SCHOOL OF ACCOUNTANCY, BUSINESS and HOSPITALITY

Accountancy Department
SHORT TERM 2021
A.Y. 2020-2021

MGMT 1033 (Strategic Cost Management)

Week 3 – Variable Costing

Topic: a. Concept of variable costing

b. Variable costing versus absorption costing
c. Advantages and disadvantages of variable costing
d. Variable costing problems
e. Practical applications of variable costing.

Learning Outcomes: At the end of this module, you are expected to:
a. Explain the meaning and underlying concept of variable costing;
b. Discuss the advantages and disadvantages of using variable costing as
a method of product costing;
c. Describe absorption costing;
d. Compare variable costing with absorption costing;
e. Prepare income statements under variable costing and absorption
costing;
f. Reconcile net income computed under absorption costing and net
income computed under variable costing;
g. Explain the difference in net operating income, inventory values and
treatment of operating costs between variable costing and absorption
costing; and
h. Explain why managers prefer direct costing to absorption costing.

LEARNING CONTENT:

Variable Costing: A Tool for Evaluating Management Performance

VARIABLE COSTING (from the term itself) is a costing methodology – a method of incorporating
various costs to a certain product or service. But what makes this costing methodology a unique one is its
treatment of FIXED MANUFACTURING COSTS.
You have learned in your Intermediate Accounting 1 particularly under PAS 2 – Inventories, ALL
DIRECT COSTS related in the manufacturing of INVENTORIES or rendering of services are
CAPITALIZED part of the cost of the product/inventory or service (aka PRODUCT COST or SERVICE
COST).

These DIRECT COSTS, in Cost Management language, can be classified as:

a. Variable Manufacturing Costs, i.e., Direct Materials, Direct Labor, Variable Manufacturing
Overhead
b. Fixed Manufacturing Costs, i.e., Fixed Manufacturing Overhead

The foregoing treatment of costs where ALL DIRECT COSTS (Both Variable and Fixed Manufacturing
Costs) are treated as PRODUCT COST is otherwise known as ABSORPTION COSTING (aka FULL
COSTING, TRADITIONAL COSTING, CONVENTIONAL COSTING, OR NORMAL COSTING).

Eh Sir, ang tanong ngayon, kung ang requirement pala ng external financial reporting ay ang paggamit ng
IAS 2 (i.e., Absorption Costing), anu den ang essence ng VARIABLE COSTING???

This realization is a good starting point to appreciate the value of VARIABLE COSTING. But before
we delve on the significance of variable costing, let us first familiarize ourselves on the concept of
variable costing as a costing methodology.

ABSORPTION COSTING minus FIXED MANUFACTURING COSTS is your VARIABLE

COSTING

As the term suggests, ONLY VARIABLE MANUFACTURING COSTS are treated as PRODUCT
COST under variable costing. In a more detailed presentation, products costs under variable costing
include the following:
a. Direct Material
b. Direct Labor
c. Variable Manufacturing Overhead

Eh Sir, how about the other costs???

Under variable costing or DIRECT COSTING, the following are treated as PERIOD COSTS. Again,
when we say PERIOD COSTS, these are COSTS recognized as EXPENSE in the period they are incurred
via the income statement, REGARDLESS OF PRODUCTION or SALES. These costs are:
a. Fixed Manufacturing Overhead Costs;
b. Variable Selling and Administrative Expenses; and
c. Fixed Selling and Administrative Expenses.

Luh…Grabe, Sir. Totoo? Yung FIXED MANUFACTURING OVERHEAD ay treated as PERIOD

COSTS under Variable Costing?

YES! A BIG YES! This is unique to variable costing system. Proponents of this product costing method
argues that the fixed part of factory overhead is more closely related to the CAPACITY TO PRODUCE
than to the production of specific units and therefore should be charged off as an expense in the period
incurred.
Sir, may isa pa akong tanong! Nalito kasi ako sa term na VARIABLE COSTING. Ang akala ko lahat ng
VARIABLE COSTS including VARIABLE SELLING AND ADMINISTRATIVE COSTS ay part ng
PRODUCT COST under variable costing. Pero hindi pala.hehe

Where is the question there? Joke lang. Yes, do not be deceived by the term VARIABLE COSTING to
include as part of the product cost the variable selling and administrative costs. Both under VARIABLE
and ABSORPTION COSTING, these costs are treated as PERIOD COSTS.

Let us rationalize further the SIGNIFICANCE of variable costing:

1. Although not permitted as a product costing method for EXTERNAL REPORTING, the use of
this system highlights the contribution margin of the product and therefore facilitates
managerial decision-making process.

Indeed, if we are to look once again on the VARIABLE INCOME STATEMENT format, it
depicts a presentation where costs are classified according to their behavior, thus showcasing its
relevance and usefulness in management control decisions. Here it is, once again:

Revenues XX
Variable Manufacturing Costs (XX)
Product/Gross Contribution Margin XX
Variable Selling and Administrative Expenses XX
Contribution Margin XX
Fixed Costs:
Manufacturing
XX
Selling and Administrative (XX)
XX
Net Operating Income XX

Also, a review of absorption costing income statement is shown below:

Revenues XX
Cost of Goods Sold (XX)
Gross Profit XX
Less Marketing and administrative Expenses (XX)
Net Operating Income XX
 2. Variable costing meets the three objectives of management control systems by showing
separately those costs that can be traced to, and controlled by each strategic business unit (SBU).

Essentially, this product costing method plays a critical role in certain aspects of management
control. Management control aims to attain the following objectives:
a. To measure progress
b. To uncover deviations
c. To Indicate corrective action

Through the aid of variable costing, the management can monitor and evaluate the activities of a
certain SBU. Generally, variable costs are controllable costs which means that these costs are a
result of a manager’s discretion and decisions. Hence, by emphasizing variable costs, it amplifies
relevant areas to look on during performance evaluation.

3. Net income using variable costing method is not affected by changes in inventory levels because
all fixed costs are deducted from income in the period in which they occur. For this reason,
appraisal of performance of product line or other segments of the business can be facilitated
without the need for arbitrary allocations of fixed costs.

4. Cost-volume-profit relationship data needed for profit planning purposes is readily obtained from
the regular accounting statements. Analysis of cost relevant to pricing is likewise simplified and
enhanced. Variable costing ties in with effective plans for cost control as standard costs and
flexible budget.

Wow, Sir! Naappreciate ko na ang significance ng variable costing. This is a good start. Although you
cannot fully grasp the gist of variable costing due to lack of experience and exposures to relevant
decision-making areas, at least we can digest its salient points which can help you prepare to become
competent future management accountants. Amen!

The following discussion which primarily focuses on computational problems could help you better
understand the concepts we previously delved on. Hence, allow me to present to you some problem-
solving activities related to variable costing which covers, among others, the following cost management
issues:
1. The effect of variable costing to the net operating income as opposed to that of absorption
costing;
2. The impact of variable costing to the amount of inventory as opposed to that of absorption
costing;
3. Reconciling net income figures under the two product costing methods;
4. Preparation of variable costing income statement as opposed to that of absorption costing; and
5. Conversion of income statement from variable costing method to absorption costing method.
Illustration 1: Variable costing income statement and reconciliation

Absorption costing income statement of ARORA company for the first two years of operations is as
follows:

*$6 per unit sold

The manufacturing cost per unit is as follows:

 Direct materials: $16
 Direct labor: $20
 Variable manufacturing overhead: $4
 Fixed manufacturing overhead: $28

Sales and production data for two years is given below:

Units produced:
 Year-1: 25,000 units
 Year-2: 25,000 units
Units sold:
 Year-1: 20,000 units
 Year-2: 30,000 units

Required:
1. Prepare a variable costing income statement using above information.
2. Reconcile net operating income figures obtained under two costing systems.
Solution
(1) Variable costing income statement:

(2) Reconciliation of net operating income:

For reconciliation of net operating income figures:

When fixed manufacturing overhead cost is deferred in inventory, it is added to the variable costing
income figure and when fixed manufacturing cost is released from inventory, it is deducted from the
variable costing income figure.
Illustration 2: Variable and absorption costing unit product costs and income statements

ZKB company manufactures a unique device that is used by internet users to boost Wi-Fi signals.
The following data relates to the first month of operation:
 Beginning inventory: 0 units
 Units produced: 40,000 units
 Units sold: 35,000 units
 Selling price: $120 per unit

Marketing and administrative expenses:

 Variable marketing and administrative expenses per unit: $4
 Fixed marketing and administrative expenses per month: $1,120,000

Manufacturing costs:
 Direct materials cost per unit: $30
 Direct labor cost per unit: $14
 Variable manufacturing overhead cost per unit: $4
 Fixed manufacturing overhead cost per month: $1,280,000

Management is anxious to see the success as well as profitability of newly designed unique booster.

Required:
1. Calculate unit product cost and prepare income statement under variable costing system and
absorption costing system.
2. Prepare income statement under two costing system.
3. Prepare a schedule to reconcile the net operating income under variable and absorption costing
system.

Solution:
(1) Calculation of unit product cost:

*$1,280,000/40,000 units
(2) Income statements:

a. Absorption costing:

b. Variable costing:
(3) Reconciliation schedule:

Illustration 3: Impact of Change in Production on Variable and Absorption Costing

AJX company manufactures and sells a single product. Company sold the same number of units this year
as it did last year but generated different profit for two years. The president asks for the explanation of
difference in net operating income for two years.

The income statements of two years are as follows:

Sales, production and production for two years are as follows:

Variable selling and administrative expenses of AJX are $4.00 per unit sold. A new manufacturing
overhead rate is computed each year.

Required:
1. Calculate unit product cost for both the years under absorption costing and direct costing
(variable costing).
2. Prepare a contribution margin format income statement for two years.
3. Reconcile the net operating income figures for each year under two costing methods.
4. Explain how operations would have different in year 2 if the company had been using just in time
(JIT) manufacturing and inventory control methods.
Solution:

(1) Computation of unit product cost:

Year 1:
Unit product cost under variable costing: $12
Unit product cost under absorption costing: $12 + $30* = $42
*$1,200,000/40,000 units

Year 2:
Unit product cost under variable costing: $12
Unit product cost under absorption costing: $12 + $24* = $36
*$1,200,000/50,000 units

(2) Variable costing income statement:

(3) Reconciliation of net operating income:

(4) Just in time manufacturing method:
If the company had been using just in time manufacturing and inventory control methods in year
2 the difference in net operating income under variable costing and absorption costing would
have been very little to zero. The central idea of just in time manufacturing is to eliminate
inventories. For better understanding of the impact of JIT read our article variable and absorption
costing with just in time (JIT) manufacturing system.

Illustration 4: Constant Production and Change in Sales – Variable and Absorption Costing

Fine Producers suffered a loss for the first month of operations. Following is the income statement of Fine
Producers prepared by an accounting service providing firm.

The loss created a serious problem because company was planning to use the statement to encourage
investors to purchase the stock of the company. Some other relevant data is given below:
 Units produced during the first month: 50,000 units
 Units sold during the first month: 40,000 units

Variable costs:
 Direct materials: $2.00 per unit
 Direct labor: $1.60 per unit
 Variable manufacturing overhead: $0.40 per unit
 Variable selling and administrative expenses: $1.50 per unit

Required:
1. What costing method was used by the accounting firm for preparing income statement of Fine
Producers? Can an absorption costing income statement show a profit rather than loss? Support
your answer by preparing a reconciliation schedule.
2. Prepare company’s income statement using variable costing and absorption costing for the
second month if 60,000 units were sold in the second month and there were no closing
inventories.
3. Reconcile the second month’s net operating income under both the costing approaches.
Solution:

(1) Costing method used by accounting firm:

Accounting firm used variable costing method to prepare income statement of Fine Producers.
Yes, an income statement prepared on the basis of absorption costing can show a profit rather
than loss because a portion of fixed manufacturing overhead cost would be absorbed by ending
finished goods inventory. Under absorption costing, this absorbed fixed cost would be deferred to
the next period and would reduce the burden of current period.

The net operating loss for the first month of operation under variable costing is $10,000 and the
cost to be absorbed under absorption costing system is $30,000*. It results in a net operating
profit of $20,000 (30,000 – $10,000). The computations are shown below:

*Fixed manufacturing overhead/Units manufactured

= $150,000/50,000 units
= $3.00 per unit

(2) Income statements for second month:

a. Absorption costing:
*Unit product cost under absorption costing: Direct materials + Direct labor + Variable manufacturing
overhead + Fixed manufacturing overhead
= $2.00 + $1.60 + $0.40 + $3.00
= $7.00
**Units manufactured in second month: Units sold + Units in ending inventory – Units in beginning
inventory
= 60,000 units + 0 units – 10,000 units
= 50,000 units

b. Variable costing:

*Unit product cost under variable costing: Direct materials + Direct labor + Variable manufacturing
overhead
= $2.00 + $1.60 + $0.40
= $4.00

(3) Reconciliation:
If the company sells 60,000 units in second month, the sales of the second month will be more than
production. In that case, the fixed manufacturing overhead cost deferred in inventory in first month will
be released from inventory in the second month and the net operating income under absorption costing
will be less than the net operating income under variable costing.
After understanding the concept of variable costing vis-à-vis absorption costing, and engaging into
reinforcement of these concepts through problem-solving activities as illustrated above, let us end this
discussion by looking into its practical applications in the professional landscape.

1. Managers generally prefer variable costing because it separates fixed from variable costs as in
CVP analysis. As a result, it is easier to compare actual operating income to planned operating
income. With absorption costing, actual operating income corresponds well with planned
operating income only when inventory levels remain unchanged. With variable costing, income is
more closely associated with sales while absorption costing is influenced by units produced and
units sold.

2. Variable costing signals managerial ability. Through the application of variable costing, it creates
meaningful signals where manager’s performance is appraised based on income prepared under
variable costing.
In general terms, if income performance is expected to reflect managerial performance, then
managers have the high to expect the following:
a. As sales revenue increases from one period to next, all other things being equal, income
should increase.
b. As sales revenue decreases from one period to the next, all other things being equal,
income should decrease.
c. As sales revenue remains unchanged from one period to the next, all other things being
equal, income should remain unchanged.

Interestingly, income under variable costing always follows this expected association between
sales revenue and income; under absorption costing, at times, it does not.

The important point is that variable costing is not affected by the change in inventory because
all fixed costs are deducted from income in the period in which they occur; fixed costs are not
included in inventory so that inventory changes do not affect net income.

3. Variable costing could also be used for evaluation of segmented reports. Implicit in an evaluation
is an associated decision whether to continue to operate a plant or not, or whether to keep or drop
a product line.
4. Variable costing helps managers in financial planning and control.

References:
Cabrera, M. and Cabrera, G. Strategic Cost Management 2019-2020 Edition. Manila. GIC Enterprises
& Co., Inc. 2019.
https://www.accountingformanagement.org/