STRATEGIC COST MANAGEMENT (STCM)

STCM 03 : Absorption and Variable Costing

Prepared by: R. Pascual

Intended Learning Outcomes:

✓ Explain the nature and characteristics of product and period cost.

✓ Identify the difference in the profit or loss statement prepared under the absorption and variable costing system.
✓ Discuss the treatment of fixed factory overhead under Variable and Absorption costing
✓ Identify the variables that have direct impact on profit under absorption and variable costing system.

Lecture Notes:

This lesson describes two applications of the contribution format income statements that were introduced in earlier
lessons. First, it explains how manufacturing companies can prepare variable costing income statements, which rely on the
contribution format, for internal decision-making purposes. The variable costing approach will be contrasted with absorption
costing income statements, which were generally used for external reports. Ordinarily, variable costing and absorption
costing produce different net operating income figures, and the difference can be quite large. In addition to showing how
these two methods differ, we will describe the advantages of variable costing for internal reporting purposes and we will
show how management decisions can be affected by the costing method chosen.

I. NATURE AND TREATMENT OF FIXED FACTORY OVERHEAD

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

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

THROUGHPUT COSTING – a costing method that includes only direct materials in the cost of unit of product. It treats
everything else as period costs.

TREATMENT OF COSTS – which of the following are product costs / inventoriable costs for each costing method?

Type of Cost Absorption Costing Variable Costing Throughput Costing

Direct Materials
Direct Labor X
Variable factory overhead X
Fixed factory overhead X X
Variable Selling and admin expenses X X X
Fixed Selling and admin expenses X X X

Legend:

- Product cost
X - Period cost

II. DISTINCTION BETWEEN PRODUCT AND PERIOD COST

Product costs (Manufacturing costs) – include all costs incurred to produce the physical product

o Direct materials – major material inputs that can be physically and conveniently traced directly to the final
product
o Direct labor – the cost of labor that can be physically and conveniently traced to the final product
o Manufacturing Overhead – includes all costs other than direct materials and direct labor that must be
incurred to manufacture a product.

Period costs (Non-manufacturing costs) – all other costs incurred not related to the production of the physical product

o Marketing or selling costs – costs necessary to get the order and deliver the product
 o General and administrative costs – all executive, organization and clerical costs

PRODUCT vs. PERIOD COST

A product cost is an inventoriable cost that is subject to allocation between sold and unsold units. Current
income is reduced only by the amount allocated to the sold units.

UNSOLD UNITS → Asset (as Inventory)

PRODUCT COST
SOLD UNITS → Expense (as Cost of Goods Sold)

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

PERIOD COST FULLY EXPENSED in the period incurred

ABSORPTION vs. VARIABLE COSTING

ABSORPTION COSTING VARIABLE COSTING

Rationale All manufacturing costs – variable and
fixed – are necessary ingredients for
production to take place and should
not be ignored in determining product
cost.
Acceptability Consistent with accounting standards.
This method is applicable for financial
reporting and tax purposes.
Fixed factory overhead is incurred in
order to have the capacity to produce
units in a given period. These costs
are incurred whether or not the
capacity is actually used to make
output. These costs have no future
service potential and should be
charged against the period and not
included in the product cost
This violates matching principle ( and
not acceptable for financial reporting
and tax purposes.

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
already sold.

Inventories Fixed factory overhead is treated as Fixed factory overhead is treated as

product cost. The peso amount of period cost. The peso amount of
inventory under absorption costing is inventory under variable costing is
always greater than that of variable always lesser than that of absorption
costing. costing.
Income statement Distinguishes between production and Distinguishes between variable and
other costs. Production costs fixed costs. All variable costs are first
pertaining to sold units are first deducted from revenue to arrive at the
deducted from sales to arrive at gross contribution margin, and then fixed
profit, and then other costs are costs are deducted to obtain profit.
deducted to obtain net income.
Income Computation Income computed by variable costing may differ from income computed by
absorption costing because of the difference in the amount of FFOH recognized
as expense during an accounting period. This is also caused by the
difference between production and sales volume. In the long run, however, both
methods would yield the same results since sales cannot continuously exceed
production, nor production can continuously exceed sales.
Why Variable Costing?

Advantages
Variable costing reports are simpler and more
understandable.
The problems involved in allocating fixed costs are
eliminated.
Data needed for break-even and cost-volume-profit
analyses are readily available.
Variable costing is more compatible with the standard cost
accounting system. Variable costing reports provide useful
information for pricing decisions and other decision-making
problems encountered by management.
Disadvantages
This costing is not in accordance with GAAP; hence, it is
not acceptable for external reporting.
Segregation of costs into fixed and variable might be
difficult.
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.
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.

RECONCILIATION OF INCOME UNDER ABSORPTION and VARIABLE COSTING

• The cause of the difference between the income computed under absorption and variable costing is primarily a
timing difference – when to recognize the FFOH as an expense.
• In variable costing, it is expensed when FFOH is incurred, while in absorption costing, it is expensed in the period
when the units to which such FFOH relates are sold.
• The relationship between production and sales generally indicates the following income patterns:

1. When production is equal to sales, there is no change in inventory. FFOH expensed under absorption
costing equals FFOH expensed under variable costing.
PRODUCTION = SALES  Income (Absorption) = Income (Variable)

2. When production is greater than sales, there is n increase in inventory FFOH expensed under absorption
costing is less than FFOH expensed under variable costing. Therefore, absorption income is greater than
variable income.

PRODUCTION > SALES  Income (Absorption) > Income (Variable)

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. Therefore, absorption income is less than
variable income.

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

Summary:

Production vs. Sales Effect in inventory Difference in income

Production = Sales No change AC income = VC income
Production > Sales Increase AC income > VC income
Production < Sales Decrease AC income < VC income

How to reconcile the income under two methods?

Note that the main difference between absorption and variable costing income is the treatment of fixed factory overhead.
To reconcile the income under both methods, we compute for fixed manufacturing overhead in relation to the change in
inventory. Thus,
INCOME, absorption costing ₱ xxx
Add: FFOH in beginning inventory xxx
Total ₱ xxx OR ∆ Income = ∆ Inventory x FFOH/u
Less; FFOH in ending inventory (xxx)
Income, Variable costing ₱ xxx

APPLICATION

1. ABS Company operated at a normal capacity of 1,000 units in the year 2020. The company sold 80% of these
units at a price of ₱12 per unit. Manufacturing costs incurred during the year are as follows:

Manufacturing:
Materials ₱1,500
Labor 1,000
Variable Factory Overhead 500
Fixed Factory Overhead 2,000
Selling and Administrative
Variable ₱1,500
Fixed 800

REQUIRED:
1) Inventory cost per unit under absorption and variable costing.
2) Cost of ending inventory under absorption and variable costing.

2. CBN Company makes state-of-the-art dress. Each dress sells for ₱2,000 each. Data for 2020’s operations are as
follows:

Units:
Beginning Inventory 5
Production 80
Ending Inventory 15
Variable costs:
Direct Materials ₱24,000
Direct Labor 16,000
Factory Overhead 8,000
Selling and Administrative 4,000
Fixed Costs:
Factory Overhead ₱20,000
Selling and Administrative 2,000
REQUIRED:
1) Prepare income statements under both absorption and variable costing.
2) Provide computations explaining the differences in income between the two costing methods.

3. The following information are taken from the books of GMA Company, which assumes first-in, first-out (FIFO) for
inventory cost flow:

Inventory (in units) 2019 2020

Beginning inventory -None- ???
Production 10,000 units 9,000 units
Ending inventory 3,500 units 1,000 units

Sales (₱2/unit) ??? ???

Variable manufacturing costs (₱0.75/unit) ₱7,500 ₱6,750
Fixed manufacturing costs ₱5,000 ₱5,400
Selling and administrative costs (50% variable) ₱4,500 ₱7,500

REQUIRED:
1) Determine 2019 profit under variable and absorption costing.
2) Reconcile the two income figures in No. 1.
3) Determine 2020 profit under variable and absorption costing.
4) Reconcile the two income figures in No. 3.
III. SUMMARY OF THE LESSON

Variable and absorption costing are alternative methods of determining unit product costs. Under variable costing,
only those manufacturing costs that vary with output are treated as product costs. This includes direct materials, variable
overhead, and ordinarily direct labor. Fixed manufacturing overhead is treated as a period cost and it is expensed on the
income statement as incurred. By contrast, absorption costing treats fixed manufacturing overhead as a product cost, along
with direct materials, direct labor, and variable overhead. Under both costing methods, selling and administrative expenses
are treated as period costs and they are expensed on the income statement as incurred.

Because absorption costing treats fixed manufacturing overhead as a product cost, a portion of fixed manufacturing
overhead is assigned to each unit as it is produced. If units of product are unsold at the end of a period, then the fixed
manufacturing overhead cost attached to those units is carried with them into the inventory account and deferred to a future
period. When these units are later sold, the fixed manufacturing overhead cost attached to them is released from the
inventory account and charged against income as part of cost of goods sold. Thus, under absorption costing, it is possible
to defer a portion of the fixed manufacturing overhead cost from one period to a future period through the inventory account.

Unfortunately, this shifting of fixed manufacturing overhead cost between periods can cause erratic fluctuations in
net operating income and can result in confusion and unwise decisions. To guard against mistakes when they interpret
income statement data, managers should be alert to changes in inventory levels or unit product costs during the period

- END –

You are blessed!

Sir P 😊