ABSORPTION COSTING

and VARIABLE
COSTING
ABSORPTION COSTING or FULL COSTING

• A product costing method that includes all the

manufacturing costs in the cost of a unit of product.
• Under the absorption costing method, fixed factory
overhead is treated as a product cost.
VARIABLE COSTING

• A product costing method that includes only the variable

manufacturing costs in the cost of a unit of product.
• Under the variable costing method, fixed factory
overhead is treated as a period cost.
PRODUCT COST COMPONENTS

Absorption Costing Variable Costing

Direct materials Direct materials
+ Direct labor + Direct labor
+ Variable MOH + Variable MOH
+ Fixed MOH . + .
Product Cost . Product Cost .
DISTINCTIONS BETWEEN PERIOD COSTS
AND PRODUCT COSTS
PERIOD COST PRODUCT COST
• Cost that is charged against current • Cost that is included in the
revenue during a time period computation of product cost that is
regardless of the difference between apportioned between the sold and
production and sales volumes. unsold units.
• Does not form part of the cost of • An inventoriable cost. The portion of
inventory. the cost that has been allocated to
the unsold units becomes part of the
cost of inventory.
• Reduces income for the current • Reduces current income by the
period by its full amount. portion allocated to the sold units;
the portion allocated to unsold units
is treated as an asset, being part of
the cost of inventory.
PRINCIPAL DIFFERENCES BETWEEN ABSORPTION
AND VARIABLE COSTING METHODS

ABSORPTION COSTING VARIABLE COSTING

 Cost segregation Seldom segregates costs Costs are segregated into
into variable and fixed variable and fixed
costs
 Cost of inventory Cost of inventory includes Cost of inventory includes
all the manufacturing only the variable
costs: direct materials, manufacturing costs:
direct labor, variable direct materials, direct
manufacturing overhead, labor, and variable
and fixed manufacturing manufacturing overhead
overhead
 Treatment of fixed Fixed factory overhead is Fixed factory overhead is
factory overhead treated as product cost. treated as period cost.
PRINCIPAL DIFFERENCES BETWEEN ABSORPTION
AND VARIABLE COSTING METHODS

ABSORPTION COSTING VARIABLE COSTING

 Income statement Distinguishes between Distinguishes between
production and other variable and fixed costs
costs Sales
Sales - Variable costs
- Cost of sales .
Gross profit . Contribution
- S&A costs . margin
Profit . - Fixed costs
.
. Profit
.
 Net income Net income between the two methods may differ from
each other because of the difference in the amount of
fixed overhead costs recognized as expense during an
accounting period. This is due to variations between
DIFFERENCE IN NET INCOME UNDER
ABSORPTION AND VARIABLE COSTING

• Variable and absorption costing methods of accounting for

fixed manufacturing overhead result in different levels of
net income in most cases. The differences are timing
differences, i.e., when to recognize the fixed manufacturing
overhead as an expense.
• In variable costing, it is expensed during the period when
the fixed overhead is incurred.
• In absorption costing, it is expenses in the period when the
units to which such fixed overhead has been related are
sold.
PRODUCTION EQUALS SALES

• When production is equal to sales, there is no change in

inventory. Fixed overhead expensed under absorption
costing equals fixed overhead expensed under variable
costing. Therefore, absorption costing income equals
variable costing income.
PRODUCTION IS GREATER THAN SALES

• When production is greater than sales, there is an increase

in inventory. Fixed overhead expensed under absorption
costing is less than fixed overhead expensed under variable
costing. Therefore, absorption costing income is greater
than variable costing income.
PRODUCTION IS LESS THAN SALES

• When production is less than sales, there is an decrease in

inventory. Fixed overhead expensed under absorption
costing is greater than fixed overhead expensed under
variable costing. Therefore, absorption costing income is
less than variable costing income.
RECONCILIATION OF ABSORPTION AND
VARIABLE COSTING INCOME FIGURES

Absorption costing income

xx
+ Fixed overhead in the beginning inventory
xx
Total xx
- Fixed overhead in the ending inventory
xx
Variable costing income xx
ACCOUNTING FOR DIFFERENCE IN
INCOME

Change in inventory (production less sales)

xx
x Fixed MOH cost per unit xx
Difference in income xx
ARGUMENTS FOR THE USE OF
VARIABLE COSTING

1. Variable costing reports are simpler and more

understandable.
2. Data needed for break-even and cost-volume-profit
analyses are readily available.
3. The problems involved in allocating fixed costs are
eliminated.
4. Variable costing is more compatible with the standard
cost accounting system.
5. Variable costing reports provide useful information for
pricing decisions and other decision-making problems
encountered by management.
ARGUMENTS AGAINST VARIABLE
COSTING

1. Segregation of costs into fixed and variable might be

difficult, particularly in the case of mixed costs.
2. The matching principle is violated by using variable
costing, which excludes fixed overhead from product costs
and charges the same to period costs regardless of
production and sales.
3. With variable costing, inventory costs and other related
accounts, such as working capital, current ratio, and acid-
test ratio are understated because of the exclusion of
fixed overhead in the computation of product cost.
ILLUSTRATION

• During the year 200A, Wouie Corporation’s production was

equal to its normal capacity of 1,000 units. It sold 900 units
at a price of P50 per unit.
• The following costs were incurred during the year:
Total Cost per
Cost Unit
Variable selling and
Direct materials P12,000 P12 administrative cost per unit
Direct labor 10,000 10 =
Variable manufacturing 8,000 8 Total cost
overhead
Units sold
Fixed manufacturing overhead 6,000 6
Variable selling and 4,500 5
administrative
ILLUSTRATION

Required:
1. Product costs per unit under absorption and variable
costing.
2. Income under absorption costing.
3. Income under variable costing.
4. Computation of and accounting for the difference in
income.
 PRODUCT COSTS PER
UNIT
Absorption Variable  The difference between the two
Costing Costing product costs per unit is the fixed
manufacturing overhead per unit.
Direct materials P12 P12  Under both methods, selling and
Direct labor 10 10 administrative costs, whether
Variable manufacturing 8 8 variable or fixed, are treated as
overhead period costs.
Fixed manufacturing 6 -
overhead
Income under absorption costing
Sales (900 units x P50) P45,000
Less cost of goods sold (900 x P36) 32,400
Gross income P12,600
Less selling and administrative
expenses P4,500
Variable (900 x P5) 3,000 7,500
Fixed
Income – absorption costing P 5,100
Income under variable costing
Sales (900 units x P50) P45,000
Less variable costs
Cost of goods sold (900 x P30) P27,000
Selling and administrative (900 x 4,500 31,500
P5)
Contribution margin P13,500
Less fixed costs
Manufacturing overhead P 6,000
Selling and administrative 3,000 9,000
Computation of and accounting for the difference in income

Absorption costing income

P5,100
Variable costing income 4,500
Difference in income P
600

Accounting:
Change in inventory [Production less Sales] (1,000 – 900)
100 units
STANDARD COSTS UNDER ABSORPTION
AND VARIABLE COSTING

• When a firm uses the standard costing system and income

statements are prepared under the absorption and variable
costing methods:
1. Cost of goods sold are computed at standard.
2. The standard cost of goods sold is adjusted to actual costs by
adding unfavorable variances and/or deducting favorable
variances.
3. In absorption costing, both the variable and fixed manufacturing
cost variances are used as adjustment to the standard cost of
goods sold.
4. In variable costing, only the variable manufacturing cost
variances are used as adjustments to the standard cost of goods
sold.
ILLUSTRATION

• Irish Corporation uses a standard costing system for a

product that it manufactures. For the year 200A, the
following standards were established based on normal
production of 1,000 units: Cost per
Unit
Materials 2 pcs. @ P6 per P12
piece
Labor 5 hrs. @ P4 per 20
hour
Variable manufacturing overhead 5 hrs. @ P3 per 15
hour
Fixed manufacturing overhead 5 hrs. @ P2 per 10
hour
Total standard cost per unit P57
ILLUSTRATION

• Following are the actual data for the year 200A:

Production 1,100
units
Sales 950 units
Selling price P80
Materials (2,250 @ P5.80) 13,050
Labor (5,420 hrs. @ P4.30 per 23,306
hour)
Variable manufacturing overhead 15,718
Fixed manufacturing overhead 12,000
Selling and administrative Variable 5,700
expenses
Fixed 8,000
ILLUSTRATION

Required:
1. Variances for each cost element of production.
2. Operating income under absorption costing and variable costing
methods.
3. Values of actual ending finished goods inventory under absorption
costing and variable costing methods.
4. Total fixed costs expensed under absorption costing and variable
costing methods.
5. Actual manufacturing contribution margin under variable costing
method.
6. Actual contribution margin under variable costing method.
7. Total variable costs expensed under absorption costing and variable
costing methods.
 Variances
Actual costs
- Standard costs
Variances .

Standard costs
Actual production
x Standard cost per
unit
Standard costs
Standard costs: .
Materials 1,100 x P12
= P13,200
Labor 1,100 x 20
= 22,000
Variable MOH 1,100 x 15
= 16,500
Materials Labor Var. MOH Fxd. MOH
Fixed MOH 1,100 x 10
Actual costs =13,05011,00023,306 15,718 12,000
Standard costs 13,200 22,000 16,500 11,000
Variances 150 F 1,306 U 782 F 1,000 U
ILLUSTRATION

Required:
1. Variances for each cost element of production.
Kb
2. Operating income under absorption costing and variable costing
methods.
3. Values of actual ending finished goods inventory under absorption
costing and variable costing methods.
4. Total fixed costs expensed under absorption costing and variable
costing methods.
5. Actual manufacturing contribution margin under variable costing
method.
6. Actual contribution margin under variable costing method.
7. Total variable costs expensed under absorption costing and variable
costing methods.
 Absorption Costing Variable Costing
Sales (950 units x P80) P76,000 P76,000
Cost of goods sold/Variable costs:
Standard cost of goods sold:
(950 x P57) P54,150
(950 x P47) P44,650
Add (deduct) variances:
Materials–favorable (150) (150)
Labor –unfavorable 1,306 1,306
Variable MOH–favorable (782) (782)
Fixed MOH–unfavorable 1,000 -
Actual cost of goods sold P55,524 P45,024
Add variable S&A expenses - 5,700
Total cost of goods sold/Variable costs P55,524 P50,724
Gross income/Contribution margin P20,476 P25,276
Less operating expenses/Fixed costs
Fixed MOH - P12,000
Fixed S&A expenses 8,000 8,000
Variable S&A expenses 5,700 -
Total operating expenses/Fixed costs P13,700 P20,000
Income P 6,776 P 5,276
THE EXTREMES

• SUPERVARIABLE COSTING OR THROUGHPUT COSTING –

treats direct materials as the only variable costs.
• Only materials costs are inventoried; work-in-process or finished
goods inventories are not recorded.
• Direct labor and manufacturing overhead costs are all treated as
period costs, expensing them as they are incurred.
• Sales less cost of goods sold (purely materials) = Throughput
• Throughput costing results in even lower income than does variable
costing when production exceeds sales.
• Throughput costing penalizes high production and rewards low
production. Hence, it is very much in tune with JIT and other
philosophies that seek lower inventories.
• SUPERABSORPTION COSTING – treats costs from all links in
the value chain as inventoriable costs.