ADMS 2510 Lecture Notes - Total Absorption Costing, Financial Statement, Lean Manufacturing
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Variable Costing: A costing method that includes only variable manufacturing costs-direct materials, direct
labour, and variable manufacturing overhead-in the cost of a unit of product.
Fixed manufacturing overhead is not treated as a product cost under this method. Rather, is treated as period
cost and is expensed against revenue.
Variable costing is also referred as direct costing or marginal costing.
Fixed manufacturing overhead cost deferred in inventory: The portion of the fixed manufacturing overhead
cost of a period that goes into inventory under the absorption costing method as a result of production
Fixed manufacturing overhead cost released from inventory: The portion of the fixed manufacturing
overhead cost of a prior period that becomes an expense of the current period under the absorption costing
method as a result of sales exceeding production.
Change in production has no effect on operating income when variable costing is used but it effect the
operating income when the absorption costing is used.
Under variable costing, revenue essentially drives operating income. Under absorption costing, both
revenue and production drive operating income. The two drivers create confusion for the user of
operating income because it is difficult to perceive income without selling the production, something
absorption costing does.
To avoid mistakes when absorption costing is used, readers of financial statements should be alert to
changes in inventory levels. Under absorption costing, if there is an increase in inventories, fixed
manufacturing overhead costs are deferred in inventories and operating income is increased. If there is
a decrease in inventories, fixed manufacturing overhead costs are released from inventories and
operating income decreases. Thus, fluctuations in operating income can be due to changes in
inventories rather than to changes in sales.
Absorption break-even analysis would require the analysis of two drivers, sales and production.
A basic problem with absorption costing is that fixed manufacturing overhead costs appear to be
variable with respect to the number of units sold, but they are not.
Practically speaking, absorption costing is required for external reports in the United States and is the
predominant method used in Canada.
When lean production is used, the differences in operating income will largely disappear and both
variable and absorption costing will show basically the same operating income figure.
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