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Variable and absorption costing?

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What are the differences between variable and absorption costing? Why is variable costing not allowed for GAAP reporting? Which method is more useful for internal decision-making? Why? As a manager, which would you prefer? Why?

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Solution Summary

The difference between variable and absorption costing is discussed. The method that is more useful for internal decision making is analyzed.

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Variable Costing versus Absorption Costing

A. Alternative Income Statement Presentations
1. Absorption Costing--under absorption costing all product costs are assigned to the units produced and are expensed when the units are sold
a. Format--under absorption costing revenues are first reduced by all product cost to arrive at an intermediate figure called gross margin and then reduced by all period costs to arrive at a final net income figure.

Sales
- Cost of Goods Sold:
Direct Materials
Direct Labor
Variable Manufacturing Overhead
Fixed Manufacturing Overhead
= Gross Margin
- Selling and Administrative Expenses:
Variable Selling and Administrative Expenses
Fixed Selling and Administrative Expenses
= Net Income

b. Application--absorption costing is a more effective tool for long-run decision making since it focuses attention on revenues and total production costs

2. Variable Costing--under variable costing variable product costs are assigned to the units produced and expensed when the units are sold and fixed product costs are treated as period costs and expensed when incurred

a. Format--under variable costing revenues are first reduced by all variable costs to arrive at an intermediate figure called contribution margin and then reduced by all fixed costs to arrive at a final net income figure.

Sales
- Variable Costs:
Variable Cost of Goods Sold:
Direct Materials
Direct Labor
Variable Manufacturing Overhead
Variable Selling and Administrative Expenses
= Contribution Margin
- Fixed Costs:
Fixed Manufacturing Overhead
Fixed Selling and Administrative Expenses
= Net Income

b. Application--variable costing is a more effective tool for short-run decision making since it focuses on revenues and variable costs

B. Comparison of Absorption Costing Versus Variable Costing
1. Production > Sales--if the number of units produced is greater than the number of units sold, absorption costing will produce a higher ...

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