CHAPTER 7 ABSORPTION AND VARIABLE COSTING324 paRT 2—- MANAGEMENT ACCOUNTING ABSORPTION COSTING OR FULL COSTING . = a product costing method that includes all the manufacturing costs (direct materials, direct labor, 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 Cesting Variable Costing Direct materials | Direct materials + Direct labor | + Direct labor | + VariableFO+ | + Variable FOH + Fed FOH fe | “autos | saat DISTINCTIONS BETWEEN PERIOD COSTS AND PRODUCT COSTS PERIOD COST ___ PRODUCT CosT | 1. Cost that is charged against | 1 Cost that i is included in the senate sau, time Computaticn of product cost that is pete ede portioned between the sold and unsol production and sales | ee volumes. oni eS S| D 2 Doss ai on Partofthe cost | 2. An inventoriable Cost. The portion | of the cost that has been allocated {o the unsold units becomes part of __the cost of inventorChapter 7 Absorption Costing and Variable c rable Costin % 325 PERIOD COsT 3. Reduces income for the a 5 cowipewemucs |* Seoronsineny te 1@ Sold units; the portion allocated to unsold units is treated as an asset, being part of the cost of inventory. PRINCIPAL DIFFERENCE: PONCE DirreRt 'S BETWEEN ABSORPTION AND VARIABLE ABSORPTION COSTING VARIABLE COSTING 1, Cost ‘Seldom segregittes costs ' Coa ae egal Seqegoon | inoveraeantbadaass | vasiesnghel Cost of inventory includes al | Cost of inventory includes | 2. Cost of the manufacturig costs: ‘only the variable Cosel, | Matis, bor vaiabe | mauleungcas factory oveead, and fixed | mates aor, and vale | factory overheas fecory overhead 3. Treatment Faatrer Ct | riedtatoy oeteatis | Fuelacay omens fedtctoy | reded as prodiet ans. | voted 2 procs Distingushes beeen Disingushes between production and her co's | vanable and fined costs yes 8 aw| s x Income || — Cos grotrtancos) | 6 x Gross prot a | OM * ~ SBA Costs | - BC % Prof Profit & Wat income beeen he two methods may flr om e221 hor pecause che dfernceintre amount ted He ecopized as expense dung an aooutng oveead co avalos between sales and producon riod, This is due o varia frthe long run, rower, ban matods ve susitay the ine sales cannot continuously excee Sn invally exceed sales production, nor aroducton can ‘cont 5. Net incomepART 2— MANAGEMENT ACCOUNTING 326 DIFFERENCE IN NET INCOME UNDER ABSORPTION AND VARIABLE COSTING Variable and absorption costing methods of accounting for fixed manufacturing avérhead result in, different leyels, 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 sg Add Fixed overhead in the beginning inventory » xx Total : = Less Fixed overhead in the ending inventory Variable costing incomeChapter 7 — Absorption Costing Ptlon Costing and Variable Costing 327 ACCOUNTING FOR DIFFERENCE IN INCOME Change in invento: ry (Production less Sal x Fixed FOH cost per unit oo Difference in income BR 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 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. Ilustrative Example: Wouie Corporation's production was equal to Ce eg 100 units. It sold 900 units at a price of P50 per its normal capacity of 1,0 unit,PART 2 MANAGEMENT ACCOUNTING 330 consists of variable manufacturin + ‘The cost of goods sold consists of Say Fixed Jactory overhead is not charged to the cost costs only. 0 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* * Consists of variable manufacturing costs only. Fixed factory overhead is not an inventoriable cost 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 be Difference in income Poo STANDARD COSTS UNDER ABSORPTION AND VARIABLE COSTING standard costing system and income statements 'e absorption and variable costing methods: When a firm ‘uses the are prepared under th 1. Costs of goods sold. are computed at standard.Chapter 7 Absorption Cos tion Costing and Variable Costing 331 oe Tt eae Sak st Goods sold is adjusted to actual costs by a rable jane ieee variances and/or deducting favorable 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 varances are used as adjustments to the standard cost of goods sold. Illustrative Example: Irish Corporation uses a stardard 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: st per Unit Materials 2 pes. @ P6 per piece P12 Labor 5 hrs, @ P4 per hour 20 Variable overhead 5 hrs @ P3 per hour 15 Fixed factory overhead (5 hrs @ P2) a Total standard cost per unit Following are the actual data for the year 200A: 1,100 units Production Sales Selling price Materials (2,250 @ P5.80) Labor (5,420 hrs. @ P4.30) per hour) fone Variable overhead 12.000 Fixed factory overhead ‘ 2a istrati ses: Variable 3; Selling and administrative expenses: \ 2" 57a Fixed Required: ion 1. Variances for each cost e ement of procuct332 PART 2—MANAGEMENT ACCOUNTiyg Materials labor Variable FOH Fixed roy 6 P15,718 —P12,099 913,050 °23,30 x ual costs Saundcot 19200 22000 16500 11.969 oe p150F P130GU Pp _78ZF 000 u aranc B P.1.009 * Standard costs = actual production x standard cost per unit Materials Labor Variable FOH Fixed FOH 1,100 x P12 P13,200, 1,100x 20 22,000 1,100x 15 16,500 1,100x 10 = 11,000 . Comparative Income Statzments - Absorption and Variable Costing Absorption Variable Costing Costing Sales (950 units x P80) P76,000 76,000 Cost of goods sold/Variatle costs: Standard cost of goods sold: (950 x P57) P54,150 (950 x P47) 4a. 650 Add (Deduct) variances: Materials ~ favorable (150) (150) Labor — unfavorable 1,306 1,306 Variable OH — favoraale (782) (782) Fixed OH - unfavorable 1,000 — Actual cost of goods sold 55,524 Pas,024 ‘Add variable selling and administrative expenses = 5,100 Total cost of goods sold/Variable costs P55,524 50,724 toss income/Contribution margin P20,476 25,276 Less Operating Expenses/Fixed costs: Fixed FOH pe P12,000° Fixed selling and administrative epenses 8,000 8,000 Variable selling and ‘ administrative e«penses 5700's r — 8,700 ot operating expenses/Fixed costs 13,700 oaChapter 7 — Absorption Costing and Variable Costing 333 * The total actual fixed overhead cost incurred during the period, Difference in income (6,776 - 5,276) P1500 Accounted for as follows: Change in inventory [Production - Sales] (1,100 - 950) 150 units x Fixed FOH cost per unit P10 Difference in income P1500 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. Sales less cost of goods sold (purely materials) = Throughput d. Throughput costing results in even lower income than does variable costing when production exceeds sales. 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 alll links in the value chain as inventcriable costs.