MAS-03: ABSORPTION & VARIABLE COSTING

ABSORPTION COSTING - is a costing me method that includes all manufacturing costs direct materials
direct labor variable and fixed factory overhead in the cost of a unit of product. It
treats fixed factory overhead (FFOH) as a product cost. Absorption costing is also
called as full costing.

VARIABLE COSTING - a costing method that includes only variable manufacturing costs materials, direct
labor, and variable manufacturing overhead-in the cost of a unit of product It treats
FFOH as a period cost. Variable costing is also called direct costing.

PRODUCT vs. PERIOD COST

A product cost is an inventoriable cost that subject to allocation between sold and unsold units.
Current income is reduced only by the amount a allocated to the sold units. Consider the following allocation:
UNSOLO UNITS → Asset (as Inventory)
PRODUCT COST
SOLD UNITS → Expense (as Cost of Goods Solo)

A period cost is a cost that is charged as expense against income, regardless of the sales
performance. No allocation is necessary, current income is reduced by the full amount of the period cost

PRODUCT COST FULLY EXPENSED in the period incurred, regardless of sales

ABSORPTION vs. VARIABLE COSTING

1) RATIONALE
Supporters of variable costing argue that FOH costs are incurred whether or not production occurs.
Having no future service potential, TOH costs should be fully expensed in the same period incurred.
Supporters of absorption costing believe that all manufacturing cost -- variable and fixed -- are necessary
for production to take place and hence should not be ignored in determining product costs.

2) INVENTORIES
Since FFOH costs are simply expensed (e, period cost) under the variable costing, the peso amount
of inventories under variable costing is always lower than the peso amount of inventories under absorption
costing.

3) ACCEPTABILITY
Since treating FFOH as pet of inventory cost Consistent with accounting standards, only absorption
costing is acceptable for financing reporting and tax purposes. Variable costing, which violates the
'matching principle, is acceptable only tor internal use by management.

NOTE: Matching principle is an accounting principle that calls for the recognition of expense by
matching it with the related revenue in the same accounting period. It supports the treatment of cost of
sales as expense only when related units have been sola

4) INCOME STATEMENT
Under absorption costing, the income statement distinguishes between production and other costs
Production costs pertaining to sold units are first deducted from sales to arrive at the gross profit, and then
other costs and expenses are deducted to obtain net income

Under variable costing, the income statement distinguishes between variable and fixed costs. All
variable costs are first deducted from sales to arrive at the contribution margin, and then fixed costs are
deducted to obtain profit.

5) INCOME COMPUTATION
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 exceed sales. (NOTE the term income in this context,
like in many accounting literatures, is liberally used to mean profit)
RECONCILIATION OF INCOME UNDER ABSORPTION COSTING & VARIABLE COSTING
Under variable costing, FFOH Costs are fully expensed as incurred ( regardless of sales), while
under absorption costing, FFOH costs are expensed when related units are sold. Consider the
following patterns:

● Pattern No. 1 : When production equals sales, there is no change in inventory. FFOH expensed
under absorption costing equals FFOH expensed under variable costing.
PRODUCTION = SALES Income (Absorption) = Income (variable)

● Pattern No 2: When production is greater than sales, there is an increase in inventory. FFOH
expensed under absorption costing is less than FFOH expensed under variable costing. Therefore,
absorption income greater than variable income

PRODUCTION > SALES Income (Absorption) > Income (variable)

● Pattern No, 3: When production is less than sales, there is a decrease in inventory. FFOH
expensed under absorption costing is greater than FFOH expensed under variable costing.

PRODUCTION < SALES Income (Absorption)< Income (Variable)

● Basic Formula:
Income = Inventory x unit FFOH
Where:
Inventory Ending Inventory Beginning Inventory
Inventory Units Produced Units Sold

● Alternative Formula
Income, Absorption costing P xxx
Add FFOH In beginning inventory xxx
Total P xxx
Less FFOH in ending inventory (xxx)
Income, Variable costing P xxx

ADVANTAGES OF USING VARIABLE COSTING

1. Variable costing reports are simpler and more understandable
2. The problems involved in allocating 1xed c0sts are eliminated
3. Data needed for break-even and cost-volume-profit analyses are readily available
4. Variable costing is more compatible with the standard cost accounting system.
5. Variable costing reports provide useful information tor pricing decisions and other operational
problems encountered by management.

DISADVANTAGES OF USING VARIABLE COSTING

1. Variable costing is not in accordance with GAAP hence, It 1s not acceptable for external reporting.
2. Segregation of costs into fixed and variable might be difficult
3. The matching principle is violated by using variable costing, which excludes FFOH from product
costs and charges the same as period costs regardless of production and sales.
4. With variable costing, inventory costs and other related accounts, such as working capital, current
ratio, and acid-test ratio are understated because of the exclusion of FFOH in the computation of
product cost.

EXERCISES ABSORPTION and VARIABLE COSTING

1. Adriel Company makes state-of the art toy car. Each toy car sells for P 1,000 each. Data for 2018's
operations are as follows
Units: Variable Costs.
Beginning Inventory 5 Direct Materials P 18,000
Production 60 Direct Labor 12,000
Ending Inventory 15 Factory Overhead 6,000
Selling and Administrative 2,000
Fixed Costs
Factory Overhead P 15,000
Selling and Administrative 1,000
REQUIRED:
1. Determine the inventory cost per unit under
A) Absorption costing
 B) Variable costing
2. Determine the cost of ending Inventory under
A) Absorption costing
B) Variable costing
3. Prepare income statements under: (A) absorption costing and (E8) variable costing.
4. How much is the difference in income between the two costing methods?
5. What causes the difference in income between the two costing methods?
(Adapted: Managerial Accounting by Garrison)
SOLUTION GUIDE to requirement 1
(A) Absorption Costing (B) Variable Costing
Total Per Unit Per Unit
DM
DL
VFOH
FFOH
Total

SOLUTION GUIDE to requirement 3

ADRIEL. COMPANY
Income Statement, for the period of 2018
(A) ABSORPTION Costing (B) VARIABLE Costing
Sales Sales
- Cost of sales - Variable costs
Gross profit Contribution margin
- Expenses - Fixed cost
Net income Profit

The following information are taken from the books of Bea Company, which assumes first-in, first-out
(FIFO) for inventory cost flow
Inventory (in unit) 2017 2018
Beginning inventory - None - ???
Production 10,000 units 9,000 units
Ending victory 3500 units 1,000 units

Sales (P 2 per unit) ??? ???

Variable manufacturing costs (P 0.75 per unit) P 7,500 P 6,750
Fixed manufacturing costs P 5,500 P 5,400
Selling and administrative costs (50% variable) P 4,500 P 7,500

REQUIRED:
1. Determine 2017 profit under variable or absorption costing
2. Reconcile the two profit figures in 2017
3. Determine 2018 profit under variable and absorption costing
4. Reconcile the two profit figures in 2018.
(Adapted Cost Accounting by Horngren, et. al)
SOLUTIONS & ANSWERS to all requirements
(1) 2017 (2) 2018
Absorption Variable Absorption Variable
Sales P13,000 Sales P 13,000 Sales P 23,000 Sales P 23,000
CGS (8,125) VC (7,125) CGS (15,175) VC (12,375)
GP 4,875 CM P 5,875 GP P 7,825 CM P 10,652
Expense (4,500) FC (7,250) Expense (7,500) FC (9,150)
Income P375 Less (P 1,375) Income P 325 Profit P 1,475

(2) 2017 CGS = 6,500 P 1.25 = P8,125

VC = (6,500 x P 0.75)+ (4,500x 50% )P 7,125
FC= 5,000 + (4,50U X 30) =P 7,250

Reconciliation: Income = (3,500 – 0) P 0.50- P1, 750 → 375 - (- 1,375)

4).2018. CGS (3.500 x P125) + (8,000 x P 1 35) P 15,175 (using FIFO)

VC (11,500 x P 0.75) + (7,500 x 505)P12,175
FC 5,400 + (7,500 50%) 9,-0

Reconciliation a Income A inventory x unit FFOH

Beginning inventory (2017 layer): 3,500 x PO.S0 = P 1,750
Ending inventory (2018 layer): 1,000 x P 0.60 = (600)
P1,150 → 1,475 – 325
 WRAP-UP EXERC1SES (IRUE OR FALSE; MULIIPLE-CHOICE)

1. Which of the following costs is treated differently under absorption and variable costing?
a. Direct labor c. Fixed manufacturing overhead
b. Raw materials d. Variable manufacturing overhead
2. Under absorption costing, fixed manufacturing overhead costs are best described as
a. Direct period costs c. Direct product costs
b. Indirect period costs d. Indirect product costs
3. Under variable costing, fixed manufacturing overhead costs are best described as
a. Direct period costs c. Direct product costs
b. Indirect period costs d. Indirect product costs
4. Under variable costing, all product costs are variable.
5. Under variable costing, all variable costs are treated as product costs.
6. In a manufacturing company where FFOH cost are incurred, the cost of inventory under absorption costing
is typically higher than the cost of inventory under variable costing .
Items 7 to 9 are based on the following information
White Company manufactures a single product Unit variable production costs are P 20 and fixed
production costs are P 1 50,000. White uses a normal activity of 10,000 units. White began the year with
no inventory. produced 12,000 units, and solid 7 500 units.
7. What s the unit product cost under variable costing
a. P 20.00 c. P 35.00
b. P 32.50 d. P 40.00
8. what is the unit product cost under absorption costing?
a. P 20.00 c. P 35.00
b. P 32.50 d. P 40.00
9. What is the volume (capacity) variance under absorption costing?
a 24,000 unfavorable c. P 30,000 unfavorable
b. 24,000 favorable d. P 30,000 favorable
NOTE: volume variance(actual production-normal production) x unit FFOH
10. There is no volume or capacity variance under variable costing
11. If production is higher than sales, then absorption costing income is expected to be
a. Lower than variable costing income
b. Higher than variable costing income
c. Equal t0 the variable c0sting income
d. Incomparable with variable costing income
12 Black Company produced 10,000 units and sold 9,000 units. Fixed manufacturing overhead costs were P
20,000, and variable manufacturing overhead costs were P 3 per unit. Which of the following best
describes the profit under the absorption costing method?
a. P 2,000 more than profit under variable costing method
b. P5,000 more than profit under variable costing method
c. P2,000 less than profit under variable costing method
d. P 5, 000 less than profit under variable costing method
13 Green Company has operating income of P S0,000 under direct costing Beginning and ending inventories
were 13,000 units and 18,000 units, respectively.
If the fixed factory overhead application rate is P 2 per unit, then what is the operating income under the
absorption costing
a P70,000 c. P 50,000
b. P60,000 d. P40,000
14 Violet Company had 16,000 units in its beginning inventory he company s variable production costs Were
P6 per unit and its fixed manufacturing overhead costs were 4 per unit. The company s net income tor the
year was P 24,000 lower under absorption costing than it was under variable costing How many units
does the company have in its ending inventory
a. 22,000 units c. 6,000 units
b. 10, 000 units d. 4,000 units
15, Pink Co had a net income of Pa 85, 500 using variable costing and net income of P 90,000 using
absorption costing total fixed manufacturing overhead cost was P 150,000, and production was 100,000
units. How did the inventory level change during the year
a. 3,000 units increase c. 3,000 units decrease
b. 4,500 units increase d. 4,500 units decrease
16. Under a just-in-tine (UIT) production environment, income under absorption costing tends to be equal
with income under variable costing
17. Variable costing income fluctuates with production and does not react to changes in sales.
18. Variable costing is unacceptable for
a. Financial reporting c. Cost-volume-profit analysis
b. Transfer pricing d Short term decision making