing is a method of inventory costing in which only variable manufacturing
costs (direct and indirect) are included as inventoriable costs. Fixed costs are treated
as costs of the period in which they are incurred.
Variable nonmanufacturing costs are still trated as period costs and are expensed.
Absorption costing is a method of inventory costing in which all variable
manufacturing costs and all fixed manufacturing costs are included as inventoriable
costs.
All nonmanufacturing costs in the value chain (such as research and development and
marketing), whether variable or fixed, are period costs and are recorded as expenses
when incurred.
Fixed manufacturing costs make the difference!
Absorption costing:

Variable costing:

Differences in Income
Operating Income will differ between Absorption and Variable Costing
The amount of the difference represents the amount of Fixed Product Costs capitalized
as Inventory under Absorption costing, and expensed as a period costs under Variable
Costing.
The basis of the difference between variable costing and absorption costing is how
fixed manufacturing costs are accounted for.

Comparative income effects:

Whenever production (the quantity produced not the quantity sold) deviates form the
denominator level, there will be a production-volume variance:
p-v variance = Budgeted fixed manuf. Costs - fixed manuf OH allocated
or
p-v variance = fixed manuf. Cost/unit x (denominator level actual output units
produced)
-When production > budgeted prod. this year has a favourable production-volume
variance.
-When production > budgeted prod. this year has an unfavourable productionvolume variance.
The production-volume variance, which relates only to fixed manufacturing overhead,
exists under absorption costing but not under variable costing.

Why do variable costing and absorption costing usually report different operating
income numbers?
In general, if inventory increases during an accounting period, less operating income
will be reported under variable costing than under absorption costing. Conversely, if
inventory decreases, more operating income will be reported under variable costing
than absorption costing.
The difference between operaring income under absorption costing and variable
costing can be computed by:
Absorption costing Op. Income Variable-costing Op. Income
=
Fixed manuf. Costs in ending inventory Fixed manuf. costs in beginning invent
(Under absorption costing)
Fixed manuf. Costs in ending inventory are deffered to a future period under absorption
costing

Performance Issues and Absorption Costing

-Managers may seek to manipulate income by producing too many units, that is
producing more ending inventory.
-Production beyond demand will increase the amount of inventory on hand
-This will result in more fixed costs being capitalized as inventory
-That will leave a smaller amount of fixed costs to be expensed during the period
-Costs of Goods sold are reduced.
-Profit increases, and potentially so does a managers bonus
Solution:
-One way to prevent the unnecessary build up of inventory for bonus purposes is to
base managers bonuses on profit calculated using Variable Costing
-Drawback: complicated system of producing two inventory figures one for external
reporting and the other for bonus calculations
Other Manipulation Schemes beyond Simple Overproduction
-Deciding to manufacture products to absorb the highest amount of fixed costs,
regardless of demand (cherry-picking)

-Accepting an order to increase production, even though another plant in the same firm
is better suited to handle that order
-Deferring maintenance
Management Countermeasures for Fixed Cost Manipulation Schemes
-Careful budgeting and inventory planning
-Incorporate an internal carrying charge for inventory
-Change (lengthen) the period used to evaluate performance
-Include nonfinancial as well as financial variables in the measures to evaluate
performance
Counting production volume variance (Rational imputation)

Production capacity
- Capacity available the level of capacity given production plant facilities adjusted for
possible disruption
-Capacity utilized the level of capacity used in reality for production purposes
-In our example, lets assume that capacity available = 1000 units, capacity utilized =
800 units (production)
Costing systems compared: