ABSORPTION AND VARIABLE COSTING

ABSORPTION COSTING OR FULL COSTING

- A product costing method that includes all the manufacturing costs (direct materials, direct labor, and both
the variable and fixed factory overhead) in the cost of a unit of product.
- Under the absorption costing method, fixed factory overhead is treated as a product cost.

VARIABLE COSTING
- A product costing method that includes only the variable manufacturing costs (direct materials, direct
labor and variable overhead) in the cost of a unit of product.
- Under the variable costing method, fixed factory overhead is treated as period cost.

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

DISTINCTION BETWEEN PERIOD COSTS AND PRODUCT COSTS

PERIOD 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.
PRODUCT COST
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.

PRINCIPAL DIFFERENCES BETWEEN ABSORPTION AND VARIABLE COSTING METHODS

ABSORPTION VARIABLE
1. Cost Segregation Seldom segregates costs into Costs are segregated into
variable and fixed costs variable and fixed
2. Cost of Inventory Cost of inventory includes all the Cost of inventory includes only
manufacturing costs: materials, the variable manufacturing
labor, variable factory overhead costs: materials, labor and
and fixed factory overhead. variable factory 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 variable
production and other costs and fixed costs
Sales Sales
-COGS -VC
Gross Profit CM
- S & A Costs -FxC
Profit Profit
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
the 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.

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 recognized the fixed
manufacturing overhead as an expense. In variable costing, it is expensed during the period when the fixed
overhead is incurred, while in absorption costing, it is expensed in the period when the units to which such fixed
overhead has been related are sold.

PRODUCTION EQUALS SALES

When production is equal 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 income is
greater than variable costing income.

PRODUCTION IS LESS THAN SALES

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

Reconciliation of Absorption and Variable Costing Income

Absorption Costing Income Xx
Add: Fixed overhead in the beginning inventory Xx
Total Xx
Less: Fixed overhead in the ending inventory Xx
Variable costing income Xx

Accounting for difference in Income

Change in inventory (production less sales) xx
x Fixed FOH per unit xx
Difference in income xx

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 analysis are readily available
3. The problems involved in allocating fixed costs are eliminated
4. Variable costing is more compatible with the standard cost accounting system
5. Variable costing reports provide useful information for pricing decisions and other decision-making
problems encountered by management.

Arguments Against Variable Costing

1. Segregation of costs into fixed and variable might be difficulty, particularly 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 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.

ILLUSTRATIVE EXAMPLE
During the year 200A, Wouie 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 12,000 12
Direct labor 10,000 10
Variable factory overhead 8,000 8
Fixed factory overhead 6,000 6
Variable selling and administrative 4,500 5
Fixed selling and administrative 3,000 3
Required:
1. Product costs per unit under absorption and variable costing
2. Income under absorption costing
3. Income under variable costing
4. Computation of and accounting for the difference in income