CHAPTER 7

ABSORPTION
AND VARIABLE
COSTING
ABSORPTION COSTING OR FULL COSTING

- a product costing method that includes all the manufacturing costs (direct
materials, and both the variable and fixed factory overhead) in the cost of
a unit of product.

 Under the absorption costing method, fixed factory overhead is

treated as a product cost.

VARIABLE COSTING

- a product costing method that includes only the variable manufacturing

costs (direct materials, direct labor, and variable overhead) in the cost of
a unit of product.

 Under the variable costing method, fixed factory overhead is treated

as a period cost.

PRODUCT COST COMPONENTS

Absorption Costing Variable Costing

Direct materials Direct materials

+ Direct labor + Direct labor
+ Variable FOH + Variable FOH
+ Fixed FOH -
Product Cost Product Cost
DISTINCTIONS BETWEEN PERIOD COSTS AND PRODUCT COSTS
PERIOD COST
1. Cost that is charged against
current revenue during a
time period regardless of
the difference between
production sales volumes.
2. Does not form part of the
cost of inventory.
3. Reduces income for the
current period by its full amount
PRODUCT COST
1. Cost that is included in the
computation of product cost
that is apportioned between
the sold and unsold units.
2. An inventoriable cost. The
portion of the cost that has been
allocated to the unsold units
becomes part of the cost of
inventory.
3. Reduces current income by
the portion allocated to the sold
units; the portion allocated to unsold
units is treated as an asset, being
part of the cost of inventory.
 PRINCIPAL DIFFERENCES BETWEEN ABSORPTION AND
VARIABLRE COSTING METHODS

ABSORPTION COSTING VARIABLE COSTING

1.Cost Seldom segregates costs Costs are segregated into
Segregation into variable and fixed cost variable and fixed

Cost of inventory includes Cost of inventory includes

2. Cost of all the manufacturing only the variable
Inventory costs: materials, labor, manufacturing costs:
variable factory overhead, materials, labor, and
and fixed factory overhead variable factory overhead

3. Treatment of
Fixed factory overhead is Fixed factory overhead is
fixed factory
treated as product cost. treated as period cost.
overhead

Distinguish between Distinguishes between

production and other costs variable and fixed costs
4. Income
S xx S xx
statement - CGS (product cost) xx - VC xx
Gross Profit xx CM xx
- S&A Costs xx - FxC xx
Profit xx Profit xx

Net income between the two methods may differ from

each other because of the difference in the amount of
fixed overhead costs recognized as expense during an
accounting period. This is due to variations between sales
5. Net income
and production. In long run, however, both methods give
substantially the same results since sales cannot
continuously exceed production, nor production can
continually exceed sales.
DIFFERENCE IN NET INCOME ABSORPTION AND VARIABLE COSTING

Variable and absorption costing methods of accounting for fixed manufacturing

overhead result in different levels of net income in most cases. The differences
are timing differences, i.e., when to recognize the fixed manufacturing overhead
as an expense. In variable costing, it is expensed during the period when the
fixed overhead is incurred, while in absorption costing, it is expensed in the
period when the units to which such fixed overhead has been related are sold.

PRODUCTION EQUALS SALES:

When production is equal to sales, there is no change in inventory. Fixed

overhead expensed under absorption costing equals fixed overhead expensed
under variable costing. Therefore, absorption costing income equals variable
costing income.

PRODUCTION IS GREATER THAN SALES

When production is greater than sales, there is an increase in inventory. Fixed

overhead expensed under absorption costing is less than fixed overhead
expensed under variable costing. Therefore, absorption income is greater than
variable costing income.

PRODUCTION IS LESS THAN SALES

When production is less than sales, there is a decrease in inventory. Fixed

overhead expensed under absorption is greater than fixed overhead expensed
under variable costing. Therefore, absorption income is less than variable costing
income.
RECONCILIATION OF ABSORPTION AND VARIABLE COSTING INCOME
FIGURES

Absorption costing income xx

Add Fixed overhead in the beginning inventory xx
Total xx
Less Fixed overhead in theending inventory xx
Variable costing income xx

ACCOUNTING FOR DIFFERENCE IN INCOME

Change in inventory (Production less Sales) xx

x Fixed FOH cost per unit xx
Difference in income xx

ARGUMENTS FOR THE USE OF VARIABLE COSTING

1. Variable costing reports are simpler and more understandable.

2. Data needed for break-even and cost-volume-profit analyses are readily
available.
3. The problems involved in allocating fixed costs are eliminated.
4. Variable costing is more compatible with the standard cost accounting
system.
5. Variable costing reports provide useful information for pricing decisions
and other decision-making problems are encountered by management.

ARGUMENTS AGAINST VARIABLE COSTING

1. Segregation of costs into fixed and variable might be difficult, particularly

in the case of mixed costs.
2. The matching principle is violated by using variable costing which
excludes fixed overhead from product costs and charges the same to
period costs regardless of production and sales.
 3. With variable costing, inventory costs and other related accounts, such as
working capital, current ratio, and acid-test ratio are understated because
of the exclusion of fixed overhead in the computation of product cost.

Illustrative Example:

During the year 200A, Wouie Corporation’s production was equal to its normal
capacity of 1,000 units. It sold 900 units at a price of P50 per unit.

The following costs were incurred during the year:

Total Cost Cost per Unit

Direct materials P12,000 P12

Direct labor 10,000 10
Variable factory overhead 8,000 8
Fixed factory overhead 6,000 6
Variable selling and administration 4,500 5*
Fixed selling and administration 3,000 3

* Variable selling and = Total = P4,500 = P5

administration cost per unit Units sold 900
‘

Required:

1. Product costs per unit under absorption and variable costing

PRODUCT COST PER UNIT

Absorption Variable
Costing Costing
Direct materials P12 P12
Direct labor 10 10
Variable factory overhead 8 8
Fixed factory overhead 6 -
Product cost per unit P36 P30

 The difference between the two product costs per unit is the fixed
FOH per unit.
  Under both methods, selling and administrative costs, whether
variable or fixed, are treated as period costs.

2. Income under absorption costing

Sales (900 unit x P50) P45,00

Less cost of goods sold (900 x P36) 32,40
Gross income P12,600
Less selling and administrative expenses:
Variable (900 x P5) P4,500
Fixed 3,000 7,500
Income – Absorption costing P5,100

Allocation of the Fixed Overhead Cost:

Total fixed overhead (1,000 units @ P6 per unit) P6,000

Charged to cost of goods sold
(900 units sold x P6 per unit) P5,400
Allocated to inventory cost
(100 unsold units x P6) 600 P6,000

Cost of ending inventory:

Number of units
(1,000 units produced – 900 units sold) 100
x Cost per unit – absorption P36
Cost of ending inventory P3,600*

* Includes fixed overhead cost of P600.

3. Income under variable costing

Sales P45,000
Less variable costs:
Cost of goods sold (900 x P30) P27,000*
Selling and administrative (900 x P5) 4,500 31,500
Contribution margin P13,500
Less fixed costs:
Factory overhead P6,000**
 Selling and administrative 3,000 9,000
Income – Variable costing P 4,500

* The cost of goods sold consist of variable manufacturing costs only. Fixed
factory overhead is not charged to the cost of goods sold.

** The whole amount of fixed factory overhead is charged as a period cost,

regardless of whether all the units produced were sold or not.

Cost of ending inventory:

Number of units 100

x Cost per unit – absorption P30
Cost of ending inventory P3,000*

4. Computation of and accounting for the difference in income

Absorption costing income P5,100

Variable costing income 4,500
Difference in income P 600

The difference in income represents the amount of fixed factory overhead

charged to inventory (treated as asset).

Accounting:
Change in inventory [Production – Sales] 100 units
(1,000 – 900)
x Fixed FOH cost per unit P6
Difference in income P600

STANDARD COSTS UNDER ABSORPTION AND VARIABLE COSTING

When a firm uses the standard costing system and income statements are
prepared under the absorption and variable costing methods.

1. Costs of goods sold are computed at standard.

 2. The standard cost of goods sold is adjusted to actual costs by adding
unfavorable variances and/or deducting favorable variances.
3. In absorption costing, both the variable and fixed manufacturing cost
variances are used as adjustment to the standard cost of goods sold.
4. In variable costing, only the variable manufacturing cost variances are
used as adjustments to the standard cost of goods sold.

Illustrative Example:

Irish Corporation uses a standard costing system for a product that it

manufactures. For the year 200A, the following standards were established
based on normal production of 1,000 units:

Total Cost
Materials 2pcs. @ P6 per piece P12
Labor 5hrs. @ P4 per hour 20
Variable overhead 5 hrs. @ P3 per hour 15
Fixed factory overhead (5 hrs @ P2) 10
Total labor cost per unit P57

Following are the actual data for the year 200A:

Production 1,100 units

Sales 950 units
Selling price P 80
Materials (2,250 @ P5.80) 13,050
Labor (5,420 hrs. @ P4.30 per hour) 23,306
Variable overhead 15,718
Fixed factory overhead 12,000
Selling and administrative expenses: Variable 5,700
Fixed 8,000

Required:

1. Variable for each cost element of production

Materials Labor Variable FOH Fixed FOH

Actual costs P13,050 P23,306 P15,718 P12,000
Standard costs* 13,200 22,000 16,500 11,000
 Variances P 150 F P 1,306 U P 782 F P 1,000 U

* Standard costs = actual production x standard cost per unit

Materials 1,100 x P12 = P13,200

Labor 1,100 x 20 = 22,000
Variable FOH 1,100 x 15 = 16,500
Fixed FOH 1,100 x 10 = 11,000

‘
2. Comparative Income Statements - Absorption and Variable Costing
Absorption Variable
Costing Costing

Sales (950 units x P80) P76,000 P76,000

Cost of goods sold/Variance costs:
Standard cost of goods sold:
(950 x P57) P54,150
(950 x P47) P44,650
Add (Deduct) varaines:
Materials – favorable ( 150) ( 150)
Labor – unfavoble 1,306 1,306
Variable OH – favorable ( 782) ( 782)
Fixed OH – unfavorable 1,000 -
Actual cost of goods sold P55,524 P45,024
Add variable selling and
administrative expenses - 5,700
Total cost of goods sold/Variable costs P55,524 P50,724
Gross income/Contribution margin P20,476 P25,276
Less Operating Expenses/Fixed costs:
Fixed FOH P - P12,000*
Fixed selling and
administrative expenses 8,000 8,000
Variable selling and
administrative expenses 5,700 -
Total operating expenses/Fixed costs P13,700 P20,000
Income P 6,776 P 5,276

* The total actual fixed overhead cost incurred during the period.
 Differences in income (P6,776 – P5,276) P1,500

Accounted for as follows:

Change in inventory [Production – Sales]

(1,100 – 950) 150 units
x Fixed FOH cost per unit P 10
Difference in income P1,500

THE EXTREMES

1. SUPERVARIABLE COSTING OR THROUGHPUT COSTING - treats

direct materials as the only variable costs.

FEATURES:

a. Only materials costs are inventoried; work-in-process or finished goods

inventories are not recorded.
b. Direct labor and manufacturing overhead costs are all treated as period
costs, expensing them as they are incurred.
c. Cost of goods sold in the cost of materials put into process.
d. Sales less cost of goods sold (purely materials) = Throughput
e. Throughput costing results in even lower income than does variable
costing when production exceeds sales.
f. Throughput costing penalizes high production and rewards low
production. Hence, it is very much in tune with JIT and other philosophies
that seek lower inventories.

2. SUPERABSORPTION COSTING – treats costs from all links in the value

chain as inventoriable costs.