Big Picture

Week 6&7: Unit Learning Outcomes (ULO): At the end of the unit, you are expected
to:
a. explain the concept of variable and absorption costing.
b. describe the concept and importance ofcost-volume-profit relationship in the
operation of the business.

Big Picture in Focus: ULOa.explain the concept of variable and absorption

costing

Metalanguage
In this section, the most essential terms relevant to the topic and to demonstrate
ULOawill be operationally defined to establish a common frame of reference as to
how the texts work in your chosen field or career.
1. Absorption costing – (also known as full costing) is an approach to product
costing that assigns all manufacturing costs (direct materials, direct labor and
all factory overhead) to the items produced. Thus, inventoriable cost include
all the cost elements of production; and period include all non-manufacturing
costs. This method is typically used for external income statement reporting.

2. Variable costing –(also known as direct costing) is an approach to product

costing that assigns only variable manufacturing costs (direct materials, direct
labor and variable factory overhead) to the items produced. Thus,
inventoriable cost are limited to the variable manufacturing costs; and period
include all fixed costs and variable non-manufacturing costs. This method is
typically used for internal income statement reporting.

Please proceed immediately to the “Essential Knowledge”.

Essential Knowledge
This portion discusses the cost accumulation and presentation techniques to product
costing. Cost accumulation and presentation procedures are accomplished using
one of two methods: absorption costing or variable costing. Each method uses the
same basic data, but structures and processes the data differently.

1. Product Cost Components

Absorption Costing Variable Costing

Direct materials Direct materials
+ Direct labor + Direct labor
+ Variable FOH + Variable FOH
+ Fixed FOH -
Product Cost Product Cost

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2. Distinction between Period costs and Product costs

Period Cost Product Cost

1. Cost that is charged against
current revenue during a time
period regardless of the
difference between production
and sales volumes.
2. Does not form part of the cost of
inventory.
3. Reduces income for the current
period by its full amount.
1. Cost that is included in the
computation of product cost
that is apportioned between the
sold and unsold units.
2. An inventoriable cost. The
portion of the cost that has been
allocated to the unsold units
becomes part of the cost of
inventory.
3. Reduces current income by the
portion allocated to the sold
units; the portion allocated to
unsold units is treated as an
asset, being part of the cost of
inventory.

3. Principal differences between Absorption and Variable Costing Method

Absorption Costing Variable Costing

1. Cost segregation Seldom segregates costs Costs are segregated into
into variable and fixed variable and fixed
costs
2. Cost of inventory Cost of inventory includes Cost of inventory includes
all the manufacturing only the variable
costs: materials, labor, manufacturing costs:
variable factory overhead, materials, labor, and
and fixed factory variable factory overhead
overhead
3. Treatment of fixed Fixed factory overhead is Fixed factory overhead is
factory overhead treated as product cost treated as period cost
4. Income Statement Distinguishes between Distinguishes between
production and other variable and fixd costs.
costs. Sales XX
Sales XX -Variable costs XX
-COGS (production XX Contr. margin XX
costs) -Fixed costs XX
Gross Profit XX Profit XX
-S&A costs XX
Profit XX

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 5. Net Income Net income between the two methods may differ from
each other because of the difference in the amount of
fixed overhead costs 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.

4. Difference in Net Income under Absorption and Variable Costing

Variable and absorption costing methods of accounting for fixed manufacturing

overhead result in different levels of net income in most cases. The differences are
timing differences, i.e., when to recognize the fixed manufacturing overhead as an
expense. In variable costing, it is expensed during the period when the fixed
manufacturing overhead is incurred, while in absorption costing, it is expensed in the
period when the units to which such fixed manufacturing overhead are sold.

 Production equals Sales

When production is equals to sales, there is no change in inventory.
Fixed overhead expensed under absorption costing equals fixed
overhead expensed under variable costing. Therefore, absorption
costing income equals variable costing income.

 Production is greater than Sales

When production is greater than sales, there is an increase in
inventory. Fixed overhead expensed under absorption costing is less
than fixed overhead expensed under variable costing. Therefore,
absorption costing income is greater than variable costing income.

 Production is less than Sales

When production is less than sales, there is an decrease in inventory.
Fixed overhead expensed under absorption costing is greater than
fixed overhead expensed under variable costing. Therefore, absorption
costing income is less than variable costing income.

5. Reconciliation of Absorption and Variable Costing Income Figures

Absorption costing income P XX

Add: Fixed overhead in the beginning inventory XX
Total XX
Less: Fixed overhead in the ending inventory XX
Variable costing income P XX

6. Accounting for Difference in Income

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 Change in inventory (production less sales) P XX
Multiple by: FOH cost per unit XX
Difference in income P XX

7. Arguments for the use of Variable costing

1) Variable costing reports are simpler and more understandable.
2) Data needed for break-even and cost-volume-profit analyses ae readily
available.
3) The problems involved in allocating fixed costs are eliminated.
4) Variable costing is more compatible with standard cost accounting system.
5) Variable costing reports provide useful information for pricing decisions and
other decision – making problems encountered by management.

8. Arguments against Variable costing

1) Segregation of costs into fixed and variable might be difficult, particular in the
case of mixed costs.
2) 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.
3) With variable costing, inventory costs and other elated 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.

Sample problem:
During the year 2020, Clove Corporation’s production was equal to its normal
capacity of 1,000 units. It sold 900 units at a price of P50 per unit.

The following costs were incurred during the year:

Total Cost Cost per unit
Direct materials P 12,000 P12
Direct labor 10,000 10
Variable factory overhead 8,000 8
Fixed factory overhead 6,000 6
Variable selling & administrative 4,500 5*
Fixed selling & administrative 3,000 3

*variable selling &adm. cost per unit = P4,500 ÷ 900 = P5.

I. Product cost per unit

Product cost per unit
Absorption Costing Variable Costing
Direct materials P 12 P 12
Direct labor 10 10
Variable factory overhead 8 8
Fixed factory overhead 6 -

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 Product cost per unit P 36 P 30

II. Income under absorption costing

Sales (900 units x P50) P 45,000
Less: Cost of goods sold (900 units x
32,400
P36)
Gross Profit 12,600
Less: selling & administrative expenses
Variable (900 x P5) P 4,500
Fixed 3,000 7,500
Income P 5,100

III. Income under variable costing

Sales (900 units x P50) P 45,000
Less: Variable costs
Cost of goods sold (900 x P30) P 27,000
selling & administrative expenses 4,500 31,500
Contribution Margin 13,500
Less: Fixed costs
Factory overhead 6,000
selling & administrative expenses 3,000 9,000
Income P 4,500

IV. Computation of and accounting for the difference in income

Absorption costing income P5,100
Variable costing income 4,500
Difference in income P 600
Let’s Check!
I. Questions:

1. “The central issue in variable costing is timing.” Explain.

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2. Why is direct costing a misnomer? Explain

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3. Under absorption costing, how is it possible to increase net operating

income without increasing sales?
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