Product Costing

Absorption and Variable Costing

Chapter 3
 At the end of the lesson, you should be able to
…
1. Differentiate absorption costing against variable costing;
2. Explain the rationale of the use of variable costing in managerial
planning and control;
3. Differentiate inventory valuation under absorption costing against
variable costing;
4. Prepare an income statement absorption costing and variable costing.
5. Reconcile absorption costing net income and variable costing net
income.
 Income and Performance Evaluation
• One of the tools for performance evaluation is the assessment
of the entity’s financial performance – income
• Income is used as a measurement of performance both in the
totality of an entity and by reporting segments or departments.
• This poses a question – How should income be correctly
measured by an entity?
 Income and Performance Evaluation
• Cost information provided by cost accounting is a vital information
used by the management in order for them to determine how much a
product or service costs them.
• To be able to generate target income, costs and expenses that are
matched against revenues should be clearly determined.
• Going back to the default basic goal of cost management, costs
should be properly managed and regulated to achieve higher profits.
 Income and Performance
Evaluation
The preceding insights now brings the
call for product costing procedures to be
utilized for the proper evaluation of
financial performance.
 Product Costing Methods

Absorption Costing Variable Costing

Sales Sales xx,xxx
xx,xxx
Less: Variable costs (x,xxx)
Less: Cost of goods sold (x,xxx)
Contribution margin x,xxx
Gross profit
x,xxx Less: Fixed costs (x,xxx)
Less: Operating expenses (x,xxx) Net income xx,xxx
Net income
xx,xxx
 Absorption Costing
• Also known as full costing method.
Sales xx,xxx • Used in presenting income information to external
Less: Cost of goods sold (x,xxx) users of accounting information.
Gross profit x,xxx • In conformity with GAAP.
Less: Operating expenses (x,xxx) • All direct materials, direct labor, variable
manufacturing overhead, and fixed manufacturing
Net income xx,xxx
overhead forms part of the cost of the products.
• Variable and fixed selling and administrative
expenses forms part of operating expenses.
• Product costs are split into two – finished goods
inventory when unsold and cost of goods sold upon
selling.
 Variable Costing
Sales • Also known as contribution margin approach.
xx,xxx • Used in presenting income information to
Less: Variable costs internal users of accounting information.
(x,xxx) • not conformity with GAAP.
Contribution margin • direct materials, direct labor, and all variable
x,xxx costs are deducted to sales to determine
Less: Fixed costs contribution margin.
(x,xxx) • All fixed costs during the period are deducted
Net income against the contribution margin to determine
xx,xxx net income.
 Features of Variable Costing
• Costs are identified as variable cost and fixed cost, not
COGS and OPEX.
• Fixed manufacturing overhead is treated as a period
Variable Costing
cost and is charged directly of the entire amount Sales xx,xxx
matched against revenues for that period.
Less: Variable costs (x,xxx)
• Variable costing recognizes that only production costs
that vary directly with the volume of production shall be Contribution margin x,xxx
“treated” as product cost. Fixed manufacturing
overhead shall become a period cost since whatever Less: Fixed costs (x,xxx)
level of production, they will be still incurred.
Net income xx,xxx
• Under variable costing, fixed overhead costs must not
become product costs. If in the event an entity has zero
production, inventory costs would still amount to the
fixed overhead costs itself even if in reality, there’s no
inventory!
 Features of Variable Costing
The main difference between variable costing method and absorption costing method is
the treatment of FIXED MANUFACTURING OVERHEAD.
• In absorption costing, fixed manufacturing overhead is part of product costs. With
that, fixed manufacturing overhead related to unsold products becomes part of
finished goods inventory and will only be charged against revenue at the point of
sale. Thus, in comparison with variable costing, there is a “deferred fixed overhead”
cost not charged against revenue until products are sold.
• In variable costing, all fixed manufacturing overhead is charged and matched against
sales, thereby all fixed overhead id deducted to sales. There is no deferral of fixed
overhead in relation to inventory, thus providing a more precise measurement of
income on the premise that “whatever the level of production and sale, we will still
be incurring these fixed overhead costs.”
 Pro-forma (and explanatory) Statements of Income
Absorption Costing (GAAP Income Statement)

Gidjette Company
Income Statemets
For the period ended December 31, 2021
Sales Units sold x selling price xx,xxx
Less: Cost of goods sold Units sold x direct material cost per unit
Units sold x direct labor cost per unit
Units sold x variable overhead cost per unit
Units sold x (total fixed overhead cost/units produced) (x,xxx)
Gross Profit xx,xxx
Less: Operating expenses Units sold x variable selling and administrative expenses per unit
Total fixed selling and administrative expenses (x,xxx)
Net Income xx,xxx
 Pro-forma (and explanatory) Statements of Income
Variable Costing (Contribution Margin Income Statement)

Gidjette Company
Contribution Margin Income Statement
For the period ended December 31, 2021
Sales Units sold x selling price xx,xxx
Less: Variable Costs
Variable COGS Units sold x direct material cost per unit
Units sold x direct labor cost per unit
Units sold x variable overhead cost per unit
Variable S/A expenses Units sold x (total fixed overhead cost/units produced) (x,xxx)
Contribution Margin xx,xxx
Less: Fixed Costs Total fixed manufacturing overhead costs
Total fixed selling and administrative expenses (x,xxx)
Net Income xx,xxx
Problems
Problem 1 Production = Sales; No ending inventory
Nobita Company makes Doraemon laptop tables that sells for P250 each. The company’s annual
production and sales level is 120,000 laptop tables. In addition to P4,305,000 fixed manufacturing
overhead and P1,590,500 fixed administrative expenses, the following per-unit costs have been
determined for each laptop table:
Direct materials P 60.00
Direct labor 30.00
Variable manufacturing overhead 8.00
Variable selling expense 22.00
P 120.00
Total variable cost per unit

Prepare the entity’s GAAP income statement and internal contribution margin income statement. Ignore tax
effect.
Nobita Company
Problem 1 Production = Sales; No ending inventory
Income Statements
For the period ended December 31, 2021

Sales (120k laptop tables x P250) P 30,000,000

Less: Cost of goods sold
Direct materials (120k laptop tables x P60) P 7,200,000
Direct labor (120k laptop tables x P30) 3,600,000
Variable manufacturing overhead (120k laptop tables x P8) 960,000
Fixed manufacturing overhead (120k laptop tables x P35,875) 4,305,000 16,065,000
Gross Profit 13,935,000
Less: Operating expenses
Variable selling expense (120k laptop tables x P22) 2,640,000
Fixed administrative expenses 1,590,500 4,230,500
Net Income P 9,704,500
Nobita Company
Problem 1 Production = Sales; No ending inventory
Income Statements
For the period ended December 31, 2021

Sales (120k laptop tables x P250) P 30,000,000

Less: Variable costs
Direct materials (120k laptop tables x P60) P 7,200,000
Direct labor (120k laptop tables x P30) 3,600,000
Variable manufacturing overhead (120k laptop tables x P8) 960,000
Variable selling expense (120k laptop tables x P22) 2,640,000 14,400,000
Contribution Margin 15,600,000
Less: Fixed costs
Fixed manufacturing overhead 4,305,000
Fixed administrative expenses 1,590,500 5,895,500
Net Income P 9,704,500
 Points to consider
• When production level =sales level, there will be equal amounts of net
income under absorption costing and variable costing.
• When production level = sales level, there is no inventory left. Therefore,
there will be no fixed manufacturing overhead cost that will be retained as
ending inventory to be deferred next period as matching to revenues.
• When production level = sales level, all costs were released and matched
against revenue. All manufacturing costs were charged as cost of goods
sold.
 Problem 2 Production > Sales; No beginning inventory, ending inventory
retained

Nobita Company makes Doraemon laptop tables that sells for P250 each. The company’s annual
production level is 120,000 laptop tables. 100,000 tables were sold. In addition to P4,305,000 fixed
manufacturing overhead and P1,590,500 fixed administrative expenses, the following per-unit costs
have been determined for each laptop table:
Direct materials P 60.00
Direct labor 30.00
Variable manufacturing overhead 8.00
Variable selling expense 22.00
P 120.00
Total variable cost per unit

1. Prepare the entity’s GAAP income statement and internal contribution margin income statement. Ignore tax
effect.
2. Reconcile absorption costing net income and variable costing net income.
 Problem 2 Production > Sales; No beginning inventory, ending inventory retained
Nobita Company
Income Statements
For the period ended December 31, 2021

Sales (100 k laptop tables x P250) P 25,000,000

Less: Cost of goods sold
Direct materials (100 k laptop tables x P60) P 6,000,000
Direct labor (100 k laptop tables x P30) 3,000,000
Variable manufacturing overhead (100 k laptop tables x P8) 800,000
Fixed manufacturing overhead (100 k laptop tables x P35,875) 3,587,500 13,387,500
Gross Profit 11,612,500
Less: Operating expenses
Variable selling expense (100 k laptop tables x P22) 2,200,000
Fixed administrative expenses 1,590,500 3,790,500
Net Income P 7,822,000
 Problem 2 Production > Sales; No beginning inventory, ending inventory retained
Nobita Company
Income Statements
For the period ended December 31, 2021

Sales (100 k laptop tables x P250) P 25,000,000

Less: Variable costs
Direct materials (100 k laptop tables x P60) P 6,000,000
Direct labor (100 k laptop tables x P30) 3,000,000
Variable manufacturing overhead (100 k laptop tables x P8) 800,000
Variable selling expense (100 k laptop tables x P22) 2,200,000 12,000,000
Contribution Margin 13,000,000
Less: Fixed costs
Fixed manufacturing overhead 4,305,000
Fixed administrative expenses 1,590,500 5,895,500
Net Income P 7,104,500
 Points to consider
• When production level >sales level, absorption costing net income is greater
than variable costing net income.
• In absorption costing, the fixed manufacturing overhead component of ending
inventory has been deferred to be charged to revenue in the next period.
• In variable costing, all fixed manufacturing overhead have been deducted to
obtain net income.
• With theses, absorption costing net income will be greater than variable
costing net income.
 Problem 2 Production > Sales; No beginning inventory, ending inventory retained
Fixed manufacturing overhead component of ending inventory : 20,000 laptop table x P35,875 = P717,500

Absorption costing net income P 7,822,000

Less: Fixed manufacturing overhead component of ending inventory
20,000 laptop tables x P35,875 717,500
Variable costing net income P 7,104,500

Variable costing net income P 7,104,500

Add: Fixed manufacturing overhead component of ending inventory
20,000 laptop tables x P35,875 717,500
Absorption costing net income P 7,822,000
 Problem 3 Production < Sales; With beginning and ending inventory
Nobita Company makes Doraemon laptop tables that sells for P250 each. The company’s annual
production level is 120,000 laptop tables. There were 50,000 unsold laptop tables from last year. 140,000
tables were sold this year. In addition to P4,305,000 fixed manufacturing overhead and P1,590,500 fixed
administrative expenses, the following per-unit costs have been determined for each laptop table:
Direct materials P 60.00
Direct labor 30.00
Variable manufacturing overhead 8.00
Variable selling expense 22.00
P 120.00
Total variable cost per unit

1. Prepare the entity’s GAAP income statement and internal contribution margin income statement. Ignore tax
effect.
2. Reconcile absorption costing net income and variable costing net income.
 Problem 3 Production < Sales; With beginning and ending inventory
Nobita Company
Income Statements
For the period ended December 31, 2021

Sales (140 k laptop tables x P250) P 35,000,000

Less: Cost of goods sold
Direct materials (140 k laptop tables x P60) P 8,400,000
Direct labor (140 k laptop tables x P30) 4,200,000
Variable manufacturing overhead (140 k laptop tables x P8) 1,120,000
Fixed manufacturing overhead (140 k laptop tables x P35,875) 5,022,500 18,742,500
Gross Profit 16,257,500
Less: Operating expenses
Variable selling expense (140 k laptop tables x P22) 3,080,000
Fixed administrative expenses 1,590,500 4,670,500
Net Income P 11,587,000
 Problem 3 Production < Sales; With beginning and ending inventory
Nobita Company
Income Statements
For the period ended December 31, 2021

Sales (140 k laptop tables x P250) P 35,000,000

Less: Variable costs
Direct materials (140 k laptop tables x P60) P 8,400,000
Direct labor (140 k laptop tables x P30) 4,200,000
Variable manufacturing overhead (140 k laptop tables x P8) 1,120,000
Variable selling expense (140 k laptop tables x P22) 3,080,000 16,800,000
Contribution Margin 18,200,000
Less: Fixed costs
Fixed manufacturing overhead 4,305,000
Fixed administrative expenses 1,590,500 5,895,500
Net Income P
12,304,500
 Points to consider
• When production level <sales level, absorption costing net income is lesser than
variable costing net income.
• In absorption costing, the fixed manufacturing overhead component of beginning
inventory is now deducted ro the current period to obtain net income.
• In variable costing, only the fixed cost for the current period are deducted to obtain
net income
• With these, absorption costing net income will be lesses than variable costing net
income.
 Problem 3 Production < Sales; With beginning and ending inventory
Fixed manufacturing overhead component of beginning inventory : 50,000 laptop table x P35,875 =
P1,793,750
Fixed manufacturing
Absorption overhead component of ending inventory : 30,000 laptop tables x P 35,875=
costing net income P P1,076,250
11,587,000
Add: Fixed manufacturing overhead component of beginning inventory
50,000 laptop tables x P35,875 1,793,750
Less: Fixed manufacturing overhead component of ending inventory
30,000 laptop tables x P 35,875 - 1,076,250
Variable costing net income P 12,304,500

Variable costing net income P 12,304,500

Less: Fixed manufacturing overhead component of beginning inventory
50,000 laptop tables x P35,875 - 1,793,750
Add: Fixed manufacturing overhead component of ending inventory
30,000 laptop tables x P 35,875 1,076,250
Absorption costing net income P 11, 587,000
 Quick Notes
• Absorption costing income statement follows GAAP – cost of godds sold includes all
product costs like direct materials, direct labor, and variable and fixed manufacturing
overhead costs. Operating expenses include all variable and fixed selling and
administrative expenses.
• Variable costing income statement is for internal use – costs are categorized as variable
and fixed. However, total fixed manufacturing overhead costs are deducted and matched
against revenue and is not split as component of cost of godds sold as component of
ending inventory.
• The main difference between absorption versus variable costing is the treatment of fixed
manufacturing overhead cost.
 Quick Notes

Absorption costing Variable costing

Sales xx,xxx Sales xx,xxx

Less: Cost of goods sold (x,xxx) Less: Variable costs (x,xxx)

Gross Profit x,xxx Contribution Margin x,xxx

Less: Operating expenses (x,xxx) Less: Fixed costs (x,xxx)

Net income xx,xxx Net income xx,xxx

 Quick Notes

• If production = sales, ACNI = VCNI

• If production > sales, ACNI > VCNI
• If production < sales, ACNI < VCNI
 Quick Notes

ACNI VCNI
+Fixed cost BI -Fixed cost BI
- Fixed cost EI +Fixed cost EI
VCNI ACNI
 Thank you
for listening!
 ACTIVITY NO. 1
ZKB company manufacturers a unique device that is used by internet users to boost wi-fi signals. The following data relates to the
first month of operation:
• Beginning inventory: o units
• Units produced: 40,000 units
• Units sold: 35,000 units
• Selling price: $120 per unit
Marketing and administrative expenses:
• Variable marketing and administrative expense per unit : $ 4
• Fixed marketing and administrative expense per month: $1,120,000
Manufacturing cost:
• Direct materials cost per unit: $ 30
• Direct labor cost per unit: $14
• Variable manufacturing overhead cost per unit: $4
• Fixed manufacturing overhead cost per month: $1,280,000
Management is anxious to see the success on new booster in terms of its revenue and profitability.
Required:
1. Calculate the unit product cost and prepare income statement under variable costing system and absorption
costing system.
2. Prepare income statement under two costing system.