Module 03

ABSORPTION & VARIABLE COSTING

STUDY OBJECTIVES
After studying this chapter, you should be able to:
□ Define and explain variable and absorption costing.
□ Explain the difference between variable and absorption costing and calculate unit product cost
under each method.
□ Prepare income statements using variable costing and absorption costing.
□ Understand why net operating income usually different under variable costing technique
compared to the operating income under absorption costing technique.
□ Identify the advantages and disadvantages of using absorption or full costing method.
□ Reconcile correctly incomes from both absorption and variable costing methods.

ASSIGNMENT O3 (Please use your Assignment/Worksheet/Quiz Notebook)

Essay
1. Differentiate product costs from period costs.
2. What constitutes the product costs used in absorption costing technique and in variable
costing technique?
3. What are the common classifications of costs/expenses in a traditional income
statement and in a contribution format income statement?
4. What is the relationship of the quantity of production and sales in the net operating
income computation under absorption costing method and variable costing method?

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VARIABLE COSTING VS. ABSORPTION COSTING
"Managerial accounting is quite different from financial accounting. External reporting rules are
replaced by internal specifications as to how data are to be accumulated and presented. Hopefully,
these internal specifications are sufficiently logical that they enable good economic decision
making." Now that you have accumulated knowledge on various managerial accounting concepts, you
are in a good position to look more closely at some of the techniques for internal reporting. This
lesson's initial topic pertains to an internal reporting method for measuring and presenting inventory
and income, known as variable costing.

 ABSORPTION COSTING

Before diving into the specifics of variable costing, let's revisit the basic tenants of the traditional
approach known as absorption costing (also known as "full costing"). Generally accepted
accounting principles require absorption costing for external reporting. Under absorption
costing, normal manufacturing costs are considered product costs and included in inventory. As
sales occur, the cost of inventory is transferred to cost of goods sold; meaning that the gross
profit is reduced by all costs of manufacturing, whether those costs relate to direct materials,
direct labor, variable manufacturing overhead, or fixed manufacturing overhead. Selling,
general, and administrative costs (SG&A) are classified as period expenses.

The rationale for absorption costing is that it causes a product to be measured and reported at
its complete cost. Just because costs like fixed manufacturing overhead are difficult to identify
with a particular unit of output does not mean that they were not a cost of that output. As a
result, such costs are allocated to products. However valid the claims are in support of
absorption costing, the method does suffer from some deficiencies as it relates to enabling
sound management decisions. These deficiencies will become clear as you examine variable
costing. For now, suffice it to say that absorption costing information may not always provide
the best signals about how to price a product, reach conclusions about discontinuing a product,
and so forth.

 Required under GAAP for FS distributed to external users

 Under absorption costing, the cost of goods manufactured (“Inventory”) includes
direct materials, direct labor, and factory overhead costs. Both fixed and
variable factory costs are included as part of factory overhead. In the financial
statements, these costs are included in Cost of Goods Sold (income statement)
and Inventory (balance sheet).


 VARIABLE COSTING

To mitigate for deficiencies in absorption costing data, strategic finance professionals will often
generate supplemental data based on variable costing techniques. As its name suggests, only
variable production costs are assigned to inventory and cost of goods sold. These costs generally
consist of direct materials, direct labor, and variable manufacturing overhead. Fixed
manufacturing costs are regarded as period expenses along with SG&A costs.

The variable costing approach shifts fixed manufacturing costs from the product cost category
to the period cost group. In some ways, this understates the true cost of production. How then
can it aid in decision making? The short answer is that the fixed manufacturing overhead is
going to be incurred no matter how much is produced. In the long run, a business must recover
those costs to survive. But, on a case by case basis, including fixed manufacturing overhead in a
product cost analysis can result in some very wrong decisions.

 For internal use in decision making that managers often use

 a.k.a. Direct Costing
 Under variable costing, the cost of goods manufactured (“Inventory”) includes
direct materials, direct labor, and variable factory overhead costs. Fixed factory
costs are included as part of period expense.
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 Summary of Concepts between Absorption Costing and Variable Costing

Cost classifications – Absorption versus Variable Costing

ABSORPTION VARIABLE COSTING
COSTING
Direct Materials
Direct Labor Product Cost
Product Cost
Variable Manufacturing overhead
Fixed Manufacturing overhead
Variable Selling and Administrative Expense Period Cost
Period Cost
Fixed Selling and Administrative Expenses

UNIT COST COMPUTATION/CALCULATION

To illustrate the computation/calculation of unit product costs under both absorption and variable
costing consider the following example.

Example:
A small company that produces a single product has the following cost structure
Number of units produced 6,000
Variable costs per unit:
Direct materials P2
Direct labor P4
Variable manufacturing overhead P1
Variable selling and administrative expenses P3
Fixed costs per year:
Fixed manufacturing overhead P30,000
Fixed selling and administrative expenses P10,000

Required:
1. Compute the unit product cost under absorption costing method.
2. Compute the unit product cost under variable / marginal costing method.

Unit product Cost - Absorption Costing Method

Direct materials P2
Direct labor P4
Variable manufacturing overhead P1
Fixed manufacturing overhead (P30,000/6,000 units) P5
Unit production cost P12

Unit product Cost – Variable Costing Method

Direct materials P2
Direct labor P4
Variable manufacturing overhead P1
Unit production cost P7

Under the absorption costing, notice that all production costs, variable and fixed, are included
when determining the unit product cost. Thus if the company sells a unit of product and
absorption costing is being used, then P12 (consisting of P7 variable cost and P5 fixed cost) will be
deducted on the income statement as cost of goods sold. Similarly, any unsold units will be carried
as inventory on the balance sheet at P12 each.

Under variable costing, notice that all variable costs of production are included in product costs.
Thus if the company sells a unit of product, only P7 will be deducted as cost of goods sold, and
unsold units will be carried in the balance sheet inventory account at only P7.

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INCOME COMPARISON OF VARIABLE AND ABSORPTION COSTING

How to determine the OPERATING PROFIT MARGIN…

TRADITIONAL INCOME STATEMENT CONTRIBUTION FORMAT INCOME

(commonly used in Absorption Costing) STATEMENT
(commonly used in Variable Costing)

Sales XXX Sales XXX

Cost of goods sold XXX Variable COGS XXX
Gross profit XXX Manufacturing Margin XXX
SAE XXX Variable SAE XXX
Income from operations XXX Contribution Margin XXX
Fixed costs:
Fixed Mfg. Costs XXX
Fixed SAE XXX XXX
Income from operations XXX

The income statements prepared under absorption costing and variable costing usually
produce different net operating income figures. This difference can be quite large though
there can also be times that they are equal. Consider the following example:

Example:

Following data relates to a manufacturing company:

Number of units produced each year 6,000

Variable cost per unit:

Direct materials P2
Direct labor P4
Variable Manufacturing Overhead P1
Variable selling and Administrative expenses P3

Fixed costs per year:

Fixed manufacturing overhead P30,000
Fixed selling and administrative expenses P10,000

Units in beginning inventory 0

Units produced 6,000
Units Sold 5,000
Units in ending inventory 1,000
Selling price per unit P20

Selling and administrative expenses:

Variable per unit P3
Fixed per year P10,000

Required:

1. Prepare income statements using:

a. Absorption costing system
b. Variable costing system

2. Prepare a reconciliation schedule

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 Absorption Costing Income Statement

Sales (5,000 units×P20 per unit) P100,000

Less: Cost of goods sold
Beginning inventory P0
Add: Cost of goods manufactured (6,000 units×P12per unit) P72,000
Goods available for sale P72,000
Less: Ending inventory P12,000
Cost of goods sold P60,000
Gross Margin (P100,000 – P60,000) P40,000
Less: Selling and administrative expenses
Variable selling and administrative expenses (5,000 × P3) P15,000
Fixed selling and administrative expenses P10,000
P25,000
Net operating income (P40,000 – P25,000) P15,000
========

Variable Costing Income Statement

Sales (P5,000units×P20 per unit) P100,000

Less: Variable expenses
Variable cost of goods sold:
Beginning inventory P0
Add: Variable manufacturing costs(6,000 units×P7 per unit) P42,000
Goods available for sale P42,000
Less: Ending inventory (1,000 units×P7 per unit) P 7,000
Variable cost of goods sold P35,000
Variable selling and administrative expenses P15,000 50,000
(5,000 units × P3 per unit)

Contribution margin (P100,000 − P50,000) 50,000

Less: Fixed expenses
Fixed manufacturing overhead P30,000
Fixed selling and administrative expenses P10,000
40,000
Net operating Income (P50,000 − P40,000) P10,000
=======

Several points can be noted from the income statements prepared above:

Under absorption costing, if inventories increase then some of the fixed manufacturing costs of the
current period will not appear on the income statement as part of cost of goods sold. Instead, these costs
are deferred to a future period and are carried on the balance sheet as part of the inventory account. Such
a deferral of cost is known as fixed manufacturing overhead deferred in inventory.

The process involved can be explained by referring to income statements prepared above. During the
current period 6,000 units have been produced but only 5,000 units have been sold leaving 1,000 unsold
units in the ending inventory. Under the absorption costing system each unit produced was assigned P5
in fixed overhead cost. Therefore each unit going into inventory at the end of the period has P5 in fixed
manufactured overhead cost attached to it, or a total of P5,000 for 1,000 units (1,000 × P5). This fixed
manufacturing overhead cost of the current period deferred in inventory to the next period, when
hopefully these units will be taken out of inventory and sold. This deferral of P5,000 of fixed

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manufacturing overhead costs can be clearly seen by analyzing the ending inventory under the absorption
costing method:

Variable manufacturing costs (1,000 units × P7 per unit) P7,000

Fixed manufacturing overhead costs (1,000 × P5 per unit) P5,000
---------
Total ending inventory value P12,000
=======

In summary, under absorption costing, of the P30,000 in fixed manufacturing overhead costs incurred
during the period, only P25,000 (5,000 P per unit) has been included in the cost of goods sold. The
remaining P5,000 (1000 units not sold @ P5 per unit) has been deferred in inventory to the next period.

Under variable costing method the entire P30,000 in fixed manufacturing overhead costs has
been treated as an expense of the current period.

The ending inventory figure under the variable costing method is P5,000 lower than it is under
the absorption costing method. The reason is that under variable costing, only the variable
manufacturing costs are assigned to units of product and therefore included in the inventory:

Variable manufacturing costs (1000 units × P7 per unit) = P7,000

The P5,000 difference in ending inventories explains the difference in net operating income
reported between the two costing methods. Net operating is P5,000 higher under absorption
costing since, as explained above, P5,000 of fixed manufacturing overhead cost has been
deferred in inventory to the next period under that costing method. Hopefully, when the
units relating to this P5,000 fixed cost will be sold in the next period the cost attached to
these units will be included in the cost of goods sold of the next period. This is called fixed
manufacturing overhead cost released from inventory.

RECONCILIATION OF THE NET OPERATING INCOME

Formula:

Absorption Income xxx

+: Beg. Inventory units @ FFOH/u* xxx
-: End. Inventory units @ FFOH/u* xxx
Variable Income xxx

*FFOH/u = fixed factory overhead per unit

Using information from the illustrative example above,

Absorption Income P15,000

+: Beg. Inventory units @ FFOH/u 0 0 units x P5**
-: End. Inventory units @ FFOH/u 5,000 1,000 units x P5**
Variable Income P10,000

**FFOH/u = Total Fixed Manufacturing Overhead/No. of Units Produced

= P30,000/6,000 units
= P5

Also, differences in the operating income under the two methods can be computed by using this
formula:

∆ in Operating Income = ∆ in Inventory Units x FFOH/u

Note: The sign ‘∆’ denotes “change” or “difference”.

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Using information from the illustrative example above,

∆ in Operating Income = ∆ in Inventory Units x FFOH/u

= (End. Inventory units – Beg. Inventory units) x FFOH/u
= (1,000 units – 0 unit) x P5
= P5,000

EFFECTS ON INCOME FROM OPERATIONS

 IF, Units Manufactured = Units Sold

THEN, Absorption Costing Income = Variable Costing Income

 IF, Units Manufactured > Units Sold

THEN, Absorption Costing Income > Variable Costing Income

 IF, Units Manufactured < Units Sold

THEN, Absorption Costing Income < Variable Costing Income

ADVANTAGES AND DISADVANTAGES OF ABSORPTION COSTING SYSTEM

 ADVANTAGES OF ABSORPTION COSTING

 It recognizes the importance of fixed costs in production.

 When production remains constant but sales fluctuate absorption costing will
show less fluctuation in net profit and,
 Unlike marginal costing where fixed costs are agreed to change into variable cost,
it is cost into the stock value hence distorting stock valuation.

 DISADVANTAGES OF ABSORPTION COSTING

 As absorption costing emphasized on total cost namely both variable and fixed, it
is not so useful for management in making decision, planning and control;
 As the manager’s emphasis is on total cost, the cost volume profit relationship is
ignored. The manager needs to use his intuition to make the decision.

ADVANTAGES AND DISADVANTAGES OF VARIABLE COSTING SYSTEM

 LIMITATIONS OF VARIABLE COSTING

Practically speaking, absorption costing is required for external reports in the Philippines
and almost all over the world. A company that attempts to use variable costing (also
called direct costing and marginal costing) on its external financial reports runs the risk
that its auditors may not accept the financial statements as conforming to generally
accepted accounting principles (GAAP). Tax laws almost all over the world require the
usage of a form of absorption costing for filling out income tax forms.

Even if a company must use absorption costing for its external reports, a manager can
use variable costing statements for internal reports. No particular accounting problems
are created by using both costing methods--the variable costing method for internal
reports and the absorption costing method for external reports. The adjustment from
variable costing net operating income to absorption costing net operating income is a
simple one that can be easily made at year-end.

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 Top executives are typically evaluated based on the earnings reported to shareholders on
the external financial reports. This creates a problem for top executives who might
otherwise favor using variable costing for internal reports. They may feel that since they
are evaluated based on absorption costing reports, decisions should also be based on
absorption costing data.

 MAIN ADVANTAGES OF VARIABLE COSTING

 The data that are required for cost volume profit (CVP) analysis can be taken directly from a
variable costing format income statement. These data are not available on a conventional
income statement based on absorption costing.
 Under variable costing, the profit for a period is not affected by changes in inventories.
Other things remaining the same (i.e. selling prices, costs, sales mix, etc.), profits move in
the same direction as sales when variable costing is in use.
 Managers often assume that unit product costs are variable costs. This is a problem under
absorption costing, since unit product costs are a combination of both fixed and variable
costs. Under variable costing, unit product costs do not contain fixed costs.
 The impact of fixed costs on profits is emphasized under the variable costing and
contribution approach. The total amount of fixed costs appears explicitly on the income
statement. Under absorption, the fixed costs are mingled together with the variable costs
and are buried in cost of goods sold and in ending inventories.
 Variable costing data make it easier to estimate the profitability of products, customers, and
other segments of the business. With absorption costing, profitability is obscured by
arbitrary allocations of fixed costs.
 Variable costing ties in with cost control methods such as standard costs and flexible
budgets.
 Variable costing net operating income is closer to net cash flow than absorption costing net
operating income. This is particularly important for companies having cash flow problems.

ARGUMENTS BETWEEN ABSORPTION COSTING AND VARIABLE COSTING

With all of these advantages one might wonder why absorption costing continues to be used almost
exclusively for external reporting purposes and why it is predominant choice for internal reports as well.
This is partly due to tradition, but absorption costing is also attractive to many accountants because they
believe it better matches costs with revenues.

Advocates of absorption costing argue that all manufacturing costs must be assigned to products in order
to properly match the costs of producing units of product with the revenues from the units when they are
sold. The fixed costs of depreciation, taxes, insurance, supervisory, salaries, and so on, are just as essential
to manufacturing products as are the variable costs.

Advocates of variable costing argue that fixed manufacturing costs are not really the costs of any particular
unit of product. These costs are incurred to have the capacity to make products during a particular period
and will be incurred even if nothing is made during the period. Moreover, whether a unit is made or not,
the fixed manufacturing cost will be exactly the same. Therefore, variable costing advocates argue that
fixed manufacturing costs are not part of the costs of producing a particular unit of product and thus the
matching principle dictates that fixed manufacturing costs should be charged to the current period.

At any rate, absorption costing is the generally accepted method for preparing mandatory external
financial reports and income tax returns. Probably because of the cost and possible confusion of
maintaining two separate costing systems-one for external reporting and one for internal reporting-most
companies use absorption costing for both external and internal reports.

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 WORKSHEET O3 (Please use your Assignment/Worksheet/Quiz Notebook)

PROBLEM 1
Blossom Company operated at a normal capacity of 1,000 units in the year 2019. 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 1,500
Labor 1,000
Variable factory overhead 500
Fixed factory overhead 2,000
Selling and Administrative:
Variable 1,500
Fixed 800

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

PROBLEM 2
Bubbles makes state-of-the-art beach hats. Each hat sells for P2,000 each. Data for 2019’s operation is
as follows:

Units:
Beginning Inventory 5
Production 80
Ending Inventory 15
Variable Costs:
Direct Materials 24,000
Direct Labor 16,000
Factory Overhead 8,000
Selling and Administrative 4,000
Fixed Costs:
Factory Overhead 20,000
Selling and Administrative 2,000

Required:
1. Prepare income statements under both absorption costing and variable costing.
2. Provide computations explaining the differences in income between the two costing
methods.

PROBLEM 3
Buttercup Corp. had sales of 75,000 units and production of 100,000 units during its first year of
operation. Other information for the year included:
Direct Labor P187,500
Variable manufacturing overhead P100,000
Direct Materials P150,000
Variable selling expenses P120,000
Fixed administrative expenses P130,000
Fixed manufacturing overhead P200,000
There was no beginning and ending work-in process inventory.

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 Required:
1. Compute the per unit cost under each of the following methods:
a. Variable Costing
b. Absorption Costing
2. Compute the cost of goods manufactured and the cost of goods sold using the
different costing methods.
3. 3. Compute the value of the ending finished goods inventory under the different
costing methods.

PROBLEM 4
ProfeX Corp. uses the absorption costing method. The company’s budgeted fixed overhead was
determined to be at P500,000 with a normal capacity of P50,000 units. The net income, units
produced and sold during the company’s first three period of operation follows:
Period 1 Period 2 Period 3
Net Income P70,000 P80,000 P75,000
Units Produced 50,000 50,000 50,000
Units Sold 40,000 55,000 50,000

Required:
1. Using the reconciliation approach, determine the net income of the company if it was
using the variable costing method.
2. Assuming that the company was using variable costing instead of absorption costing,
compute the net income of the company under the absorption costing method for the
three periods presented.

QUIZ O2 (Please use your Assignment/Worksheet/Quiz Notebook)

INSTRUCTIONS: Write the letter of your answer.

1. Using absorption costing, fixed manufacturing overhead costs are best described as
a. Direct period costs
b. Indirect period costs
c. Direct product costs
d. Indirect product costs

2. If production is higher than sales, then absorption costing income is expected to be

a. Higher than variable costing income
b. Equal to the variable costing income
c. Lower than variable costing income
d. Erratic under variable costing

3. HJW Company produced 10,000 units and sold 9,000 units. Fixed manufacturing overhead costs
were P20,000, and variable manufacturing overhead costs were P3 per unit. For the period, one
would expect net income under the absorption costing method to be
a. 2,000 more than net income under variable costing method
b. 5,000 more than net income under variable costing method
c. 2,000 less than net income under variable costing method
d. 5,000 less than net income under variable costing method

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4. Ur Universe Company has operating income of P50,000 using direct costing for a given period.
Beginning and ending inventories for were 13,000 units and 18,000 units, respectively. If the
fixed factory overhead application rate is P2 per unit, the operating income using the absorption
costing is:
a. 40,000
b. 50,000
c. 60,000
d. 70,000

5. Sunshine Company had 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. Given these facts, the number of units in the ending
inventory must have been
a. 22,000 units
b. 10,000 units
c. 6,000 units
d. 4,000 units

6. HJW1023 Co. had a net income of P85,500 using variable costing and net income of P90,000
using absorption costing. Total fixed manufacturing overhead cost was P150,000, and
production was 100,000 units. Between the beginning and end of the year, the inventory level
a. increased by 4,500 units
b. decreased by 4,500 units
c. increased by 3,000 units
d. decreased by 3,000 units

7. Chocoleyt Company’s 2019 fixed manufacturing overhead costs totaled P100,000 and variable
selling costs totaled P80,000. Under direct (variable) costing, how should these costs be
classified?

Period Costs Product Costs

a. 0 180,000
b. 80,000 100,000
c. 100,000 80,000
d. 180,000 0

8. Under variable costing,

a. Net income will tend to move upward and downward in response to changes in level of
production.
b. Inventory costs will always be lower than under the absorption costing.
c. Net income will tend to vary inversely with production changes.
d. Net income will always be higher than under the absorption costing.

9. Which of the following must be known in order to institute a direct (variable) costing system?
a. The controllable and noncontrollable components of all costs related to production.
b. Standard production rates and times for all elements of production.
c. Contribution margin and break-even point for all goods in production.
d. The variable and fixed components of all costs related to production.

10. Income under absorption costing may differ from income determined under variable costing.
How is this difference calculated?
a. Change in the quantity of units in inventory times the fixed factory overhead rate per unit.
b. Number of units produced during the period times the fixed factory overhead rate per unit.
c. Change in quantity of units in inventory times the variable manufacturing cost per unit.
d. Number of units produced during the period times the variable manufacturing cost per unit.

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 11. What accounts for profit difference between absorption costing and variable costing method?
a. Difference in fixed cost incurred.
b. Difference in variable cost incurred.
c. Difference in sales revenue.
d. Difference in inventory valuation.

12. When production exceeds sales, fixed manufacturing overhead costs

a. Are released from inventory under absorption costing.
b. Are deferred in inventory under absorption costing.
c. Are released from inventory under variable costing.
d. Are deferred in inventory under variable costing.

13. Variable costing and absorption costing will show the same incomes when there are no
a. Beginning inventories c. Variable costs
b. Ending inventories d. Beginning and ending inventories

14. Which of the following statements is correct regarding absorption costing and variable costing?
a. Overhead costs are treated in the same manner under both costing methods.
b. If finished goods inventory increases, absorption costing results in higher income.
c. Variable manufacturing costs are lower under variable costing.
d. Gross margins are the same under both costing methods.

15. Absorption costing and variable costing differs in that Edom Co. had the same activity in 2019 as
in 2018 except that production was higher in 2019 than in 2018. Edom will show
a. Higher income in 2019 than in 2018.
b. The same income in both years.
c. The same income in both years under variable costing.
d. The same income in both years under absorption costing.

/mddsr

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