Variable Costing and

the Costs of Quality

and Sustainability
Ch. 8 of Managerial Accounting by Ronald W. Hilton 10th ed.
PowerPoint Slides by: Dr. Muhammad Nabeel Ashraf
Section 1: Absorption and Variable
(Marginal)
Costing
• In the product-costing systems we have studied so far, manufacturing
overhead is applied to Work-in-Process Inventory as a product cost
along with direct material and direct labor. When the manufactured
goods are finished, these product costs flow from Work-in- Process
Inventory into Finished-Goods Inventory. Finally, during the
accounting period when the goods are sold, the product costs flow
from Finished-Goods Inventory into Cost of Goods Sold, an expense
account. The following diagram summarizes this flow of costs.
• Since the costs of production are stored in inventory accounts until
the goods are sold, these costs are said to be inventoried costs.
Fixed Manufacturing Overhead: The Key
• In our study of product-costing systems, we have included both
variable and fixed manufacturing overhead in the product costs that
flow through the manufacturing accounts. This approach to product
costing is called absorption costing (or full costing), because all
manufacturing-overhead costs are applied to (or absorbed by)
manufactured goods.
• We now introduce an alternative approach to product costing called
variable costing (or direct costing or marginal costing), in which only
variable manufacturing overhead is applied to Work-in-Process
Inventory as a product cost.
• The distinction between absorption and variable costing is
summarized in Exhibit 8–1 .
• Notice that the distinction involves the timing with which fixed
manufacturing overhead becomes an expense. Under variable
costing, fixed overhead is expensed immediately, as it is incurred.
Under absorption costing, fixed overhead is inventoried until the
accounting period during which the manufactured goods are sold. But
under both approaches, fixed overhead is eventually expensed.
Definition
• Absorption costing
• Marginal costing

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Absorption costing
• It is costing system which treats all manufacturing costs including
both the fixed and variable costs as product costs

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Marginal costing
• It is a costing system which treats only the variable manufacturing
costs as product costs. The fixed manufacturing overheads are
regarded as period cost

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 Absorption Costing
Cost
Manufacturing cost Non-manufacturing cost

Direct Direct Overheads

Materials Labour Period cost

Finished goods Cost of goods sold Profit and loss account

Marginal Costing
Cost
Manufacturing cost Non-manufacturing cost

Direct Direct Variable Fixed

Materials Labour Overheads overhead Period cost

Finished goods Cost of goods sold Profit and loss account

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Presentation of costs on
income statement

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 Trading and profit ans loss account
Absorption costing Marginal costing
$ $
Sales X Sales X
Less: Cost of goods sold X Less: Variable cost of
Goods sold X
Gross profit X Product contribution margin X

Less: Expenses Less: variable non- manufacturing

Selling expenses X expenses
Admin. expenses X Variable selling expenses X
Other expenses X X Variable admin. expenses X
Other variable expenses X
Total contribution expenses X
Variable and fixed manufacturing
Less: Expenses
Fixed selling expenses X
Fixed admin. expenses X
Other fixed expenses X
Net Profit X Net Profit X
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• FitDat.com began operations on January 1, 20x0, to manufacture its
electronic personal fitness monitors. Cost, production, and sales data
for the first three years of FitDat.com’s operations are given in
Exhibit 8–2. Comparative income statements for 20x0, 20x1, and
20x2 are presented in Exhibit 8–3, using both absorption and variable
costing.
Reconciling Income under Absorption and
Variable Costing
• Examination of Exhibit 8–3 reveals that the income reported under
absorption and variable costing is sometimes different. Although
income is the same for the two product costing methods in 20x0, it is
different in 20x1 and 20x2. Let’s figure out why these results occur.
A Shortcut to Reconciling Income
• When inventory increases or decreases during the year, reported
income differs under absorption and variable costing. This results
from the fixed overhead that is inventoried under absorption costing
but expensed immediately under variable costing. The following
formula may be used to compute the difference in the amount of
fixed overhead expensed in a given time period under the two
product-costing methods.
• As the following table shows, this difference in the amount of fixed
overhead expensed explains the difference in reported income under
absorption and variable costing.
Length of Time Period
• he discrepancies between absorption-costing and variable costing
income in Exhibit 8–3 occur because of the changes in inventory
levels during 20x1 and 20x2.
• It is common for production and sales to differ over the course of a
week, month, or year. Therefore, the income measured for those time
periods often will differ between absorption and variable costing.
• This discrepancy is likely to be smaller over longer time periods. Over
the course of a decade.
• For example, FitDat.com cannot sell much more or less than it
produces. Thus, the income amounts under the two product costing
methods, when added together over a lengthy time period, will be
approximately equal under absorption and variable costing.
• Notice in Exhibit 8–3 that FitDat.com total income over the three-
year period is $900,000 under both absorption and variable
costing. This results from the fact that the company produced and
sold the same total amount over the three-year period.
Cost-Volume-Profit Analysis
• One of the tools used by managers to plan and control business operations
is cost-volume-profit analysis. FitDat.com’s break-even point in units can be
computed as follows:

• If FitDat.com sells 35,000 fitness monitors, income should be zero, as

Exhibit 8–5 confirms. Notice that at the break-even point, $1,680,000 is
both the total revenue (35,000 units x $48 price/unit) and total cost
($700,000 fixed cost plus variable cost of 35,000 units x $28 per unit).
Inconsistency in income under two
approaches
• Now return to Exhibit 8–3 and examine the 20x1 income statements
under absorption and variable costing. In 20x1, FitDat.com sold 35,000
units, the break-even volume. This fact is confirmed on the variable-
costing income statement, since operating income is zero. On the
absorption-costing income statement, however, the 20x1 operating
income is $180,000. What has happened here?
• The answer to this inconsistency lies in the different treatment of fixed
manufacturing overhead under absorption and variable costing. Variable
costing highlights the separation between fixed and variable costs, as do
cost-volume-profit analysis and breakeven calculations. Both of these
techniques account for fixed manufacturing overhead as a lump sum. In
contrast, absorption costing is inconsistent with CVP analysis, because
fixed overhead is applied to goods as a product cost on a per-unit basis.
Pricing Decisions
• Many managers prefer to use absorption-costing data in cost-based
pricing decisions. They argue that fixed manufacturing overhead is a
necessary cost incurred in the production process. To exclude this
fixed cost from the inventoried cost of a product, as is done under
variable costing, is to understate the cost of the product. For this
reason, most companies that use cost-based pricing base their prices
on absorption-costing data.
• Proponents of variable costing argue that a product’s variable cost
provides a better basis for the pricing decision. They point out that
any price above a product’s variable cost makes a positive
contribution to covering fixed cost and profit.
Definition of an Asset
• Another controversy about absorption and variable costing hinges on
the definition of an asset. An asset is a thing of value owned by the
organization with future service potential. By accounting convention,
assets are valued at their cost. Since fixed costs comprise part of the
cost of production, advocates of absorption costing argue that
inventory (an asset) should be valued at its full (absorption) cost of
production. Moreover, they argue that these costs have future service
potential since the inventory can be sold in the future to generate
sales revenue.
• Proponents of variable costing argue that the fixed-cost component of a
product’s absorption-costing value has no future service potential. Their
reasoning is that the fixed manufacturing-overhead costs during the current
period will not prevent these costs from having to be incurred again next
period. Fixed-overhead costs will be incurred every period, regardless of
production levels. In contrast, variable costs incurred to manufacture a
product will not be repeated.
• To illustrate, FitDat.com produced 15,000 more fitness monitors in 20x1
than it sold. These units will be carried in inventory until they are sold in
some future year. FitDat.com will never again have to incur the costs of
direct material, direct labor, and variable overhead incurred in 20x1 to
produce those fitness monitors. Yet FitDat.com will have to incur
approximately $600,000 of fixed-overhead costs every year, even though
the firm has the 15,000 units from 20x1 in inventory.
External Reporting
• For external reporting purposes, generally accepted accounting
principles require that income reporting be based on absorption
costing. Federal tax laws also require the use of absorption costing in
reporting income for tax purposes.
Why Not Both?
• Using computerized accounting systems, it is straightforward for a
company to prepare income statements under both absorption and
variable costing. Since absorption-costing statements are required for
external reporting, managers will want to keep an eye on the effects
of their decisions on financial reports to outsiders. Yet the superiority
of variable-costing income reporting as a method for dovetailing with
operational analyses cannot be denied. Preparation of both
absorption-costing and variable-costing data is perhaps the best
solution to the controversy.
JIT Manufacturing Environment
• In a just-in-time inventory and production management system, all
inventories are kept very low. Since finished-goods inventories are
minimal, there is little change in inventory from period to period.
Thus, in a JIT environment, the income differences under absorption
and variable costing generally will be insignificant.
Example

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A company started its business in 2005. The following information
Was available for January to March 2005 for the company that produced
A single product:
$
Selling price pre unit 100
Direct materials per unit 20
Direct Labour per unit 10
Fixed factory overhead per month 30000
Variable factory overhead per unit 5
Fixed selling overheads 1000
Variable selling overheads per unit 4

Budgeted activity was expected to be 1000 units each month

Production and sales for each month were as follows:
Jan Feb March
Unit sold 1000 800 1100
Unit produced 1000 1300 900
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• Required:
• Prepare absorption and marginal costing statements for the three months

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Absorption costing

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 January February March
$ $ $
Sales 100000 80000 110000
Less: cost of good sold ($65) 65000 52000 71500
28000 38500
Adjustment for Over-/(under)
Absorption of factory overhead 9000 (3000)
Gross profit 35000 37000 35500
Less: Expenses
Fixed selling overheads 1000 1000 1000
Variable selling overheads 4000 3200 4400
Net profit 30000 32800 30100

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Marginal costing

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 January February March
$ $ $
Sales 100000 80000 110000
Less: Variable cost of good
sold ($35) 35000 28000 385500
Product contribution margin 65000 52000 71500
Less: Variable selling overhead4000 3200 4400
Total contribution margin 61000 48800 67100
Less: Fixed Expenses
Fixed factory overhead 30000 30000 30000
Fixed selling overheads 1000 1000 1000
Net profit 30000 32800 30100

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Wk1:
Standard fixed overhead rate
= Budgeted total fixed factory overheads
Budgeted number of units produced

= $30000
1000 units
= $30 units
Wk 2:
Production cost per unit under absorption costing:
$
Direct materials 20
Direct labour 10
Fixed factory overhead absorbed 30
Variable factory overheads 5
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Wk 3:
(Under-)/Over-absorption of fixed factory overheads:
January February March
$ $ $
Fixed overhead 30000 39000 27000
Fixed overheads incurred 30000 30000 30000
0 9000 (3000)
1000*$30 1300*$30 900*$30

Wk 4: No fixed factory overhead

Variable production cost per unit under marginal costing:
$
Direct materials 20
Direct labour 10
Variable factory overhead 5
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