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SCM - Variable Costing
SCM - Variable Costing
Variable Costing
• Prepare the profit or loss statement under the variable costing system.
• Explain the nature and characteristics of a product cost and period cost.
• Identify the difference in the profit or loss statement prepared under the absorption costing and
variable costing systems.
• Account for the differences in the profit under the absorption costing and variable costing systems.
• Understand the behavior of profit in relation to level of activity under variable and absorption
costing systems.
• Explain the importance of normal capacity to profit.
• Compute the volume variance and understand its connection to normal capacity.
• Property treat cost variances on the statement of profit or loss.
• Explain the difference in absorption costing profit from one reporting period to another.
• Identify the variables that have direct impact on profit under the absorption costing and variable
costing systems.
PROFIT MODELLING
There are two (2) profit determination models that are popularly used – the variable costing and the
absorption costing. The variable costing is used for management reporting while the absorption costing is
used for external reporting.
• The variable costing is also called marginal costing or direct costing income statement
• It is not in accordance with the established financial reporting standards. Rather, it follows the
economic model of determining profit and gives business managers much more accurate
perspective on how profit and operating wealth are accumulated and controlled.
A more detailed format of the variable costing statement of profit or loss follows.
Variable Costing
Pro-Forma Statement of Profit or Loss
For a Given Period
Sales P x
Less: Variable costs of goods sold x
Manufacturing margin x
Less: Variable selling and administrative expenses x
Contribution margin x
Less: Controllable direct fixed costs and expenses x
Controllable margin x
Less: Noncontrollable direct fixed costs and expenses x
Segment (direct) margin x
Less Indirect fixed costs and expenses x
Profit P x
The margins are sorted to serve the specific needs in management activities.
• Absorption costing operates within the framework of the International Financial Reporting
Standards.
• It is also known as “full costing” or “traditional costing”.
• It classified costs and expenses according to the functional nature of business operations such as
cost of goods sold, marketing, selling and administrative expenses.
• The pro-forma absorption costing statement of profit or loss is shown below:
Table 3.3. Pro – Forma Condensed Statement of Profit or Loss – Absorption Costing
Absorption Costing
Pro-Forma Condensed Statement of Profit or Loss
For a Given Period
Sales P x
Less: Costs of goods sold x
Gross Profit x
Less: Marketing selling and administrative expenses x
Earnings before interest and tax x
Less: Interest Expense x
Profit before tax x
Less: Provision for income tax x
Profit P x
Note: If we are to differentiate the two profit determination models, variable costing focuses on presenting
the fixed and variable components of cost or what was known as the cost behavior. On the other hand,
absorption costing classifies cost based on the functional nature of business operations such as cost of goods
sold, marketing, selling and administrative expenses.
The next topic will discuss in detail their main point of difference.
• Under the absorption costing method, the fixed overhead is a product cost and therefore is
deducted from sales based on the number of units sold (i.e., units sold x standard unit fixed
overhead).
• In variable costing, the fixed overhead is a period cost and, therefore, treats the entire budgeted
fixed overhead as expense during the period.
EFEM Corporation gives you the following production data with respect to its March 2019 operatons:
Required: Determine the cost of goods sold and value of ending inventory, assuming all the production
costs are considered as:
1. Product costs
2. Period costs
Solutions/ Discussions:
• Management accounting uses the standard costing system. Hence, the computation of the uint costs
is based on the standard costs.
• The unit product cost is P 400 (P 4 million/ 10,000 units).
• The costs distribution shall be as follows:
• Under variable costing system, the entire P 4 million is deducted outright as an operating expense
and no amount is deferred to inventory.
In this chapter, the term “cost” refers to the cost of production, while the term “expenses” refer to
marketing, selling, distribution, and administration expenses.
Understanding the Profit Behavior under the Absorption and Variable Costing Systems
The difference in the accounting for fixed overhead and the reconciliation of profit between the absorption
costing and variable costing systems are amplified by considering the following illustration.
Sample Problem 4.2. Profit (Loss) Calculation, Assuming Normal Capacity Equals Actual Production.
Mela Corporation has the following standard costs and production data in 2019:
1. Formulas
SFxOR = BFxOH
2. The Case Environment NC
Notice that the cases have the same level of production at 20,000 units which is equal to the normal
capacity. This is an important observation! It means we do not have volume variance in this sample
problem.
Next, in case letter “A”, sales are greater than production, in case letter “B”, sales are less than
production, and in case letter “C”, sales equal production.
Variable Costing Page 4
VARIABLE COSTING Chapter 3
Now, let us compute the profit or loss by getting the differences in sales, costs, and expenses under
each costing systems. Costs and expenses include all of the variable cost of goods sold, fixed
overhead, variable expenses, and fixed expenses. The profit under each method is computed as
follows:
The fixed overhead under the absorption costing method is based on the number of units sold (i.e.,
22,000 units) because it is a product cost and therefore is expensed based on the number of units
sold.)
The fixed overhead under the variable costing method is a period cost. As such all the budgeted
fixed overhead is deducted from sales without regard to the number of units sold. The budgeted
fixed overhead and budgeted fixed expenses are computed as follows:
To emphasize, budgeted fixed overhead and fixed expenses are based on normal capacity.
In case actual fixed overhead is given, the same shall be included in the variable costing income
statement, instead that of the budgeted fixed overhead.
However, under the absorption costing system, the fixed overhead is reported based on standard
costs and the difference between the actual and standard fixed overhead is reported as fixed
overhead variance to be reflected in the profit or loss statement.
The fixed expenses are allocated over normal capacity for more strategic reason and are used
purposely for this particular problem. For short-term analysis, the standard fixed expense rate is
related to units sold.
In case A, the difference in profit is P 40,000 (i.e., P 1,040,000 – P 1,000,000). The difference in
profit between absorption and variable costing methods may be accounted for using four (4)
methods, as follows: (Note: It is important that you familiarized yourselves on the different methods
since a lot of different scenarios or requirements may be presented to you in problem-solving
assessments.)
Method 1. Direct reconciliation. Get the difference in the amount of fixed overhead charged under
the two methods, as shown below:
Note that sales, variable cost of goods sold, variable expenses, and fixed expenses are the same
under each method. Only the fixed overhead differs in the amount between the absorption and
variable costing methods. The difference in the fixed overhead amount explains the difference in
profit between the two profit modeling systems.
Method 2. Production and sales perspective. Get the change in production and sales and multiply it
by the standard unit fixed overhead rate.
This emphasizes that the change in profit between the two costing systems is on the fixed overhead
accounting. This method is the normal technique we will use in accounting for the change in profit
between the absorption costing and variable costing systems.
Method 3. Beginning and inventory units perspective. Another way to get the change in inventory is
by getting the difference in the beginning and ending inventory units. Check it.
Method 4. Beginning and inventory amounts perspective. Get the changes in the values of
beginning and ending inventories under each of the methods.
in P = (BI – EI) x
Ending inventory
SFxOR
(2,000 units x P 140) 280,000
(2,000 units x P 120) 240,000 (40,000)
The beginning inventory is already released to expenses while the ending inventory cost is deferred
to the inventory account.
Unit variable costs include the costs of direct materials, direct labor, and variable overhead. The
fixed overhead is a period cost and not a product cost, under the variable costing method.
Refer to the solutions/ discussions of profit in Sample Problem “4.2”, item no. 3. We will find out
that the sum of variable cost and fixed overhead is P 3,080,000 (i.e., P 2,640,000 + 440,000) and is
the cost of goods sold under the absorption costing system.
The variable cost of goods sold under the variable costing method, as determined in solutions/
discussions of Sample Problem “3.2” Item no. 3, is also P 2,640,000.
Throughout this text, we will use the direct and shorter method of computing the cost of goods sold
(i.e., units sold x unit cost).
Absorption Variable
Sales (20,000 x P 200) P 3,800,000 P 3,800,000
Variable Cost of Goods Sold (20,000 x P 120) (2,400,000) (2,400,000)
Fixed Overhead (20,000 x P 20) (400,000) (400,000) {budgeted amount}
Variable expenses (20,000 x P 10) (200,000) (200,000)
Fixed expenses (100,000) (100,000) {unchanged}
Profit (loss) P 900,000 P 900,000
This means production equals sales, and cost of goods manufactured equals the cost of goods sold.
At this point, let us summarize our profit or loss data under each of the discussed independent cases in the
previous pages, to wit:
• When sales are lower than production, the fixed overhead charged in the absorption costing is
lower and its profit is higher than variable costing.
• Note that the fixed overhead charged in the variable costing is constant regardless of the level of
sales while the fixed overhead charged in the absorption costing changes in relation to units sold.
In variable costing, as sales increase, profit also increases; as sales decline, profit also declines. This
observation follows a manager’s normal train of thought with regard to the relationship of sales and profit.
This differs from the reports using absorption costing where there are instances that sales are increasing but
profit is declining, and vice-versa.
Now, we should also say that if variable costing follows sales, then, absorption costing follows production.
That is, if production is greater than the sales, absorption costing income is greater than that of variable
costing. And if production is less than sales, absorption costing profit is less than that of variable costing.
Sample Problem 3.3. Profit (Loss) Calculation, Normal Capacity Differs From the Actual Production
Hunter X Hunter Corporation has the following standard costs and production data in 2019:
Required: Determine the operating income under absorption costing and variable costing under each of the
following independent cases:
Solutions/ Discussions:
Case A – Sales (22,000 units) > Production (21,000 units), With Volume Variance
1. First, compute the volume variance because the actual production is not equal to the normal
capacity.
Normal capacity in units 20,000
- Actual capacity in units 21,000
Volume variance in units (1,000) F VV = NCU - ACU
x Standard fixed overhead rate P 20
Volume variance in pesos P 20,000 F NCU > ACU = UF
2. A cost variance is the difference between the actual costs and standard costs.
• If actual costs are greater than standard costs, the cost variance is unfavorable.
• If actual costs are less than standard costs, the cost variance is favorable.
Under the standard costing system, the costs are recorded at standard. Financial reports, however,
are prepared at actual data. As such, unfavorable variances are added to standard cost of goods
sold, while favorable variances are deducted from standard cost of goods sold to get the actual cost
of goods sold. That is why unfavorable cost variance is also called debit variance, while favorable
cost variance is called credit variance.
Volume variance is included only in the absorption costing income statement. Since volume
variance relates to fixed overhead which is a product cost under the absorption method, hence, the
volume variance is considered. Under the variable costing, however, the fixed overhead is a period
cost, an expense and is not subject to cost variance analysis.
Absorption Variable
Sales (22,000 x P 200) P 4,400,000 P 4,400,000
Variable cost of goods sold (22,000 x P 120) (2,640,000) (2,640,000)
Fixed overhead (22,000 x P 20) (440,000) (400,000)
Volume variance – favorable 20,000 F n.a. Budgeted amount
Variable expenses (22,000 x P 10) (220,000) (220,000)
Fixed expenses (100,000) (100,000) Unchanged
UF variance is Profit (loss) P 1,020,000 P 1,040,000
added to Std.
CGS or deducted U = Unfavorable variance F = Favorable variance
from profit
The favorable volume variance is added because the profit is computed directly. The normal
Fav. Variance is treatment, though, for a favorable cost variance is to deduct if from the standard cost of goods sold.
deducted from Also note the volume variance is treated only under the absorption costing method.
the Std. CGS
The difference in profit of P 20,000 is accounted for as follows:
Case B – Sales (15,000 units) < Production (18,000 units), With Capacity Variance
1. First, compute the capacity variance because the actual production is not equal to the normal
capacity.
Normal capacity 20,000 Units
- Actual capacity 18,000
Volume variance in units 2,000 U
x Standard fixed overhead rate P 20
Volume variance in pesos P 40,000 U
Absorption Variable
Sales (15,000 x P 200) P 3,000,000 P 3,000,000
Variable cost of goods sold (15,000 x P 120) (1,800,000) (1,800,000)
Fixed overhead (15,000 x P 20) (300,000) (400,000)
Volume variance – unfavorable (40,000)U n.a. Budgeted amount
Variable expenses (15,000 x P 10) (150,000) (150,000)
Fixed expenses (100,000) (100,000) Unchanged
Profit (loss) P 610,000 P 550,000
The unfavorable volume variance is deducted from profit. The normal treatment of an unfavorable
variance is as addition to the standard cost of goods sold. Using a direct method of computing
profit, an increase in cost of goods sold is a deduction from profit.
Normal capacity refers to the average production level of the business over a long range of time or over the
period covered in the budget. It is influenced, one way or another, by plant capacity, market size, budgetary
capability, legal restrictions, cultural orientations, and other variables.
Normal capacity
is the expected
Budgeted capacity is the targeted production level of operations in a given period. capacity over the
long-term
Sample Problem 3.4. Normal Capacity v. Budgeted Capacity
Let us assume the following levels of production of a business operation in the last seven years:
The normal capacity of the business is 42,000 units. It is the average production level of the business in the
last seven years. The company’s normal capacity is set based on its past production records. Normal
capacity rests in the middle of the ups and downs of the company’s production levels. It serves as the
benchmark in assessing the production absorption capacity of the business on its plant capacity. It is
preferred to be used as a denominator in computing the fixed overhead and fixed expenses rates.
The 70,000 units is the budgeted capacity (or expected actual capacity). Budgeted capacity is the expected
production in the next accounting cycle or business cycle which may be in months, quarter, year, or other
meaningful expressions.
If the normal capacity is not given, the budgeted capacity is used as a denominator in determining the
standard fixed overhead rate.
If the normal capacity and the budgeted capacity are not available, then use the practical capacity, the
maximum capacity, and lastly, the actual capacity.
Note: Given that the previous module was about Standard Costing, if you were able to understand the
concepts of different capacities used in standard costing, it will be easier for you to understand the topic we
are discussing right now.
There are lots of concepts here that need to be noted and remembered. These are the terms and
procedures commonly taken for granted in managerial accounting topics which can be very relevant in
solving strategic cost management problems.
The profit and loss statement under the absorption costing follows the international financial reporting
standards and the variable costing follows the economic model of determining the profit.
Sample Problem 3.5. Profit (Loss) Under the Variable Costing and Absorption Costing
Gotong Company disclosed the following data relative to its July 2019 operations:
Required:
1. Prepare the statement of profit or loss under absorption costing and variable costing systems.
2. Show supporting computations for the volume variance.
Solutions/ Discussions:
• The absorption statement of profit or loss is presented on the next page. In the right box are
computational guidelines and are not part of the presented statement profit or loss.
ABSORPTION COSTING
Gotong Company
Statement of Profit or Loss
For the Month Ended, July 31, 2019
• The ending inventory is 5,000 units (i.e., 4,000 beg. Inventory + 13,000 sales – 12,000 production)
• Production cost variances are considered in computing the actual cost of goods sold.
Unfavorable cost variance (U) means that actual production cost is greater than standard production
cost. Favorable cost variance (F) indicates that actual production cost is lesser than standard production
cost. The cost of goods sold to be deducted from sales should be the actual cost of goods sold. Ergo, to
compute the actual cost of goods sold, the unfavorable cost variance is added to, and the favorable cost
variance is deducted from, the standard cost of goods sold.
The difference in operating profit between absorption costing and variable costing is P 6,000 (i.e., P
196,000 of absorption costing – P 190,000 of variable costing). This difference in operating profit is
accounted for as shown below:
Total fixed expenses, that is marketing, distribution and administrative are period expenses, and are
therefore, unit sales related.
Because of this argument, the computation of unit fixed expenses takes two (2) options: (1) based on the
units sold; and (2) based on normal capacity. Take note that the other basis is on normal capacity which
reflects a strategic and long-term basis. To summarize, we will have:
Formula Comments
Std. Fixed Expenses = Budgeted Fixed Expenses/ The use of the normal production capacity assumes
Normal Sales Capacity the sales and production would be the same in the
long-run. This basis in computing the standard fixed
expenses is strategic in its applications.
Std. Fixed Expenses = Budgeted Fixed Expenses/ The use of the budgeted sales capacity gives emphasis
Budgeted Sales Capacity to profit and short-term activities of the business. This
method endorses short-term approach in profit
planning and profit management.
If a company is determining its short-term profit, the total fixed expenses is calculated as a function of sales
rather than of production. And since management accounting is traditionally related to operating activities,
the fixed expenses are traditionally determined using the number of units sold.
As learned in this chapter, variable costing follows sales and absorption costing follows production.
This means that to increase profit in the variable costing system, the trigger point is sales. An enterprise
should keep on generating and creating sales to upend profit. This approach emphasizes the value of
customers that is criticized by other strategists as short-range. Under this costing system, sales would be
realistically higher than production thereby creating an almost zero level of inventory. This would make the
supply situation lower than the demand and would further trigger an increase, and continuing increase, in
prices to the disadvantage of the buying public. This does not promote stability of production. In this
costing system, the strategic pricing is critically influenced by the seller.
Using the absorption costing system, the trigger point is production. Management would be encouraged to
always make production greater than sales to make profit. This results to a continuing increase in inventory
leading to an oversupply situation and, eventually, industry slowdown. It emphasizes long term availability of
resources. In this costing system, the strategic pricing in the market is actively influenced by both the buyer
and the seller.