ABSORPTION AND VARIABLE COSTING

Comparison:

Absorption(Full Costing) Variable(Direct Costing)

Inclusion in the cost of a unit of All mfg. costs (DM, DL, VFOH,
product FxFOH)
Treatment of FxFOH Product cost
Inventories Peso amount is higher
Rationale Advocates believe that all mfg. costs
– variable and fixed – are essential
to the production process and should
not be ignored when determining
product costs.
Acceptability for financial and Acceptable since treating FxFOH as
tax purposes inventoriable cost is consistent with
accounting standards.
Income statement Distinguishes between production
and other costs; [sales less
appropriate production costs equals
gross profit less other costs equals
income].
Changes in production volume Net income affected
Only variable mfg. costs (DM, DL
(and VFOH)
Period cost
Peso amount is always smaller
Advocates argue that fixed mfg.
costs are incurred whether or not the
capacity is actually used to make
output; thus, having no future service
potential, should be charged against
the period and not included in the
product cost.
Not acceptable since it violates the
‘matching principle’.
Distinguishes between variable and
fixed costs; [revenue less variable
costs equals contribution margin less
fixed costs equals income].
Net income not affected

 Income computed by variable costing may differ from income computed by absorption costing because of the
difference in the amount of FxFOH recognized as expense during the accounting period, and the difference
between production and sales volume. In the long run, both methods would yield the same results since sales
cannot continuously exceed production, nor production can continuously exceed sales.
 The cause of the difference between income computed under both costings is primarily when to recognize
FxFOH as an expense, since in
 Variable costing, FxFOH is expensed when incurred;
 Absorption costing, FxFOH is expensed in the period when the units to which it relates are sold.

Income patterns indicated by the relationship between production and sales:

1. When production = sales, there is no change in inventory.

 FxFOH equal in both costings

Prod’n.= sales then income (Abs) = Income (Var)

2. When production > sales, there is increase in inventory.

 FxFOH expensed (Abs) <FxFOH expensed (Var)

Prod’n> sales then income (Abs) > income (Var)

3. When production < sales, there is decrease in inventory.

 FxFOH expense (Abs) >FxFOH expensed (Var)

Prod’n< sales then income (Abs) < income (Var)

Point of Reconciliation:

Income, absorption costing xxx

Add: FxFOH in beginning inventory xxx
Total xxx
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Less: FxFOH in ending inventory xxx
Income, variable costing xxx
===
or in income = in inventory x FxFOH/u

Advantages of using variable costing and the contribution approach in internal reports and analysis:

1. More useful for CVP analysis (since they categorize costs on the basis of their behavior).
2. Income is not affected by changes in production volume
3. Avoids misunderstandings concerning unit product costs.
4. Fixed costs are more visible.
5. Understandability (because data are organized by behavior).
6. Control is facilitated (since it ties in with cost control methods such as flexible budgets).
7. Incremental analysis is more straight-forward (since it corresponds closely with the current out-of-pocket
expenditure necessary to produce and sell products and services and can therefore be used more readily in
incremental analysis).

Disadvantages:

1. Not in accordance with GAAP

2. Segregation of costs into fixed and variable might be difficult.
3. Matching principle is violated.
4. Inventory costs and other related accounts, such as working capital, current ratio and acid-test ratio are
understated because of the exclusion of FxFOH in the computation of product cost.

Exercises:

1. A company operated at a normal capacity of 1,000 units in the year 2020. The company sold 80% of these
units at a price of P12 per unit. Manufacturing costs incurred during the year are as follows:

Manufacturing:
Materials P1,500
Labor 1,000
Variable FOH 500
Fixed FOH 2,000
Selling and Administrative:
Variable P1,500
Fixed 800

Required:
a. Inventory cost per unit under absorption and variable costing.
b. Cost of ending inventory under absorption and variable costing.

2. A company makes state-of-the-art product. Each product sells for P2,000 each. Data for its operations are as
follows:

Units:
Beginning inventory 5
Production 80
Ending inventory 15
Variable Costs:
Direct materials P24,000
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 Direct labor 16,000
Factory overhead 8,000
Selling and administrative 4,000
Fixed Costs:
Factory overhead P20,000
Selling and administrative 2,000

Required:
a. Prepare income statement under both absorption and variable costing.
b. Provide computations explaining the differences in income between the two costing methods.

3. The following information are taken from the books of a company which assumes FIFO for inventory cost flow:

Inventory (in units) 2019 2020

Beginning inventory -none- ???
Production 10,000 u 9,000 u
Ending inventory 3,500 u 1,000 u

Sales (P2/unit) ??? ???

Variable manufacturing costs P7,500 P6,750
Fixed manufacturing costs P5,000 P5,400
Selling & admin. costs (50% variable) P4,500 P7,500

Required:
a. Determine 2019 profit under variable and absorption costing.
b. Reconcile the two income figures in letter a.
c. Determine the 2020 profit under variable and absorption costing.
d. Reconcile the two income figures in letter c.

4. A company manufactures a single product. Unit variable production costs are P20 and fixed production costs are
P150,000. It uses a normal activity of 10,000 units. It began the year with no inventory, produced 12,000 units and
sold 7,500 units.

Required: Determine -
a. The product cost under variable costing
b. The product cost under absorption costing
c. Capacity or volume variance under absorption costing
 Note: capacity/volume variance = (actual less normal production) x FxFOH/u

5. A company has operating income of P50,000 using direct costing for a given period. Beginning and ending
inventories for that period were 13,000 units and 18,000 units, respectively. The fixed factory overhead application
rate is P2 per unit.

Required: Determine the operating income using absorption costing.

6. A company has 16,000 units in its beginning inventory. During the year, the company’s variable production costs
were P6 per unit and its fixed manufacturing overhead costs were P4 per unit. The company’s net income for the
year was P24,000 lower under absorption costing than it was under variable costing.

Required: the number of units in the ending inventory

7. In its first year of operations, a company had the following costs when it produced 100,000 and sold 80,000 units
of its only product:

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 Mfg. Costs – Fixed P180,000
Variable 160,000
Selling and admin. costs – Fixed 90,000
Variable 40,000

Required: Determine how much lower the company’s net income would be if it used variable costing instead of full
absorption costing.

8. At the end of a company’s first year of operations, 1,000 units of inventory remained on hand. Variable and fixed
manufacturing costs per unit were P90 and P20, respectively.

Required: Determine how much higher the pre-tax income would be of the company uses absorption rather than
variable costing.

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