Costing Process of Products and Services

Two general approaches are used for costing products for the purpose of valuing inventories and cost of goods sold. One approach is called absorption costing. Absorption costing is generally used for external financial reports. The other approach called variable costing is preferred by some companies for internal decision making and must be used when an income statement is prepared in the contribution format.

Ordinarily absorption costing and variable costing produce different figures for net income and the difference can be quite large. Under variable costing, only those costs of production that vary with output is treated as product cost. This would generally include direct material, direct labor and the variable portion of manufacturing overhead. The fixed manufacturing overhead is treated as a cost of the period and charged for the period. The variable costing is sometimes referred to as direct costing, marginal costing, differential costing, incremental costing and comparative costing.

The break even profit analysis examines the behavior of total revenues, total costs and operating income as changes occur in the output level, the selling price, the variable cost per unit and/or the fixed costs of a product. Managers use cost volume analysis to help answer questions such as: How will total revenues and total costs be affected if the output level changes? In this manner, marginal costing and break even analysis guides the manager's planning.

In costing products and services, the companies use either variable or absorption costing. Under the concept of variable costing, only those production costs that vary with the output are treated as product costs. This includes direct material, direct labor and variable overheads. The fixed manufacturing overhead is treated as period cost and charged off against the revenue as it is incurred, the same as selling and administrative expenses. By contrast, the absorption costing treats manufacturing overhead as a