Research for the TOPIC:

IV. The Variable Costing System: A Decision Making Tool of

Management

1. Overview of absorption and Variable Costing

2. Income Comparison of Absorption and Variable Costing

3. Advantages and disadvantages of Absorption and Variable

Costing

4. Impace Just-In-Time (JIT) Inventory Method

In partial fulfilment for the Book Report

For

FINANCIAL MANAGEMENT

FIN 069

Submitted by:

AIZA L. BALBALLEGO

Submitted to:

PELILIA C. VELOSO, CPA, LLB, DBA

Professor
IV. The Variable Costing System: A Decision Making Tool of Management

General Objective:

To determine when an expense will be recognize (when a asset will be re-classified as an

expense)
Expense (Expiration of Benefits) is incurred when an asset is used up or sold for the
purpose of generating income.

1. Overview of absorption and Variable Costing

Costing: An Overview
 The fixed costs that differentiate variable and absorption costing are primarily overhead
expenses, such as salaries and building leases that do not change with changes in
production levels. A company has to pay its office rent and utility bills every month
regardless of whether it produces 1,000 products or no products at all, for example.
Types of Costs as to purpose:

Product Costs
o The costs of goods manufactured or the cost of goods purchased for resale.
o These costs are inventoried until the goods are sold.
o When product costs are expensed, it will form part of the cost of goods sold.
o Can be found in three types of inventories, raw materials, work-in process, and
finished goods.
 Period Costs
o All other non-product costs in an organization
o Such costs are not inventoried but are expensed as time passes.
o Examples
 Selling expenses ( Delivery Expense, Advertising Expense, Sales
Commission)
 General and Administrative ( Accounting, Professional Fee, Research and
Development)
o When Period Costs are expensed, it will form part of the operating expenses.

Absorption Costing
Absorption costing, also known as full costing, entails allocating fixed overhead costs
across all units produced for the period, resulting in a per-unit cost, unlike variable costing,
which combines all fixed overhead costs into one expense, reporting them as a single line
item on a balance sheet to be taken against net income. In contrast, absorption costing will
result in two categories of fixed overhead costs: those attributable to the cost of goods sold
and those attributable to inventory.
Variable Costing
Variable costing can make it more difficult to determine ideal pricing for its goods and
services since it does not directly consider all of the costs the company has to cover to be
profitable. However, by looking only at the costs directly associated with production,
variable costing makes it easier for a company to compare the potential profitability of
manufacturing one product over another.
 However, absorption costing is not as helpful as variable costing for comparing the
profitability of different product lines. Variable costing, on the other hand, enables a
company to run a cost-volume-profit analysis. This analysis is designed to reveal the break-
even point in production by determining how many products a company must manufacture
and sell to reach the point of profitability.
2. Income Comparison of Absorption and Variable Costing

 The income statements prepared under absorption costing and variable costing usually
produce different net operating income figures. This difference can be quite large. Here
we will explain the basic reason of this difference in income. The explanation for this
difference needs two separate income statements one under absorption costing and other
under variable costing. We will prepare two income statements that will produce different
income figures and then explain the reasons of difference.
Example:
Following data relates to a manufacturing company:
Absorption Costing Income Statement

Sales (5,000 units×$20 per unit) $100,000

Less cost of goods sold:

Beginning inventory $0
Add Cost of goods manufactured (6,000 units×$12per unit) $72,000

Goods available for sale $72,000

Less ending inventory $12,000

Cost of goods sold $60,000

Gross Margin ($100,000 – $60,000) $40,000

Less selling and administrative expenses

Variable selling and administrative expenses (5,000 × 3) $15,000
Fixed selling and administrative expenses $10,000
 $25,000

Net operating income ($40,000 – $25,000) $15,000

Variable Costing Income Statement

Sales ($5,000units×$20 per unit) $100,000

Less variable expenses:

Variable cost of goods sold:
Beginning inventory $0
Add variable manufacturing costs (6,000 units×$7 per unit) $42,000

Goods available for sale $42,000

Less ending inventory (1,000 units×$7 per unit) $7,000

Variable cost of goods sold $35,000

variable selling and administrative expenses
$15,000
(5,000 units × $3 per unit)

50,000

Contribution margin ($100,000 − $50,000) 50,000

Less fixed expenses:

Fixed manufacturing overhead $30,000
Fixed selling and administrative expenses $10,000
 $40,000

Net operating Income ($50,000 − $40,000) $10,000

3. Advantages and disadvantages of Absorption and Variable Costing

Variable Costing
 Product cost is compromised solely of variable manufacturing costs
 Fixed manufacturing overhead is viewed as a cost of being ready to produce, not an
actual production cost since it will remain constant no matter how many units are
produced. Hence, expense immediately.
 Also called as Direct or Marginal Costing
 Direct materials, Direct Labor, and Variable Overhead.

Advantage

It can be used in constructing the contribution format approach income

statement to highlight the cost behaviour structure of the entity
Net income unaffected by changes in production levels
Net income closely tied to the changes in sales level – not production levels
which makes it easier to predict the level of operating income.
Fixed costs are not accounted for as an inventoriable cost – simplifying the
record keeping – no need for allocation.
Companies can also break down each department or product line under
variable costing, which provides a more thorough analysis of a company’s
business operation.
Disadvantages

 Does not conform to generally accepted accounting principles

 Cost are required to be separated into fixed and variable – cost segregation
techniques can be subjective.
 Expensing fixed production costs as a period expense lowers net income for
each accounting period.
 Too much emphasis may be given to variable costs at the expense of
disregarding fixed costs – fixed costs should still be recovered from operations.
Absorption Costing
 All costs related to the manufacture of a good are production costs. ( Direct
Materials, Direct Labor, Variable and Fixed Overhead)
 Advantages

One of the big advantages of absorption costing is that it is the method

required for a company to be in compliance with generally accepted
accounting principles (GAAP). Even if a company decides to use variable
costing in-house, it is required by law to use absorption costing in any
external financial statements it publishes. Absorption costing is also the
method that a company is required to use for calculating and filing its taxes.
Absorption costing also provides a more accurate accounting of net
profitability, especially when a company doesn't sell all of its products in
the same accounting period in which they are manufactured. Every expense
is allocated to products manufactured whether or not they are sold.
Results in the preparation of a traditional income statements.
Is considered GAAP and is generally accepted for tax reporting
Considers all cost when setting the price (cost plus pricing method)

Disadvantages

 Does not consider excess capacity since fixed costs are already allocated to the
different units
 Distort the results of decisions made to discontinue a business segment – fixed
cost will remain whether the company will eliminate the segment or not.

4. Impace Just-In-Time(JIT) Inventory Method

 Just in time (JIT) is an inventory management system, used to manage the stock that is
kept in storage. It involves receiving goods from suppliers as and when they are required,
rather than carrying a large inventory at once.
Advantages of just in time inventory management
Companies like to use JIT as it is seen as a more cost efficient method of holding stock.
Its purpose is to minimise the amount of goods you hold at any one time, and this has
numerous advantages:
Less space needed: With a faster turnaround of stock, you don’t need as much warehouse
or storage space to store goods. This reduces the amount of storage an organisation needs
to rent or buy, freeing up funds for other parts of the business.
Waste reduction: A faster turnaround of stock prevents goods becoming damaged or
obsolete while sitting in storage, reducing waste. This again saves money by preventing
investment in unnecessary stock, and reducing the need to replace old stock.
Smaller investments: JIT inventory management is ideal for smaller companies that don’t
have the funds available to purchase huge amounts of stock at once. Ordering stock as and
when it’s needed helps to maintain a healthy cash flow.
All of these advantages will save the company money.