49. Variable Costing versus Absorption Costing

Question 1

Why can fixed production costs create a problem on the income statement?

Answer 1

• The full cost of inventory should be conveyed on the balance sheet, including fixed production costs.
• Shifts in production or sales volume result in changing inventory levels. As inventory levels adjust, prior period fixed production costs are released from the balance sheet and current period fixed production costs are retained onto the balance sheet.
• This release and retention can lead to confusion when income is used as an internal performance measure.

Question 2

Briefly describe how costs are reflected when using the absorption costing income statement compared to the variable costing income statement. Which income statement should be used for external financial reporting?

Answer 2

• Absorption Costing Income Statement: Tracks the full production cost of inventory to the balance sheet and onto the income statement. This traditional statement is required for external financial reporting.
• Variable Costing Income Statement: The only production costs used to value the inventory on the balance sheet are the variable costs of production. Fixed production costs are fully expensed to the income statement in the period in which they occur. This statement is not allowed for external financial reporting.

Question 3

Why can using the absorption costing income statement lead to troubling management incentives?

Answer 3

• Timing is important in performance measurement and incentives.
• Spending money to produce more than can be sold is generally not desirable. However, reducing inventory (producing less than is sold) is not rewarded on the absorption costing income statement compared to the variable costing income statement.
• To increase income, companies should focus on increasing sales prices, increasing sales volume, or decreasing costs, but absorption costing presents a fourth option of increasing production.

Question 4

List the main benefits and limitations of the absorption costing system

Answer 4

Benefits:
•By allocating fixed costs to production, managers have a more complete measure of the full costs of inventory.
•Financial reporting standards require a full cost valuation of inventory on the balance sheet; therefore, it is necessary for external financial reporting.

Limitations:
•Creates a troubling incentive in managers to overproduce and build inventory.

Question 5

List the main benefits and limitations of the variable costing system.

Answer 5

Benefit:
•Avoid the troubling incentive to overproduce and build inventory.

Limitations:
•Inventory is undervalued on the balance sheet because all fixed costs are expensed to the income statement. Managers need to be aware of this if inventory costs are used in decisions like pricing.
•Variable costing systems do not comply with external financial reporting standards, so organizations using these systems internally still need to use an absorption costing system for external financial reports.