Ethiopian Civil Service University, Addis Ababa

BA In ACFN/PFM

Income Effect of Alternative product Costing Methods

Module No.- AcFn2051/PFM 2031

BA IN ACFN/PFM
Year 2nd, Semester I
 Ethiopian Civil Service University, Addis Ababa
BA In ACFN/PFM

Session Plan

 Variable and Absorption Costing

 Role of various denominator levels in absorption costing
 Adjusting inventories for external reporting

CS (DR) GAURAV AGGARWAL

12/23/2021 2
COST AND MANAGEMENT ACCOUNTING I
 Ethiopian Civil Service University, Addis Ababa
BA In ACFN/PFM

Absorption Costing Vs Variable costing

 Absorption costing, also called full costing, is what you are used to under Generally
Accepted Accounting Principles. 
 Under absorption costing, companies treat all manufacturing costs, including both fixed and
variable manufacturing costs, as product costs.
• Variable costing is The cost of manufacturing a product includes only variable
manufacturing costs.
• Fixed factory overhead is a period cost and is expensed on each month’s income statement.
• The difference between sales and variable cost of goods sold is termed contribution margin.

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 Ethiopian Civil Service University, Addis Ababa
BA In ACFN/PFM

Product Costs Versus Period Costs

Product costs include Period costs include all

direct materials, direct selling costs and
labor, and manufacturing administrative costs.
overhead.
Inventory Cost of Good Sold Expense

Sale

Balance Income Income

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Sheet
12/23/2021 Statement COST AND Statement 4
 Ethiopian Civil Service University, Addis Ababa
BA In ACFN/PFM

Product cost under absorption costing

 The product cost, under absorption costing, would be calculated as:
 Direct Materials+ Direct Labor+ Variable Overhead+ Fixed Overhead= Total Product
Cost
 You can calculate a cost per unit by taking the total product costs / total units
PRODUCED.  Yes, you will calculate a fixed overhead cost per unit as well even
though we know fixed costs do not change in total but they do change per unit. 
We will assign a cost per unit for accounting reasons.  When we prepare the
income statement, we will use the multi-step income statement format.

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 Ethiopian Civil Service University, Addis Ababa
BA In ACFN/PFM

Absorption Costing Example

• Bradley Company had the following information for May:
• Direct materials $13,000
• Direct labor $15,000
• Variable overhead $5,000
• Fixed overhead $6,000
• Fixed selling expenses $15,000
• Variable selling expenses $0.20 per unit
• Administrative expenses $12,000
• 10,000 units produced
• 9,000 units sold (1,000 remain in ending finished goods inventory)
• Sales price $8 per unit

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 Ethiopian Civil Service University, Addis Ababa
BA In ACFN/PFM

Solution
 First, we need to calculate the absorption product cost per unit:
 Direct Materials$ 13,000+ Direct Labor$ 15,000+ Variable Overhead$  5,000+ Fixed
Overhead$  6,000= Total Product Cost$39,000÷ Total Units Produced÷ 10,000=
Product cost per unit$ 3.90
 Next, we can use the product cost per unit to create the absorption income
statement.  We will use the UNITS SOLD on the income statement (and not units
produced) to determine sales, cost of goods sold and any other variable period
costs.

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12/23/2021 7
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 Ethiopian Civil Service University, Addis Ababa
BA In ACFN/PFM

Solution

 Company Income Statement (absorption)For Month Ended May

 Sales (9,000 x $8 per unit) $ 72,000
 – Cost of Goods Sold (9,000 x $3.90 per unit)                        35,100
 = Gross Profit           36,900
 Less: Operating Expenses:   
 Selling Expenses (15,000 fixed + variable 0.20 x 9,000 units sold)                       16,800   
 + General and Admin. Expenses                        12,000      
 = Total Expenses            28,800
 = Net Operating Income    $8,100
CS (DR) GAURAV AGGARWAL
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 Ethiopian Civil Service University, Addis Ababa
BA In ACFN/PFM

Absorption Costing, Important Points

• Remember the following under absorption costing:

• Typically used for financial reporting (GAAP)
• ALL manufacturing costs are included in the cost (direct materials, direct labor, fixed
and variable overhead)
• Can be misleading as some costs are not affected by products
• Fixed manufacturing overhead costs are applied to units PRODUCED and not just unit
sold
• Income statement shows Sales – Cost of Goods sold = Gross Margin (or Gross Profit) –
Operating Expenses = Net Income and is based on the number of units SOLD.

CS (DR) GAURAV AGGARWAL

12/23/2021 9
COST AND MANAGEMENT ACCOUNTING I
 Ethiopian Civil Service University, Addis Ababa
BA In ACFN/PFM

Variable Costing

 Variable costing (also known as direct costing) treats all fixed manufacturing costs
as period costs to be charged to expense in the period received. Under variable
costing, companies treat only variable manufacturing costs as product costs. The
logic behind this expensing of fixed manufacturing costs is that the company would
incur such costs whether a plant was in production or idle. Therefore, these fixed
costs do not specifically relate to the manufacture of products. 

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12/23/2021 10
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 Ethiopian Civil Service University, Addis Ababa
BA In ACFN/PFM

Product cost under Variable Costing

 Product costs, under variable costing, includes the VARIABLE costs only like direct materials, direct labor and
variable overhead.  Fixed overhead would not be included as a product cost!  We calculate product cost per
unit as:
 Direct Materials+ Direct Labor+ Variable Overhead= Total Product Cost÷ Total Units Produced= Product cost
per unit
 The income statement we will use in not Generally Accepted Accounting Principles so is not typically included
in published financial statements outside the company. 
 This contribution margin income statement would be used for internal purposes only.  You should remember,
the contribution margin income statement separates variable costs and fixed costs (whether product or
period does not matter) and calculates a contribution margin (this is sales – variable costs). 
 Now, let’s continue with our example Bradley Company.

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 Ethiopian Civil Service University, Addis Ababa
BA In ACFN/PFM

Variable Costing Example

• Bradley Company had the following information for May:
• Direct materials $13,000
• Direct labor $15,000
• Variable overhead $5,000
• Fixed overhead $6,000
• Fixed selling expenses $15,000
• Variable selling expenses $0.20 per unit
• Administrative expenses $12,000
• 10,000 units produced
• 9,000 units sold (1,000 remain in ending finished goods inventory)
• Sales price $8 per unit

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12/23/2021 12
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 Ethiopian Civil Service University, Addis Ababa
BA In ACFN/PFM

Solution
 First, we need to calculate the absorption product cost per unit:
 Direct Materials$ 13,000+ Direct Labor$ 15,000+ Variable Overhead$ 5,000= Total
Product Cost$ 33,000÷ Total Units Produced÷ 10,000= Product cost per unit$ 3.30
 Next, we calculate the contribution margin format income statement under
variable costing:

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 Ethiopian Civil Service University, Addis Ababa
BA In ACFN/PFM

Solution

 Company Income Statement (absorption)For Month Ended May

 Sales (9,000 x $8 per unit) $ 72,000
Less:
Variable Costs:    Cost of goods sold (9,000 x $3.30 per unit)  29,700 
Selling expenses (9,000 x $0.20 per unit)  1,800   
 Total variable costs   31,500
 Contribution Margin   40,500
Less
Fixed Costs:    Fixed overhead  (fixed portion only)  6,000   
Selling expenses (fixed portion only)     15,000   
Administrative expenses  12,000   
 Total Fixed expenses     33,000
 Net Operating Income    $ 7,500

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 Ethiopian Civil Service University, Addis Ababa
BA In ACFN/PFM

Variable Costing, Important Points

• ONLY includes variable costs meaning costs that increase with volume
• Does not include FIXED costs as volume levels do not change these costs (fixed
costs treated as period costs not product costs)
• Can provide more accurate information for decision makers as costs are better tied
to production levels
• Can be applied to ALL costs and not just product costs.
• Uses Contribution Margin Income Statement showing Sales – VARIABLE expenses =
Contribution Margin – Fixed Expenses = Net Income and is based on the number of
units SOLD.
CS (DR) GAURAV AGGARWAL
12/23/2021 15
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 Ethiopian Civil Service University, Addis Ababa
BA In ACFN/PFM

SUMMARY

• Product costs are calculated differently under each method:

Absorption Variable
• Direct Materials Include Include
Direct Labor Include Include
Overhead: Variable Overhead Include Include   
Fixed Overhead Include DO NOT include
Total Product Costs Sum sum
÷ Total Units Produced ÷ Total Units Produced ÷ Total Units Produced
Product Cost per Unit = Cost per unit = Cost per unit

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12/23/2021 16
COST AND MANAGEMENT ACCOUNTING I
 Ethiopian Civil Service University, Addis Ababa
BA In ACFN/PFM

Next Topic
Cost Allocation

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12/23/2021 COST AND 17
 Ethiopian Civil Service University, Addis Ababa
BA In ACFN/PFM

Thank you

CS (DR) GAURAV AGGARWAL

12/23/2021 COST AND 18