COLLEGE OF BUSINESS AND ACCOUNTANCY

Topic
Absorption and Variable Costing

Learning Objectives:
At the end of this module, the student should be able to:
Explain the meaning and underlying concept of variable costing.
Prepare income statements under variable costing and absorption costing.
Reconcile net income computed under absorption costing and net income computed under
variable costing.
Know why the managers prefer direct costing to absorption costing.

Biblical Values Integration:

For I know the plans I have for you,” declares the LORD, “plans to prosper you and not to harm you,
plans to give you hope and a future.
-Jeremiah 29:11
Introduction:

Planning decisions typically analysis of how alternative inventory-costing choices would affect
reported income. Reported income is considered crucial in evaluating performance of managers.

The inventory costing choices relate to which manufacturing costs are treated as inventoriable cost.
There are three of inventory costing:
1. Absorption costing
2. Variable Costing
3. Throughput costing

Body:
Absorption costing
- It is a method of product costing in which all manufacturing costs, fixed and variable are
treated as product inventoriable costs.
- Other terms: full, traditional, conventional, and normal costing

Variable costing
 - it is a method of inventory costing in which all variable manufacturing costs are included as
inventoriable costs. All fixed manufacturing costs are excluded from inventoriable costs, fixed
manufacturing costs are instead treated as costs of the period in which it is incurred.
- Other term: direct costing

Product cost versus Period cost

Product Cost versus Period cost
Costs incurred to produce the Costs incurred outside of the
product Definition production activities

Allocated to:

1.For unsold units – will form

part of Inventory (Asset)
Treatment FULLY expensed immediately
2. For sold units – will form
part of the Cost of Goods Sold
(Expense)
Diminishes current income by
that portion identified with
Diminishes income for the
the sold units only with the
Effect on the Net Income current period by its full
remainder being deferred to
amount
the next accounting period as
part ending inventory
Direct materials Administrative Expenses
Direct labor Examples Selling Expenses
Factory overhead

EXERCISE:
Identify whether the following costs are product cost or period cost:
Item Classification on the FS Period/Product Cost
Flour Inventory Product Cost
Milk Inventory Product Cost
Eggs Inventory Product Cost
Electricity Untilities Period
Box Selling expense Period
Paper and ribbon Selling expense Period
Molding pan Ppe N/A
Baking oven ppe N/A
Dishwashing liquid Supplies expense Product Cost
Upa kay bunso inventory Product Cost
Pro-forma Condensed Statement of Profit or Loss – Variable Costing
Variable Costing
Pro-Forma Statement of Profit or Loss

Sales P xx
Less: Variable costs xx
Contribution Margin Less: Fixed costs xx
Net income xx
P xx

Pro-forma Condensed Statement of Profit or Loss – Absorption Costing

Absorption Costing
Pro-Forma Statement of Profit or Loss

Sales P xx
Less: Cost of Goods Sold xx
Gross Profit xx
Less: Administrative and Selling Expenses xx
Net income P xx

Advantages of using Variable Costing

1. It meets the objectives of management control systems by showing separately those costs
that can be traced to and controlled by each strategic business unit (SBU).
2. Variable costing reports are simpler and more understandable.
3. Appraisal of performance of product line or other segments of the business can be facilitated
without the need for arbitrary allocations of fixed cost.
4. Data needed for break-even and cost volume profit analysis are readily available
5. Variable costing reports provide useful information for pricing decisions and other
decisionmaking problems encountered by management.
Disadvantages of using Variable Costing
1. It may encourage a shortsighted approach to profit planning at the expense of the long-run
situation.
2. It tends to give the impression that variable costs are recovered first, that fixed costs are
recovered later and that finally profits are realized.
3. It is not acceptable for external reporting and tax purposes.

Comparison between Variable Costing and Absorption Costing

Variable Costing Absorption Costing

Rationale
Cost segregation
Cost of Inventory
Treatment of fixed factory
overhead
Acceptability of using the
method
Income statement
Net income
Reconciliation of income
1. 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.
Supporters of VC argue that
Fixed Factory Overhead costs Supporters of AC believe that
are incurred whether or not all manufacturing costs –
production occurs. variable and fixed – are
necessary for production to
Having no future service take place and hence should
potential, FFOH should be fully not be ignored in determining
expensed in the same period product costs.
incurred.
Costs are segregated into Seldom segregates costs into
variable and fixed. variable and fixed cost.
Cost of inventory includes only Cost of inventory includes ALL
the variable manufacturing the manufacturing costs:
costs: direct materials, direct direct materials, direct labor,
labor and variable factory variable factory overhead and
overhead fixed factory overhead.
Treated as period cost Treated as product cost
Acceptable only for internal
reporting purposes for the
management.
Acceptable for external
reporting and tax purposes.
It violates the matching
principle.
Distinguishes between variable Distinguishes between
and fixed costs. production and other costs.
Net income between variable costing and absorption costing
may differ because of the amount of FFOH recognized as
expense during a period, caused by the difference between
production and sales.
In the long run, however, both methods would yield the same
income since sales cannot continuously exceed production, nor
production can continuously sales.
2. 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 the fixed overhead expensed under variable
costing. Therefore, absorption costing income is greater than variable costing income.

The reason is fixed overhead charged against sales being a product cost under the absorption
costing is constant regardless of the level of sales while the…..

3. Production is Less than Sales

When production is less than sales, there is a decrease in inventory. Fixed overhead expensed
under absorption costing is greater than the fixed overhead expensed under variable costing.
Therefore, absorption costing income is less than variable costing income.

Throughput costing
- Also known as super-variable costing
- It is a variation on variable costing in which only the direct materials form part of the
product cost. It classifies ALL the direct labor and manufacturing overhead costs as fixed
period costs.
References:
Managerial Economics Third Management Accounting Concepts and Applications by Ma.
Elenita Balatbat Cabrera, Latest Edition

Management Advisory Services by Rodelio S. Roque, Latest Edition

Exercises:
1. Lumalaban Company manufactures calculators and began operations in 2021. For 2021,
Lumalaban budgeted to produce and sell 20,000 units. Actual data for 2021 are given as follows:

Selling price P400

Units produced 20,000

Units sold 17,500

Variable costs per unit:

 Direct materials P30
Direct labor 25
Variable manufacturing overhead 60
Variable selling and administrative 45

Fixed costs:
Fixed manufacturing overhead P1,100,000
Fixed selling and administrative 2,330,000

Required:
A. What is the unit product cost for the month under variable costing?
B. What is the unit product cost for the month under absorption costing?
C. What is the net operating income for the month under variable costing?
D. What is the net operating income for the month under absorption costing?
E. What is the total period cost for the month under the variable costing?
F. What is the total period cost for the month under the absorption costing?

Use the following format in computing income under the two costing methods:

Absorption Costing Variable Costing

Sales Sales
Less: COGS Less: Variable costs
Variable Manufacturing cost Variable Manufacturing cost
Fixed manufacturing cost Variable Selling and administrative
COGS Total variable costs
Gross profit Contribution margin
Less: Operating expenses Less: Fixed costs
Variable Selling and administrative Fixed manufacturing cost
Fixed Selling and administrative Fixed selling and administrative
Total Operating expenses Total fixed costs
Net Income Net income

2. HindiSusuko Company prepared the following absorption-costing income statement for the year
ended December 31, 2021.

Sales (16,000 units) P320,000

Cost of goods sold 216,000
Gross margin P104,000
Selling and administrative expenses 46,000
Operating income P 58,000

Additional information follows:

 Selling and administrative expenses include P1.50 of variable cost per unit sold. There was no
beginning inventory, and 17,500 units were produced. Variable manufacturing costs were P11
per unit. Actual fixed costs were equal to budgeted fixed costs.

Required:
Prepare a variable-costing income statement for the same period.

3. Magtatagumpay Corporation began business in 2021. Production for the year was 100,000
bottles of mouthwash, and sales were 98,000 bottles. Costs incurred during the year were as
follows:

Ingredients used P28,000

Direct labor 13,000
Variable overhead 24,000
Fixed overhead 12,000
Variable selling expenses 5,000
Fixed selling and administrative expenses 14,000
Total actual costs P96,000

Required:
A. What was the actual production cost per bottle under variable costing? Under absorption
costing?
B. What was variable Cost of Goods Sold for 2021 under variable costing?
C. What was Cost of Goods Sold for 2021 under absorption costing?
D. What was the value of ending inventory under variable costing? Under absorption costing?
E. How much fixed overhead was charged to expense in 2021 under variable costing? Under
absorption costing?

DO IT YOURSELF:
1. The term that is most descriptive of the type of cost accounting often called direct costing is:
A. Absorption costing
B. Variable costing
C. Relevant Costing
D. Prime costing

2. In a variable costing system, product cost includes

A. direct materials, direct labor, variable overhead
B. direct materials, direct labor, fixed overhead
C. direct labor, variable overhead, fixed overhead
D. direct materials, variable overhead, fixed overhead
3. When absorption costing is used, all of the following costs are considered product costs
except
A. direct labor C. variable selling and administrative costs B. variable overhead
D. fixed overhead

4. Which of the following is an argument against the use of direct (variable) costing? A.
Absorption costing overstates the balance sheet value of inventories.
B. Variable factory overhead is a period cost.
C. Fixed factory overhead is difficult to allocate properly.
D. Fixed factory overhead is necessary for the production of a product.

5. Grey Corporation manufacturing costs were as follows:

Direct materials and direct labor P700,000

Other variable manufacturing costs 100,000
Depreciation of factory building and manufacturing equipment 80,000
Other fixed manufacturing overhead 18,000

What amount should be considered product cost for external reporting purposes?
A. P700,000 B. P800,000 C. P880,000 D. P898,000

6. The total production cost for 20,000 units was P21,000 and the total production cost for
making 50,000 units was P34,000. Once production exceeds 25,000 units, additional fixed
costs of P4,000 were incurred. The full production cost per unit for making 30,000 units is:
A. P0.30 B. P0.68 C. P0.84 D. P0.93

7. At the end of Yang Co.’s first year of operations, 1,000 units of inventory remained on hand.
Variable and fixed manufacturing cost per unit were P90 and P20,
respectively. If Yang uses absorption costing rather than direct (variable) costing, the result
would be a higher pretax income of
A. P20,000. B. P70,000. C. P0. D. P90,000.

8. During May, Karev Corp. produced 10,000 units of Product X. Costs incurred by Karev during
May were as follows
Direct materials P10,000
Direct labor 20,000
Variable manufacturing overhead 5,000
Variable selling and general 3,000
Fixed manufacturing overhead 9,000
Fixed selling and general 4,000
Total P51,000

What are the unit costs under absorption and variable costing methods, respectively?
A. P5.10; P3.80 C. P4.40; P3.50
B. P3.80 P5.10 D. P3.50: P4.40

9. Izzie Industries manufactures a single product using standard costing. Variable production
costs are P13 and fixed production costs are P125,000. Izzie uses a normal activity of 12,500
 units to set its standard costs. Izzie began the year with 1,000 units in inventory, produced
11,000 units, and sold 11,500 units. The standard cost of goods sold under absorption costing
would be
A. P115,000 B. P149,500 C. P253,000 D. P264,500

10. George Company had P100,000 income using absorption costing. George has no variable
manufacturing costs. Beginning inventory was P5,000 and ending inventory was P12,000.
What is the income under variable costing?
A. P100,000. B. P107,000 C. P88,000 D. P93,000

1.B 2.A 3. C 4. D 5. D 6. D 7. A 8. C 9. D 10. D