Module 5

Lesson : 05
Absorption and Variable Costing
 ABSORPTION COSTING

A principle whereby fixed as well as

variable costs are allocated to cost unit
and total overheads are absorbed
according to activity level.

2
 MARGINAL COSTING
A principle whereby variable costs are charged
to cost units and the fixed cost attributable to
relevant period is written off in full against the
contribution for that period.

3
Characteristics of Marginal Costing
1. Segregation of Costs into Fixed and Variable
2. Marginal Costs as Product Costs
3. Fixed Costs as Period Costs
4. Valuation of Inventory
5. Contribution
6. Pricing

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 Absorption Costs Vs. Marginal Costs
Absorption Costs
1. Classification of Fixed &
Variable Cost Un-necessary
2. Stock Valuation based on
full production cost
3. Higher profit
4. Product pricing based on
full costs
5. Controllability of Fixed Cost
not possible
Marginal Costs
1. Fixed & Variable Cost need
to be separated
2. Stock Valuation based on
Variable Cost only
3. Lower profit
4. Product pricing based on
variable costs only
5. Only controllable costs are
included in product costs
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 Absorption Costs Vs. Marginal Costs

Absorption Costs Marginal Costs

6. Fits in well with standard 6. Pricing variability is closely
absorption costing related to variable costs.
7. Tax recommended by 7. Tax not recommended by
accounting standards standards
8. Contribution has to be 8. Contribution already
calculated separately to computed to help in
ensure good decision decision making

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 Advantages of Marginal Costing
1. Production Priority set based on higher C/S ratio
2. Product deletion or department Closure
decisions based on Contribution Margin
3. CVP analysis
4. Most profitable use of existing resources
5. Fixing minimum prices
6. Method is simpler & most easily understood
7. Clerical cost is lower

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 Disadvantages of Marginal Costs
1. In case of semi-variable or semi-fixed costs,
segregation of Fixed and Variable costs is
difficult
2. Inventory valuation not acceptable for tax
purposes
3. Contradicts with International accounting
standards
4. Contradicts with Matching principle

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 Absorption and Variable Costing
Absorption Variable
Costing Costing

Direct materials
Direct labor Product costs
Product costs Variable mfg. overhead

Fixed mfg. overhead

Period costs
Period costs Selling & Admin. exp.

The difference between absorption and variable

costing is the treatment of fixed manufacturing overhead.
8-9
 Absorption and Variable Costing
Mellon Co. produces a single product with
the following information available:
Number of units produced annually 25,000
Variable costs per unit:
Direct materials, direct labor
and variable mfg. overhead $ 10
Selling & administrative
expenses $ 3
Fixed costs per year:
Mfg. overhead $ 150,000
Selling & administrative
expenses $ 100,000

8-10
 Absorption and Variable Costing
Unit product cost is determined as follows:

Absorption Variable
Costing Costing
Direct materials, direct labor, and
variable mfg. overhead $ 10 $ 10
Fixed mfg. overhead
($150,000 ÷ 25,000 units) 6 -
Unit product cost $ 16 $ 10
Selling and administrative expenses are always treated as period expenses and
deducted from revenue.

8-11
 Absorption Costing
Income Statements
Mellon Co. had no beginning inventory, produced 25,000
units and sold 20,000 units this year at $30 each.

Absorption Costing
Sales (20,000 × $30) $ 600,000
Less cost of goods sold:
Beginning inventory $ -
Add COGM (25,000 × $16) 400,000
Goods available for sale $ 400,000
Ending inventory (5,000 × $16) 80,000 320,000
Gross margin $ 280,000
Less selling & admin. exp.
Variable (20,000 × $3) $ 60,000
Fixed 100,000 160,000
Net income $ 120,000

8-12
 Variable Costing
Income Statements
Now let’s look at variable costing by Mellon Co.

Variable Costing
Sales (20,000 × $30) $ 600,000
Less variable expenses:
Beginning inventory $ -
Add COGM (25,000 × $10) 250,000
Goods available for sale $ 250,000
Ending inventory (5,000 × $10) 50,000
Variable cost of goods sold $ 200,000
Variable selling & administrative
expenses (20,000 × $3) 60,000 260,000
Contribution margin $ 340,000
Less fixed expenses:
Manufacturing overhead $ 150,000
Selling & administrative expenses 100,000 250,000
8-13
Net income $ 90,000
 Comparing Absorption and
Variable Costing
Let’s compare the methods.
Cost of
Goods Ending Period
Sold Inventory Expense Total
Absorption costing
Variable mfg. costs $ 200,000 $ 50,000 $ - $ 250,000
Fixed mfg. costs 120,000 30,000 - 150,000
$ 320,000 $ 80,000 $ - $ 400,000

Variable costing
Variable mfg. costs $ 200,000 $ 50,000 $ - $ 250,000
Fixed mfg. costs - - 150,000 150,000
$ 200,000 $ 50,000 $ 150,000 $ 400,000

8-14
 Reconciling Income Under Absorption
and Variable Costing
We can reconcile the difference between
absorption and variable net income as follows:
Variable costing net income $ 90,000
Add: Fixed mfg. overhead costs
deferred in inventory
(5,000 units × $6 per unit) 30,000
Absorption costing net income $ 120,000

Fixed mfg. overhead $150,000

= = $6.00 per unit
Units produced 25,000
8-15
 Evaluation of Variable Costing

Management finds it Consistent with

easy to understand. CVP analysis.

Emphasizes contribution in
Advantages
short-run pricing decisions.

Impact of fixed Profit for period not

costs on profits affected by changes
emphasized. in fixed mfg. overhead.
8-16
 Evaluation of Absorption Costing
Fixed manufacturing overhead is
treated the same as the other product
costs, direct material and direct labor.

Consistent with long-run

Advantages pricing decisions that must
cover full cost.

External reporting
and income tax law
require absorption costing.
8-17
 OPERATING LEVERAGE
Operating leverage refers to the use of fixed costs in
an organization's overall cost structure.
An organization that has a relatively high proportion
of fixed costs and low proportion of variable costs
has a high degree of operating leverage.

Operating Leverage Factor = Contribution Margin

Net Income

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 ILLUSTRATION # 1
Consolidated Industries is studying the addition of a new valve to its product
line. The value would be used by manufacturers of irrigation equipment.
The company anticipates starting with a relatively low sales volume and then
boosting demand over the next several years.
A new salesperson must be hired because consolidated current sales force is
working at capacity. Two compensation plans are under consideration:

Plan A: An annual salary of Rs.22,000 plus a 10% commission based on

gross sales
Plan B: An annual salary of Rs.66,000 and no commission

Consolidated Industries will purchase the valve for Rs.50 and sell it for
Rs.80. Anticipated demand during the first year is 6000 units.(ignore
income tax)

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 REQUIRED
1. Compute the break even point for Plan A and Plan B
2. What is meant by the term operating leverage?
3. Analyze the cost structures of both plans at the anticipated
demand of 6000 units. Which of the two plans has a higher
operating leverage factor
4. Assume that the general economic downturn occurred during
year 2, with product demand falling from 6000 to 5000 units.
Determine the percentage decrease in company net income if
Consolidated had adopted Plan A
5. Repeat requirement 4 from Plan B. Compare Plan A and Plan B,
and explain a major factor that underlies any resulting differences
6. Briefly discuss the likely profitability impact of an economic
recession for highly automated manufacturers. What can you say
about the risk associated with these firms

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 Solution
plan A plan B
• sales 480,000 480,000
less variable costs 300,000 300,000
commission 48,000 nil
contribution 132,000 180,000
less fixed costs 22,000 66,000
profit 110,000 114,000
operating leverage 1.2 1.58
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 calculation of Break Even Point (BEP)
Break even point:
Plan A 22,000/22 = 1000 units
plan B 66000/30 = 2200 units
Contribution:
PLAN A 80 –{[80*10 %] +50} =22
PLAN B(80-50) =30

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 If 5000 units sold
Plan A plan B
• Sales 400,000 400,000
• less variable cost 250,000 250,000
• Commission 40,000 nil
• contribution 110,000 150,000
• fixed costs 22,000 66,000
• profit 88,000 84,000
• Decrease in profit 22,000 30,000

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 Conclusion
In a severe economic downturn, organizations
having higher fixed cost suffer more, but
incase of boom enjoy high profit.

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 Cost-Volume-Profit Analysis
• CVP includes all fixed costs to compute
breakeven.
– Variable costing and CVP are consistent as both treat
fixed costs as a lump sum.
• Absorption costing defers fixed costs into
inventory.
– Absorption costing is inconsistent with CVP because
absorption costing treats fixed costs on a per unit
basis.

8-25
 Illustration # 2
Two businesses Y Ltd. And Z Ltd. Sell the same type of
product in the same type of market. Their budgeted
income statement for the coming year are as follows:
Y Ltd. Z Ltd.
Sales 150,000 150,000
Less:
Variable Cost (120,000) (100,000)
Fixed Costs ( 15, 000) (35,000)
_________ _______
Profit 15,000 15,000
_________ ________

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 Illustration # 2
Required:
1. Calculate the BEP for each business.
2. State which business is likely to earn greater
profits in condition of:
a) Heavy demand for the product
b) No demand for the product
And briefly give your reasons.

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 SOLUTION # 2
Y LTD. PER UNIT Z LTD PER UNIT
Sales (1000 x 150) 150,000 150 150,000 150
Variable cost 120,000 120 100,000 100
Contribution 30,000 30 50,000 50
Fixed Cost 15,000 15 35,000 35
Profit 15,000 15 15,000 15
C/s Ratio 20% 33.3%
BEP in sales Rs. 15000/0.20 35000/0.33
=75,000 =105,000
BEP in units 15000/30 35000/50
=500 =
Operating leverage 30000/15000 50000/15000
=2 =3.3

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If demand increases by 50%
Y LTD. Z LTD
Sales ( 1500x 150) 225,000 225,000
Variable cost 180,000 150,000

Contribution 45,000 75,000

Fixed Cost 15,000 35,000
Profit 30,000 40,000
Operating leverage 45000/30000 75000/40000
=1.5 =1.8

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 If demand reduces by 20%
Y LTD. Z LTD
Sales ( 800x 150) 120,000 120,000
Variable cost 96,000 80,000
Contribution 24,000 40,000
Fixed Cost 15,000 35,000
Profit 9,000 5,000
Operating leverage 24000/9000 40000/5000
=2.7 =8

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 Illustration # 3
Tim’s bicycle shop sells 21-speed bicycles.
For the purpose of a cost-volume-profit analysis, the shop owner has divided
into two categories as follows:

High sale price invoice cost sale commission Rs.500, Rs.275, Rs.25
Medium quality Rs.300, Rs.135, Rs.15
Mix ratio High 25% and Medium 75%
Fixed cost Rs.65,000
Find out contribution margin and c/s ratio
Find out breakeven point in Rs. And in units
How many units of each type must be sold to earn a target
Net income of Rs.48,750?
Assume a constant sales mix

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 Solution # 3
Products Sale price Mix ratio Variable Unit WA cont. W A
cost cont. sales
High 500 25% 300 200 50 125
Quality
Medium 300 75% 150 150 112.50 225
Quality
800 100% 162.50 350

Breakeven Point in Units 65,000/162.50 = 400 Bicycles

Weighted average C/S ratio = 162.50/350 *100 = 46.43%
Breakeven Point in Rs. = 65,000/46.43 = Rs. 140,000/-
High 400*25% = 100*500 = 50,000
Medium 400*75%=300*300 = 90,000
Target income=65,000+48,750=113,750/162.5=700 bicycles
High 700*25%=175 and Medium 700*75%=525
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