Briefly describe the following variable & absorption costing terms in advanced management accounting study

Briefly describe the following variable & absorption costing terms in advanced management accounting study

(Terms used in Chapter 7)

 

1.    Variable costing

2.    Absorption costing

3.    Variable costing income statement

4.    Absorption costing income statement

5.    Income effects of variable costing

6.    Income effects of absorption costing

7.    Theoretical capacity

8.    Practical capacity

9.    Normal utilization vs master-budget utilisation

 

 

Variable and absorption costing differ mainly in how they treat fixed manufacturing overhead. Variable costing expenses it immediately; absorption costing includes it in inventory until the goods are sold.

1–2. Costing methods

Term	Brief description
1. Variable costing	An inventory-costing method in which only variable manufacturing costs—direct materials, direct labour (if variable), and variable manufacturing overhead—are product costs. Fixed manufacturing overhead is a period expense in the period incurred.
2. Absorption costing	An inventory-costing method in which inventory “absorbs” both variable and fixed manufacturing costs. Fixed manufacturing overhead is therefore included in inventory and expensed through cost of goods sold when units are sold.

In both methods, non-manufacturing costs—such as selling, marketing, distribution, and administration—are normally period costs rather than inventory costs.

3–4. Income-statement formats

Term	Brief description
3. Variable costing income statement	Usually uses a contribution-margin format: Sales − variable costs = contribution margin; contribution margin − fixed costs = operating income. It is especially useful for CVP analysis, pricing decisions, and short-run decisions.
4. Absorption costing income statement	Usually uses a conventional gross-margin format: Sales − cost of goods sold = gross margin; gross margin − selling and administrative expenses = operating income. Cost of goods sold includes both variable and fixed manufacturing costs.

A simplified variable-costing format is:

Sales − Variable costs = Contribution margin

Contribution margin − Fixed costs = Operating income

5–6. Income effects

Term	Brief description
5. Income effects of variable costing	Operating income depends primarily on sales volume, not production volume, because all fixed manufacturing overhead is expensed immediately. Producing units that remain unsold does not defer any fixed manufacturing cost.
6. Income effects of absorption costing	Operating income is affected by both sales and production volume. When production exceeds sales, inventory rises and some fixed manufacturing overhead is deferred in closing inventory, so absorption-costing income is higher than variable-costing income. When sales exceed production, inventory falls and previously deferred fixed overhead is released into cost of goods sold, so absorption-costing income is lower.

The key reconciliation is:

Difference in operating income = Change in inventory units × Fixed manufacturing overhead per unit

·       If inventory increases, absorption-costing profit is higher.

·       If inventory decreases, variable-costing profit is higher.

·       If inventory is unchanged, profits are the same.

This distinction is important because absorption costing can create an incentive to overproduce purely to defer fixed overhead into inventory, even if demand has not increased.

7–9. Capacity concepts

Term	Brief description
7. Theoretical capacity	The maximum output possible if operations run at full efficiency continuously, with no downtime, maintenance, breakdowns, holidays, setups, or interruptions. It is an ideal benchmark and is generally unattainable in practice.
8. Practical capacity	Theoretical capacity adjusted for unavoidable operating interruptions, such as scheduled maintenance, holidays, and normal downtime. It measures the output that can realistically be achieved under efficient operating conditions.
9. Normal utilisation vs master-budget utilisation	Both are demand-based capacity measures, but their time horizons differ. Normal capacity utilisation is average expected demand over a longer period—often two to three years—allowing for seasonal, cyclical, and trend effects. Master-budget capacity utilisation is management’s expected capacity usage for the current budget period, typically one year.

Why capacity matters

Under absorption costing, a company calculates a fixed manufacturing overhead rate:

Budgeted fixed manufacturing overhead rate = Budgeted fixed manufacturing overhead / Chosen denominator-level capacity

 

A lower denominator capacity produces a higher fixed overhead cost per unit.

The four measures serve different purposes:

• Theoretical capacity highlights all downtime but is rarely suitable as a normal costing denominator.
• Practical capacity identifies unavoidable unused capacity clearly.
• Normal utilisation smooths temporary demand fluctuations.
• Master-budget utilisation reflects near-term expectations but may cause unit costs to fluctuate substantially from year to year.

 

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