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Cost Elements in Product Cost: Conceptually, variable costing and absorption costing differ only in the treatment of fixed factory manufacturing overhead in the accounting records and financial statement.
In both the costing, it is agreed that selling and administrative overhead, whether variable or fixed, are period costs and these costs are not treated as product costs with the result that selling and administrative overheads are not included in the costs of inventories, and costs of goods sold.
Similarly, it is also agreed that variable manufacturing costs are product costs, i. The disagreement between the two is only in regard to the treatment of fixed manufacturing costs.
Under absorption costing, fixed manufacturing costs are charged to inventory and cost of goods sold. Under variable costing, these costs are not charged to inventory and cost of goods sold but are treated as period expenses when incurred.
Variable costing and absorption costing do influence inventory value differently.
The following data are taken from the records of a manufacturing company: Based on the above information, the unit costs for inventory valuation under the two costing techniques will be as follows: Under absorption costing, inventories will be valued and reported on the balance sheet at Rs per unit; under variable costing, the unit cost for inventory valuation is Rs The difference of Rs 25 in the unit cost is due to the treatment of fixed manufacturing overhead Rs 2, 50, under absorption costing, fixed manufacturing overhead is spread over all the units manufactured, whereas variable costing does not charge fixed manufacturing overhead to production.
It is significant to note that, under both the techniques, selling and administrative expenses, variable and fixed both, are not charged to product but are treated merely as expenses period costs in the period when they are incurred.
Difference in Net Income: The magnitude of any difference in net income is a function of the fixed manufacturing costs per unit and the change in inventory levels.
Under absorption costing all costs are divided into three categories: Further, fixed manufacturing overhead in absorption costing are charged to units produced on the basis of per unit fixed manufacturing overhead rate obtained by dividing the standard fixed manufacturing overhead by normal output level as follows: If actual production is equal to normal output level, the total fixed manufacturing overhead budgeted at normal output level will be charged to units produced.
If actual production is more or less than the normal output level, greater if actual production is greater or lesser if actual production is lesser fixed manufacturing will be first charged to units produced.
Subsequently, if actual production is above or below the normal or standard capacity, adjustments are made for capacity volume variance since the amount of fixed manufacturing overhead incurred will always be equal to actual fixed manufacturing overhead.
If the volume capacity variance is favourable, i. If the volume capacity variance is unfavourable, i. A proforma of income statement prepared under-absorption costing is given in Exhibit. No Capacity Variance in Variable Costing: All fixed costs, and variable selling, distribution and administrative costs are deducted from this balance to arrive at the net income.
Since fixed manufacturing costs are not charged to products under variable costing, there can be no volume capacity variance. Income Statement Absorption Costing: In case of a constant production schedule over time while sales are allowed to fluctuate each period, the absorption costing net income will fluctuate up and down with sales but the constant production will have a leveling effect on the swings.
In other words, the peaks will neither be as high nor as low as the corresponding sales. Variable costing net income, on the other hand, will have swings that match those of sales, in both direction and relative height and depth.
For the situation, where production fluctuates while sales remain rather constant, a different story is told. In this case, absorption costing net income will fluctuate with production in both directions and relative height and depth.
Variable costing net income will remain constant to correspond with sales. Differences between Absorption Costing and Variable Costing: The differences between absorption costing and variable costing have been further exhibited below:Under variable costing, only variable costs of production (direct material, direct labour and variable manufacturing overhead) are subtracted from sales revenue to determine a balance which is known by different names, such as marginal contribution, marginal income (profit), marginal revenue, marginal balance, profit pick-up etc.
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