A Comparison of Alternative Inventory-Costing Methods

Variable costing and absorption costing may be combined with actual, normal, or standard costing. Exhibit 9-6 compares product costing under these six alternative inventory-costing systems.

Exhibit 9-6

Comparison of Alternative Inventory-Costing Systems

Table shows the comparison of alternative inventory-costing systems for actual, normal, and standard costing.

The variable direct manufacturing costs and variable manufacturing overhead costs are a part of variable costing and fixed direct manufacturing costs and fixed manufacturing overhead costs along with variable costing particulars are a part of absorption costing.

  1. Variable direct manufacturing costs

    • Actual Costing: Actual prices times the actual quantity of inputs used

    • Normal Costing: Actual prices times the actual quantity of inputs used

    • Standard Costing: Standard prices times the standard quantity of inputs allowed for actual output achieved

  2. Variable manufacturing overhead costs

    • Actual Costing: Actual variable overhead rates times the actual quantity of cost-allocation bases used

    • Normal Costing: Budgeted variable overhead rates times the actual quantity of cost-allocation bases used

    • Standard Costing: Standard variable overhead rates times the standard quantity of cost-allocation bases allowed for actual output achieved

  3. Fixed direct manufacturing costs

    • Actual Costing: Actual variable overhead rates times the actual quantity of cost-allocation bases used

    • Normal Costing: Actual prices times the actual quantity of inputs used

    • Standard Costing: Standard prices times the standard quantity of inputs allowed for actual output achieved

  4. Fixed manufacturing overhead costs

    • Actual Costing: Actual fixed overhead rates times the actual quantity of cost-allocation bases used

    • Normal Costing: Budgeted fixed overhead rates times the actual quantity of cost-allocation bases used

    • Standard Costing: Standard fixed overhead rates times the standard quantity of cost-allocation bases allowed for actual output achieved.

Variable costing has been controversial among accountants because of how it affects external reporting, not because of disagreement about the need to delineate between variable and fixed costs for internal planning and control. Accountants who argue that variable costing should be allowed for external financial reporting maintain that the fixed portion of manufacturing costs is more closely related to the capacity to produce than to the actual production of specific units. Fixed costs should therefore be expensed, not inventoried, they argue.

Accountants who support absorption costing for external reporting maintain that inventories should carry a fixed-manufacturing-cost component because both variable manufacturing costs and fixed manufacturing costs are necessary to produce goods. Therefore, both types of costs should be inventoried in order to match all manufacturing costs to revenues, regardless of their different behavior patterns. For external reporting to shareholders, companies around the globe tend to follow the current generally accepted accounting principle (GAAP) that all manufacturing costs, including fixed costs, are inventoriable. This also eases the burden on firms and auditors to attempt to disentangle fixed and variable costs of production, a distinction that is not always clear-cut in practice.

Similarly, for tax reporting in the United States, managers must take direct production costs, as well as fixed and variable indirect production costs, into account in the computation of inventoriable costs in accordance with the “full absorption” method of inventory costing. Indirect production costs include items such as rent, utilities, maintenance, repair expenses, indirect materials, and indirect labor. For other indirect cost categories (including depreciation, insurance, taxes, officers’ salaries, factory administrative expenses, and strike-related costs), the portion of the cost that is “incident to and necessary for production or manufacturing operations or processes” is inventoriable for tax purposes only if it is treated as inventoriable for the purposes of financial reporting. Accordingly, managers must often allocate costs between those portions related to manufacturing activities and those not related to manufacturing.*