Chapter 5

Income Effect of Alternative Product Costing Methods

Two general approaches are used in manufacturing companies for costing products for the
purposes of valuing inventories and cost of goods sold. The first approach is called absorption
costing. Absorption costing is generally used for external financial reports and tax reporting. The
other approach, called variable costing, is preferred by some managers for internal decision
making and must be used when an income statement is prepared in the contribution format.
Ordinarily, absorption costing and variable costing produce different figures for net operating
income, and the difference can be quite large. In addition to showing how these two methods
differ, we will consider the arguments for and against each costing method and we will show
how management decisions can be affected by the costing method chosen.

Absorption versus Variable Costing Approaches

In the previous section, we have discussed that under absorption costing, all production costs are
absorbed into products and the unsold stock is measured at total cost of production, whereas,
invariable costing only variable costs of production are allocated to products and the unsold
stock (inventory) is measured at variable cost of production. Fixed production costs are treated
as a cost of the period in which they are incurred. In this section, the income effect of the two
costing approach, before you proceed reading with this section be aware of the general income
statement under the two approaches:

Absorption Variable
Revenues xx Revenues xx
Less: CGS (xx) Less: Variable costs (CGS&VC) (xx)
Gross Margin xx Contribution Margin xx
Less: S&A Exp (V&F) (xx) Less: Fixed Costs (xx)
Operating Income xx Operating Income xx

The income statements prepared based on the two costing methods differs in their treatment of
fixed manufacturing costs and the classification and presentation of costs on the income
statement. On the traditional (absorption) costing method income statement, costs are classified

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on the basis of functions: Manufacturing, Selling, Administrative, etc. Whereas on a variable
(direct) costing method income statement costs are classified on the basis of behaviour pattern:
Fixed and Variable.

ILLUSTRATION 1
In 2011, ABC Company began producing a product that has the following selling price, variable
costs, and contribution margin.

Unit Selling Price Br 25

Unit variable costs:
Direct Material 4
Direct Labor 7
Manufacturing overhead 2
Selling and Administrative 2
Total unit variable cost 15
Unit contribution margin Br 10

Annual fixed costs of ABC Company include:

Fixed Manufacturing overhead Br 120, 000

Selling and Administrative 80, 000
Now, if the company
produced and sold 30,000 units of products during the year, what is operating income under the
two approaches?
At a production volume of 30,000 units, costs per unit under the two approaches is computed as
follow:
Cost per unit
Cost items Absorption approach Variable approach
Direct Material 4 4
Direct Labor 7 7
Variable manufacturing overhead 2 2
Fixes manufacturing overhead 4 0
Total cost per unit 17 13

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Absorption Costing Approaches Income Statement:
ABC Company
Income Statement
For Year ended, Dec. 31, 2011
Sales (30,000units x 25) Br 750,000
Less: Cost of goods sold (30,000 x 17) 510,000
Gross Margin Br 240,000
Less: Selling and Administrative Expenses:
Variable (30,000 x 2) Br 60,000
Fixed 80,000 140,000
Operating income Br 100, 000

Direct Costing Approach Income Statement:

ABC Company
Income Statement
For Year ended Dec. 31, 2011
Sales (30,000 x 25) Br 750,000
Less: variable costs:
Cost of goods sold (30,000 x 13) Br 390,000
Variable Selling and administrative (30,000 x2) 60,000 450,000
Contribution margin 300,000
Less: Fixed costs:
Fixed manufacturing costs Br 120, 000
Fixed selling and Administrative costs 80, 000 200,000
Operating income Br 100, 000

You may inquire, so where is the income effect of the two costing methods; the income
statement prepared under the two approaches shows the same operating income. Yes, you are
right, but this is if there is no change in the inventory level, i.e., when productions units equals
with sales units, during the period. However, when there is change in inventory level during the
period the operating income under the two approaches is different as the following examples,
which are continuation of the previous illustration shows.
ILLUSTRATION 2
Consider illustration 1 above except that out of the 30,000 units of products produced only
20,000 units were sold during the period. Look at the income statements under the two
approaches.

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Absorption Costing Approach
ABC Company
Income statement
For the year ended, Dec. 31, 2011
Sales (20,000 x 25) Br 500,000
Less: Cost of goods sold (20,000 x 17) 340,000
Gross margin 160,000
Less: Selling and Administrative Expenses:
Variable selling and Admin. (20,000 x 2) Br 40,000
Fixed selling and Admin. 80,000 120,000
Operating income Br 40, 000

Direct Costing Approach

ABC Company
Income Statement
For the Year ended, Dec. 31, 2011
Sales (20,000 x 25) Br 500,000
Less: Variable Expenses:
Cost of goods sold (20,000 x 13) Br 260,000
Selling and Administrative (20,000 x 2) 40,000 300,000
Contribution margin 200, 000
Less: Fixed Costs:
Fixed manufacturing overhead Br 120, 000
Fixed selling and Administrative 80, 000 200,000
Operating income Br 0

Practice Exercise
Consider illustration 2 above and the company produced 30,000 units during 2012 and sold
40,000 units, the other information’s remaining the same; prepare (determine) income statement
under the two approaches.

Now, you see the income effect of the two costing methods, when there is change in inventory
level. The difference in operating income under both illustration 2 and exercise above is
explained by the amount of fixed manufacturing overhead assignment in “inventory” by
absorption costing, whereas immediately expensing the amount in the period incurred.

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