Variable Costing in the Value of Inventory

There are several ways for a company to calculate the value of its inventory. The two most popular methods are variable costing and absorption costing. Variable costing only includes costs that change based on the rate of inventory production. Absorption costing allows inventory to absorb both variable costs and fixed costs.

Under variable costing, only the costs that change based on production are included in the cost of inventory. The variable costs associated with inventory are usually direct labor, direct materials and variable manufacturing overhead. For example, the cost of gas, electricity and water for a factory are variable manufacturing overhead expenses, because they fluctuate based on the amount of production. On the other hand, the factory rent and property tax are considered fixed manufacturing costs and aren't included in inventory value. These costs may change according to tax rates or land value, but production level is not the driving cause of cost.

Variable costing is often used to determine cost-volume-profit relationships. Because every cost associated with inventory has a direct correlation with production volume, accountants can see how costs behave at different production levels. For example, the company may be able to get a better deal on raw materials purchases if they buy at a certain level. Cost-volume-profit analysis helps managers understand the minimum amount of inventory they need to produce to break even on their costs. It also guides them how much inventory to produce to generate the most profit.

Valuing inventory by variable costs makes it easier to compare products' profitability. Management will often evaluate product lines by variable cost when thinking about discontinuing a product or replacing it with a new item. Since all of the costs are only incurred when inventory is produced, all the costs can be avoided if production stops. On the other hand, absorption inventory cost is usually inflated with expenses like the factory supervisor salary. Absorption value isn't as useful for decision-making because the factory supervisor will probably maintain the same salary even if the company discontinues one or two products.

Although variable inventory is popular for internal use, it's not acceptable for reporting purposes. U.S. generally accepted accounting principles require inventory to be valued with absorption costing on company financial statements. The Internal Revenue Service also requires companies to measure the cost of inventory goods sold using absorption costing. To make the financial statements suitable for annual reporting, accountants must include fixed costs in inventory value.