Overview of Absorption and Variable Costing

1. General

a. Cost accumulation involves determining which manufacturing costs are recorded as product
costs and which are recorded as period costs.
b. Cost presentation involves determining how costs are shown on external financial statements
or internal management reports.
c. The two methods of cost accumulation and presentation are absorption costing and variable
costing.

2. Absorption costing, also known as full costing, is a cost accumulation and reporting method
that treats the costs of all manufacturing components (direct material, direct labor, variable
overhead, and fixed overhead) as inventoriable or product costs.
Absorption costing presents expenses on an income statement according to their functional
classifications. A functional classification is a group of costs that were all incurred for the
same principle purpose. Examples include cost of goods sold, selling expenses, and
administrative expenses. The absorption costing income statement format is as follows:
Revenue – Cost of Goods Sold – Selling & Administrative Expenses = Income before Tax
Non-manufacturing costs (selling and administrative) are considered to be period costs and
are expensed in the period incurred.

3. Variable costing, also known as direct costing, is a cost accumulation and reporting method
that includes only variable production costs (direct material, direct labor, and variable
overhead) as inventoriable or product costs. The variable costing income statement presents
expenses according to cost behavior (variable and fixed):
Revenue – Variable CGS = Product CM – Variable S&A Expenses = Total CM – Fixed
Expenses (OH and S&A) = Income before Tax
Cost of goods sold is more appropriately called variable cost of goods sold since it is
composed of only the variable production costs (DM, DL, VOH) related to the units sold.
Product contribution margin is the difference between selling price and variable cost of
goods sold and indicates how much revenue is available to cover all period costs and to
potentially provide net income. Product contribution margin is commonly called
manufacturing margin. Total contribution margin is the difference between revenue and all
variable costs regardless of the area of incurrence (production or nonproduction).

4. Thus, two differences exist between absorption and variable costing: one relates to cost
accumulation and the other relates to cost presentation.
a. The cost accumulation difference is that absorption costing treats fixed overhead as a
product cost while variable costing treats it as a period cost.
Absorption costing advocates contend that fixed overhead costs should be considered
product costs since production could not take place without the incurrence of fixed
overhead.
Variable costing advocates contend that fixed overhead costs would be incurred whether
or not any products are manufactured; thus, such costs are not caused by production and
cannot be product costs.
b. The cost presentation difference is that absorption costing classifies expenses by function
whereas variable costing categorizes expenses by behavior first and then by function.

5. Absorption costing is the traditional approach to product costing and must be used for external
financial statements and tax returns.
Authoritative accounting bodies such as the FASB and the SEC believe absorption costing
furnishes external parties with a more informative picture of earnings, as compared to variable
costing.
Variable costing is not acceptable for external reporting and tax returns. Since variable costing
distinguishes costs by behavior, variable costing reports are more useful for managerial
activities such as budgeting, cost-volume-profit analysis, and relevant costing
where an understanding of cost behavior is extremely important.

Phantom profits are temporary absorption costing profits caused by producing more
inventory than is sold. Absorption costing creates phantom profits when more inventory is
produced than is sold because fixed overhead costs are deferred in the ending inventory
whereas all fixed costs are expensed under variable costing in the period incurred. When
previously produced inventory is sold, phantom profits disappear.

Absorption costing income will be greater than variable costing income if production is
greater than sales as some fixed overhead cost is deferred as part of inventory cost on
the balance sheet under absorption costing whereas the total amount of fixed overhead
cost is expensed as a period cost under variable costing. Absorption costing income will be less
than variable costing income if production is less than sales. Absorption costing expenses all of
the current period fixed overhead cost as well as releasing some fixed overhead cost from
beginning inventory where it had been deferred from a prior period.
Variable costing shows on the income statement only current period fixed overhead, so that the
additional fixed overhead released from beginning inventory makes absorption
costing income lower.
The differences in income between the two methods are only timing differences based on
when fixed overhead costs flow through to the income statement as part of cost of goods sold
under absorption costing. Total income over the life of the enterprise will ultimately be the
same under both methods. The process of deferring and releasing fixed overhead costs into and
from inventory does make it possible to manipulate income under absorption costing by
adjusting levels of production relative to sales. This leads some people to believe that variable
costing might be more useful for external reporting purposes than absorption costing.
To plan, control, and make decisions, managers need to understand and be able to project how
costs will change in reaction to changes in activity levels. Thus, variable costing is more
useful than absorption costing since variable costing provides information about the behavior
of costs.
 1. Vidal Corporation produces a single product. The following is a cost structure applied to its first year of
operations.

Sales price $15 per unit

Variable costs:
SG&A $2 per unit
Production $4 per unit
Fixed costs (total cost incurred for the year):
SG&A $14,000
Production $20,000

During the first year, Vidal Corporation manufactured 5,000 units and sold 3,800. There was no
beginning or ending work-in-process inventory.

a. How much income before income taxes would be reported if Vidal Corporation uses
absorption costing?
b. How much income before income taxes would be reported if variable costing was used?
c. Show why the two costing methods give different income amounts.

2. Owens Athletics, Inc. has developed a new design to produce hurdles that are used in track and field
competition. The company's hurdle design is innovative in that the hurdle yields when hit by a runner and
its height is extraordinarily easy to adjust. Management estimates expected annual capacity to be 90,000
units; overhead is applied using expected annual capacity. The company's cost accountant predicts the
following current year activities and related costs:

Standard unit variable manufacturing costs $12

Variable unit selling expense $5
Fixed manufacturing overhead $495,000
Fixed selling and administrative expenses $136,000
Selling price per unit $35
Units of sales 80,000
Units of production 85,000
Units in beginning inventory 10,000

Other than any possible under- or overapplied fixed overhead, management expects no variances from the
previous manufacturing costs. Under- or overapplied fixed overhead is to be written off to Cost of Goods
Sold.

Required:
1. Determine the amount of under- or overapplied fixed overhead using (a) variable costing and
(b) absorption costing.

2. Prepare projected income statements using (a) variable costing and (b) absorption costing.

3. Reconcile the incomes derived in part 2.

 3. Dynamic Designs, Inc. has developed a new design to produce track shoes that are used in cross-country
races. The company's shoe design is innovative in that the insole is made od a product that provides a
greater cushion and adapts more easily to a runner’s foot. Management estimates expected annual
capacity to be 80,000 units; overhead is applied using expected annual capacity. The company's cost
accountant predicts the following current year activities and related costs:

Standard unit variable manufacturing costs $140

Variable unit selling expense $6
Fixed manufacturing overhead $2,400,000
Fixed selling and administrative expenses $164,000
Selling price per unit $225
Units of sales 70,000
Units of production 81,000
Units in beginning inventory 15,000

Other than any possible under- or overapplied fixed overhead, management expects no variances from the
previous manufacturing costs. Under- or overapplied fixed overhead is to be written off to Cost of Goods
Sold.

Required:
1. Determine the amount of under- or overapplied fixed overhead using (a) variable costing and
(b) absorption costing.

2. Prepare projected income statements using (a) variable costing and (b) absorption costing.

3. Reconcile the incomes derived in part 2.

4. On December 30, a fire destroyed most of the accounting records of the Stone Division, a small one-
product manufacturing division that uses standard costs and flexible budgets. All variances are written off
as additions to (or deductions from) income; none are pro-rated to inventories. You have the task of
reconstructing the records for the year. The general manager informs you that the accountant has been
experimenting with both absorption costing and variable costing.

The following information is available for the current year:

a. Cash on hand, December 31 $10

b. Sales $128,000
c. Actual fixed indirect manufacturing costs 21,000
d. Accounts receivable, December 31 20,000
e. Standard variable manufacturing costs per unit 1
f. Variances from standard of all variable manufacturing costs $5,000 U
g. Operating income, absorption-costing basis $14,400
h. Accounts payable, December 31 18,000
i. Gross profit, absorption costing at standard (before deducting
variances) 22,400
j. Total liabilities 100,000
k. Unfavorable budget variance, fixed manufacturing costs 1,000 U
l. Notes receivable from chief accountant 4,000
m. Contribution margin, at standard (before deducting variances) 48,000
n. Direct-material purchases, at standard prices 50,000
o. Actual selling and administrative costs (all fixed) 6,000
Required:

Compute the following items (ignore income tax effects).

1. Operating income on a variable-costing basis.

2. Number of units sold.
3. Number of units produced.
4. Number of units used as the denominator to obtain fixed indirect cost application rate per
unit on absorption-costing basis.
5. Did inventory (in units) increase or decrease? Explain.
6. By how much in dollars did the inventory level change (a) under absorption costing, (b)
under variable costing?
7. Variable manufacturing cost of goods sold, at standard prices.
8. Manufacturing cost of goods sold at standard prices, absorption costing.