Recall this statement from the first managerial accounting chapter: “Managerial accounting is quite
different from financial accounting. External reporting rules are replaced by internal specifications as to
how data are to be accumulated and presented. Hopefully, these internal specifications are sufficiently
logical that they enable good economic decision making.” Now that you have accumulated knowledge
on various managerial accounting concepts, you are in a good position to look more closely at some
of the techniques for internal reporting. This chapter’s initial topic pertains to an internal reporting
method for measuring and presenting inventory and income, known as variable costing.
Before diving into the specifics of variable costing, let’s revisit
the basic tenants of the traditional approach known as
absorption costing (also known as “full costing”). Generally
accepted accounting principles require absorption costing
for external reporting, and it formed the basis for the
discussion of inventory costing found in preceding chapters.
Under absorption costing, normal manufacturing costs are
considered product costs and included in inventory. As sales
occur, the cost of inventory is transferred to cost of goods
sold; meaning that the gross profit is reduced by all costs of
manufacturing, whether those costs relate to direct materials,
direct labor, variable manufacturing overhead, or fixed
manufacturing overhead. Selling, general, and administrative
costs (SG&A) are classified as period expenses.
The rationale for absorption costing is that it causes a product to be measured and reported at its
complete cost. Just because costs like fixed manufacturing overhead are difficult to identify with a
particular unit of output does not mean that they were not a cost of that output. As a result, such
costs are allocated to products. However valid the claims are in support of absorption costing, the
method does suffer from some deficiencies as it relates to enabling sound management decisio