Warner Company

Introduction

Warner Company is a manufacturing firm which uses Absorption costing as a management tool in costing their products. It is typically used for external income statement reporting wherein it allocates all manufacturing costs (variable and fixed) to products.

There are two methods of product costing: Variable costing and Absorption costing. Variable costing is an approach to products costing that allocates only variable manufacturing costs (direct materials, direct labor, and variable factory overhead) to items produced. Thus, inventoriable costs are limited to the variable manufacturing costs. Absorption costing has an impact on inventory values and profits because treatment of fixed factory overhead is different. The variable costing income statement would not have a capacity variance because fixed manufacturing costs are period costs and are therefore not charged to inventories. Although the profit can differ under the two costing methods, profit under variable costing is not always higher or lower than absorption costing. The difference between profits under the two methods is determined by the relationship of production to sales.

In addition the difference in net profits is due solely to the treatment of fixed manufacturing costs. That is absorption costing includes those costs in the inventory costs while variable costing treats them as expenses to be charged to the period incurred. During any given time period the amount of fixed costs in inventory will increase or decrease as production differs from sales. If production is greater than sales, fixed costs will be deferred to the future periods in the inventory under absorption costing. These costs would be expensed under variable costing. Therefore absorption costing will have a higher net profit. Conversely if sales are greater than production fixed costs in the beginning inventory are released in the current period and added to the fixed costs incurred during the current...