Absorption Costing versus Variable Costing ‘You have learned that product costs consist of al the costs incurred in the produc- tion of a product: direct materials, direct labor, and manufacturing overhead. The process of classifying all these costs as product costs is referred to as absorption costing (or full costing). Absorption costing is the cost accumulation method required by generally accepted accounting principles (GAAP) and by regulatory bodies such as the Internal Revenue Service. This is the type of costing you have done in previous chapters. ‘The underlying principle that absorption costing satisfies is the matching principle, which states that expenses should be matched with the revenues they generate. You may remember discussing this principle in your financial account- ing course. Based on the matching principle, all product costs flow through Raw Materials Inventory, Work in Process Inventory, and Finished Goods Inventory until the goods are sold. Even though the company may have already paid cash for these items, the costs are not expensed on the income statement until the inventory has been sold. For example, the wages paid to direct labor workers are not treated as an expense at the time the payroll checks are written. Instead, they are charged to ‘Work in Process Inventory so that they will become part of the product's cost.‘You have learned that some costs are variable and some costs are fixed. You have also learned that to make predictions about costs and income, you must first separate costs by their behavior, whether fixed or variable. Any costs that are mixed must be divided into their fixed and variable components. If inventory unit costs combine variable costs (typically direct materials, direct labor, and overhead) with fixed costs (cypically overhead), how can managers make sound decisions? One way is to use variable costing (or direct costing), in which only variable product costs are accu- ‘mulated in the inventory accounts. In variable costing, fixed manufacturing overhead is treated as a period expense rather than a product cost, meaning itis expensed in the period in which iti incurred, Exhibic F3-1 shows how various product cost compo- nents are accounted for under variable versus absorption costing. As you can see, the only difference between the two methods isthe treatment of fixed overhead costs. Cost of goods gals statement | L Variable costing bs ‘Absorption costing Variable costing Product Direct materials Direct materials Product costs Direct labor Direct labor costs: \Varable manufacturing overhead Fixed manulacturing overhead Feeling scenes ee aceite _Rostainnievete sors Fed ealing stporece Naria nist en Income Effects of Variable Costing Ieshould be clear now that the difference berwcen absorption and variable costing isa timing difference in the expensing of fixed overhead costs, Of course, changing the tm- ingofan expense will change reported income. Let's explore these changes using Bradley “Textile Mill’ cost for jersey fabric, Well look at three scenarios: one in which produc tion volume and sales volume are equals one in which production volume is greater than sales volume; and one in which production volume is less than sales volume. The absorption and variable product costs for a yard of Bradley's fabric are as follows: Absorption Costing Direct materials $1.26 Direct labor 0.54 Variable overhead 0.30 Fixed overhead 1.50 Total cost per yard $3.60 $2.10Absorption Costing versus Variable Costing You have learned that product costs consist of al the costs incurred in the produc- tion of a product: direct materials, direct labor, and manufacturing overhead. The process of classifying all these costs as product costs is referred to as absorption costing (or full costing). Absorption costing is the cost accumulation method required by generally accepted accounting principles (GAAP) and by regulatory bodies such as the Internal Revenue Service. This is the type of costing you have done in previous chapters. ‘The underlying principle that absorption costing satisfies is the matching principle, which states that expenses should be matched with the revenues they generate. You may remember discussing this principle in your financial account- ing course. Based on the matching principle all product costs flow through Raw Materials Inventory, Work in Process Inventory, and Finished Goods Inventory until the goods are sold. Even though the company may have already paid cash for these items, the costs are not expensed on the income statement until the inventory has been sold. For example, the wages paid to direct labor workers are not treated as an expense at the time the payroll checks are written. Instead, they are charged to ‘Work in Process Inventory so that they will become part of the product's cost.