Managerial Accounting 6.7: Using Variable Costing to Make Decisions

Summary

In this educational video, Professor Kurt Heisinger from Sierra College explains the differences between absorption costing and variable costing in manufacturing. Absorption costing includes both fixed and variable manufacturing costs in inventory until sold, aligning with GAAP, whereas variable costing expenses fixed costs immediately, only inventorying variable costs. The key distinction lies in the treatment of fixed manufacturing costs. Variable costing, though not GAAP compliant, offers advantages for internal decision-making, enabling cost-volume-profit analysis and preventing profit inflation through increased production.

Takeaways

• 📚 Absorption costing includes both fixed and variable manufacturing costs in inventory until the goods are sold, complying with GAAP.
• 🏭 Fixed manufacturing costs, such as the lease on a factory, are considered part of the product costs in absorption costing.
• 🔄 Variable manufacturing costs, like direct materials, are included in inventory under absorption costing until sold.
• 💼 Nonmanufacturing costs are treated as period costs and expensed immediately, not included in inventory.
• 📊 Variable costing only includes variable manufacturing costs in inventory, expensing fixed costs as incurred, unlike absorption costing.
• 📉 Fixed costs in variable costing are recognized as period costs on the income statement, not carried in inventory.
• 🔑 The primary difference between the two costing methods is the treatment of fixed manufacturing costs.
• 📈 Variable costing supports effective cost-volume-profit analysis, aiding in determining break-even points and profit margins.
• 🚫 Variable costing prevents managers from inflating profits by increasing production and inventory levels, a potential issue with absorption costing.
• 🛑 While variable costing does not comply with GAAP, it is beneficial for internal decision-making and management purposes.
• 🧐 Both costing methods treat all other costs the same, highlighting that the key distinction lies in how fixed costs are handled.

Q & A

What is the main difference between absorption costing and variable costing in a manufacturing environment?

The main difference lies in the treatment of fixed manufacturing costs. In absorption costing, both fixed and variable manufacturing costs are included in inventory until the goods are sold. In contrast, variable costing includes only variable manufacturing costs in inventory, while fixed manufacturing costs are expensed as incurred.

According to the script, which costing method complies with GAAP?

Absorption costing complies with GAAP, as it includes all manufacturing costs, both fixed and variable, in the inventory until the goods are sold.

What are the examples of fixed manufacturing costs mentioned in the script?

The script mentions the lease on the factory where products are produced as an example of fixed manufacturing costs.

What are the examples of variable manufacturing costs mentioned in the script?

Direct materials that go into the product being made are given as an example of variable manufacturing costs.

How are nonmanufacturing costs treated under absorption costing?

Nonmanufacturing costs, such as selling, administrative, and marketing costs, are treated as period costs under absorption costing. They are expensed in the period in which they are incurred and do not go into inventory.

Why might a company prefer to use variable costing over absorption costing?

A company might prefer variable costing for internal decision-making purposes, as it enables effective cost-volume-profit analysis and prevents managers from increasing production solely to inflate profits.

What is the potential issue with using absorption costing and increasing production?

The potential issue is that increasing production can lead to inflated profits by spreading fixed costs over more units in inventory, rather than recognizing them as expenses on the income statement, which might not reflect the actual sales performance.

How does variable costing help in cost-volume-profit analysis?

Variable costing helps in cost-volume-profit analysis by clearly separating fixed and variable costs, allowing managers to determine break-even points, target profit points, and the margin of safety more accurately.

What is the primary distinction between absorption costing and variable costing as per the script?

The primary distinction is the treatment of fixed manufacturing costs. In absorption costing, these are considered product costs and go into inventory, while in variable costing, they are treated as period costs and expensed immediately on the income statement.

Why does the script mention that variable costing does not comply with GAAP?

The script mentions that variable costing does not comply with GAAP because it does not include fixed manufacturing costs in inventory, which is a requirement under GAAP for absorption costing.

How does the treatment of fixed manufacturing costs differ between absorption and variable costing in terms of financial reporting?

In absorption costing, fixed manufacturing costs are included in inventory and are not expensed until the goods are sold. In variable costing, these costs are expensed immediately on the income statement as they are incurred, and do not contribute to the inventory valuation.

Outlines

00:00

🔍 Introduction to Costing Methods

In this introductory paragraph, Professor Kurt Heisinger outlines the purpose of the video, which is to explain the differences between absorption costing and variable costing in a manufacturing setting. The video will first discuss absorption costing, followed by variable costing, and then compare the two methods. The paragraph sets the stage for a deeper dive into costing principles that are essential for understanding financial accounting and managerial decision-making.

Keywords

💡Absorption Costing

Absorption costing is an accounting method that includes both fixed and variable manufacturing costs in the inventory valuation until the goods are sold. It is in compliance with Generally Accepted Accounting Principles (GAAP). In the video, absorption costing is described as including costs such as the lease on the factory and direct materials used in production, treating them as part of the product costs. This method is crucial for understanding how costs are allocated to inventory and subsequently recognized on the income statement when sales occur.

💡Variable Costing

Variable costing is an alternative costing method that only includes variable manufacturing costs in inventory until the goods are sold, while expensing all fixed manufacturing costs as they are incurred. Unlike absorption costing, variable costing does not comply with GAAP but is beneficial for internal decision-making. The script explains that variable costing treats costs such as factory rent as period costs, immediately expensed on the income statement, which contrasts with the treatment of these costs in absorption costing.

💡Fixed Manufacturing Costs

Fixed manufacturing costs are those costs that do not change with the level of production, such as the lease on a factory. In the video, these costs are highlighted as a key differentiator between absorption and variable costing. While they are included in the inventory valuation under absorption costing, they are expensed immediately under variable costing, affecting the timing of when these costs are recognized on the income statement.

💡Variable Manufacturing Costs

Variable manufacturing costs vary directly with the level of production, such as direct materials used in making a product. The script explains that both absorption and variable costing include these costs in inventory until the goods are sold. However, the treatment of variable costs in relation to fixed costs is what distinguishes the two costing methods.

💡Inventory Valuation

Inventory valuation refers to the process of determining the value of the inventory for financial reporting purposes. The video script discusses how absorption costing and variable costing affect inventory valuation differently, with absorption costing including both fixed and variable costs, while variable costing only includes variable costs.

💡Period Costs

Period costs, as mentioned in the script, are expenses that are recognized on the income statement in the period they are incurred, rather than being capitalized into inventory. Examples given include selling costs, administrative costs, and marketing costs. The script explains that under absorption costing, nonmanufacturing costs like these are treated as period costs and expensed immediately.

💡Income Statement

The income statement is a financial statement that summarizes a company's revenues, costs, and expenses during a specific period. The script discusses how both absorption and variable costing methods affect the income statement, particularly in how fixed manufacturing costs are treated—either as part of inventory or as immediate expenses.

💡Cost-Volume-Profit Analysis

Cost-volume-profit (CVP) analysis is a tool used to understand the relationship between costs, sales volume, and profit. The script highlights that variable costing is particularly useful for CVP analysis because it clearly separates fixed and variable costs, allowing managers to calculate break-even points and target profit levels more effectively.

💡Break-Even Point

The break-even point is the level of sales where total costs equal total revenue, resulting in neither profit nor loss. The script mentions that variable costing facilitates the calculation of the break-even point by clearly distinguishing between fixed and variable costs.

💡Target Profit Points

Target profit points are the sales levels needed to achieve a desired profit. The script explains that variable costing aids in determining these points by providing a clear breakdown of costs, which is essential for effective financial planning and decision-making.

💡Margin of Safety

Margin of safety refers to the difference between actual sales and the break-even point. The script notes that variable costing supports the assessment of the margin of safety by enabling a clear understanding of how changes in sales volume affect profitability.

Highlights

Absorption costing includes all manufacturing costs, both fixed and variable, in inventory until goods are sold.

Fixed manufacturing costs refer to expenses like the lease on the factory.

Variable manufacturing costs include direct materials used in production.

Absorption costing complies with GAAP, making it a standard in financial accounting.

Nonmanufacturing costs, such as selling and marketing, are treated as period costs and expensed immediately.

Variable costing only includes variable manufacturing costs in inventory, expensing fixed costs as incurred.

Fixed costs like factory rent are expensed immediately under variable costing, not carried in inventory.

The primary difference between the two costing methods is the treatment of fixed manufacturing costs.

Variable costing is advantageous for internal decision-making despite not complying with GAAP.

Variable costing facilitates effective cost-volume-profit analysis, aiding in determining break-even points and target profits.

Variable costing prevents managers from inflating profits by increasing production unnecessarily.

Absorption costing can lead to issues if managers increase inventory levels to spread fixed costs, potentially inflating profits.

Variable costing treats fixed manufacturing overhead costs as period costs, expensing them immediately.

In absorption costing, fixed manufacturing overhead costs are considered product costs and go into inventory.

All other costs are treated the same in both costing methods, regardless of whether absorption or variable costing is used.

The choice between costing methods ultimately hinges on how fixed manufacturing costs are treated and the company's goals.

Transcripts

This is Kurt Heisinger, accounting professor  at Sierra College and author of Managerial  

Accounting. This video describes the difference  between absorption costing and variable costing  

in a manufacturing environment. We will start  by looking at absorption costing on this  

slide. And the next slide we'll take a look at  variable costing and then we'll compare the two.  

So absorption costing includes all manufacturing  costs, fixed and variable, in inventory until the  

goods are sold. So when we say fixed manufacturing  costs, we're talking about for example, the lease  

on the factory where we produce our products. And  we're talking about variable manufacturing costs  

we're talking about things like direct materials  that go into the product that we are making. This  

method does comply with GAAP so if you've had  financial accounting you've followed this method,  

this is absorption costing method. Also all  nonmanufacturing costs, things like selling  

costs, and administrative costs, marketing costs  for example to promote our products, are treated  

as period costs. And what that means is those  costs are expensed in the period in which they  

are incurred. They do not go into inventory,  but they appear on the income statement as  

an expense. So let's look at variable costing next.  As the name implies, variable costing, this costing  

method includes all variable manufacturing  costs ininventory until the goods are sold,  

just like absorption costing in terms of what we  do with variable manufacturing costs, however the  

difference is that all fixed manufacturing  costs are expensed as incurred. Meaning they  

are on the income statement as an expense in the  period in which they are incurred. So costs again  

like the rent on the factory building, that's a  fixed cost, those costs are expensed as incurred.  

They are not attached to the product, they do  not go into inventory, they go directly to the  

income statement as an expense. So with variable  costing, variable manufacturing costs, they go  

in to inventory until the goods are sold then they  become expensed. But fixed manufacturing costs are  

expensed immediately. This chart summarizes the  difference between absorption costing and variable  

costing. And you'll notice that really the only  difference is with fixed manufacturing costs  

and how those fixed manufacturing costs are fixed  manufacturing overhead is handled. So if you look  

at absorption costing, fixed manufacturing costs  are considered to be product costs. And if you  

look at variable costing, the fixed manufacturing  costs are period costs. So you'll see those fixed  

manufacturing costs here, we call them  fixed manufacturing overhead cost, same thing  

as fixed manufacturing costs, and you'll see  here that they are period costs. Which means  

that fixed manufacturing overhead in a variable  costing scenario, go directly to the income  

statement as an expense. That's what you see  over here on this side. And with absorption  

costing, fixed manufacturing overhead costs go  into inventory, or considered to be product cost.  

So that's the primary distinction. All other costs  are treated the same, whether we use absorption  

costing or variable costing. So it all comes down  to how fixed manufacturing costs are treated.

What are the advantages then of using  variable costing. We know that variable  

costing does not comply with GAAP but it's great  for internal decision making purposes. So variable  

costing, it does lead to effective what we call  cost-volume-profit analysis. If you go back to  

my lectures on YouTube related to cost volume  profit analysis, you'll see how it's helpful  

to have fixed cost and variable cost broken out, so  we can figure out things like break-even points, or  

target profit points, or the margin of safety. So  variable costing enables us to do that. And then  

secondly, variable costing prevents managers from  increasing production solely for the purpose of  

inflating profit. There can be some real issues  if we use absorption costing with increasing  

production, and increasing our inventory levels,  which is not always a good thing if we're not  

selling the product. We increase our inventory  levels and those fixed costs essentially are  

kind of hidden in inventory and don't go to the  income statement until the goods are sold, and it's  

a way to spread out those fixed costs over more  units in inventory on the balance sheet rather  

than putting them in an expense account on the  income statement. So it creates issues, potential  

issues, for managers to inflate profit. And that's  why some companies prefer to use variable costing.