Variable

Costing
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.
 • Variable Costing is premised on the philosophy that costs are either
fixed or variable.
• Variable costs relate to units sold. The difference between sales and
variable costs is called the contribution margin. It is used to absorb fixed
costs and generate profit.
• The variable costing is also called marginal costing or direct costing
income statement
• It follows the economic model of determining profit and gives business

The Variable managers much more accurate perspective on how profit and operating
wealth are accumulated and controlled.

Costing • Variable costs may be segregated into

• variable cost of goods sold and
• variable selling and administration expenses.
• Fixed costs may be segregated into
• direct fixed costs and expenses which can be
• controllable or
• non-controllable
• indirect fixed costs and expenses.
The Absorption Costing
• 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 Difference between Absorption
and Variable Costing Methods
• The difference between absorption and
variable costing methods lies on how the
fixed overhead is treated.
• 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.
 Product Cost vs. Period Cost
EFEM Corporation gives you the following production data with respect to its March 2019 operations:
• Management accounting uses the standard costing system. Hence, the computation of
the unit costs is based on the standard costs.
• The unit product cost is P 400 (P 4 million/ 10,000 units).
• The cost distribution shall be as follows:
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.
Case A – Sales (22,000 units) > Production (20,000 units)
2. The Case Environment

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.
4. The Difference in Profit

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.)
Discussion: Case B – Sales (19,000 units) < Production (20,000 units)
Variable costing profit follows the trend in sales.
• When sales are greater than production, variable costing profit is
greater than absorption costing profit; and
• When sales are lower than production, variable costing profit is less
than absorption costing profit.
• When sales equal production, the profit (loss) between variable
costing and absorption costing is equal.
Under absorption costing,
• When sales exceed production, the cost of fixed overhead recorded in the absorption
costing is greater than that of the variable costing.
• This is because the amount of fixed overhead charged against income is
determined based on the number of actual units sold.
• Therefore, inasmuch as sales in units are greater than production, the fixed
overhead recorded under the absorption costing is also greater, resulting to
higher cost of goods sold and lower profit than that of the variable costing
system.
• 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
Now, we should also say that if
sales decline, profit also declines.
variable costing follows sales, then,
This
absorption costing follows
observation follows a manager’s
production. That is, if production is
normal train of thought regarding
greater than the sales, absorption
the relationship of sales and profit.
costing income is greater than that
This differs from the reports using
of variable costing. And if
absorption costing where there are
production is less than sales,
instances that sales are increasing
absorption costing profit is less
but profit is declining, and
than that of variable costing.
vice-versa.
Profit (Loss) Calculation, Normal Capacity Differs
From the Actual Production
2. The profit (loss) is computed as follows:
The Normal Capacity
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 75,000 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
The P/L Statements: Absorption Costing and Variable Costing
The unit product costs:
• 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.
Absorption Costing vs. Variable Costing: The Strategic Issue

• 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.