Strategic Cost Management JPFranco

Variable and Absorption Costing with Segment Reporting

Lecture Notes

Absorption Costing (also called traditional or full costing) is a product costing in which
all manufacturing costs (direct materials, direct labor, variable manufacturing overhead
and fixed manufacturing overhead) are treated as product or inventoriable costs. The
income statement prepared using absorption costing classifies costs and expenses
according to their functional nature (that is, cost of goods sold, selling & administrative
expenses). This approach is the accepted method for external reporting and tax
reporting purposes.

Variable Costing (also called marginal or direct costing) is a product costing in which all
the variable manufacturing costs (that is, except fixed manufacturing overhead) are
included as product or inventoriable costs. Fixed manufacturing overhead is treated as
a period cost and therefore expensed outright as incurred.

The income statement prepared using variable costing classifies costs and expenses
according to their behavior (that is, fixed and variable). Variable costing is useful for
management reporting.

Proponents of variable costing maintained that the fixed portion of manufacturing

overhead is more related to the capacity to produce rather than as part of the
production cost in producing a specific unit.

Pro-forma Income Statement Using Variable Costing

Net Sales Pxx
Less: Variable Cost of Goods Sold xx
Manufacturing Margin xx
Less: Variable Selling & Administrative Expenses xx
Contribution Margin xx
Less: Traceable Fixed Costs (Direct Fixed Costs) xx
Segment (Direct) Margin xx
Less: Indirect Fixed Costs (Common Fixed Costs) xx
Net Income Pxx

Treatment of Costs and Expenses Under Absorption Costing and Variable Costing
Cost and Expenses Absorption Costing Variable Costing
Direct materials Product cost Product cost
Direct labor Product cost Product cost
Variable factory Product cost Product cost
overhead

Page 1 of 1
 Fixed factory overhead PRODUCT COST PERIOD COST
Variable S&A expenses Period cost Period cost
Fixed S&A expenses Period cost Period cost
It must be noted that the basic difference between absorption costing and variable
costing is their treatment of the fixed overhead – creating a difference in the reported
net income! In absorption costing, fixed overhead costs are included in work in process
inventory. When units are completed, these costs are transferred to finished goods and
only when the units are sold do these costs flow through to the income statement as
part of cost of goods sold. In variable costing, fixed overhead costs are considered to
be period costs – like selling and administrative costs – and are taken immediately, in
its entirety, to the income statement as period expenses.

The difference in net income occurs because under absorption costing some fixed
overhead costs is capitalized in inventories (that is, included in product costs) rather
than being immediately expensed on the income statement. If inventories increase
during the period, under absorption costing some of the fixed overhead costs of the
current period will be deferred in ending inventories, unlike in variable costing where all
of the fixed overhead costs are expensed outright as period costs.

Relationship with Production and Sales…

When the units produced exceed the units sold (P>S), hence, inventories increase, net
operating income will be higher under absorption costing than under variable costing.
This occurs because some of the fixed overhead costs of the period is deferred in
ending inventories in the balance sheet under absorption costing, whereas under
variable costing all of the fixed overhead costs incurred in the current period flows
through to the income statement. In contrast, when the units sold exceed the units
produced (P<S), hence, inventories decrease, net operating income is lower under
absorption costing than under variable costing. This occurs because some of the fixed
overhead costs that had been deferred in previous periods is released from inventories
under absorption costing in the current period. When the units produced and the units
sold are equal (P=S), hence, no change in inventories occur, net operating income under
absorption costing and variable costing will be the same.

In summary:
Case Where Profit (Loss)
1 Production > Absorption Costing Income > Variable Costing
Sales Income
2 Production < Absorption Costing Income < Variable Costing
Sales Income
3 Production = Absorption Costing Income = Variable Costing
Sales Income

Therefore, to reconcile:

Page 2 of 2
Variable Costing Income Pxx Absorption Costing Income
Pxx
Add: Fixed Cost in Ending Inv. xx Add: Fixed Cost in Beginning Inv. xx
Less: Fixed Cost in Beginning Inv. (xx) Less: Fixed Cost in Ending Inv. (xx)
Absorption Costing Income Pxx Variable Costing Income
Pxx

Illustrative Problem
Veron had the following information for its planned production and sales in units for the
coming years:
Production Sales Beg. Inv. End. Inv.
Year 1 10,000 8,000 0 2,000
Year 2 10,000 11,000 2,000 1,000
Year 3 10,000 10,000 1,000 1,000
Year 4 8,000 8,500 1,000 500
Year 5 12,000 11,000 500 1,500
Year 6 12,000 12,000 1,500 1,500

In addition, the following information were made available:

Selling price per unit P50
Direct materials per unit 20
Direct labor per unit 5
Variable overhead per unit 5
Selling & administrative cost per unit 8
Budgeted fixed overhead P60,000
Budgeted fixed selling & administrative expense 30,000
The actual production is equal to the normal capacity for any given year.
Required: Prepare an income statement using (a) absorption costing and (b) variable
costing in each of the given year.

YEAR 1 (Absorption Costing)

Sales (8,000 units x P50) P400,000
Less: Cost of Goods Sold
Beginning Inventory P 0
Cost of Goods Manufactured (10,000 units x P36*) 360,000
Total Goods Available for Sale P360,000
Less: Ending Inventory (2,000 units x P36) 72,000
288,000
Gross Profit Margin P112,000
Less: Operating expenses
Variable S & A Expenses (8,000 units x P8) P 64,000

Page 3 of 3
 Fixed S & A Expenses 30,000 94,000
Net Operating Income (AC) P
18,000

*Note:
Per unit cost of goods manufactured is computed as
Direct materials P20
Direct labor 5
Variable overhead 5
Fixed overhead 6 (P60,000 / 10,000 units)
P36
YEAR 1 (Variable Costing)
Sales (8,000 units x P50) P400,000
Less: Variable Manufacturing Costs (8,000 units x P30)
240,000
Manufacturing Margin P160,000
Less: Variable selling & administrative expenses (8,000 units x P8) 64,000
Contribution Margin P 96,000
Less: Fixed costs
Fixed overhead P60,000
Fixed S & A expenses 30,000
90,000
Net Operating Income (VC) P 6,000

To reconcile:
Absorption costing income P18,000
Add: Fixed overhead in Beginning Inv. 0
Less: Fixed overhead in Ending Inv. (2,000 units x P6) (12,000)
Variable costing income P 6,000

YEAR 2 (Absorption Costing)

Sales (11,000 units x P50) P550,000
Less: Cost of Goods Sold
Beginning Inventory (2,000 units x P36) P 72,000
Cost of Goods Manufactured (10,000 units x P36) 360,000
Total Goods Available for Sale P432,000
Less: Ending Inventory (1,000 units x P36) 36,000
396,000
Gross Profit Margin P154,000
Less: Operating expenses
Variable S & A Expenses (11,000 units x P8) P 88,000
Fixed S & A Expenses 30,000 118,000
Net Operating Income (AC) P

Page 4 of 4
36,000

YEAR 2 (Variable Costing)

Sales (11,000 units x P50) P550,000
Less: Variable Manufacturing Costs (11,000 units x P30)
330,000
Manufacturing Margin P220,000
Less: Variable selling & administrative expenses (11,000 units x P8)
88,000
Contribution Margin P132,000
Less: Fixed costs
Fixed overhead P60,000
Fixed S & A expenses 30,000
90,000
Net Operating Income (VC) P 42,000

To reconcile:
Absorption costing income P36,000
Add: Fixed overhead in Beginning Inv. (2,000 units x P6) 12,000
Less: Fixed overhead in Ending Inv. (1,000 units x P6) (6,000)
Variable costing income P42,000

YEAR 3 (Absorption Costing)

Sales (10,000 units x P50) P500,000
Less: Cost of Goods Sold
Beginning Inventory (1,000 units x P36) P 36,000
Cost of Goods Manufactured (10,000 units x P36) 360,000
Total Goods Available for Sale P396,000
Less: Ending Inventory (1,000 units x P36) 36,000
360,000
Gross Profit Margin P140,000
Less: Operating expenses
Variable S & A Expenses (10,000 units x P8) P 80,000
Fixed S & A Expenses 30,000 110,000
Net Operating Income (AC) P
30,000

YEAR 3 (Variable Costing)

Sales (10,000 units x P50) P500,000
Less: Variable Manufacturing Costs (10,000 units x P30)
300,000

Page 5 of 5
Manufacturing Margin P200,000
Less: Variable selling & administrative expenses (10,000 units x P8)
80,000
Contribution Margin P120,000
Less: Fixed costs
Fixed overhead P60,000
Fixed S & A expenses 30,000
90,000
Net Operating Income (VC) P 30,000

To reconcile:
Absorption costing income P30,000
Add: Fixed overhead in Beginning Inv. (1,000 units x P6) 6,000
Less: Fixed overhead in Ending Inv. (1,000 units x P6) (6,000)
Variable costing income P30,000

YEAR 4 (Absorption Costing)

Sales (8,500 units x P50) P425,000
Less: Cost of Goods Sold
Beginning Inventory (1,000 units x P36) P 36,000
Cost of Goods Manufactured (8,000 units x P37.50*) 300,000
Total Goods Available for Sale P336,000
Less: Ending Inventory (500 units x P37.50) 18,750
317,250
Gross Profit Margin P107,750
Less: Operating expenses
Variable S & A Expenses (8,500 units x P8) P 68,000
Fixed S & A Expenses 30,000 98,000
Net Operating Income (AC) P
9,750

*Note:
Per unit cost of goods manufactured is computed as
Direct materials P20
Direct labor 5
Variable overhead 5

Page 6 of 6
 Fixed overhead 7.50(P60,000 / 8,000 units)
P37.50

YEAR 4 (Variable Costing)

Sales (8,500 units x P50) P425,000
Less: Variable Manufacturing Costs (8,500 units x P30)
255,000
Manufacturing Margin P170,000
Less: Variable selling & administrative expenses (8,500 units x P8) 68,000
Contribution Margin P102,000
Less: Fixed costs
Fixed overhead P60,000
Fixed S & A expenses 30,000
90,000
Net Operating Income (VC) P 12,000

To reconcile:
Absorption costing income P 9,750
Add: Fixed overhead in Beginning Inv. (1,000 units x P6) 6,000
Less: Fixed overhead in Ending Inv. (500 units x P7.50) (3,750)
Variable costing income P12,000

YEAR 5 (Absorption Costing)

Sales (11,000 units x P50) P550,000
Less: Cost of Goods Sold
Beginning Inventory (500 units x P37.50) P 18,750
Cost of Goods Manufactured (12,000 units x P35*) 420,000
Total Goods Available for Sale P438,750
Less: Ending Inventory (1,500 units x P35) 52,500
386,250
Gross Profit Margin P163,750
Less: Operating expenses
Variable S & A Expenses (11,000 units x P8) P 88,000
Fixed S & A Expenses 30,000 118,000
Net Operating Income (AC) P
45,750

*Note:

Page 7 of 7
Per unit cost of goods manufactured is computed as
Direct materials P20
Direct labor 5
Variable overhead 5
Fixed overhead 5 (P60,000 / 12,000 units)
P35

YEAR 5 (Variable Costing)

Sales (11,000 units x P50) P550,000
Less: Variable Manufacturing Costs (11,000 units x P30)
330,000
Manufacturing Margin P220,000
Less: Variable selling & administrative expenses (11,000 units x P8)
88,000
Contribution Margin P132,000
Less: Fixed costs
Fixed overhead P60,000
Fixed S & A expenses 30,000
90,000
Net Operating Income (VC) P 42,000

To reconcile:
Absorption costing income P45,750
Add: Fixed overhead in Beginning Inv. (500 units x P7.50) 3,750
Less: Fixed overhead in Ending Inv. (1,500 units x P5) (7,500)
Variable costing income P42,000

YEAR 6 (Absorption Costing)

Sales (12,000 units x P50) P600,000
Less: Cost of Goods Sold
Beginning Inventory (1,500 units x P35) P 52,500
Cost of Goods Manufactured (12,000 units x P35) 420,000
Total Goods Available for Sale P472,500
Less: Ending Inventory (1,500 units x P35) 52,500
420,000
Gross Profit Margin P180,000
Less: Operating expenses
Variable S & A Expenses (12,000 units x P8) P 96,000

Page 8 of 8
 Fixed S & A Expenses 30,000 126,000
Net Operating Income (AC) P
54,000

YEAR 6 (Variable Costing)

Sales (12,000 units x P50) P600,000
Less: Variable Manufacturing Costs (12,000 units x P30)
360,000
Manufacturing Margin P240,000
Less: Variable selling & administrative expenses (12,000 units x P8)
96,000
Contribution Margin P144,000
Less: Fixed costs
Fixed overhead P60,000
Fixed S & A expenses 30,000
90,000
Net Operating Income (VC) P 54,000

To reconcile:
Absorption costing income P54,000
Add: Fixed overhead in Beginning Inv. (1,500 units x P5) 7,500
Less: Fixed overhead in Ending Inv. (1,500 units x P5) (7,500)
Variable costing income P54,000

IN SUMMARY:
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
(P>S) (P<S) (P=S) (P<S) (P>S) (P=S)
VC - Income P 6,000 P42,000 P30,000 P12,000 P42,000 P54,000
Add: FOH in EI 12,000 6,000 6,000 3,750 7,500 7,500
Less: FOH in BI (0) (12,000) (6,000) (6,000) (3,750) (7,500)
AC - Income P18,000 P36,000 P30,000 P 9,750 P45,750 P54,000

Legend:
P = Production; S = Sales
VC = Variable costing; AC = Absorption costing
FOH = Fixed Overhead
EI = Ending Inventory; BI = Beginning Inventory
Gamit ang Illustrative Problem sa itaas, anu-ano ang pwede nating maobserbahan? Ang
reason ng difference sa operating income/loss as a result of using absorption or
variable costing ay ang treatment sa fixed overhead! Sa absorption costing, and fixed
overhead ay nananatiling product cost. At bilang product cost, dadaan muna ito sa
inventories. Magiging expense or period cost lamang ito kung naibenta na (part of cost
of goods sold). Sa variable costing, 100% ng fixed overhead ay treated as period cost

Page 9 of 9
agad or expensed agad!

Masasabi na kung ang Production ay equal sa Sales, gaya ng Year 3 at Year 6, wala
naman pagkakaiba ang computed operating income. Pero sa mga panahon na mataas
ang Production kesa sa Sales, makikita na mas mataas ang operating income gamit
ang absorption costing, gaya ng Year 1 at Year 5. At sa mga Years 2 at 4 naman na mas
mataas ang Sales kesa Production, mas malaki ang computed operating income.

Kaya sa mga panahon na mataas ang Production kesa sa Sales, nananatili sa

inventories (ending inventory) ang portion ng fixed overhead (dahil nga hindi pa
naibebenta). At kung mataas ang ending inventory, ano ang epekto sa cost of goods
sold? Sympre mas mababa ito na magiging dahilan kung bakit mas mataas ang
operating income under absorption costing! Ito talaga ang isa sa characteristic ng
absorption costing. Unlike kasi kung variable costing, lahat ng fixed overhead costs are
expensed agad-agad!

Kung sa mga panahon naman na ang Production ay mas mababa kesa sa Sales, mas
mataas ang magiging operating income using variable costing! Bakit? Dahil sa mga
panahon na ito ang mga fixed overhead costs na nasa ending inventory last period/last
year ay marerelease na! Narereleased ito bilang bahagi ng beginning inventory ng
current year. At dahil nasa beginning inventory ito, dadagdag ito sa computation ng cost
of goods sold, na magpapababa naman ng macocompute na operating income using
absorption costing.

Ang pagprepare ng income statement using variable costing ay kapareho lamang ng

concept ng income statement prepared under Cost-Volume-Profit Analysis! Tandaan din
na walang effect ang changes sa inventory sa pagcompute ng operating income under
variable costing. Apektado lamang ito ng changes sa Sales! Example sa Years 2 at 5
(sales at 11,000 units), kung saan pareho ang Sales, same lang din ang nacompute na
operating income, kahit na magkaiba ang given na inventories sa mga years na ito.

Can Operating Income Be Affected by Changes in Inventory Levels?

Yes, and so care must be considered in rendering decisions using absorption costing
income. Readers of financial statements should be alert to changes in inventory levels.
Under absorption costing, if inventories increase, fixed overhead costs are deferred in
inventories, which in turn increases operating income. If inventories decrease, fixed
overhead costs are released from inventories, which in turn decreases operating income.
When using absorption costing, fluctuations in operating income can be caused by
changes in inventory levels as well as changes in unit sales.

SEGMENT REPORTING
A segment is any profit-making entity within an organization in which managers seek
cost, revenue and profit data.

Page 10 of 10
Direct fixed expenses are fixed expenses that are directly traceable to a segment.
These are sometimes called avoidable fixed expenses because when the segment in
which these costs are associated where eliminated, such costs are avoided. Direct fixed
expenses existed only because of the segment, so if the segment had never existed,
such fixed costs would not have been incurred.

Common fixed expenses are fixed expenses jointly caused by two or more segments
but are not directly traceable in whole or in part to any one segment. These expenses
will continue even if one or more of the segments is eliminated.

Segment margin is contribution margin less traceable fixed costs. It represents the
margin available after a segment has covered all of its own traceable costs.

Illustrative Problem
The accounting staff of J&J Law Firm constructed the following financial report with
information from its two major services: Family Cases and Commercial Cases.
J&J Law Firm Family Cases Commercial
Cases
Revenues P1,000,000 P400,000 P600,000
Variable costs 220,000 100,000 120,000
Contribution margin P 780,000 P300,000 P480,000
Fixed costs 760,000 360,000 400,000
Operating Profit P 20,000 P(60,000) P 80,000
(Loss)
Only 50% of the fixed costs are traceable in each service. The manager is considering
dropping the Family Case Segment of the Law Firm to cut on costs. However, he is also
considering a marketing campaign to promote the Family Case Service by incurring an
additional P40,000 as advertisement cost, but is expected to generate P100,000
additional client revenues.

Required: Should the Family Cases Service be dropped? If not, what is the increase in
income that can be expected from the marketing campaign to promote this segment?

Answer: The Family Cases Service should not be dropped because it still has a segment
margin of P120,000 (P300,000 CM – P180,000 Traceable Fixed Costs). Dropping this
segment will decrease operating profit to P100,000 loss! (CM of Commercial Cases
only: P480,000 less P200,000 (traceable fixed cost to Commercial Cases) = P280,000
segment margin. This segment margin will be used to cover common fixed costs of
P380,000). Drop only a segment if the segment margin is NEGATIVE.

The marketing campaign will generate an additional of P35,000 in profit (75% CM ratio x
P100,000 sales = P75,000 – P40,000 additional advertising cost).

Page 11 of 11