Answer

VARIABLE COSTING VERSUS ABSORPTION COSTING

Both generally accepted accounting principles and tax regulations require manufacturing
companies to use an absorption costing system. Under an absorption system, fixed
manufacturing costs-both direct and indirect-are treated as product costs. That is, they are
assigned (or attached) to products during the manufacturing process, and absorbed into
inventory. They remain attached to the products in the work-in-process inventory, and,
subsequently, in the finished goods inventory, until the products are sold. At that time
they are removed from finished goods inventory, and placed on the income statement as
part of cost of goods sold.

A company that treated its fixed manufacturing costs as period costs, i.e., did not assign
them to products but expensed them on the income statement in the period when they
were incurred, ordinarily would receive a qualified opinion on its audited financial
statements. In effect, by not attaching these costs to products, and expensing them when
the products are sold, it is violating the matching principle.

Absorption costing therefore must be used to value inventories for financial statements
prepared under Generally Accepted Accounting Principles (GAAP), and it must be used
for tax computing purposes. This does not mean that it must be used for managerial
purposes, however. For internal reporting and control purposes, management can use any
kind of information it wishes. There is only one criterion: the information must be useful.
Because of the complexities associated with absorption costing, many companies have
chosen to use something somewhat more intuitive, and therefore useful, for internal
purposes: variable costing.

The difference between the two types of costing lies exclusively in the treatment of the
fixed portion of manufacturing overhead. This is illustrated in Exhibit 8. As this exhibit
indicates, absorption costing treats fixed manufacturing overhead as a product cost,
whereas variable costing treats it as a period cost.

As the following example shows, the difference between these two forms of costing can
have a significant impact on an organization's financial statements.

Example: Two companies are identical in every respect except one: Company A uses absorption
costing, while Company V uses variable costing. In Month 1, both companies produce and sell 1,000
units of their product. In Month 2, both companies produce 1,500 units of their product, but sell
only 1,000 units. In Month 3, both companies produce 500 units, but sell 1,000 units (obtaining the
remaining 500 units from the finished goods inventory left over at the end of Month 2).

Answer
VARIABLE COSTING VERSUS ABSORPTION COSTING
Both generally accepted accounting principles and tax regulations require manufacturing
companies to use an absorption costing system. Under an absorption system, fixed
manufacturing costs-both direct and indirect-are treated as product costs. That is, they are
assigned (or attached) to products during the manufacturing process, and absorbed into
inventory. They remain attached to the products in the work-in-process inventory, and,
subsequently, in the finished goods inventory, until the products are sold. At that time
they are removed from finished goods inventory, and placed on the income statement as
part of cost of goods sold.

A company that treated its fixed manufacturing costs as period costs, i.e., did not assign
them to products but expensed them on the income statement in the period when they
were incurred, ordinarily would receive a qualified opinion on its audited financial
statements. In effect, by not attaching these costs to products, and expensing them when
the products are sold, it is violating the matching principle.

Absorption costing therefore must be used to value inventories for financial statements
prepared under Generally Accepted Accounting Principles (GAAP), and it must be used
for tax computing purposes. This does not mean that it must be used for managerial
purposes, however. For internal reporting and control purposes, management can use any
kind of information it wishes. There is only one criterion: the information must be useful.
Because of the complexities associated with absorption costing, many companies have
chosen to use something somewhat more intuitive, and therefore useful, for internal
purposes: variable costing.

The difference between the two types of costing lies exclusively in the treatment of the
fixed portion of manufacturing overhead. This is illustrated in Exhibit 8. As this exhibit
indicates, absorption costing treats fixed manufacturing overhead as a product cost,
whereas variable costing treats it as a period cost.

As the following example shows, the difference between these two forms of costing can
have a significant impact on an organization's financial statements.

Example: Two companies are identical in every respect except one: Company A uses absorption
costing, while Company V uses variable costing. In Month 1, both companies produce and sell 1,000
units of their product. In Month 2, both companies produce 1,500 units of their product, but sell
only 1,000 units. In Month 3, both companies produce 500 units, but sell 1,000 units (obtaining the
remaining 500 units from the finished goods inventory left over at the end of Month 2).