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Direct Costing
Direct materials $2
Direct labor 4
Variable overhead 1
Total cost per unit $7
Probably no subject in all of managerial accounting has created as much controversy among accountants as has
direct costing. The controversy isn't over whether costs should be separated as between variable and fixed in
matters relating to planning and control. Rather, the controversy is over the theoretical justification for excluding
fixed overhead costs from the cost of units produced and therefore from inventory.
Advocates of direct costing argue that fixed overhead costs relate to the capacity to produce rather than to the
actual production of units of product in a given year. That is, they argue that costs for facilities and equipment,
insurance, supervisory salaries, and the like, represent costs of being ready to produce and therefore will be
incurred regardless of whether any actual production takes place during the year. For this reason, advocates of
direct costing feel that such costs should be charged against the period rather than against the product.
Advocates of absorption costing argue, on the other hand, that so far as product costing is concerned; it makes no
difference whether a manufacturing cost is variable or fixed. They argue that fixed overhead costs such as
depreciation and insurance are just as essential to the production process as are the variable costs, and therefore
cannot be ignored in costing units of product. They argue that to be fully costed, each unit of product must bear
an equitable portion of all manufacturing costs.
Although this difference in the handling of fixed overhead might seem slight, it can have a substantial impact on
both the clarity and the usefulness of statement data.
If inventories decrease, then some of the fixed manufacturing overhead costs that
had been deferred in inventories in previous periods will be released to the
income statement as part of cost of goods sold as well as all of the current fixed
manufacturing overhead costs.
Since only the current fixed manufacturing overhead costs are expensed under
variable costing, the net operating income reported under absorption costing will
be less than the net operating income reported under variable costing.