ABSORPTION COSTING AND VARIABLE COSTING

Management Accounting Review

/RCROQUE

DIFFERENCE BETWEEN ABSORPTION (AC) AND VARIABLE COSTING (VC) METHODS

Cost/Expense Type AC VC
Direct Materials Product Product
Direct Labor Product Product
Variable Overhead Product Product
Fixed Overhead PRODUCT PERIOD
Variable selling and administrative expenses Period Period
Fixed selling and administrative expenses Period Period

Notes:

1. The only difference between absorption costing and variable costing is in the treatment of the fixed
manufacturing overhead.
2. Variable costing charged to the product only variable manufacturing costs. Variable costing uses an
income statement format that categorizes costs by both their function and behavior.
3. Absorption costing charged to the product all manufacturing costs, whether it is a variable or fixed
costs. Absorption costing uses income statement format that categorizes costs by manufacturing and
non-manufacturing costs.
4. Computation of Income Difference

(Predetermined Fixed Overhead Rate per unit = Budgeted Fixed Overhead ÷ Normal Capacity)

➢ Change in Production vs. Sales x Predetermined ÷ Budgeted Fixed Overhead Rate per
unit

OR

➢ Change in Inventories x Predetermined ÷ Budgeted Fixed Overhead Rate per unit

PRODUCTION VS. SALES

If Profit (Loss)
Production > Sales AC Income > VC Income
Production < Sales AC Income < VC Income
Production = Sales AC Income = VC Income

PERIOD COST PRODUCT COST

1. Refers to an item charged against current
revenue on the basis of time period regardless
of the difference between production and sales
volume.
2. Does not form part of the cost of inventory.
3. Diminishes income for the current period by
its full amount.
1. Refers to an item included in product costing
which s apportioned between the sold and unsold
units.
2. The portion of the cost, which has been
allocated to the unsold units, becomes part of the
inventory.
3. Diminishes current income by that portion
thereof identified with the sold units only with the
remainder being deferred to the next accounting
period as part of the cost of ending inventory.

PRINCIPAL DIFFERENCES BETWEEN VARIABLE AND CONVENTIONAL ABSORPTION

COSTING:

ABSORPTION COSTING VARIABLE COSTING

1. Cost segregation
2. Cost of Inventory
Seldom segregates costs into
variable and fixed costs
Cost of inventory includes all the
manufacturing costs: materials
labor, variable factory overhead,
and fixed factory overhead.
Costs are segregated into
variable and fixed
Cost of inventory includes only
the variable manufacturing
costs: materials, labor, and
variable factory overhead.
3. Treatment of fixed factory Fixed factory overhead is Fixed factory overhead is
overhead treated as product cost. treated as period cost
4. Income statement Distinguishes between Distinguishes between variable
production and other costs. and fixed costs
5. Net Income Net income between two methods may differ from each other
because of the difference in the amount of fixed overhead cost
recognized as expense during an accounting period. This is due to
variations between sales and production. In the long run, however,
both methods give substantially the same results since sales cannot
continuously exceed production, nor production can continually
exceed sales.

VARIANCE ANALYSIS

Variance Type Absorption Variable*

Direct Materials Included Included
Direct Labor Included Included
Variable Overhead Spending Included Included
Variable Overhead Efficiency Included Included
Fixed Overhead Spending Included EXCLUDED
Fixed Overhead Volume Included EXCLUDED

* The ACTUAL fixed overhead is used in the computation of profit (loss).

ARGUMENTS AGAINST VARIABLE COSTING

1. Segregation of costs into fixed and variable might be difficult, particularly in the case of mixed
costs.

2. The matching principle is violated by using variable costing which excludes fixed overhead
from production costs and charges the same to period costs regardless of production and sales.

3. With variable costing, inventory costs and other related accounts, such as working capital,
current ratio, and acid-test ratio are understand because of the exclusion of fixed overhead in
the computation of product cost.

THROUGHPUT COSTING (or SUPERVARIABLE COSTING)

An extreme form of variable costing in which only direct material costs are included as inventoriable
costs. All other costs are costs of the period in which they are incurred.

Throughput margin = Revenue – Direct material cost of the goods sold

Test 1. TRUE OR FALSE QUESTIONS.

________ 1. In absorption costing, costs are seldom segregated into variable and fixed costs.
________ 2. In variable costing, costs are not segregated into variable and fixed.
________ 3. Fixed factory overhead is treated as product cost for both the variable and conventional
absorption costing methods.
________ 4. In the long run, both methods (absorption and variable) give substantially the same net
income results since sales cannot continuously exceed production, nor production can
continually exceed sales.
________ 5. When production is equal to sales, the fixed overhead expensed under absorption
costing equals the fixed overhead expenses under variable costing.
________ 6. One of the arguments concerning variable costing is that the segregation of cost into
fixed and variable might be difficult, particularly in the case of mixed costs.
________ 7. The matching principle is violated by using variable costing which excludes fixed
overhead from product costs and charges the same to period costs regardless of
production and sales.
________ 8. Throughput margin is equal to revenue less direct material cost of the goods sold.
________ 9. 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 fixed
overhead in the computation of product cost.
________ 10. Fixed manufacturing overhead under absorption costing is expensed in the period when
the units to which such fixed overhead has been related are sold.
________ 11. When production is higher than sales, absorption costing profit is lower than variable
 costing profit.
________ 12. If all the products manufactured during the period are sold in that period, variable costing
profit is equal to absorption costing profit.
________ 13. When production is lower than sales, variable costing profit is lower than absorption
costing profit.
________ 14. When production and sales level are equal, variable costing profit is lower than
absorption costing profit.
________ 15. Direct costing and variable costing are different terms that means the same thing.
________ 16. In a variable costing income statement, sales revenue is typically lower than in
absorption costing income statement.
________ 17. In a variable costing system, fixed overhead costs are included as cost of inventory.
________ 18. Under the direct costing method, the contribution margin discloses the excess of
revenues over fixed costs.
________ 19. In direct costing, fixed factory overhead forms part of the inventory value.
________ 20. The difference in profit between variable costing and absorption costing is due entirely to
the treatment of fixed manufacturing overhead.

Test 2. MULTIPLE CHOICE QUESTIONS.

1. Under variable costing, fixed manufacturing overhead is

A. Expensed immediately when incurred.
B. Never expensed.
C. Applied directly to finished-goods inventory.
D. Applied directly to work-in-process inventory.
E. Treated in the same manner as variable manufacturing overhead.

2. All of the following are inventoried under variable costing, except

A. Direct materials.
B. Direct labor.
C. Variable manufacturing overhead.
D. Fixed manufacturing overhead.
E. Items C and D above.

3. All of the following are expensed under variable costing, except

A. Variable manufacturing overhead.
B. Fixed manufacturing overhead.
C. Variable selling and administrative costs.
D. Fixed selling and administrative costs.
E. Items C and D above.

4. All of the following costs are inventoried under absorption costing, except
A. Direct materials.
B. Direct labor.
C. Variable manufacturing overhead.
D. Fixed manufacturing overhead.
E. Fixed administrative salaries.

5. All of the following are inventoried under absorption costing, except

A. Direct labor.
B. Raw materials used in production.
C. Utilities cost consumed in manufacturing.
D. Sales commissions.
E. Machine lubricant used in production.

PROBLEMS

Problem 1

Variable manufacturing costs (DM is P3.20) P8.00 per unit

Fixed manufacturing overhead (planned and actual) P3,000
Variable selling and administrative costs P1.50 per unit
Fixed selling and administrative costs P2,500
Units Sold 1,200 units
Units produced 1,500 units
Beginning inventory 150 units
Selling price per unit P30
1. Operating income under absorption costing method is _____________________
2. Operating income under is variable (direct) costing method _____________________
3. Operating income under throughput costing method is _____________________
4. The amount of ending inventory reported under absorption costing method is ______________
5. If the number of units sold is equal to its production of 2,000 units, the amount of ending inventory
reported under absorption costing method is _____________________
6. If 1,600 units were sold instead, what would be the operating income under variable costing
method? _____________________

Problem 2

A company had income of P80,000 using absorption costing for a given period. Beginning and
ending inventories for that period were 18,500 and 17,000 units, respectively. The fixed overhead
application rate was P11 per unit. (Ignore income taxes)

7. What would the income be if variable costing was used? ____________________

Problem 3

A company had income of P70,000 using variable costing for a given period. Beginning and
ending inventories for that period were 22,000 and 20,000 units, respectively. Ignoring income taxes, if
the fixed overhead application rate was P6.25 per unit,

8. What would the income be if absorption costing was used? ______________________

Problem 4

Perspire company produces a single product. Last year, the company’s net operating income
computed using absorption costing method was P10,400 and its operating income computed using
variable costing method was P9,100. The company’s unit product cost was P18 under variable costing
and P20 under absorption costing.

9. If the ending inventory consisted of 2,520 units, the beginning inventory in units must have been
______________________

Problem 5

Franz began business at the start of this year and had the following costs: variable
manufacturing cost per unit, ₱12 (DM is ₱4); fixed manufacturing costs, ₱60,000; variable selling and
administrative costs per unit, ₱2; and fixed selling and administrative costs, ₱220,000. The company sells
its units for ₱45 each. Additional data follow:
Planned production in units 10,000
Actual production in units 10,000
Number of units sold 8,500

10. The net income/(loss) under variable costing is ______________________

11. The amount of ending inventory under absorption costing is ______________________
12. The net income/(loss) under throughput costing is ______________________

Problem 6

Salvador Corp began operations in January. The company produced 10,000 units and
sold 8,000 units in its first year of operations. Costs for the year were as follows:

Fixed Manufacturing Costs P 250,000

Variable Manufacturing Costs 180,000
Fixed selling and administrative costs 75,000
Variable selling and administrative costs 80,000

13. The difference between the operating income of Salvador using the variable and absorption
costing methods? _______________________