Absorption and Variable Costing, Inventory Management

Absorption and Variable costing are very important tools for cost accounting. Both of these costing methods allow you to see the cost of your inventory, in a different way. For example the absorption method allows you to assign all costs to the product, while variable costing allows only variable costs to be assigned to the product. Inventory management is extremely important as well because it ties into efficiency and lowering your costs so that your company can be as profitable as it can in operations.
Throughout this paper I will discuss the importance of both costing methods, how it is implemented as well as using the income statement for costing. Most companies don’t necessarily look at the costs of all departments; they break down the departments into separate entity’s called profit centers. The companies do this because by breaking down each department they can see if there are any problem areas that they should correct, involving the performance of the individual profit centers. To look at the overall company’s performance, most people find it useful to look at the income statement.
However, this income statement is of little use for determining the viability of the individual business units or segments. Instead, it is important to develop a segmented income statement for each profit center. That is why these two costing methods have been developed. One of them is based on variable costing and the other is based on absorption costing. They are costing methods because they refer to the way in which product costs are determined. Product costs are inventoried; and they include direct materials, direct labor and overhead.

Period costs are expensed in the period they are incurred. These are usually selling and administrative expenses or other expenses to run your company day to day. The one difference between the two costing systems is fixed factory overhead. Absorption costing is a costing system that assigns all manufacturing cost to the produce, including fixed factory overhead. Absorption costing includes direct materials, direct labor, variable overhead, and fixed overhead. The four costs define the cost of the product. Under absorption costing, fixed overhead is viewed as a product cost, not a period cost.
Fixed overhead is assigned to the product through the use of predetermined fixed overhead rate and is not expensed until the product is sold. Absorption costing has product costs of direct materials, direct labor, variable overhead, and fixed overhead. While the period costs include just selling and administrative expenses. Variable costing assigns only the variable manufacturing costs to the product; these costs include direct materials, direct labor, and variable overhead. As you can see variable costing stresses the difference between fixed and variable manufacturing costs.
Fixed overhead is than treated as a period expense and is excluded from the product cost. The reason for this is because fixed overhead is a cost of staying in business. After the period is over, any benefits provided by this capacity are expired and are not inventoried. Fixed overhead of any period is than seen as expiring in that period and is charged in total against revenues for the period. The product costs for variable costing include direct materials, direct labor and variable overhead. The period costs include fixed overhead, and selling and administrative expenses.
Now we move onto the relationship between the variable costing income and the absorption costing income. The relationship changes as the production and the sales change. If you sold more than was produced, variable costing income is greater than the absorption costing income. But if you sold more than you produced that would mean that you were selling the beginning inventory and units produced. Under the absorption method, the units that are coming out of the inventory have the fixed overhead from the period attached to the inventory.
So the amount of the fixed overhead expensed by absorption costing is greater than what the current period’s fixed overhead by the amount of fixed overhead flowing out of the inventory. The variable costing income is greater than the absorption costing by the amount of fixed overhead coming out of the beginning inventory from the current period. But if the production and the sales are equal than there is no difference between the two reported incomes. The income relationship is consider to be that if production is greater than sales than the absorption income is reater than the variable income. But if the production is less than the sales than the absorption income is less than the variable income. So than if the production equals the sales than the absorption income is also equal to the variable income. The differences between the absorption and variable costing are the recognition of when the expenses are occurred. The recognition of the expenses associated with the fixed factory overhead. With the absorption costing, the fixed factory will than be assigned to the units produced.
This actually presents two problems, first, how do we convert the factory overhead applied on the basis of direct labor hours or the machine hours into factory overhead applied to the units produced? Also, what is than done when actual factory overhead does not equal applied factory overhead? Now we move onto the variable costing and the segmented income statements. The variable costing is a useful tool in preparing a segmented income statement because it gives us useful information on the variable and fixed expenses. A segment can be considered a division, department, product lines, customers class among other things.
In the segmented income statements, the fixed expenses are broken down into two categories; direct fixed expenses and the common fixed expenses. The additional subdivision highlights controllable versus the non-controllable costs and than enhances the manager’s ability to evaluate each segment’s contribution to the overall firms performance. The direct fixed expenses are the fixed expenses that are directly traceable to a segment. They are sometimes referred to as avoidable fixed expenses, because they disappear if the segment is eliminated.
Two or more segments jointly cause common fixed expenses. These expenses persist even if one of the segments to which they are common is eliminated. The segment margin is a profit contribution that each segment makes toward covering a firm’s common fixed costs. The segment should be at least able to cover both of its own variable costs and direct fixed costs. A negative segment margin drags the firm’s total profit down. Segment income statements are useful in management decision-making. The reason so is so that you can run your company at the most efficient level, while raising your profit margin.
This is a very interesting topic because it helps show the importance of inventory control and how it affects your operating income. The inventory management is very key to a company. The reason for this is because when your costs are to high and your profit margin is too low than there is probably a reason of your inventory being to high or the overhead being to high. The stress of inventory management cannot be understated for many companies but especially manufacturing companies. Apart from the product cost of the inventory, there are other types of costs that relate to inventories of raw materials, work in process, and the finished goods.
Inventory must be bought, received, stored, and moved. The inventory related costs include the demand for a product that is known with near certainty for a period of time. Two major costs are usually associated with this, if the inventory is purchased from an outside source, then the costs are referred to as ordering costs and carrying costs. If the product is produced internally, then the costs are called setup costs and carrying costs. Ordering costs are the costs to place and receive the order. Carrying costs are costs of keeping the inventory in your warehouse or store.
There also can be a third categories, which includes stock out costs, which are the costs of not having a product available when demanded by the customer or the cost of not having a raw material available when needed for production. A company that uses these types of costing methods will definitely have a better grasp of the costs associated with their products. This will help a company become more efficient and have a better idea of which product is making the most money and which product is making the least amount of money.
Yet again, this is not used for your company as a whole usually but it is used for each product individually. So if I had a red yoyo and a green yoyo and was selling a lot of each and equal than I would break them down individually between red and green and possibly see that the green yoyo is more expensive a product and therefore I would either have to sell it at a higher prices (even though it is exactly the same product except the color), or I would have to stop selling the green yoyo and just sell the red yoyo.
In order to run any type of company a manager must show extreme care to the inventory management, because you can have the best selling product on the market but if your not efficient enough with your inventory than you may put a huge damper on the future of your company and not allow your company to grow properly. I think if managers use all of these techniques they will have better understanding of there company and how to exercise the correct inventory management.