VARIABLE COSTING AND ABSORPTION

COSTING
• Variable Costing is a technique in which only variable
costs are taken into account for purposes of
product costing, inventory valuation and other
allied important management decisions.
• In Absorption Costing , total costs are taken into
account for these purpose.
• The two techniques are complementary in nature.
• Variable costing helps management in arriving at
profit-maximizing decisions in certain situations.
 VARIABLE COSTING AND ABSORPTION
COSTING - A Comparison
Principle underlying Variable Cost is that :
• fixed manufacturing overheads are not inventoriable
costs;
• they are period costs and
• must not be matched against the revenue for the year.
•
In contrast to this, Absorption Costing indicates that:
• manufacturing fixed overheads are inventoriable
costs;
• they are product costs and
• must be matched against the revenue of the year in
which the sales are made.
 INCOME STATEMENT ( VARIABLE COSTING)

Particulars Amount Amount

(Rs) (Rs)
Sales Revenue ( units sold * selling price) **

(-) Variable Costs ( production cost) :

Direct Material Cost *

Direct Labour Cost *

Variable Manufacturing Overhead *

TOTAL COST OF GOODS MANUFACTURED **

(+) Cost of Inventory in the beginning of the year *

(units*variable cost)
(-) Cost of Inventory at the end of the year *
(units*variable cost)
COST OF GOODS MANUFACTURED AND SOLD **
 CONTRIBUTION (manufacturing) ***
(-) Variable Non Production Cost :
Selling and Distribution Cost *
Administrative Costs *
Other Costs (specify) *
**
CONTRIBUTION (final) ***
(-) Fixed Cost :
Fixed Production Cost
Fixed Non-Production Cost **
Income before Income Tax ***
(-) Income Tax *
Net Income after Taxes ***
 INCOME STATEMENT (ABSORPTION COSTING)
Particulars Amount Amount
(Rs) (Rs)
Sales Revenue ( units sold * selling price) **
(-) Total Cost of Manufacturing :

Direct Material Cost *

Direct Labour Cost *

Variable Manufacturing Overhead *

Fixed Manufacturing Overhead *

TOTAL COST OF GOODS MANUFACTURED **
(+) Cost of Inventory in the beginning of the year *
(units*variable cost)
(-) Cost of Inventory at the end of the year *
(units*variable cost)
COST OF GOODS MANUFACTURED and SOLD **
 INCOME STATEMENT (ABSORPTION COSTING)
Particulars Amount Amount
(Rs) (Rs)
Gross Margin **
(-) Non Production Costs:

Administrative Cost *

Selling and Distribution Cost *

Other Costs * **

Income before Income Tax ***

(-) Income Tax *
Net Income after Taxes ***
 VARIABLE COSTING and SHORT TERM DECISION
MAKING

• This deals with the use of variable costing in profit planning

and decision making .
• The core of the variable costing is the contribution margin .
• It is out of the total contribution earned that fixed costs are to
be met and
• The excess of the contribution over fixed costs represents
profit .
• Therefore maximizing the contribution will lead to
maximizing the profit.
 The short term decision areas using variable costing are :
• Fixing price on special orders
• Optimal sales mix
• Adding a new product line
• Dropping a product line
• Developing a production plan if certain inputs (material or
labor) is in short supply
• Making or buying component parts
• Selling a product in a limited market
ILLUSTRATION 1 : ( Dropping a Product Line)

X Ltd. Makes a profit of Rs. 40,000 from the production and sale of three
products as shown below :

Particulars Products Total

X Y Z
Sales Rs. 50,000 Rs. 60,000 Rs.80,000 Rs.1,90,000

Less: Variable Cost 16,000 40,000 26,000 82,000

Fixed Cost 12,000 36,000 20,000 68,000
(allocated)

Profit / (Loss) 22,000 ( 16,000) 34,000 40,000

On the basis of the income statement prepared under the absorption costing
and supplied to management , the management is considering dropping
product Y , because it is incurring a loss of Rs. 16,000. The management is
fully aware that it will still have to incur the total fixed cost which was earlier
apportioned among the three products.
Should the management carry out the proposal ?
 Solution : Incase product Y is dropped.
Particulars Product Total
X Z

Sales Rs. 50,000 Rs. 80,000 1,30,000

Less: Variable Costs 16,000 26,000 42,000
Contribution 34,000 54,000 88,000
Less: Fixed Cost 68,000

Net Profit 20,000

• Although product Y is an unprofitable line,
• Its elimination has converted Rs.40,000 profit into a
much lower figure of Rs.20,000.
• The reason is that this product was making a
contribution of Rs. 20,000,( Sales 60,000 (-) Variable
40,000) to fixed costs
• Which are to be incurred , irrespective of the fact
whether product Y is continued or eliminated .
 ILLUSTRATION 2: ( Adding a Product Line )

Assume that X Ltd., has found a substitute Product W

in place of Product Y . The marketing and production
departments of the company have furnished to the
management the following information regarding the
new Product W :
• Sales revenue Rs. 1,00,000
• Variable cost Rs. 60,000
No additional fixed cost will be incurred.
 Solution :
Particulars Products Total
X Z W
Sales Revenue Rs. 50,000 Rs. 80,000 Rs.1,00,000 2,30,000
Less: Variable 16,000 26,000 60,000 1,02,000
Costs
Contribution 34,000 54,000 40,000 1,28,000
Less: Fixed Cost 68,000

Net Profit 60,000

Yes , product W should be introduced because it will increase

the existing profit by Rs. 20,000
ILLUSTRATION 3: ( Make or Buy )

A company manufactures part XA , XB and XC required for its main product

X1 . The cost per unit and the quantities for each of the parts are stated below :

XA XB XC

Number of units Produced 20,000 15,000 30,000

Cost per unit :

Material Rs.2.00 Rs.2.50 Rs.1.50

Labour 4.00 4.50 3.50
Variable Overhead 1.00 2.00 1.00
Fixed Overhead 8.00 9.00 7.00
15.00 18.00 13.00
• Increasing demand and limited production capacity
necessitates that supplies of one of the parts be
obtained from outside – production facilities of any of
the parts can be diverted to any other parts .
• Quotations from outsides are :
XA : Rs.13
XB : Rs.16
XC : Rs.11
• Using Variable Costing method state with reasons
your recommendations as to which part should be
procured from outside .
 Solution :
Particulars on unit basis XA XB XC
1. Buying Cost Rs.13 Rs.16 Rs.11
2. Make Cost (Variable only)

Material Rs.2.00 Rs.2.50 Rs.1.50

Labour 4.00 4.50 3.50
Variable Overhead 1.00 2.00 1.00
Total 7.00 9.00 6.00

Excess Price paid when component 6.00 7.00 5.00

is purchased [ 1 (-) 2 ]
Units required 20,000 15,000 30,000
Total Excess Price 1,20,000 1,05,000 1,50,000

Since the excess price to be paid is the lowest in the case of XB

component , this part should be procured from outside.
ILLUSTRATION 4 : (Acceptance / Rejection of Special Offer)
Sleepwell Ltd. is considering accepting a special order for 50,000
mattresses which it received from a large chain of departmental
stores. The order specified a price of Rs.30 per unit. This
compared unfavorably with the company’s regular price of Rs.38
per unit. The accounting department prepared the following
analysis in an attempt to show that there would be cost saving
from the additional sales .

Cost per unit without Cost per unit with the

the additional sales additional sales
(1,00,000 units) Rs. (1,50,000 units) Rs.

Variable cost 20 20
Fixed Cost 9 6
Total 29 26
• No additional fixed costs would be incurred because
there was idle capacity and so the average cost per
unit will be reduced from Rs.29 to Rs.26 .
• The chief executive of the firm believes he would be
justified in reducing the price by Rs.8 to sell to the
departmental store .
• Should the order for the 50,000 units at a price of
Rs. 30 be accepted ?
• Give reasons, making such assumptions as you
consider to be relevant.
Solution :
Contribution margin based income statement with and without
acceptance of special order :

Particulars If special order If special order

is accepted is not accepted
Sales Revenue :
Regular Sales (1,00,000 * Rs.38) Rs.38,00,000 Rs.38,00,000
Special Order Sales (50,000 * Rs.30) 15,00,000 -
Total Sales Revenue 53,00,000 38,00,000
Less : Variable Costs @ Rs. 20 per unit (30,00,000) (20,00,000)
Contribution ( final) 23,00,0000 18,00,000
Less : Fixed Costs :
(1,50,000 * Rs.6) # ( 9,00,000) # -
(1,00,000 * Rs. 9 ) * - ( 9,00,000) *
Net Income 14,00,000 9,00,000
• The company is advised to accept the order of
departmental store to supply 50,000 mattresses
• It will increase income of the company by Rs.5,00,000.
• It is assumed that the sales to the departmental store
at a concessional price (Rs.30) will have no impact on
regular sales price of Rs.38 .
• As a precautionary measure , the company is advised
to enter into the contract with the departmental store
that the latter would not sell the mattresses at a price
below Rs.38.
THANK YOU