STRATEGIC COST MANAGEMENT

Absorption & Variable Costing

Absorption Costing – is a costing method that includes all manufacturing costs – direct materials, direct labor, variable and
fixed factory overhead – in the cost of a unit of product. It treats fixed factory overhead (FFOH) as a product cost. Absorption
costing is also known as full costing.

Variable Costing – is a costing method that includes only variable manufacturing costs – direct materials, direct labor, and
variable factory overhead – in the cost of a unit of product. It treats fixed overhead as a period cost. Variable costing is also
called direct costing.

Product Cost vs. Period Cost

A product cost is an inventoriable cost that is subject to allocation between sold and unsold units. Current income is
reduced only by the amount allocated to the sold units. While period cost is a cost charged as expense against income,
regardless of the sales performance. No allocation is necessary so current income is reduced by the full amount of the period
cost.

UNSOLD UNITS  Asset (as inventory)

PRODUCT
COST SOLD UNITS  Expense (as COGS)

PERIOD COST FULLY EXPENSED (Whether sold or unsold)

Absorption vs. Variable Costing

 Inventories
 Under absorption costing, FFOH is considered as a product cost; while under variable costing, it is treated as a
period cost. Because of this, the peso amount of inventories under variable costing is always smaller than the peso amount of
inventories under absorption costing.

 Rationale
 Supporters of variable costing argue that FFOH costs are incurred in order to have the capacity to product units in a
given period. These costs are incurred whether or not the capacity is actually used to make output. Thus, FFOH, having no
future substantial service potential, should be charged against the period and not included in the product cost.
 Supporters of absorption costing believe that all manufacturing costs – variable and fixed – are necessary
ingredients for production to take place and should not be ignored in determining product costs.

 Acceptability
 Since treating FFOH as an inventoriable cost is consistent with accounting standards, only absorption costing is
acceptable for financial reporting and tax purposes. Variable costing, which violates the ‘matching principle’, is not acceptable for
financial reporting and tax purposes.

 Income Statement
 An income statement prepared under absorption costing distinguishes between production and other costs.
Production costs pertaining to sold units are first deducted from sales to arrive at gross profit, and then other costs are deducted
to obtain net income.
 Under variable costing, the income statement distinguishes between variable and fixed costs. All variable costs are
first deducted from revenue to arrive at the contribution margin, and then fixed costs are deducted to obtain profit.

 Income Computation
 Variable costing income may differ from absorption costing because of the difference in the amount of FFOH
recognized as expense during an accounting period. This is actually caused by the difference between production and sales
volume. In the long run, however, both methods would yield the same results since sales cannot continuously exceed
production, nor production can continuously exceed sales.

Illustration: Computation of Unit Cost and Ending Inventory under Absorption and Variable Costing

Kulafu Co. operated at a normal capacity of 1,000 units in the year 2014. The company sold 80% of these units at a
price of P12 per unit. Manufacturing costs incurred during the year are as follows:
Manufacturing:
Materials P 1,500
Labor 1,000
 Variable Factory Overhead 500
Fixed Factory Overhead 2,000

Selling and Administrative:

Variable P 1,200
Fixed 800

Required:
1. Inventory cost per unit under absorption and variable costing.
2. Cost of ending inventory under absorption and variable costing.
Illustration: Difference in Income between Absorption and Variable Costing

Kurimaw Co. makes state-of-the-art pajamas. Each pajama sells for P1,000 each. Data for 2014’s operation are as follows:
Units:
Beginning Inventory 5
Production 80
Ending Inventory 15
Variable Costs:
Direct Materials P 24,000
Direct Labor 16,000
Factory Overhead 8,000
Selling and Administrative 4,000
Fixed Costs:
Factory Overhead P 20,000
Selling and Administrative 2,000

Required:
1. Prepare income statements under both absorption and variable costing. Net income: AC-P4,500; VC-P2,000
2. Provide computation explaining the difference in income between the two costing methods. (80-70) x P250 = P2,500

Reconciliation of Income under Absorption and Variable Costing

 The difference between the absorption costing income and variable costing income is primarily a timing difference –
when to recognize the FFOH as an expense.
 In variable costing, it is expensed when FFOH is incurred, while in absorption costing, it is expensed in the period when
the related units are sold.
 The relationship between production and sales generally indicate the following income patterns:
 When production is equal to sales, there is no change in inventory. FFOH expensed under absorption costing
equals FFOH expensed under variable costing.
 When production is greater than sales, there is an increase in inventory. FFOH expensed under absorption
costing is less than FFOH expensed under variable costing. Therefore, absorption income is greater than
variable income.
 When production is less than sales, there is a decrease in inventory. FFOH expensed under absorption
costing is greater than FFOH expensed under variable costing. Therefore, absorption income is less than
variable income.
 POINT OF RECONCILIATION:
Income – Absorption P xxx
Add: FFOH in beginning inventory xxx
Total P xxx OR ∆ Income = ∆ Inventory x FFOH/u
Less: FFOH in ending inventory (xxx)
Income – Variable P xxx

Illustration: Reconciliation of Income under Absorption and Variable Costing

The following information is taken from the books of Bakulaw Company, which assumes first-in, first-out (FIFO) for
inventory cost flow:
2013 2014
Beginning inventory None ?
Production 10,000 units 9,000 units
Ending inventory 3,500 units 1,000 units

Sales (P2 per unit) ? ?

Variable manufacturing costs (P0.75/unit) P 7,500 P 6,750
Fixed manufacturing costs 5,000 5,400
Selling and administrative costs (50% variable) 4,500 7,500
Required:
 1. Determine the 2013 profit under absorption and variable costing.
2. Reconcile the two income figures in No. 1.
3. Determine the 2014 profit under absorption and variable costing.

Advantages of Using Variable Costing:

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

Disadvantages of Using Variable Costing:

1. Not in accordance with GAAP; hence, it is not acceptable for external reporting.
2. Segregation of costs into fixed and variable might be difficult.
3. The matching principle is violated.
4. Inventory costs and other related accounts, such as working capital, current ratio, and acid-test ratio are understated
because of the exclusion of FFOH in the computation of product cost.