Variable Costing vs. Absorption Costing

Variable Costing vs.
Absorption Costing
Lets take a look at the overview of these costing approaches:
Garrison and Noreen, (2013)
The above power point presentation slide illustrates a manufacturing business cost
structure. Take note of the Fixed Manufacturing Overhead, there lies the difference
between the two methods.
From the Income Statement that you have learned in your previous major
subjects like Fundamentals of Accounting, Financial Accounting, and Cost
Accounting, the operating performance of an entity for a period ended on a certain
date can be a net profit or a net loss. Then, looking at the Cost of Goods Sold
section, there is this Finished Goods Inventory, End or Merchandise
Inventory, where End is deducted from the items available for sale. Thus, the
ending finished goods inventory contributes to an increase in net profit. Can you
still remember that these accounts are used under the periodic inventory costing
method? They remain unsold for a certain period that ended; therefore, they are
not classified costs of goods sold.
In this module, the cost classification will be product or period costs, and
variable or fixed costs. For a manufacturer, the valuation of inventories (or product
costs) and the cost of goods sold (or period costs), in total or on a per unit basis are
very important. Full absorption costing and variable costing are other cost
classifications that we will learn this time. For your information, the Income
Statement that you prepared in your previous accounting subjects (Fundamental
Accounting, Financial Accounting and Cost Accounting) is that of a full absorption
costing approach. Moreover, they are prepared to cater to the needs of external
information users. From the income statement of a manufacturer, you identified
that the inventories are product costs while the cost of goods sold is a period cost.
Supplementary to the income statement is the Cost of Goods Manufactured, which
Variable Costing vs. Absorption Costing

presents the total product or manufacturing costs: the direct materials, direct labor
and manufacturing overhead. Fixed and variable costs do not appear in the
statement, but take note that this manufacturing cost is composed of variable and
fixed costs.
Another costing approach used in the income statement report is variable
costing. This costing method specifically caters to the needs of managers, a basic
tool in their decision making agenda.
How do we differentiate absorption costing from variable costing? To distinguish
one from the other, presented below is a summary of variable costing against
absorption costing:
EXHIBIT 7-1 Variable Costing versus Absorption Costing (Garrison and
Noreen, 2010)
Another issue to be considered in absorption and variable costing methods is the

income effect of the size of inventory at the end of a particular reporting period. The
matrix that follows shows (Exhibit 7-1) the Comparative Income Effects Absorption
and Variable Costing (Garrison and Noreen 13th Ed. 2010 page 286.
RELATION
BETWEEN
PRODUCTIO
EFFEC
T ON
INVEN
RELATION BETWEEN
ABSORPTION AND
VARIABLE COSTING NET

N AND
SALES FOR
THE
PERIOD
Units
produced
Units
Produced
Units
Produced
TORIE
S
OPERATING INCOME
No
change
=in
invent
ories
Absorption
Costing
Net
operating
income
Invent
>ory
Increas
e
Absorptio
n Costing
Net
operating
Income
<
Invent
ories
Decrea
se
Absorptio
n
Costing
Net
Operating
Income
>
<
Variable
costing
Net operating
income
Variable
Costing
Net
Operating
Income*
Variable
Costing
Net Operating
Income**
*Net operating income is higher under absorption

costing because fixed manufacturing overhead cost
is deferred in inventory under absorption costing
as inventories increase.
** Net operating income is lower under absorption
costing because fixed manufacturing overhead
is released from inventory under absorption
costing as inventories decrease.
As mentioned earlier in the first part of this module, the two costing methods are
applied in the income statement report. Presented hereunder are two income
statements illustrating the absorption and variable costing methods. From the two
income statements, take note of the difference in net operating income brought by
the fixed manufacturing component of the ending inventory under the absorption
costing method.

Absorption Costing Method:
Sales (15,000 units x Php20 per
unit.
Php 300,000
Less: Cost of Goods Sold

Beginning Inventory
Add: Cost of goods manufactured
(16,000 units x Php12 per unit)
Php
-0192,000
Goods available for sale.
Php 192,000
Less: Ending Inventory

(1,000 units x Php12* per unit)
12,000**
Cost of Goods Sold..
180,000
Gross Margin.
Php 120,000
Less: Selling and Administrative

Expenses
Variable: 15,000 units x Php3 =
Php45,000
( Php45,000 + Php30,000 fixed )
75,000
NET OPERATING INCOME
Php 45,000
=======
===
Variable Costing Method:

Sales (15,000 units x Php20 per unit)
.
Php300,000
Less: Variable Expenses

Variable Cost of Goods Sold:
Beginning Inventory.
Add: Variable Manufacturing Costs
(16,000 units x Php7 per Unit)
..
Php
112,000
-0-

Goods available for sale..
Less: Ending Inventory
(1,000 units x Php7 per unit)
Variable Cost of Goods Sold.
Variable Selling and Administrative
Expenses
(15,000 units x Php3)
Php
112,000
7,000***
Php
105,000
45,000
Contribution Margin.
150,000
Php150,000
Less: Fixed Expenses

Fixed Manufacturing Overhead..
Php 90,000
Fixed Selling and Administrative Expenses
30,000
Php110,000
NET OPERATING INCOME
Php40,000
=======
===
The assumed ending inventories of Php12.00 per unit have a fixed

manufacturing overhead cost components of Php5.00 per unit.
**
Under the Absorption Costing approach the Php12 per unit includes the
fixed manufacturing cost component of ending inventories.
**
*
In the next income statement (variable costing approach), the ending

inventories deducted from the goods available for sale are purely variable
costs.
The fixed component of manufacturing overhead is included in the
Php90,000 Fixed Manufacturing Overhead. Thus, this explains the
difference in net operating income between the two approaches (which is
1,000 units x Php5.00 = Php5,000). Specifically, it is the fixed
manufacturing cost component of the ending inventories.
To help you understand the impact of variable costing and absorption costing in the
decision-making process of management likewise, to appreciate the role of
Management Accounting, read the following topics pages 288 - 291 of our textbook.

Variable Costing vs. Absorption Costing

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Garrison and Noreen, (2013)