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.