Topic 3: Variable Costing and Absorption Costing

Approaches to Product Costing

1. Absorption Costing – treat al manufacturing costs as product costs regardless whether fixed or
variable.
2. Variable Costing – only variable manufacturing costs are treated as product costs; the rest (fixed
manufacturing and all commercial costs regardless whether fixed or variable) are regarded as period
costs.
3. Throughput Costing (Super-Variable Costing) – only direct materials are treated as product cost; the
rest (direct labor, factory overhead, and all commercial costs regardless whether fixed or variable) are
regarded as period costs.

Unit Cost Computations

Absorption Costing Variable Costing Throughput Costing
(Full Costing) (Direct Costing) (Super Variable)
Inventoriable Cost
Direct Materials Direct Materials Direct Materials
Direct Labor Direct Labor
Variable Overhead Variable Overhead
Fixed Overhead
Expenses
Variable Selling Expense Variable Selling Expense Variable Selling Expense
Variable Administrative Expense Variable Administrative Expense Variable Administrative Expense
Fixed Selling Expense Fixed Selling Expense Fixed Selling Expense
Fixed Administrative Expense Fixed Administrative Expense Fixed Administrative Expense
Fixed Overhead Direct Labor
Variable Overhead
Fixed Overhead

Income Statement Preparation

A. Absorption Costing
Sales
Less Cost of Sales
Finished Goods Inventory, Beg
Cost of Goods Manufactured*
Total Goods Available for Sale
Less Finished Goods, End**
Gross Margin
Less Variable Selling and Administrative Expenses
Fixed Selling and Administrative Expenses
Net Income
*Full or Absorption Cost X Units Produced
**Full or Absorption Cost X Units in Ending Inventory

B. Variable Costing
Sales
Less Variable Manufacturing Costs*
Manufacturing Contribution Margin
Less Variable Selling and Administrative Expenses
Contribution Margin
Less Fixed Manufacturing Expenses (Fixed Overhead)
Fixed Selling and Administrative Expenses
Net Income
*Variable Manufacturing Costs X Units Sold
C. Throughput Costing
Sales
Less Cost of Sales (Units Sold X Standard Direct Material Cost)
Throughput Margin
Less: Operating costs
Direct Labor
Variable and Fixed Manufacturing Overhead
Variable and Fixed Selling and Administrative Expenses
Net Income

Net Income Reconciliation

Net Income under Absorption Costing
Add Fixed Overhead Assigned to Beginning Inventory (or Decrease in Ending Inventory)
Less Fixed Overhead Assigned to Ending Inventory (or Increase in Ending Inventory)
Net Income under Variable Costing

Summary of Changes and Effects of Variable Production and Sales Levels

Relationship Between
Relation Between
Effect on Absorption Costing and
Production and Remarks
Inventories Variable Costing Net
Sales for the Period
Income
No Change in Absorption Costing NI = Fixed Mfg Cost expensed for
Production = Sales
Inventories Variable Costing NI both approaches is the same
Ending Inventories Absorption Costing NI > More fixed cost is assigned to
Production > Sales
Increase Variable Costing NI ending inventory
Lesser fixed cost is assigned
Ending Inventories Absorption Costing NI < to ending inventory; Fixed cost
Production < Sales
Decrease Variable Costing NI assigned to Beginning
Inventory is released
NOTE: Absorption Costing -> Net Income f(Production) => Increased production will increase NI
Variable Costing -> Net Income f(Sales) => Increased sales will increase NI

Absorption Costing VS Variable Costing

Absorption Costing
• When sales fluctuate because of seasonality
in sales demand but production is held
constant, absorption costing avoids large
fluctuations in profit.
• Marginal costing fails to recognize the
importance of working to full capacity and its
effect on pricing decisions if cost plus method
of pricing is used.
• Prices based on marginal cost (minimum
prices) do not guarantee that contribution will
cover fixed costs.
• In the long run, all costs are variable and
absorption costing recognizes these long run
variable costs.
• It is consistent with the requirements of
accounting standards.
Variable Costing
• It shows how an organization’s cash flows and
profits are affected by changes in sales
volume since contribution varies in direct
proportion to units sold.
• By using absorption costing and setting a
production level greater than sales demand,
profits can be manipulated.
• Separating fixed and variable costs is vital for
decision making.
• For short run decisions in which fixed costs do
not change (such as short run tactical
decisions seeking to make the best use of
existing resources), the decision rule is to
choose the alternative which maximizes
contribution, fixed costs being irrelevant.
Effects of Variable Costing and Absorption Costing on the Financial Performance and Condition of
the Firm
1. Impact on the Manager
Opponents of absorption costing argue that shifting fixed manufacturing overhead costs between
periods can lead to faulty decisions. These opponents argue that variable costing income statements are
easier to understand because net operating income is only affected by changes in unit sales. This
produces net operating income figures that are consistent with managers’ expectations.
2. CVP Analysis, Decision Making and Absorption Costing
Absorption costing does not dovetail with CVP analysis, nor does it support decision making. It treats
fixed manufacturing overhead as a variable cost. This can lead to faulty pricing decisions and faulty keep-
or-drop decisions. It also assigns per unit fixed manufacturing overhead costs to production. This can
potentially produce positive net operating income even when the number of units sold is less than the
breakeven point.
3. External Reporting and Income Taxes
Practically speaking, absorption costing is required for external reports in the United States. Under the
Tax Reform Act of 1986, a form of absorption costing must be used when filling out income tax forms.
Since top executives are typically evaluated based on earnings reported to shareholders in external
reports, they may feel that decisions should be based on absorption costing data.
4. Variable Costing and the Theory of Constraints (TOC)
Companies involved in TOC use a form of variable costing. However, one difference of the TOC approach
is that it treats direct labor as a fixed cost for three reasons:
• Although direct laborers are paid an hourly wage, many companies have a commitment —
sometimes enforced by labor contracts or by the law — to guarantee workers a minimum
number of paid hours.
• Direct labor is usually not the constraint; therefore, there is no reason to increase the number of
direct laborers.
• TOC emphasizes the role direct laborers play in driving continuous improvement. Since layoffs
often devastate morale, managers involved in TOC are extremely reluctant to lay off employees.
5. Impact of Lean Production
When companies use Lean Production, the goal is to eliminate finished goods inventories and reduce
work in process inventory to almost nothing. This causes absorption costing net operating income to
essentially move in the same direction as sales. Therefore, the difference between absorption costing
and variable costing income tends to disappear.