BA 168 – Variable and Absorption Costing

Variable Costing (Direct or Marginal costing)

- Only manufacturing costs which vary with output are treated as product costs
- DM, DL, Variable portion of overhead
- Fixed OH  period cost
- FOH expensed immediately (regardless of when products sold)
- Contribution I/S format (Costs by behavior – variable, fixed costs)
o Contribution margin: Sales – Variable expenses
- Advantage/Disadvantage
o Enables CVP analysis – properly distributes V/F costs
o Easy to explain changes in net operating income  When sales go up, net operating
income goes up (for absorption  may effect yung invty produced vs sold)
o Supports decision-making  Correctly identifies marginal costs (additional variable
costs) that will be incurred to create one more unit of product
 Highlights amount of fixed OH that should be covered for the company to be
profitable

Absorption Costing (Full cost method)

- All manufacturing costs as product cost, w/n variable/fixed
- FOH included in WIP  Flow only as COGS once sold
- Income statement categorizes cost by function – manufacturing, selling and admin
- Advantage/Disadvantage
o Absorption NI may or may not agree with results of CVP analysis
 Sales to attain target profit = (Target profit + Fixed expenses) / Contribution
margin ratio
 But target profit depends on how much COGS you recognize in prior and current
period/s, so will differ from target profit under variable costing

Differences of costing methods

- Operating income is different – fixed OH capitalized in inventories (product costs) and
recognized only as COGS (expensed) when sold (deferred in ending inventory)
- When units produced > units sold (mas marami natitira in inventory)  absorption NI is higher
- When units produced < units sold (prior period FOH is released in current period as COGS) 
variable NI is higher
- When units produced = units sold  NI same for both methods
- How to reconcile difference in net income
o Determine how much FOH was deferred from last and released in current periods
o MOH deferred (released from) inventory = FOH EI – FOH BI
- If company uses Lean Production  units produced = units sold  No differences between
methods