COLLEGE OF ENGINEERING AND ARCHITECTURE

MODULE 2

Topic 5: FULL ABSORPTION COSTING &

VARIABLE COSTING

5.1 Difference in Income Statement under Absorption Costing and Variable

Costing Methods

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, while in absorption costing, it is expensed 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 a 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

Add: Fixed overhead in the beginning inventory xx
Total xx
Less: Fixed overhead in the ending inventory xx
Variable costing income xx

Accounting for difference in income

Change in inventory (production less sales) xx

Multiply by: Fixed factory overhead cost per unit xx
Difference in income xx

5.2 Underlying Concept of Variable Costing

Absorption Costing or Full Costing

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- A product costing method that includes all the manufacturing costs (direct materials,
direct labor, and both the variable and fixed factory overhead) in the cost of a unit of
product.

Variable Costing
- A product costing method that includes only the variable manufacturing costs (direct
materials, direct labor, and variable overhead) in the cost of a unit of product.

Absorption Costing Variable Costing

Direct materials Direct materials
+ Direct labor + Direct labor
+ Variable factory overhead + Variable factory overhead
+ Fixed factory overhead + __________________
Product Costs Product Costs

5.3 Advantages and Disadvantages of Variable Costing

Advantages Disadvantages
Reports are simpler and more Segregation of costs into fixed and
understandable. variable might be difficult,
particularly in the case of mixed
costs.
Data needed for break-even and cost- The matching principle is violated by
volume-profit analyses are readily using variable costing which excludes
available. fixed overhead from product costs
and charges the same to period costs
regardless of production and sales.
The problems involved in allocating fixed With variable costing, inventory
costs are eliminated. costs and other related accounts,
Variable costing is more compatible with such as working capital, current
the standard cost accounting system. ratio, and acid-test ratio are
Reports provide useful information for understated because of the
pricing decisions and other decision- exclusion of fixed overhead in the
making problems encountered by computation of product cost.
management.

5.4 Comparison between Variable Costing and Absorption Costing

Absorption Costing Variable Costing

Cost segregation Seldom aggregates costs into Complicated in formation
variable and fixed costs. and operation
Cost of inventory Cost of inventory includes all the Greater degree of
manufacturing costs: materials, government control and
labor, variable factory overhead, supervision
and fixed factory overhead.
Treatment of Fixed factory overhead is treated as Centralized management
fixed factory product costs.
overhead
Income Distinguishes between production Distinguishes between
Statement and other costs. variable and fixed costs.

Sales xx Sales xx
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Less: Cost of goods sold xx Less: Variable costs xx

Gross profit xx Contribution margin xx
Less: Operating expenses xx Less: Fixed costs xx
Net profit xx Net profit xx
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 expenses during an accounting period. This is due to
variations between sales and production. In the long run,
however, both methods give substantially the same results since
sales cannot continuously exceed production, nor production can
continually exceed sales.

5.5 Nature and Characteristics of Product Cost and Period Cost

Product Cost Period Cost

Cost that is charged against current Cost that is included in the
revenue during a time period regardless
computation of product cost that is
of the difference between production apportioned between the sold and
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 period Reduces current income by the
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.

5.6 Illustrative Example of Variable and Absorption Costing

During the year 2021, ABC 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 Cost per unit
Direct material P12,000 P12
Direct labor 10,000 10
Variable factory overhead 8,000 8
Fixed factory overhead 6,000 6
Variable operating expenses 4,500 5*
Fixed operating expenses 3,000 3

* Variable operating expenses cost per unit = Total = P4,500 = P5

Units sold 900
Required:
a. Product costs per unit under absorption and variable costing
b. Income under absorption costing
c. Income under variable costing
d. Computation of and accounting for the difference in income

Solutions:
a. Product Costs Per Unit
Absorption Variable
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Costing Costing
Direct materials P12 P12
Direct labor 10 10
Variable factory overhead 8 8
Fixed factory overhead 6 ___
Product cost per unit P36 P30

The difference between the two product costs per unit is the fixed factory overhead
per unit. Under both methods, operating expenses, whether variable or fixed, are
treated as period costs.

b. 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: Operating expenses:
Variable (900 x P5) P4,500
Fixed 3,000 7,500
Income – Absorption costing P 5,100

Allocation of fixed overhead cost:

Total fixed overhead (1,000 units x P6 per unit) P 6,000
Charged to cost of goods sold
(900 units sold x P6 per unit) P5,400
Allocated to inventory cost
(100 unsold units x P6) 600 P 6,000

Cost of ending inventory:

Number of units (1,000 units produced – 900 units sold) 100
x Cost per unit – absorption P36
Cost of ending inventory P3,600*

* Includes fixed overhead cost of P600.

c. Income under variable costing

Sales (900 units x P50) P45,000

Less: Variable cost:
Cost of goods sold (900 x P30) P27,000*
Operating expenses (900 x P5) 4,500 31,500
Contribution margin P13,500
Less: Fixed cost:
Factory overhead P6,000**
Operating expenses 3,000 9,000
Income – Variable costing P 4,500

* The cost of goods sold consists of variable manufacturing costs only. Fixed factory
overhead is not charged to the cost of goods sold.

** The whole amount of fixed factory overhead is charged as a period cost,

regardless of whether all the units produced were sold or not.

Cost of ending inventory:

Number of units 100
x Cost per unit – variable P30
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Cost of ending inventory P3,000*

* Consists of variable manufacturing costs only. Fixed factory overhead is not an

inventoriable cost.

d. Computation of and accounting for the difference in income

Absorption costing income P5,100

Variable costing income 4,500
Difference in income P 600

The difference in income represents the amount of fixed factory overhead charged
to inventory (treated as asset).

Accounting:
Change in inventory (production – sales) 100 units
(1,000 – 900)
x Fixed factory overhead cost per unit P 6
Difference