Question

Which method do you think allows for the greatest manipulation of net income: variable or absorption costing and why? Discuss any ethical concerns associated with your answer.

Answer 1

The difference between absorption costing and variable costing methods pertains mainly to the allocation of manufacturing costs and its effect on reporting of net income. Both absorption and variable cost methods are based on the accrual concept of accounting and are recognized as when they are incurred.

Under the absorption costing method, sales and marketing expenses are treated as a period cost and hence expenses are recorded as and when incurred.

In the variable costing method, product cost includes just the direct costs and variable manufacturing costs; while in absorption cost accounting, product cost also includes fixed manufacturing overheads. Thus, fixed costs are treated as a part of the production system in absorption costing.

Variable cost accounting leads to a lower product cost. Under an absorption cost method, management can record costs incurred in the current period to the next period when products are actually sold. This artificially inflates profits in the period of production by incurring less cost than would be incurred under a variable costing system.

Therefore, Variable costing will report a lower amount of profit while absorption costing will inflate the profits. Variable cost accounting is useful for internal management’s decision-making purposes because it reveals the actual profit or loss for the current year, On the other hand, absorption cost accounting is useful for creditors, government agencies, suppliers, etc.