Variable costing is a method in which the costs to be inventoried include only the variable manufacturing costs. Fixed factory overhead is treated as a period cost-it is deducted along with the selling and administrative expenses in the period incurred. That is,
Direct materials $xx
Direct labor xx
Variable factory overhead xx
Product cost $xx
Fixed factory overhead is treated as a period expense.
Variable costing is used for internal management only. Its uses include: (1) inventory valuation and income determination; (2) relevant cost analysis; (3) Break-Even and Cost-Volume-Profit (CVP) Analyses; and (4) short-term decision-making. Variable costing is, however, not acceptable for external reporting or income tax reporting. Companies that use variable costing for internal reporting must convert to Absorption Costing for external reporting.
Under absorption costing, the cost to be inventoried includes all manufacturing costs, both variable and fixed. Nonmanufacturing (operating) expenses, i.e. selling and administrative expenses, are treated as period expenses and thus are charged against the current revenue.
Direct materials $xx
Direct labor xx
Variable factory overhead xx
Fixed factory overhead xx
Product cost $xx
Another important fact to note...
Effects of the two costing methods on net income: (a) When production exceeds sales, a larger net income will be reported under absorption costing. (b) When sales exceed production, a larger net income will be reported under direct costing. (c) When sales and production are equal, net income will be the same under both methods.
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