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You may feel a bit whip-sawed by the preceding discussion. On the one hand, variable costing has been praised for its benefits in aiding decisions. On the other hand, you have been cautioned that variable costing is not a panacea and should not be used as the sole basis for making decisions.
Guiding a business is not easy. Decision making is not as simple as applying some mathematical algorithm to a single set of accounting data. A good manager must consider business problems from multiple perspectives. In the context of measuring inventory and income, a manager will want to understand both absorption costing and variable costing techniques. This information must be interlaced with knowledge of markets, customer behavior, and the like. The resulting conclusions can set in motion plans of action that bear directly on the overall fate of the organization.
An In-Depth Comparison of Variable Costing and Absorption Costing Income Statements
Much of the preceding discussion focused on per-unit cost assessments. In addition, the examples assumed that selling, general, and administrative costs were not impacted by specific actions. It is now time to consider aggregated financial data, and take into account shifting amounts of SG&A. The following income statements present information about Nepal Company; on the left is the income statement prepared using the absorption costing method, and on the right is the same information using variable costing. For now, assume that Nepal sells all that it produces, resulting in no beginning or ending inventory.
With absorption costing, the income statement produces a subtotal (gross profit) which is derived by subtracting cost of goods sold from sales. Cost of goods sold includes the $450,000 total cost of production consisting of direct materials, direct labor, variable manufacturing overhead, and the allocated fixed manufacturing overhead. From gross profit, variable and fixed selling, general, and administrative costs are subtracted to arrive at net income. This approach should look very familiar. It is the presentation that is typical of financial statements that are generated for general use by shareholders and other persons external to the daily operations of a business.
With variable costing, all variable costs are subtracted from sales to arrive at the contribution margin. Nepal's presentation divides variable costs into two categories. The variable product costs include all variable manufacturing costs (direct materials, direct labor, and variable manufacturing overhead). These costs are subtracted from sales to produce the variable manufacturing margin. Some of Nepal's SG&A costs also vary with sales. As a result, these amounts must also be subtracted to arrive at the true contribution margin. Management must take into account all variable costs (whether related to manufacturing or SG&A) in making critical decisions. For instance, Nepal may pay sales commissions that are based on sales; to exclude those from consideration in evaluating the "margin" that is to be generated from a particular transaction or event would be quite incorrect. From the contribution margin are subtracted both fixed factory overhead and fixed SG&A costs.
Because Nepal does not carry inventory, the income is the same under absorption and variable costing. The difference is only in the manner of presentation. Carefully study the arrows that show how amounts appearing in the absorption costing approach would be repositioned in the variable costing income statement. Since the bottom line is the same under each approach, this may seem like much ado about nothing. But, remember the critical points discussed earlier. "Gross profit" is not the same thing as "contribution margin," and decision logic is often driven by consideration of contribution effects. Further, when inventory levels fluctuate, the periodic income will differ between the two methods.
The Impact of Inventory Fluctuations
The following income statements are identical to those previously illustrated, except sales and variable expenses are reduced by 10%. Assume that the units relating to the "10% reduction" were nevertheless manufactured. What is the effect of this inventory build-up? The data below shows that income is higher under absorption costing by $15,000. This is consistent with a general rule of thumb: Increases in inventory will cause income to be higher under absorption costing than under variable costing, and vice versa.
To further examine the reason income is higher, remember that $450,000 was attributed to total production under absorption costing. Of this amount, 10% ($45,000) is now diverted into inventory. However, under variable costing, total product costs were $300,000 and 10% ($30,000) of that amount would be assigned to inventory. As a result, $15,000 more is assigned to inventory under absorption costing. It is no coincidence that this $15,000 amount also coincides with the degree to which income is higher! After all, the balance sheet must balance - the extra $15,000 in inventory is matched with an increase in equity brought about by the higher income under absorption costing.
Another way to view the impact of the inventory build-up is to examine the following "cups." The top set of cups initially contain the costs incurred in the manufacturing process. With absorption costing, those cups must be emptied into either cost of goods sold, or ending inventory. Trace the arrows, noting how the contents of the cups on top are split between the cups beneath.
Now, carefully compare the absorption costing drawing to the variable costing illustration that follows. You will note several important differences. Foremost among those differences is that the ending inventory cup contains less with variable costing than it does with absorption costing. Specifically, there is no fixed factory overhead in ending inventory!
These illustrations support the general conclusion about the relationships between absorption costing and variable costing income. Recognize that a reduction in inventory during a period will cause quite the opposite effect on income. Specifically, a portion of the contents of the beginning inventory cup would be transferred to expense commensurate with the decrease in inventory; since the inventory cup contains less under variable costing, expect expenses to be lower (and income to be higher).