n06 - Chapter 7 Notes Page 1 Variable Costing Absorption As...

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Chapter 7 Notes Page 1 Please send comments and corrections to me at [email protected] Variable Costing As we have seen in previous chapters, when you manufacture your own inventory, the cost of that inventory includes all of the costs associated with running the factory that produces the inventory. Generally, no part of the factory cost is expensed. Instead, it is capitalized as the cost of the inventory produced. It is only expensed when the inventory is sold. At that point the cost of the inventory becomes Cost of Goods Sold. This system is referred to as Absorption Costing. It is also know as “Full Costing” and “Full-Absorption Costing”. The thought is that the inventory absorbs all of the factory costs fully. As we have seen, inventory costs are made up of the following under Absorption Costing: Direct Labor; Direct Materials; and Manufacturing Overhead (regardless of whether it is fixed or variable). GAAP requires that a firm must use Absorption Costing for all of its financial statements that are released to outside parties. An alternative system to Absorption Costing is Variable Costing. Although GAAP does not permit Variable Costing, Variable Costing is still widely used by companies for internal purposes (e.g., in order to evaluate the performance of a manager, a product or a division). With Variable Costing, the cost of the inventory produced includes only: Direct Labor; Direct Material; and Variable Manufacturing Overhead. Under Variable Costing, Fixed Manufacturing Overhead is not treated as part of the cost of the inventory produced. Instead, Fixed Manufacturing Overhead is expensed in the current period. Currently expensing a cost is often referred to as treating it as a “period cost”. Capitalizing a cost as part of the cost of inventory is often referred to as treating it as a “product cost”. The exclusion of Fixed Manufacturing Overhead from the cost of inventory makes Cost of Goods Sold a purely Variable Cost. Absorption
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Chapter 7 Notes Page 2 Please send comments and corrections to me at [email protected] Variable Costing vs. Absorption Costing In addition to having a different definition of inventory cost, Variable Costing uses a different Income Statement format. With a Variable Costing Income Statement, we group expenses into Variable Costs and Fixed Costs. The Variable Costing Income Statement first reports a company's Sales Revenue reduced by its Variable Costs. This difference is referred to as the "Contribution Margin." The Contribution Margin represents the dollar amount that a company’s operations “contribute” to help pay its Fixed Costs. The Variable Costing Income Statement then reduces the company’s Contribution Margin by its Fixed Costs. This Contribution Margin Format used by Variable Costing is different from the
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n06 - Chapter 7 Notes Page 1 Variable Costing Absorption As...

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