Alternative Product Cost Concepts: Absorption & Variable Costing
Reading: Drury Ch. 7, "Income Effects of Alternative Cost Accumulation Systems"
[Also, refer to IAS2]
Focus is on understanding the differences between each approach and the impact the application of
each has on periodic stock valuation, on periodic profit measurement and on periodic profit reporting.
There is general agreement as to the accounting treatment of product costs and of period costs. But
there is a debate about what costs should be classified as „product costs‟. An issue of definition.
Absorption Costing (AC, or full-costing) and Variable Costing (VC, or ‘direct costing’, ‘marginal
costing’) are different approaches to product cost definition and measurement and so, to periodic stock
valuation and profit measurement. AC is the traditional approach: it considers all production costs to
be product costs. VC considers that only variable production costs are product costs. As such, the
methods differ conceptually in only one fundamental respect. Fixed production costs are treated as
part of unit product cost (i.e. inventoriable cost) in the former while they are considered to be a period
cost in the latter. The accounting treatment of fixed production costs differs under each approach.
The methods give rise to different periodic stock valuations. In AC, stocks are valued at full-cost of
production. Under VC they are valued at variable production cost. The methods may also give rise to
different periodic profit measurements.
In practice, the methods differ in their approach to profit reporting (i.e. in the presentation of the
Operating Profit Statement). AC operating profit reports focus primarily on costs classified by
business function (i.e. into production and non-production costs). They report a Gross Profit figure.
VC operating profit reports focus on cost behaviour as the primary cost classification scheme. They
report a Contribution Margin figure.
Accounting Treatment of Fixed Production Cost?
The critical issue is the nature of fixed production overheads. It is this which determines their
accounting treatment. AC considers them to be product costs, related to the production of specific
units of product; they are costs incurred to produce specific units of product and no different in nature
to other production costs. The benefits arising from incurring such costs are realised only when
products to which they relate are sold and the corresponding revenue is realised and recognised. As
such, the proper matching of costs with revenues requires that fixed production costs be included as
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part of stock value and remain unexpired until the products are sold. [Financial Accounting
perspective]. Refer Drury, Fig. 7.1, p. 231.
VC considers fixed production costs to be period costs. The potential benefits arising from such
expenditures relate to particular time periods; the benefit, and so the cost, expires with the passing of
time. Proper matching requires that they be written off as expenses in the period in which they are
incurred. They are a cost of being in business (a capacity, a capability cost) rather than a cost of doing
Examples of Standard Formats for Operating Profit Statement for a Period
Absorption Costing Approach - Operating Profit Statement for a Period - €'000
Sales Revenue 350
Less (Production) Cost of Goods Sold (198)
Gross Profit 152
Less Non-Production Costs [Period Costs] (112)
Operating Profit 40
Note: any closing stock of finished goods will be valued at full production cost per unit.
Note: distinguish actual and normal absorption costing. [Could also use standard costing.]
Variable Costing Approach - Operating Profit Statement for a Period - €'000
Sales Revenue 350
Less Variable Production Cost of Goods Sold (148)
Less Variable Non-Production Costs [Period Costs] (40)
Contribution Margin 162
Less Fixed Production Costs [Period Costs] (50)
Less Fixed Non-Production Costs [Period Costs] (72)
Operating Profit 40
Note: any closing stock of finished goods will be valued at variable production cost per unit only.
In the above example, periodic profit is the same under each approach. This may not be the case if
production and sales levels during a period are different.
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Relevance of Approach Chosen? (Does it matter which approach is used?)
The approaches will give rise to different periodic stock valuations, to different Balance Sheet
asset values. VC inventory valuations will be lower.
The reported aggregate long-term profits will be the same under AC and VC approaches (and
irrespective whether actual, normal or standard costing is used). However, there may be
differences in short-term periodic (monthly, quarterly, annual) profit measures when production
and sales are not equal during a period (i.e. when stock levels change). In the context of the need
for accounting profit measures on an annual or even shorter term basis, and the likelihood that
production and sales will not be equal in any given short-term period, the choice of approach
could be of significance.
[How true is it that production and sales will not be equal in any given short-term period in the
context of the modern operating environment?: for example, with the adoption of JIT etc?]
Finally, the issue as to which approach to information presentation and emphasis is most
advantageous for periodic internal and external perfromance reporting (i.e. for meeting user
needs) should be considered. Which approach to profit reporting is best?
[In AC there is no routine separation of production costs into variable and fixed categories in the
books-of-account, at the recording phase. This may be done subsequently as a special exercise on a
General Observations Relating to Impact
When production and sales volume are equal in a period, profits reported under each is identical.
When production volume is greater than sales volume in a period (i.e. when stock levels increase),
profits reported under AC will be greater than under VC. In AC, part of the period’s fixed
production costs are included in the closing stock value and remain unexpired at period end. Their
‘release’ to the P&L a/c is ‘deferred’. In contrast, under VC, all fixed costs incurred in a period,
including fixed production costs, are treated as period costs. They are expensed in measuring profit
for the period: closing stocks are valued at their variable production costs only.
When production volume is less than sales volume in a period (i.e. when stock levels decline),
profits reported under AC will be less than under VC. Fixed production costs previously deferred to
stocks are expensed when the products to which they relate are sold.
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A Question of Timing
Differences in profit measurement and stock valuation arise because of the different view taken of the
nature of fixed production costs. Essentially the difference is one of the timing of expensing of fixed
production costs in measuring periodic profit, i.e. the timing required for proper matching. It is a
question of ‘when?’ do fixed production costs become expense. This in turn requires consideration of
the timing of the realisation of benefits (i.e. of related revenues) arising from the particular cost
incurrence: at the time the product is sold, or, within the period in question? The nature and definition
of an asset (specifically, of ‘service’ potential) is crucial to the debate [note the cost obviation concept
and the revenue production concept].
In the long-term, aggregated profits will be the same under each approach: production will equal sales
over the long-term and all costs eventually are expensed.
So Which Approach to Use?
AC is required by financial accounting for external reporting (refer IAS 2). Perhaps this debate needs
revisiting: would VC statements be of greater value to external users of financial statements?
The issue for management accounting is which approach is best for internal reporting? Answering
this requires a Benefit - Cost evaluation of using each approach.
VC provides information that is potentially more valuable to management than AC. It emphasizes
cost behaviour, cost structure, CVP relationships and contribution margin, all considered to be of
great relevance to management for internal short-term decision making.
The analysis of costs by behaviour facilitates cost planning, cost control and performance
It facilitates segmental and/or product-line profit reporting. As such, it is potentially useful for,
segmental and/or product-line planning, control and performance evaluation purposes. For
example, it provides information that may be useful to management in determining sales-mix
The allocation of fixed production costs to units of product is unnecessary. As such, the problem
of arbitrary fixed cost allocations is avoided.
Profits are a function of sales rather than a function of both sales and production. It removes from
periodic profit measurement the effects of stock changes. It eliminates possible distortions arising
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It is more understandable, easier to interpret and cheaper to operate. It avoids some of the
‘peculiarities’ inherent in profit measurement under the AC approach; for example, how to
explain a situation in which sales go up, costs don’t change but profits go down etc.
It is more understandable and less open to (i.e., there is less scope for) short-term manipulation of
profit results by management. It avoids the possibility of fixed production costs being capitalised
in unsaleable stocks and the resulting over-statement of short-term operating profits. It removes
any incentive for management to build-up stocks (i.e., to stock-pile) in the short-term; it removes
any incentive to hold a higher level of stocks than is warranted by operational requirements.
[Refer Q 7.12 Drury, 5th Ed. Included in the question is a list of reasons for a company to change to a
VC approach: facilitates closer control of production costs, eliminates distortions in periodic profits
from seasonality, provides costs information that is more useful in determining sales policy.]
The neat separation of costs into linear variable and fixed categories is generally not possible in
practice. The classification is often simplistic, arbitrary and incorrect.
The focus in short-term decision making should be on total costs. There is a danger that the
importance of fixed costs in short-term decision making will be understated. [For example, some
so-called fixed costs may be avoidable in the short-term etc.]
The VC approach does not adequately focus management's attention on the importance of
operating at full-capacity and the effect of not doing so.
The stock of finished products will be undervalued and profit measurement may be distorted.
Fixed costs are an increasing % of total production costs in modern industry. High expenses (and
so, losses) will be reported in periods when stocks are legitimately being built-up (and as such,
the losses reported are fictitious) and excessive profits will be reported in periods in which the
stocks are sold-off. There is a potential distortion of periodic results and so, of performance
VC does not accord with the approach required for external reporting. This militates against its
adoption for internal reporting. For example, it may prove too expensive and too confusing to run
two systems simultaneously. Also, consider this from a behavioural perspective: is there a need to
align the reporting, evaluation and reward systems internally and externally?; for example, do
management bonuses depend on externally reported results?
[Does this constitute an example of the alleged malign impact of financial accounting
requirements on the development of management accounting systems?]
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Up until recently there was a general consensus in the academic literature that VC was superior for
internal reporting purposes. This continues to be the conventional wisdom. However, studies have not
indicated its widespread use. Why this gap between theory and practice?
[If its all that good, how come everyone isn't using it?]
Refer C. Drury (6th Ed. p. 238) "Some arguments in support of absorption costing" and (p.243)
“Surveys of company practice”
Reasons for use of AC include: marginal benefit from use of VC less than marginal cost of provision –
especially as stock levels don‟t fluctuate much; management are comfortable with AC and can adjust
the AC figures „mentally‟; management like the obscurity provided by AC; focuses attention on the
importance of fixed production costs and on operating at full-capacity; convergence between
performance evaluation and related rewards model and reporting model; avoid problem of fictitious
losses when planned stock-piling taking place; stock value meaningless under VC; AC theoretically
Perhaps the apparent contradiction can be resolved by consideration of the benefit-cost criteria. For
example, it was perhaps considered too incrementally expensive, relative to any potential incremental
benefit, to operate both approaches simultaneously – i.e. one system for internal reporting and another
for external reporting. This in turn raises questions as to whether modern ICT, which enables the
provision of information cheaply and the incorporation of great flexibility in system design, will give
rise to change in practice (no longer a question of „either/or‟, rather one of „both/and‟).
[However, there may be other forces at work to explain the theory-practice gap in this context.]
The debate regarding the use of AC or VC will ultimately be resolved in relation to:
The perceived merits and impact of each approach for internal and external reporting purposes; in
particular, the relevance and the value of the information (stock valuations, profit measures, report
emphasis) provided by each.
The prevailing viewpoint as to the nature of fixed production costs.
The possibilities provided by ICT.
Note that stock levels (and so the difference between production and sales levels) are unlikely to vary
greatly on an annual basis; as such, profit measures are unlikely to differ significantly as a result of
stock level changes over this time-scale. Furthermore, it is interesting to consider the debate in the
context of the application of a JIT philosophy aimed at minimizing stock levels.
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Finally, it can be argued that stock should be valued at NRV or at current replacement cost, thus,
shifting the focus of the debate.
The difference between the approaches is essentially a question of the timing of expense recognition:
when do fixed production costs become expenses? In the long-term, both approaches will give the
same aggregate measure of total profit. However, there may be differences in short-term periodic
profit measures. There will be differences in stock valuations. The question as to which approach is
best for internal reporting remains. But is it necessarily (any longer) a question of “either or......?”
The following table summarises the differences between the approaches:
Absorption Costing Variable Costing
Product Costs All production costs Variable production costs
Fixed production costs
Period Costs All non-production costs and
All non-production costs
Emphasis on functional Emphasis on cost
Presentation cost classification: costs behaviour: costs
classified as production classified as linear
or non-production related. variable or fixed costs.
Reports Gross Profit Reports Contribution
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A Summary of Alternative Product Cost Concepts: AC & VC
Focus on the differences between each approach and the impact the application of each has on
periodic profit measurement, periodic stock valuation and on periodic profit reporting.
The Nature of Absorption Costing (AC) and Variable Costing (VC)?
The accounting flow of costs under each? Refer Exhibit 7.1 in Drury.
Approach to the presentation of periodic profit statements under each?
The central conceptual issue of debate?
The nature of fixed production overheads and the appropriate accounting treatment of them in
measuring profit and valuing stocks?
Does it matter which approach is used?
Impact of each on stock valuation, periodic profit measurement and profit reporting (externally and
Comparison of the impact of each approach in the short-term and in the long-term (whether actual,
normal or standard costing in use).
Explanation of any differences in results.
Differences arising in periodic profit measurement is due to the timing of expense recognition [when
do fixed production costs become expenses?]. Differences may arise in short-term periodic profit
measures and stock valuations. In the long-term, both approaches result in the same aggregate measure
of total profit.
Evaluation of each approach: relative merits for internal (and external) reporting?
Arguments for and against each? Potential benefits and limitations of each? Value for internal and
for external reporting?
Importance of view taken on ‘service potential’ – nature of an asset?
Impact of external reporting requirements on system design for internal reporting?
Evidence of use (of company practice)?
Is it a question of “either or......?”
The likely impact of ICT (if any) on the debate?
Prevailing conventional wisdom in academic texts (academic view) v. practical reality – are these
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