Reporting Techniques in Support of Managerial Decision Making
Variable Versus Absorption Costing
Recall this statement from the first managerial accounting chapter: "Managerial accounting is quite different from financial accounting. External reporting rules are replaced by internal specifications as to how data are to be accumulated and presented. Hopefully, these internal specifications are sufficiently logical that they enable good economic decision making." Now that you have accumulated knowledge on various managerial accounting concepts, you are in a good position to look more closely at some of the techniques for internal reporting. This chapter's initial topic pertains to an internal reporting method for measuring and presenting inventory and income, known as variable costing.
Before diving into the specifics of variable costing, let's revisit the basic tenants of the traditional approach known as absorption costing (also known as "full costing"). Generally accepted accounting principles require absorption costing for external reporting, and it formed the basis for the discussion of inventory costing found in preceding chapters. Under absorption costing, normal manufacturing costs are considered product costs and included in inventory. As sales occur, the cost of inventory is transferred to cost of goods sold; meaning that the gross profit is reduced by all costs of manufacturing, whether those costs relate to direct materials, direct labor, variable manufacturing overhead, or fixed manufacturing overhead. Selling, general, and administrative costs (SG&A) are classified as period expenses.
The rationale for absorption costing is that it causes a product to be measured and reported at its complete cost. Just because costs like fixed manufacturing overhead are difficult to identify with a particular unit of output does not mean that they were not a cost of that output. As a result, such costs are allocated to products. However valid the claims are in support of absorption costing, the method does suffer from some deficiencies as it relates to enabling sound management decisions. These deficiencies will become clear as you examine variable costing. For now, suffice it to say that absorption costing information may not always provide the best signals about how to price a product, reach conclusions about discontinuing a product, and so forth.
To mitigate for deficiencies in absorption costing data, strategic finance professionals will often generate supplemental data based on variable costing techniques. As its name suggests, only variable production costs are assigned to inventory and cost of goods sold. These costs generally consist of direct materials, direct labor, and variable manufacturing overhead. Fixed manufacturing costs are regarded as period expenses along with SG&A costs.
The variable costing approach shifts fixed manufacturing costs from the product cost category to the period cost group. In some ways, this understates the true cost of production. How then can it aid in decision making? The short answer is that the fixed manufacturing overhead is going to be incurred no matter how much is produced. In the long run, a business must recover those costs to survive. But, on a case by case basis, including fixed manufacturing overhead in a product cost analysis can result in some very wrong decisions.
This last point can be made clear with a very simple illustration. Assume that a company produces 10,000 units of a product, and per unit costs are $2 for direct material, $3 for direct labor, and $4 for variable factory overhead. In addition, fixed factory overhead amounts to $10,000. The product cost under absorption costing is $10 per unit, consisting of the variable cost components ($2 + $3 + $4 = $9) and $1 of allocated fixed factory overhead ($10,000/10,000 units). Under variable costing, the product cost is limited to the variable production costs of $9. Now, let's consider a "management decision." Assume the company is approached to sell one additional unit at $9.50. This sale will not result in any added SG&A cost, or otherwise impact sales of other units.
Based on absorption costing methods, the additional unit appears to produce a loss of $0.50, and it appears that the correct decision is to not make the sale. Variable costing suggests a profit of $0.50, and the information appears to support a decision to make the sale. Management may well decide to sell the additional unit at $9.50, and produce an additional $0.50 for the bottom line. Remember, no other costs will be generated by accepting this proposed transaction. If management were limited to absorption costing information, this opportunity would likely have been passed up.