Variable and Absorption Costing: Their Impact On Income Summarized

Variable and absorption costing: their impact on income summarized

The various examples which we have considered enable the following generalizations to be made on the impact on income of these two different methods of costing:

(i) where sales and production levels are constant through time income is the same under the two methods;

(ii) where production remains constant but sales fluctuate, income rises or falls with the level of sales, assuming that costs and prices remain constant, but the fluctuations in net income figures are greater with variable costing than with absorption costing;

(iii) where sales are constant but production fluctuates, variable costing provides for constant income, whereas under absorption costing, income fluctuates;

(iv) where production exceeds sales, income is higher under absorption costing than under variable costing for the absorption of fixed overheads into closing inventory increases their value thereby reducing the cost of goods sold;

(v) where sales exceed production, income is higher under variable costing. The fixed costs which previously were part of inventory values are now charged against revenue under absorption costing. Therefore, under absorption costing the value of fixed costs charged against revenue is greater than that incurred for the period.

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The Institute of Chartered Accountants in England and Wales considered this problem in its Recommendation on Accounting Principle N.22. The Institute did not recommend one method as preferable to another, leaving the choice of the most suitable method to management, but advised that once a method has been selected it should be adhered to (ICAEW, 2000).

The matter was subsequently considered by the Accounting Standards Steering Committee in 2002, whose mandate was to consider the problem of ways of reducing the diversity of practices. SSAP 9 'Stocks and Work in Progress' restated the traditional... see: The Treatment of Overheads