Financial Examination: Definition, Elements, Advantages, and Disadvantages
Full costing and variable costing are two distinct cost accounting techniques used by companies to determine the production costs of their products.
Full costing, also known as absorption costing, considers all costs of producing a single unit of product, including fixed and variable overhead. This method allocates both fixed and variable manufacturing costs to inventory and cost of goods sold (COGS). In contrast, variable costing assigns only variable manufacturing costs to inventory, treating fixed manufacturing overhead as a period expense.
This difference affects financial statements and inventory management significantly.
Income Statement Effects: Under full costing, fixed manufacturing overhead is allocated to each unit produced and included in inventory costs. When inventory increases, some fixed costs are deferred in inventory on the balance sheet, resulting in higher reported net income if production exceeds sales. On the other hand, under variable costing, fixed manufacturing overhead is expensed in the period incurred regardless of inventory levels, so net income is more closely tied to sales volume.
Balance Sheet Effects: Full costing inventories are valued higher because they include both fixed and variable manufacturing costs, which increases current assets and total assets. Variable costing inventories reflect only variable production costs, resulting in lower inventory balances.
Inventory Management and Decision Impact: Full costing can incentivize overproduction to absorb fixed overhead into inventory and increase profits, potentially leading to excess inventory and higher carrying costs. Variable costing provides clearer insight into the true incremental cost of production, helping managers make decisions about pricing, production levels, and cost control by focusing on variable costs.
Full costing complies with GAAP and IFRS and is used for external financial reporting because it matches all production costs with revenues. Variable costing, commonly used for internal management purposes, provides more transparent cost behavior information, enhancing operational decision-making and inventory control.
In summary, the choice between full costing and variable costing has a considerable effect on the company's financial statements. Understanding these methods is crucial for making informed decisions about production, inventory management, and financial reporting.
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