BM1915

PRODUCT COSTING

Product Costing Methods

Income is one of the many important measures managers use to make decisions and evaluate operational
performance. In a manufacturing firm, two (2) alternative accounting treatments of fixed manufacturing
overhead can result in different reported income amounts for the company. The difference in reported income
can alter management’s view of the profitability of a particular decision or segment of the company (Hilton &
Platt, 2017). Normally, accountants and managers make a judgment when measuring income, and one of the
most important factors is choosing the appropriate method in calculating the product cost.
When managers realized that product costing would affect their evaluation, they started to pay attention to the
determination of product costs. The two (2) product costing methods that differ in the treatment of the fixed
manufacturing overhead are absorption costing and variable costing. In comparing these methods,
knowledge about product costs and period costs must be considered.
Table 1 shows the differences between product cost and period cost:
Product Cost Period Cost
1. It is a cost assigned to units produced until they 1. It is a cost that is matched against revenues in the
are sold. time period in which it is incurred regardless of the
difference between production and sales volume.
2. It is initially recorded as part of the inventory. 2. It does not form part of the cost of inventory.
3. It diminishes current income by that portion 3. It diminishes income for the current period by its full
identified with the sold units only with the amount.
remainder being carried over to the next
accounting period as part of the cost of ending
inventory.
4. Examples: Direct materials, direct labor, and 4. Examples: General and administrative expenses
manufacturing overhead such as rent, depreciation, utilities, and advertising
expense
Table 1. Differences between product cost and period cost

Product cost is viewed as “attaching” to the cost of the product as the goods are manufactured. It remains to
be the cost of the goods in inventory awaiting sale. As goods are sold, this will be released from inventory as
expenses (cost of goods sold) and matched against sales revenue.
Period cost is a cost that is matched against revenue in the period in which it was incurred. Therefore, it does
not form part of the manufacturing costs. Period costs include the normal operating expenses of the company.
The classification of product costs and period costs are very useful in financial statement presentation,
particularly income statement using variable costing method.
The following are the product costing methods:
1. Absorption Costing – It is also known as “full costing” or “conventional costing.” In this method, all
manufacturing costs (i.e., direct materials, direct labor, and manufacturing overhead) are recognized as
product costs, regardless of whether they are variable or fixed (Garrison et al., 2018). This means that all
manufacturing costs are assigned to (or absorbed by) the units produced.

Figure 1. Manufacturing costs for absorption costing

Figure 1 illustrates all the manufacturing costs needed to produce the product. These are the direct
materials, direct labor, variable manufacturing overhead, and fixed manufacturing overhead. As the goods

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 are produced, these costs are recognized in the balance sheet as part of inventory (as discussed in 02
Financial Statement Analysis). As the goods are sold, all the manufacturing costs of the units sold will
be part of the cost of goods sold (an account recognized in the income statement). In using the
absorption costing, the fixed overhead per unit is computed based on the level of production.
Since absorption costing includes all the manufacturing costs in costing the product, it cannot be used to
prepare a contribution margin income statement, which is one of the best measures in evaluating the
performance of a segment or department. In this regard, an alternative costing is used by the
management for internal use only. This is called variable costing.

2. Variable Costing – It is also known as “marginal costing” or “direct costing.” It recognizes that the cost of
the product must include only those production costs that vary directly within the volume of production.
This method only includes variable manufacturing costs in the cost of a unit of product. It treats fixed
manufacturing overhead as period cost.

Figure 2. Manufacturing costs for variable costing

In Figure 2, all manufacturing costs (except for the fixed manufacturing overhead) are considered part of
the cost of the product. These costs are recognized in the balance sheet as part of the inventory. As the
goods are sold, the cost of the product will be recognized in the income statement as cost of goods sold.
However, the fixed manufacturing overhead will be considered as period cost, i.e., the cost will be
expensed as incurred. This is because this cost will be incurred whether or not production occurs, and it
is improper to allocate these costs to production and defer current costs of doing business.
Under variable costing, there is a method called throughput costing. It is also known as “supervariable
costing,” which is an extreme form of variable costing in which only direct material costs are considered
product costs included as cost of inventory. All other costs are period costs that are expensed as
incurred.

Advantages of Variable Costing (Weygandt et al., 2018)

1. The use of variable costing is consistent with the cost-volume-profit (CVP) analysis and
differential cost analysis. Differential cost analysis is a decision-making technique in which the
evaluation is confined only to those factors that are different or unique among possible alternatives.
(This will further be discussed in the Differential Cost Analysis topic.) Variable costing is consistent
with CVP analysis and differential cost analysis because they both use contribution margin income
statement in analyzing the revenues and costs.
2. Net income calculated under variable costing is not affected by changes in production levels.
When using variable costing, the profit or net income of the company is not affected by changes in
inventories. It is mentioned that variable costing does not include the fixed costs in the cost of the
product because these costs do not change even if there is a change in the level of production. In
computing for the contribution margin, only variable manufacturing costs are considered as product
costs. As a result, understanding the impact of fixed and variable costs on the calculation of net
income when using variable costing is much easier.
3. Net income calculated under variable costing is greatly affected by changes in sales levels (not
production levels), therefore providing a more realistic assessment of the company’s success or
failure during a period. With the use of variable costing, estimating the profitability of products and
departments is easier. The costs to be deducted from sales to compute the contribution margin are all
variable costs, which are based on the level of sales and not on the level of production. Then, the fixed
costs are deducted from the contribution margin as period costs to reflect the net income.
 4. Because the fixed and variable cost components are shown in the contribution margin income
statement, identifying these costs and understand their effect on the business is easier.
Under absorption costing, the allocation of fixed costs to inventory makes it difficult to evaluate the
impact of fixed costs on the company’s results. If the fixed manufacturing overhead is included as part
of the cost of inventory, the portion associated with the unsold units of product is deferred or carried
forward to the next accounting period. This makes it difficult because fixed costs are incurred whether
or not production occurs, and they are normally considered as period costs in time in which they are
incurred.
Table 2 shows the principal differences between variable and absorption costing:
Variable Costing Absorption Costing
1. Cost segregation Costs are segregated into Costs are seldom segregated
variable or fixed. into variable and fixed costs.
2. Cost of inventory Cost of inventory includes only Cost of inventory includes all
the variable costs. the manufacturing costs,
variable and fixed.
3. Treatment of fixed Fixed manufacturing overhead Fixed manufacturing overhead
manufacturing overhead is treated as period cost. is treated as product cost.
4. Income statement Distinguishes between variable Distinguishes between
and fixed costs production and other costs
5. Net Income Net income may differ from each other because of the difference
in the amount of fixed overhead costs recognized as expense
during an accounting period. In the long run, however, both
methods give substantially the same results since sales cannot
continuously
exceed production, nor production can continually exceed sales.
Table 2. Differences between variable costing and absorption costing

Reconciliation of Net Income

The following observations could be developed regarding variable costing and absorption costing in relation to
production and sales (Garrison et al., 2018):
1. Production equals sales
When units produced is equal to units sold, there is no change in inventory. The same net income will
be realized regardless of the method used.
2. Production is greater than sales
When units produced exceed units sold, there is an increase in inventory. The fixed overhead
expensed under absorption costing is less than the fixed overhead expensed under variable costing.
Therefore, the net income reported under absorption costing will be greater than the net income
reported under variable costing.
3. Production is less than sales
When units sold exceeds units produced, there is a decrease in inventory. The fixed overhead
expensed under absorption costing is greater than the fixed cost expensed under variable costing.
Therefore, the net income reported under absorption costing will be less than the net income reported
under variable costing.
When inventory increases or decreases during the year, reported income differs under absorption and variable
costing. This results from the fixed overhead that is inventoried under absorption costing but expensed
immediately under variable costing. The following formula may be used to compute the difference in the
amount of fixed overhead expensed in a given period under the two (2) product costing methods (Hilton &
Platt, 2017):
𝐷𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑖𝑛 𝑓𝑖𝑥𝑒𝑑 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑 = 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑢𝑛𝑖𝑡𝑠 𝑥 𝐹𝑖𝑥𝑒𝑑 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡
The difference in fixed overhead is also the difference between the net income under the two (2) methods.
 Pro forma reconciliation
1. Absorption to Variable Costing
Absorption costing Net Income P xxx
Add: Fixed overhead in beginning inventory xxx
Less: Fixed overhead in ending inventory xxx
Variable costing net income P xxx
2. Variable to A bsorption Costing
Variable costing Net Income P xxx
Add: Fixed overhead in ending inventory xxx
Less: Fixed overhead in beginning inventory xxx
Absorption costing net income P xxx

ILLUSTRATION:
ANJY Corporation has the following information in its first year of operations in 201A:
Units produced 40,000
Units sold 36,000
Selling price per unit P60
Variable manufacturing costs P24 per unit produced
Variable selling expenses P6 per unit sold
Fixed manufacturing costs P500,000
Fixed administrative expenses P250,000
Assume that the actual production is the same as the normal operating level for the year. Income statements
under the two (2) methods will be presented as follows:

ANJY Corporation
Income Statement (Absorption Costing)
December 31, 201A

Sales (36,000 x P60) P2,160,000

Less: Cost of Goods Sold (36,000 x P36.50) 1,314,000
Gross Profit 846,000
Less: Selling and Administrative Expenses
Variable Selling (36,000 x P6) P216,000
Fixed administrative 250,000 466,000
Net Income P380,000

The cost of goods sold by P36.50 per unit is computed as the sum of variable and fixed manufacturing costs per
unit [P24 + (P500,000/40,000)]. The cost of ending inventory will be P146,000 (P36.50 x P4,000 units unsold).

ANJY Corporation
Income Statement (Variable Costing)
December 31, 201A
Sales (36,000 x P60) P2,160,000
Less: Variable Costs
Cost of Goods Sold (36,000 x P24) P864,000
Selling Costs (36,000 x P6) 216,000 1,080,000
Contribution Margin 1,080,000
Less: Fixed Costs
Manufacturing Costs 500,000
Administrative Costs 250,000 750,000
Net Income P330,000

The income statement under variable costing separates variable costs and fixed costs and shows a
contribution margin instead of a gross profit, as shown under absorption costing. The cost of ending inventory
under variable costing is P96,000 (P24 x 4,000 units unsold).
As shown in the two (2) income statements, the difference between the net income of the two (2) methods is
P50,000. This is also the difference between the cost of ending inventory and comprises the fixed
manufacturing overhead in ending inventory of P50,000 (P12.50 x 4,000 units unsold).

To reconcile the net income in the two (2) methods, it shall be computed as follows:

Variable costing net income P330,000 Absorption costing net income P380,000
Add: Fixed manufacturing costs in Less: Fixed manufacturing costs in
ending inventory (4,000 x P12.50) 50,000 ending inventory (4,000 x P12.50) 50,000
Absorption costing net income P380,000 Variable costing net income P330,000

Assume that the direct material per unit is P12, the following is the income statement using throughput costing:
ANJY Corporation
Income Statement (Throughput Costing)
December 31, 201A
Sales (36,000 x P60) P2,160,000
Less: Direct Materials (36,000 x P12) 432,000
Throughput Margin 1,728,000
Less:
Variable manufacturing costs (40,000 x
P12) P480,000
Variable Selling Expenses (36,000 XP6) 216,000
Fixed Manufacturing Costs 500,000
Fixed Administrative Expenses 250,000 P1,446,000
Net Income P282,000

In throughput costing, only the cost of materials is included in the cost of inventory. Direct labor and
manufacturing overhead costs are all treated as period costs, expensing them as they are incurred. This
means that it is based on the units produced, not on the units sold. When production exceeds sales, the net
income reported in throughput costing is much lower than variable and absorption costing.

References:
Garrison, R. H., Noreen, E. W., & Brewer, P. C. (2018). Managerial accounting. McGraw-Hill Education.
Hilton, R. W., & Platt, D. E. (2017). Managerial accounting: Creating value in a dynamic business
environment.
McGraw-Hill Education.
Weygandt, J. J., Kimmel, P. D., Kieso, D. E., & Aly, I. M. (2018). Managerial accounting: Tools for business
decision-making. John Wiley & Sons, Inc.