ABSORPTION AND VARIABLE COSTING

INCOME AND PERFORMANCE EVALUATION

 One of the tools for performance evaluation is the assessment of the entity’s financial performance- income.
 Income is used as a measurement of the performance both in the totality of an entity and by reporting segments
or departments.
 This poses a question – How should income be correctly measured by an entity?
 Cost information provided by cost accounting is a vital information used by the management in order for them to
determine how much a product or service costs them.
 To be able to generate target income, costs and expenses that are matched against revenues should be clearly
determined.
 Going back to the default basic goal of cost management, costs should be properly managed and regulated to
achieve higher profits.

PRODUCT COSTING METHODS

ABSORPTION COSTING  Also known as full costing method.

 Used in presenting income information to external users of accounting
Sales xx,xxx information.
Less: Cost of goods sold (x,xxx)  In conformity with GAAP.
Grofit profit x,xxx  All direct materials, direct labor, variable manufacturing overhead, and
Less: Operating expenses (x,xxx) fixed manufacturing overhead forms part of the cost of the products.
Net income xx,xxx  Variable and fixed selling and administrative expenses forms part of
operating expenses.
 Product costs are split into two- finished goods inventory when unsold
and cost of goods sold upon selling.

VARIABLE COSTING
Sales
Less: Variable costs
Contribution margin
Less: Fixed costs
Net income
 Also known as contribution margin approach.
xx,xxx  Used in presenting income information to internal users of accounting
(x,xxx) information.
 Not in conformity with GAAP.
x,xxx
 Direct materials, direct labor, and all variable costs are deducted to sales to
(x,xxx)
determine contribution margin.
xx,xxx  All fixed costs during the period are deducted against the contribution margin
to determine net income.

FEATURES OF VARIABLE COSTING

 Costs are identified as variable cost and fixed cost, not COGS and OPEX.
 Fixed manufacturing overhead is treated as a period cost and is charged directly of the entire amount matched against
revenues for that period.
 Variable costing recognizes that only production costs that vary directly with the volume of production shall be
“treated” as product cost. Fixed manufacturing overhead shall become a period cost since whatever level of
production, they will still be incurred.
 Under variable costing, fixed overhead costs must not become product costs. If in the event an entity has zero
production, inventory costs would still amount to the fixed overhead costs itself even if in reality, there’s no
inventory.
The main difference between variable costing method and absorption costing method is the treatment of FIXED
MANUFACTURING OVERHEAD.

 In absorption costing, fixed manufacturing overhead is part of product costs. With that, fixed manufacturing overhead
related to unsold products becomes part of finished goods inventory and will only be charged against revenue at the
point of sale. Thus, in comparison with variable costing, there is a “deferred fixed overhead” cost not charged against
revenue until products are sold.
 In variable costing, all fixed manufacturing overhead is charged and matched against sales, thereby all fixed overhead
is deducted to sales. There is no deferral of fixed overhead in relation to inventory, thus providing a more precise
measurement of income on the premise that “whatever the level of production and sale, we will still be incurring
these fixed overhead costs”.

PRO-FORMA (and explanatory) STATEMENTS OF INCOME

ABSORP COSTING (GAAP Income Statement)

Jungkook Company                
Income Statement                  
For the period ended December 31, 2021              
                     
Sales     Units sold x selling price         xx,xxx
Less: cost of goods sold Units sold x direct material cost per unit        
      Units sold x direct labor cost per unit        
      Units sold x variable overhead cost per unit      
      Units sold x (total fixed overhead cost/units produced)   (x,xxx)
Gross profit                 xx,xxx
Less: Operating expenses Units sold x variable selling and administrative expenses per unit  
      Total fixed selling and administrative expenses     (x,xxx)
Net Income                 xx,xxx

VARIABLE COSTING (Contribution Margin Income Statement)

Jungkook Company                
Contribution Margin Income Statement              
For the period ended December 31,2021              
                     
Sales     Units sold x selling price         xx,xxx
Less: Variable costs                  
Variable COGS   Units sold x direct material cost per unit        
      Units sold x direct labor cost per unit        
      Units sold x variable overhead cost per unit      
Variable S/A expenses Units sold x variable selling and adminstrative expenses per unit (x,xxx)
Contribution margin               xx,xxx
Less: Fixed costs   Total fixed manufacturing overhead costs      
      Total fixed selling and administrative expenses     (x,xxx)
Net Income                 xx,xxx

PRACTICE PROBLEM #1 (Production = Sales; No ending inventory)

BTS Company makes BT21 laptop tables that sells for ₱250each. The company’s annual production and sales level is
120,000 laptop tables. In addition to ₱4,305,000 fixed manufacturing overhead and ₱1,590,500 fixed administrative
expenses, the following per-unit costs have been determined for each laptop table:
Direct materials ₱60.00
Direct labor 30.00
Variable manufacturing overhead 8.00
Variable selling expense 22.00
Total variable cost per unit ₱120.00

Prepare the entity’s GAAP income statement and internal contribution margin income statement. Ignore tax effects.

1.) GAAP Income Statement

BTS Company
Income Statement
For the year ended December 31, 2021

Sales (120,000 laptop tables * ₱250) ₱30,000,000.00

Less: cost of goods sold
Direct materials (120,000 laptop tables * ₱60) ₱7,200,000.00
Direct labor (120,000 laptop tables * ₱30) 3,600,000.00
Variable manufacturing overhead (120,000 laptop tables * ₱8) 960,000.00
Fixed manufacturing overhead (120,000 laptop tables * ₱35.875) 4,305,000.00 16,065,000.00
Gross profit 13,935,000.00
Less: Operating expenses
Variable selling expenses (120,000 laptop tables * ₱22) 2,640,000.00
Fixed administrative expenses 1,590,500.00 4,230,500.00
Net Income ₱9,704,500.00

2.) Internal Contribution Margin Income Statement

BTS Company
Contribution Margin Income Statement
For the year ended December 31, 2021

Sales (120,000 laptop tables * ₱250) ₱30,000,000.00

Less: Variable costs
Direct materials (120,000 laptop tables * ₱60) ₱7,200,000.00
Direct labor (120,000 laptop tables * ₱30) 3,600,000.00
Variable manufacturing overhead (120,000 laptop tables * ₱8) 960,000.00
Variable selling expenses (120,000 laptop tables * ₱22) 2,640,000.00 ₱14,400,000.00
Gross profit 15,600,000.00
Less: Fixed costs
Fixed manufacturing overhead 4,305,000.00
Fixed administrative expenses 1,590,500.00 5,895,500.00
Net Income ₱9,704,500.00

POINTS TO CONSIDER!!!
 When production level = sales level, there will be equal amounts of net income under absorption costing and variable
costing.
 When production level = sales level, there is no inventory left. Therefore, there will be no fixed manufacturing
overhead cost that will be retained as ending inventory to be deferred next period as a matching to revenues.
 When production level = sales level, all costs were released and matched against revenue. All manufacturing costs
were charged as cost of goods sold.
PRACTICE PROBLEM #2 (Production > Sales; No beginning inventory, ending inventory retained)
BTS Company makes BT21 laptop tables that sells for ₱250each. The company’s annual production level is 120,000
laptop tables. 100,000 tables were sold. In addition to ₱4,305,000 fixed manufacturing overhead and ₱1,590,500 fixed
administrative expenses, the following per-unit costs have been determined for each laptop table:
Direct materials ₱60.00
Direct labor 30.00
Variable manufacturing overhead 8.00
Variable selling expense 22.00
Total variable cost per unit ₱120.00

1. Prepare the entity’s GAAP income statement and internal contribution margin income statement. Ignore tax effects.
2. Reconcile absorption costing net income and variable costing net income.

Requirement #1. GAAP Income Statement

BTS Company
Income Statement
For the year ended December 31, 2021

Sales (100,000 laptop tables * ₱250) ₱25,000,000.00

Less: cost of goods sold
Direct materials (100,000 laptop tables * ₱60) ₱6,000,000.00
Direct labor (100,000 laptop tables * ₱30) 3,000,000.00
Variable manufacturing overhead (100,000 laptop tables * ₱8) 800,000.00
Fixed manufacturing overhead (100,000 laptop tables * ₱35.875) 3,587,500.00 13,387,500.00
Gross profit 11,612,500.00
Less: Operating expenses
Variable selling expenses (100,000 laptop tables * ₱22) 2,200,000.00
Fixed administrative expenses 1,590,500.00 3,790,500.00
Net Income ₱7,822,000.00

Requirement #1. Internal Contribution Margin Income Statement

BTS Company
Contribution Margin Income Statement
For the year ended December 31, 2021

Sales (100,000 laptop tables * ₱250) ₱25,000,000.00

Less: Variable costs
Direct materials (100,000 laptop tables * ₱60) ₱6,000,000.00
Direct labor (100,000 laptop tables * ₱30) 3,000,000.00
Variable manufacturing overhead (100,000 laptop tables * ₱8) 800,000.00
Variable selling expenses (100,000 laptop tables * ₱22) 2,200,000.00 ₱12,000,000.00
Gross profit 13,000,000.00
Less: Fixed costs
Fixed manufacturing overhead 4,305,000.00
Fixed administrative expenses 1,590,500.00 5,895,500.00
Net Income ₱7,104,500.00

POINTS TO CONSIDER!!!
 When production level > sales level, absorption costing net income is greater than variable costing net income.
 In absorption costing, the fixed manufacturing overhead component of ending inventory has been deferred to be
charged to revenue in the next period.
 In variable costing, all fixed manufacturing overhead have been deducted to obtain net income.
 With these, absorption costing net income will be greater than variable costing net income.

Requirement #2. Reconcile absorption costing net income and variable costing net income.
Fixed manufacturing overhead component and ending inventory: 20,000 laptop tables x ₱35.875 = ₱717,500

RECONCILIATION
Absorption costing net income ₱7,822,000.00
Less: Fixed manufacturing overhead component of ending inventory
20,000 laptop tables x ₱35.875 717,500.00
Variable costing net income ₱ 7,104,500.00

Variable costing net income ₱ 7,104,500.00

Add: Fixed manufacturing overhead component of ending inventory
20,000 laptop tables x ₱35.875 717,500.00
Absorption costing net income ₱ 7,822,000.00

PRACTICE PROBLEM #3 (Production < Sales; With beginning inventory and ending inventory)
BTS Company makes BT21 laptop tables that sells for ₱250each. The company’s annual production level is 120,000
laptop tables. There were 50,000 unsold laptop tables from last year. 140,000 tables were sold this year. In addition to
₱4,305,000 fixed manufacturing overhead and ₱1,590,500 fixed administrative expenses, the following per-unit costs
have been determined for each laptop table:

1. Prepare the entity’s GAAP income statement and internal contribution margin income statement. Ignore tax effects.
2. Reconcile absorption costing net income and variable costing net income.

Requirement #1. GAAP Income Statement

BTS Company
Income Statement
For the year ended December 31, 2021

Sales (140,000 laptop tables * ₱250) ₱35,000,000.00

Less: cost of goods sold
Direct materials (140,000 laptop tables * ₱60) ₱8,400,000.00
Direct labor (140,000 laptop tables * ₱30) 4,200,000.00
Variable manufacturing overhead (140,000 laptop tables * ₱8) 1,120,000.00
Fixed manufacturing overhead (140,000 laptop tables * ₱35.875) 5,022,500.00 18,742,500.00
Gross profit 16,257,500.00
Less: Operating expenses
Variable selling expenses (140,000 laptop tables * ₱22) 3,080,000.00
Fixed administrative expenses 1,590,500.00 4,670,500.00
Net Income ₱11,587,000.00
Requirement #1. Internal Contribution Margin Income Statement
BTS Company
Contribution Margin Income Statement
For the year ended December 31, 2021

Sales (140,000 laptop tables * ₱250) ₱35,000,000.00

Less: Variable costs
Direct materials (140,000 laptop tables * ₱60) ₱8,400,000.00
Direct labor (140,000 laptop tables * ₱30) 4,200,000.00
Variable manufacturing overhead (140,000 laptop tables * ₱8) 1,120,000.00
Variable selling expenses (140,000 laptop tables * ₱22) 3,080,000.00 ₱16,800,000.00
Gross profit 18,200,000.00
Less: Fixed costs
Fixed manufacturing overhead 4,305,000.00
Fixed administrative expenses 1,590,500.00 5,895,500.00
Net Income ₱12,304,500.00

POINTS TO CONSIDER!!!
 When production level < sales level, absorption costing net income is lesser than variable costing net income.
 In absorption costing, the fixed manufacturing overhead component of beginning inventory is now deducted to the
current period to obtain net income.
 In variable costing, only the cost for the current period are deducted to obtain net income.
 With these, absorption costing net income will be lesser than variable costing net income.

Requirement #2. Reconcile absorption costing net income and variable costing net income.
Fixed manufacturing overhead component of beginning inventory: 50,000 laptop tables x ₱35.875 = ₱1,793,750
Fixed manufacturing overhead component and ending inventory: 30,000 laptop tables x ₱35.875 = ₱1,076,250

RECONCILIATION
Absorption costing net income ₱11,587,000.00
Add: Fixed manufacturing overhead component of beginning inventory
50,000 laptop tables x ₱35.875 1,793,750.00
Less: Fixed manufacturing overhead component of ending inventory
30,000 laptop tables x ₱35.875 -1,076,250.00
Variable costing net income ₱12,304,500.00

Variable costing net income ₱ 12,304,500.00

Less: Fixed manufacturing overhead component of beginning inventory
50,000 laptop tables x ₱35.875 -1,793,750.00
Add: Fixed manufacturing overhead component of ending inventory
30,000 laptop tables x ₱35.875 1,076,250.00
Absorption costing net income ₱ 11,587,000.00

Reconciliation
 If production = sales, ACNI = VCNI ACNI VCNI
 If production > sales, ACNI > VCNI + Fixed cost BI - Fixed cost BI
 If production < sales, ACNI < VCNI - Fixed cost EI + Fixed cost EI
VCNI ACNI