CHAPTER 5

INCOME EFFECT OF ALTERNATIVE PRODUCT COSTING METHODS

5.1. Variable and Absorption Costing

The two most common methods of costing
inventories in manufacturing companies are
variable costing and absorption costing.
Variable Costing
 Cont….
• Variable costing is a method of inventory costing in
which all variable manufacturing costs (direct and
indirect) are included as inventoriable costs.
• All fixed manufacturing costs are excluded from
inventoriable costs and are instead treated as costs
of the period in which they are incurred.
• Note that variable costing is a less-than-perfect
term to describe this inventory-costing method,
because only variable manufacturing costs are
inventoried; variable non-manufacturing costs are
still treated as period costs and are expensed.
 Cont….
•Another common term used to describe this method is
direct costing. This is also a misnomer because variable
costing considers variable manufacturing overhead (an
indirect cost) as inventoriable, while excluding direct
marketing costs.
Absorption Costing
• Absorption costing is a method of inventory costing in
which all variable manufacturing costs and all fixed
manufacturing costs are included as inventoriable costs.
• That is, inventory “absorbs” all manufacturing costs.
For example, job costing system is absorption costing.
 Cont…
•Under both variable costing and absorption costing,
all variable manufacturing costs are inventoriable
costs and 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.
Comparing Variable and Absorption Costing
• Absorption costing is required for external financial
reports and for tax reporting.
• Under absorption costing, product costs include all
manufacturing costs:
 Cont…
Direct materials.
Direct labor.
Variable manufacturing overhead.
Fixed manufacturing overhead.
• Under absorption costing, the following costs are
treated as period expenses and are excluded from
product costs:
• Variable selling and administrative costs.
• Fixed selling and administrative costs
 Cont…
• Variable costing is an alternative for internal
management reports.
• Under variable costing, product costs include only
the variable manufacturing costs:
– Direct materials.
– Direct labor (unless fixed).
– Variable manufacturing overhead.
 Cont….
• Under variable costing, the following costs are
treated as period expenses and are excluded
from product costs:
– Fixed manufacturing overhead.
– Variable selling and administrative costs.
– Fixed selling and administrative costs.
Example
Solution
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