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Summit Systems, Inc: Variable vs Absorption costing

The controller of Summit Systems Inc. devised a new costing system based on tracing the cost of activities to products. The controller was able to measure post-manufacturing activities, such as selling, promotional, and distribution activities, and allocate these activities to products in order to have a more complete view of the company's product costs. This effort produced better strategic information about the relative profitability of product lines. In addition, the controller used the same product cost information for inventory valuation on the financial statements. Surprisingly, the controller discovered that the company's reported net income was larger under this scheme than under the traditional costing approach. Why was the net income larger, and how would you react to the controller's action?

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There are two primary methods used in manufacturing companies to assign costs to products:

1. Variable costing includes direct materials, direct labor and variable manufacturing overhead costs. Fixed manufacturing overhead is not designated as part of product costs. These fixed costs are charged against income as a period cost, not a product cost.

2. Absorption costing is the same as variable costing except for fixed manufacturing overhead. Those fixed manufacturing costs are assigned to product in the same manner as the direct costs are. Absorption costing methods can provide some very good data for management to understand the true profitability by product, and internal use of the method is ...

Solution Summary

The solution provides a detailed look at the differences in the balance sheet and income statement for the two methods of costing inventory. It is a comprehensive explanation designed to promote good understanding at a base level. Under the results section, the solution explains five different scenarios which could occur.