MODULE 3

VARIABLE COSTING AS MANAGEMENT TOOL

Two general approaches are used in manufacturing companies for costing products for the purposes of
valuing inventories and cost of goods sold. One approach, called absorption costing is generally used for
external financial reports. The other approach, called variable costing, is preferred by some managers for
internal decision making and must be used when an income statement is prepared in the contribution
margin format. Ordinarily absorption costing and variable costing produce different figures for net
operating income and the difference can be quite large. In addition to showing hose these two methods
differ, we will consider the arguments for and against each costing and will be show how management
decisions can be affected by the costing method chosen. 1

Absorption Costing2

Also known as full, traditional, conventional and normal costing) is a method of product costing in which
all manufacturing costs, fixed and variable are treated as product inventoriable costs.

This method is the required method for external reporting and the reporting in most countries including
the Philippines.

Variable Costing 3

Or direct costing is a method of inventory costing in which all variable manufacturing costs are included
as inventoriable costs. All fixed manufacturing costs are excluded from inventoriable costs. Fixed
manufacturing costs are instead treated as costs in which they are incurred.

Distinction Between Period Costs and Product Costs4

Period Cost Product Cost

• Cost that is charged against current revenue • Cost that is included in the computation of
during time period regardless of the product cost that is apportioned between the
difference between production and sales sold and unsold units.
volumes
• Does not part of the cost of inventory. • An inventoriable cost. The portion of the cost
that has been allocated to the unsold units
becomes part of the cost of inventory.
• Reduce income for the current period by its • Reduces current income by the portion
full amount. allocated to the sold units; the portion
allocated to the unsold units is treated as an
asset, being part of the cost of inventory.

1
Managerial Accounting, Asia Global Edition, 2/e
2
Strategic Cost Management 2019-2020 Edition (Cabrera)
3
Strategic Cost Management 2019-2020 Edition (Cabrera)
4
Management advisory services (Roque 2016 Edition)
Principal Difference Between Absorption Costing and Variable Costing Methods5

Absorption Costing Variable Costing

1. Cost segregation Seldom segregates costs into Cost are segregated into variable and
variable and fixed costs fixed
2. Cost of Cost of inventory includes all the Cost of inventory includes only the
inventory manufacturing costs: materials, variable manufacturing costs: materials,
variable factory overhead, and fixed labor, and variable factory overhead
factory overhead
3. Treatment of Fixed factory overhead is treated as Fixed factory overhead is treated period
fixed factory product cost cost
overhead
4. Income Distinguishes between production Distinguishes between variable and
statement and other costs fixed costs
S XX S XX
CGS -XX VC -XX
Gross Profit XX CM XX
S&A Cost -XX FxC -XX
Profit XX Profit XX
5. Net income Net income between the two methods may differ from each other because of
the difference in the amount of fixed overhead costs recognized as expense
during an accounting period. This is due to variations between sales and
production. In the long run, however, both methods give substantially the same
results since sales cannot continuously exceed production, nor production can
continually exceed sales.

Why Managers Prefer Direct Costing to Absorption Costing6

In variable costing, only variable manufacturing costs are included in a unit’s product costs, and thus in
the value of inventory and cost of goods sold. Fixed manufacturing overhead is excluded. It is reported as
a separate expense and deducted from the contribution margin along with fixed selling and administrative
expense in determining operating income.

Managers generally prefer variable costing because its separates fixed from variable costs as in cost-
volume-profit analysis. As a result, it is easier to compare actual operating income to planned operating
income. With absorption costing, actual operating income corresponds well with planned operating
income only when inventory levels remain unchanged. With variable costing, income is more closely
associated with sales while absorption costing is influenced by units produced and unit sold.
Variable Costing and Performance Evaluation of Managers7

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Management advisory services (Roque 2016 Edition)
6
Strategic Cost Management 2019-2020 Edition (Cabrera)
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Strategic Cost Management 2019-2020 Edition (Cabrera)
The evaluation of managers is often to the profitability of the units they control. How income changes
from one period to the next and how actual income compares to planned income are frequently used as
signals of managerial ability. To be meaningful signals, however, income should reflect managerial effort.
In general terms, if income performance is expected to reflect managerial performance, then managers
have the high to expect the following:

1. As sales revenue increases from one period to the next, all other things being equal, income should
increase.
2. As sales revenue decreases from one period to the next, all other things being equal, income should
decrease.
3. As sales revenue remains unchanged from one period to the next, all other things being equal, income
should remain unchanged.

Variable Costing and Segmented Reporting 8

The usefulness of variable costing for performance evaluation extends beyond evaluating managers.
Managers need to be able to evaluate the activities over which they have responsibility.

The separation of fixed and variable costs basic to variable cost is critical for making accurate evaluations.
Implicit in an evaluation is an associated decision whether to continue to operate a plant or not, or
whether to keep or to drop a product line.

Without the distinction between fixed and variable costs, the evaluation of profit-making activities and
the resulting decision may be both be erroneous. Reporting the profit contributions of activities or other
units within an organization is called segmented reporting.

Segmented reports prepared on a variable costing basis produce better evaluations and decisions than
those prepared on an absorption-costing basis. Let’s take a closer look at segmented reporting and see
why this is true.

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Strategic Cost Management 2019-2020 Edition (Cabrera)
Segmented Reporting: Variable-Costing Basis9

FELCOM, INC.
Segmented Income Statement, 2000
Variable-Costing Basis
Product M Product N Total
Sales 400,000 290,000 690,000
Less: Variable expenses
Variable cost of goods sold (300,000) (200,000) (500,000)
Variable selling and adminstrative (5,000) (10,000) (15,000)
Contribution margin 95,000 80,000 175,000
Less: Direct fixed expenses
Direct fixed overhead (30,000) (20,000) (50,000)
Direct selling and administrative (10,000) (5,000) (15,000)
Segment margin 55,000 55,000 110,000
Less: Common fixed expenses
Common fixed overhead (100,000)
Common selling and administrative (20,000)
Net income (loss) (10,000)

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Strategic Cost Management 2019-2020 Edition (Cabrera)