Okay let's take a look at something called absorption versus variable costing so so far we've used a costing concept known as absorption costing and why you're asking well generally accepted accounting principles or GAAP requires absorption costing for external financial reporting in the Internal Revenue Service so the IRS requires it .
For tax preparation under absorption costing all manufacturing related costs whether fixed or variable are absorbed into the cost of the product so under absorption costing no distinction is made between manufacturing costs that arise and fall with production volume and cost that remain fixed so supporters of absorption costing argue that all .
Costs whether fixed or variable are necessary for production to occur so all these costs should become part of the individual cost of the product now on the other hand many accountants and managers don't agree they argue that fixed manufacturing costs are related to available production capacity and will be incurred regardless of the actual .
Production volume which occurs during the period so since these costs are going to be incurred regardless of volume they should be treated as a period cost and expense immediately so as I mentioned just a second ago absorption costing is required for GAAP so under absorption costing products absorb fixed manufacturing costs as well .
As variable manufacturing costs so both fixed and variable manufacturing cost is treated as an inventory Abul product cost which you can see here we've got direct materials direct labor variable manufacturing overhead and fixed manufacturing overhead now they're assigning at a per unit cost here so we get a total cost per unit of $75 now .
Under a variable costing this fixed manufacturing overhead component is considered a period cost and not a product cost so that drops the cost of the product down to $50 now variable costing only assigns variable manufacturing costs like direct materials direct labor and variable manufacturing overhead .
Fixed manufacturing overhead is treated as a period cost so something called contribution margin income statements are going to be used for internal management decisions because they're not GAAP and I'll show you what that looks like here in just a second so as discussed before absorption costing is required by gap in the IRS yet variable .
Costing is typically preferred for internal decision making and performance evaluation purposes those managers are often exposed to both sets of information so for manufacturers the costing systems will yield different results for operating income when inventory levels increase or decrease and we'll touch upon that in a minute .
So managers can easily reconcile the difference between the two income figures using this formula you take the change in inventory levels and units and multiply that times the fixed overhead per month so a contribution margin income statement is going to classify costs and expenses as fixed or variable so it will report something called .
Contribution margin in the body of the income statement so what contribution margin is is you take all of your revenue and you subtract all of the variable costs that gives you contribution margin from contribution margin then you subtract your fixed cost from that and it typically will give you the same net income as a traditional .
Income statement assuming that products produced and sold are the same so here's an example of a traditional income statement you've got sales minus cost of goods sold which gives you gross profit then you subtract your operating expenses to give you operating income for external reporting purposes now here's an example of a contribution .
Margin income statement here we're organizing costs by behavior rather than function the contribution margin income statement begins with sales you see that we subtract variable costs sales minus variable costs gives us a contribution margin this is an indicator of how much sales contribute towards fixed costs then we subtract our fixed costs and .
That gives us operating income so GAAP does not allow to use the contribution margin format for external reporting purposes but managers do find contribution margin income statements more helpful than traditional income statements for planning and decision-making purposes and later on in the course we will spend .
A significant of time preparing contribution margin income statements when we do our CVP analysis cost-volume-profit so this chart kind of gives you a nice actual summary it's a little small and I apologize about that but it does give you a nice summary about key points between variable costing and absorption costing so with .
The variable costing it treats all fixed manufacturing overhead costs as operating expenses in the period incurred rather than treating them as an inventory Abul product cost can only be used internally never for external reporting and it often does result in better decision making than absorption or what we call traditional costing .
Because it gives managers the additional cost of making one more unit of product which is the variable cost per unit it's often better for performance evaluation than absorption costing because it doesn't give managers an incentive to build unnecessary inventory well touch upon that in just a second and then it will result in a different operating .
Income than absorption costing for managers whose inventory levels do increase or decrease during the period the contribution margin income statement is organized by cost behavior again we first subtract variable expenses from sales revenue to arrive at contribution margin then we subtract out fixed expenses to arrive at operating income .
Some find it more useful than traditional income statement for planning and decision making because it distinguishes between costs that will be affected by volume the variable cost from those that are unaffected which are the fixed costs it can again only be used internally and it should show the same operating income as a traditional .
Income statement for service firms merchandising companies and manufacturers only if their inventory levels remain stable for all retailers cost of goods sold is considered a variable cost so just real quickly let's touch upon why operating income might not always be the same between the two costing systems .
It's only going to be the same if the manufacturer sells exactly what is produced during the period this is what you might find for a lien producer because they're producing inventory just in time to fill existing customer orders however traditional manufacturers often produce extra safety stock which increases the inventory levels to insure .
Against unexpected demands so if they're doing that they're producing more units that are sold your absorption costing income is going to be higher than variable costing and you're asking me why well because under absorption costing those fixed costs are going to be product cost so they're going to be held with that inventory that is sitting .
On the balance sheet is finished goods inventory only until those units are sold will it become an expense so if it sits in inventory that means your expenses will be smaller than they would have been under variable costing when those expenses would have been expensed as a period cost now the opposite is true then when inventories decline when .
Fewer units are produced and sold in this case absorption costing income would be lower than variable costing income because again more units were sold then produced which means more of those expenses would have been in not necessarily incurred but charged as an expense rather than sitting in inventory so there's some potentially undesirable .
Manager incentives created by absorption costing and managers may try to increase production to build up inventory in order to minimize or maximize their bonus and the contribution margin income statement for that reason is usually a better management tool