11/5/2016

Under
&

Learning Objectives

Explain how variable costing differs from absorption costing and compute the unit
product cost under each method

Describe how fixed manufacturing overhead costs are deferred in stock and released
from stock under absorption costing

Prepare profit and loss accounts using both variable and absorption costing, and
reconciled the two profit figures

Explain the effect of changes in production on the profit reported under both
variable and absorption costing

Explain the advantages and limitations on both the variable and absorption costing
methods

Explain how the use of JIT reduces the differences in profit reported under the
variable and absorption costing methods

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Two general approach are used for costing products for the purpose of
valuing stock and cost of goods sold.

Absorption Costing
Variable Costing/Marginal Costing

Absorption Costing is generally used for external financial reports.

Variable Costing is preferred by some managers for internal decision making

and must be used when profit and loss account is prepared in the
contribution format.

Absorption Costing
Absorption Costing is generally used for external financial reports.

Absorption costing treats all costs of production as product costs, regardless of whether
they are variable or fixed.

The cost of a unit of product under the absorption costing therefore consists of direct
materials, direct labor and both variable and fixed overhead.

Thus, absorption costing allocates a portion of fixed manufacturing overhead cost to

each unit of product, along with the variable manufacturing costs.

Because absorption costing includes all costs of production as product costs, it is

frequently referred to as the full cost method.

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Variable Costing
Under variable costing, only those costs of production that vary with output are treated
as product costs. This would generally include direct materials, direct labor and the
variable portion of manufacturing overhead.

Fixed manufacturing overhead is not treated as a product cost under this method.
Rather fixed manufacturing overhead is treated as a period cost and, like selling and
administrative expenses, it is charged off in its entirely against revenue each period.
Consequently, the cost of a unit of product in stock or in cost of goods sold under the
variable costing methods contains no element of fixed overhead cost.

Variable costing is sometimes referred to as Direct costing or Marginal costing.

-absorption versus variable costing

Absorption costing Variable costing

Direct materials
Direct labor Product costs
Product costs Variable manufacturing overhead

Fixed manufacturing overhead

Period costs
Period costs Selling and administrative expenses

Selling and Administrative expenses are never treated as product costs, regardless of
the costing method in use. Thus, under either absorption or variable costing, selling
and administrative expenses are always treated as period costs and deducted from
revenues as incurred.

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Overview of Absorption and Variable Costing

Absorption C osting Variable C osting
Income State me nt Income State me nt
Sale s Sale s

Dire ct mate rials

Dire ct labor C ost of Goods Sold

( V a ri a b l e P ro d uc t C o s t s )

C ost of Goods Sold Variable manufacturing ove rhe ad

(Fixe d and variable
product costs)
Variable
Se lliing &
Administrative
e xpe nse s
Gross Profit
Fixe d manufacturing ove rhe ad C ontribution Margin
(Gross Margin)
Fixe d
Manufacturing
ove rhe ad
Fixe d
Se lling &
Se lling &
Adminstrative Se lling & Administrative e xpe nse s
Administrative
e xpe nse s
e xpe nse s
Ne t O pe rating Income Ne t O pe rating Income

KEY: = Pe riod e xpe nse s

Boley Company, a small company that produces a single product and has the following
cost structure:
Number of units produced each year 6,000
Variable cost per unit:
Direct materials 2
Direct labor 4
Variable manufacturing overhead 1
Variable selling and administrative expenses 3
Fixed costs per year:
Fixed manufacturing overhead 30,000
Fixed selling and administrative expenses 10,000

Required:
1. Compute the unit product cost under absorption costing.
2. Compute the unit product cost under variable costing.

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Absorption costing
Direct materials 2
Direct labor 4
Variable manufacturing overhead 1
Total Variable production cost 7
Fixed manufacturing overhead
5
(30,000/6,000 production unit)
Unit product cost 5

Variable costing
Direct materials 2
Direct labor 4
Variable manufacturing overhead 1
Unit product cost 7

The Tk. 30,000 fixed manufacturing overhead will be charged off in total against
profit as a period expense along with the selling and administrative expenses.

Under the absorption costing method, notice that all production costs,
variable and fixed, are included determining the unit product cost. Thus, if
the company sells a unit of product and absorption costing is being used,
then Tk. 12 (consisting of Tk. 7 variable cost and Tk. 5 fixed cost) will be
deducted on the profit and loss account as cost of goods sold. Similarly, any
unsold units will be carried as stock on the balance sheet at Tk. 12 each.

Under the variable costing method, notice that only the variable production
costs are included in product costs. Thus, if the company sells a unit of
product, only Tk. 7 will be deducted as cost of goods sold, and unsold units
will be carried in the balance sheet stock amount at only Tk. 7 each.

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Harvey Company produces a single product with the

following information available:

Unit product cost is determined as follows:

Under absorption costing, all production costs, variable and

fixed, are included when determining unit product cost. Under
variable costing, only the variable production costs are
included in product costs.

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Income Comparison of
Absorption and Variable Costing

Lets assume the following additional information

for Harvey Company.
20,000 units were sold during the year at a price
of $30 each.
There is no beginning inventory.

Now, lets compute net operating

income using both absorption
and variable costing.

Income Comparison of
Absorption and Variable Costing

Fixed manufacturing overhead deferred in

inventory is 5,000 units $6 = $30,000.

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Income Comparison of
Absorption and Variable Costing

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
Less 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
Net operating income $ 90,000

Income Comparison of
Absorption and Variable Costing

Variable
manufacturing
Variable Costing
costs only.
Sales (20,000 $30) $ 600,000
Less variable expenses:
Beginning inventory $ -
Add COGM (25,000 $10) 250,000
Goods available for sale 250,000
Less 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
Net operating income $ 90,000

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Income Comparison of
Absorption and Variable Costing

Variable
manufacturing
Variable Costing
costs only.
Sales (20,000 $30) $ 600,000
Less variable expenses:
Beginning inventory $ -
All fixed
Add COGM (25,000 $10) 250,000
manufacturing
Goods available for sale 250,000
overhead is
Less ending inventory (5,000 $10) 50,000
expensed.
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
Net operating income $ 90,000

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We can reconcile the difference between

absorption and variable income as follows:

Variable costing net operating income $ 90,000

Add: Fixed mfg. overhead costs
deferred in inventory
(5,000 units $6 per unit) 30,000
Absorption costing net operating income $ 120,000

Fixed mfg. overhead $150,000

= = $6 per unit
Units produced 25,000 units

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Since the variable costs per unit, total fixed costs,

and the number of units produced remained
unchanged, the unit cost computations also
remain unchanged.

Unit product
cost.
Absorption Costing
Sales (30,000 $30) $ 900,000
Less cost of goods sold:
Beg. inventory (5,000 $16) $ 80,000
Add COGM (25,000 $16) 400,000
Goods available for sale 480,000
Less ending inventory - 480,000
Gross margin 420,000
Less selling & admin. exp.
Variable (30,000 $3) $ 90,000
Fixed 100,000 190,000
Net operating income $ 230,000

Fixed manufacturing overhead released from

inventory is 5,000 units $6 = $30,000.

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Variable
manufacturing
costs only.

All fixed
manufacturing
overhead is
expensed.

We can reconcile the difference between

absorption and variable income as follows:

Variable costing net operating income $ 260,000

Deduct: Fixed manufacturing overhead
costs released from inventory
(5,000 units $6 per unit) 30,000
Absorption costing net operating income $ 230,000

Fixed mfg. overhead $150,000

= = $6 per unit
Units produced 25,000 units

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of
absorption and variable costing
Boley Company, a small company that produces a single product and has the following
cost structure:
Units in beginning stock -
Units produced 6,000
Units sold 5,000
Units in ending stock 1,000
Selling price per unit 20
Selling and administrative expenses
Variable per unit 3
Fixed per year 10,000

Absorption Variable
Costing Costing
Unit product cost
Direct materials 2 2
Direct labor 4 4
Variable manufacturing overhead 1 1
Fixed manufacturing overhead
5
(30,000/6,000 units)
12 7

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of
absorption and variable costing

Absorption Costing
Sales (5,000 units *Tk. 20) 100,000
Less cost of goods sold:
Beginning stock -
Add cost of goods manufactured (6,000 units*Tk. 12) 72,000
Goods available for sale 72,000
Less ending stock (1,000 units*Tk. 12) 12,000
Cost of goods sold 60,000
Gross margin 40,000
Less selling and administrative expenses
25,000
(5,000units* Tk. 3 variable+Tk. 10,000 fixed)
Profit 15,000

of
absorption and variable costing
Variable Costing
Sales (5,000 units *Tk. 20) 100,000
Less variable expenses:
Variable cost of goods sold:
Beginning stock -
Add variable manufacturing costs (6,000 units*Tk. 7) 42,000
Goods available for sale 42,000
Less ending stock (1,000 units*Tk. 7) 7,000
Variable Cost of goods sold 35,000
Variable selling and administrative expenses(5,000units* Tk. 3 ) 15,000 50,000
Contribution margin 50,000
Less fixed expenses:
Fixed manufacturing overhead 30,000
Fixed selling and administrative expenses 10,000 40,000
Profit 10,000

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of absorption and variable costing

Absorption Costing
Sales (5,000 units *Tk. 20) 100,000
Less cost of goods sold:
Beginning stock -
Add cost of goods manufactured (6,000 units*Tk. 12) 72,000
Goods available for sale 72,000
Less ending stock (1,000 units*Tk. 12) 12,000
Cost of goods sold 60,000
Gross margin 40,000
Less selling and administrative expenses
25,000
(5,000units* Tk. 3 variable+Tk. 10,000 fixed)
Profit 15,000
Variable Costing
Sales (5,000 units *Tk. 20) 100,000
Less variable expenses:
Variable cost of goods sold:
Beginning stock -
Add variable manufacturing costs (6,000 units*Tk. 7) 42,000
Goods available for sale 42,000
Less ending stock (1,000 units*Tk. 7) 7,000
Variable Cost of goods sold 35,000
Variable selling and administrative expenses(5,000units* Tk. 3 ) 15,000 50,000
Contribution margin 50,000
Less fixed expenses:
Fixed manufacturing overhead 30,000
Fixed selling and administrative expenses 10,000 40,000
Profit 10,000

of absorption and variable costing

Absorption Costing
Sales (5,000 units *Tk. 20) 100,000 Note the difference in
Less cost of goods sold: ending stocks. Fixed
Beginning stock - manufacturing
Add cost of goods manufactured (6,000 units*Tk. 12) 72,000 overhead cost Tk. 5 per
Goods available for sale 72,000 unit is included under
Less ending stock (1,000 units*Tk. 12) 12,000 the absorption
Cost of goods sold 60,000 approach. This explains
Gross margin 40,000 the difference in ending
Less selling and administrative expenses stock and in profit
25,000
(5,000units* Tk. 3 variable+Tk. 10,000 fixed) (1,000 units* Tk. 5)=Tk.
Profit 15,000 5,000
Variable Costing
Sales (5,000 units *Tk. 20) 100,000
Less variable expenses:
Variable cost of goods sold:
Beginning stock -
Add variable manufacturing costs (6,000 units*Tk. 7) 42,000
Goods available for sale 42,000
Less ending stock (1,000 units*Tk. 7) 7,000
Variable Cost of goods sold 35,000
Variable selling and administrative expenses(5,000units* Tk. 3 ) 15,000 50,000
Contribution margin 50,000
Less fixed expenses:
Fixed manufacturing overhead 30,000
Fixed selling and administrative expenses 10,000 40,000
Profit 10,000

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of absorption and variable costing

Several points can be made from the financial statements:

1. Under absorption costing method, if there is an increase in stock then some of the
fixed manufacturing costs of the current period will not appear on the profit and
loss account as part of cost of goods sold. Instead, these costs are deferred to a
future period and are carried on the balance sheet as part of the stock count. Such a
deferral of costs is known as fixed manufacturing overhead cost deferred in stock.

During the current period, Boley company produced 6,000 units but sold only 5,000
units, thus leaving 1,000 unsold units in the ending stock. Under the absorption
costing method, each unit produced was assigned Tk. 5 in fixed overhead cost.
Therefore, each of the 1,000 units going into stock at the end of the period has Tk. 5
in fixed manufacturing overhead cost to it, or a total of Tk. 5,000 for the 1,000 units.

This fixed manufacturing overhead cost of the current period is deferred in stock to
the next period, when, hopefully, these units will be taken out of stock and sold. The
deferral of Tk. 5,000 of fixed manufacturing overhead costs can be seen clearly by
analyzing the ending stock under absorption costing method:

Variable manufacturing costs: 1,000 units*Tk. 7 7,000

Fixed manufacturing costs: 1,000 units*Tk. 5 5,000
Total stock value 12,000

of absorption and variable costing

Several points can be made from the financial statements:

2. Under the variable costing method, the entire Tk. 30,000 in fixed manufacturing
overhead costs has been treated as an expense of the current period

3. The ending stock figure under the variable costing method is Tk. 5,000 lower than
it is under absorption costing method. The reason is that under variable costing,
only the variable manufacturing costs are assigned to units of product and therefore
included in stock.

Variable manufacturing costs: 1,000*Tk. 7 Tk. 7,000

The Tk. 5,000 difference in ending stock explains the difference in profit reported
between the costing methods. Profit is Tk. 5,000 higher under absorption costing
since, Tk. 5,000 fixed manufacturing overhead cost has been deferred in stock to the
next period under that costing method.

4. The absorption costing profit and loss account makes no distinction between
variable and fixed costs; therefore, it is not well suited for CVP computations, which
are important for good planning and control. To generate data for CVP analysis, it
would be necessary to spend considerable time reworking and reclassifying costs on
the absorption statement.

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of absorption and variable costing

Several points can be made from the financial statements:

5. The variable costing approach to costing units of product blends very well with
the contribution approach to the profit and loss account, since both concepts are
based on the idea of classifying costs by behavior. The variable costing data could be
used immediately in CVP analysis.

Basic Data
Selling price 20
Variable manufacturing cost per unit produced 7
Fixed manufacturing cost per year 150,000
Variable selling and administrative expenses per unit sold 1
Fixed selling and administrative expenses per year 90,000

Three Years
Year 1 Year 2 Year 3
Together
Units in beginning stock - - 5,000 -
Units produced 25,000 25,000 25,000 75,000
Units sold 25,000 20,000 30,000 75,000
Units in ending stock - 5,000 - -

Units Product Costs

Under variable costing (variable manufacturing costs only) 7 7 7
Under absorption costing:
Variable manufacturing costs 7 7 7
Fixed manufacturing overhead costs (Tk. 150,000 spread over
6 6 6
the number of units produced in each year)
Total absorption cost per unit 13 13 13

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Absorption Costing
Three Years
Year 1 Year 2 Year 3
Together
Sales 500,000 400,000 600,000 1,500,000
Less cost of goods sold
Beginning stock - - 65,000 -
Add cost of goods manufactured (25,000*Tk. 13) 325,000 325,000 325,000 975,000
Goods available for sale 325,000 325,000 390,000 975,000
Less ending stock (5,000 units*Tk. 13) - 65,000 - -
Cost of goods sold 325,000 260,000 390,000 975,000
Gross margin 175,000 140,000 210,000 525,000
Less selling and administrative expenses 115,000 110,000 120,000 345,000
Profit 60,000 30,000 90,000 180,000

The selling and administrative expenses are computed as follows:

Year 1: 25,000 units*Tk. 1 variable + Tk. 90,000 fixed = Tk. 115,000
Year 2: 20,000 units*Tk. 1 variable + Tk. 90,000 fixed = Tk. 110,000
Year 3: 23,000 units*Tk. 1 variable + Tk. 90,000 fixed = Tk. 120,000

Variable Costing
Three Years
Year 1 Year 2 Year 3
Together
Sales 500,000 400,000 600,000 1,500,000
Less variable expenses
Variable cost of goods sold
Beginning stock - - 35,000 -
Add variable manufacturing costs (25,000*Tk. 7) 175,000 175,000 175,000 525,000
Goods available for sale 175,000 175,000 210,000 525,000
Less ending stock (5,000 units*Tk. 7) - 35,000 - -
Variable cost of goods sold 175,000 140,000 210,000 525,000
Variable selling and administrative expenses
25,000 200,000 20,000 160,000 30,000 240,000 75,000 600,000
(Tk. 1 per unit sold)
Contribution margin 300,000 240,000 360,000 900,000
Less Fixed expenses
Fixed manufacturing overhead 150,000 150,000 150,000 450,000
Fixed selling and administrative expenses 90,000 240,000 90,000 240,000 90,000 240,000 270,000 720,000
Profit 60,000 - 120,000 180,000

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Absorption Costing
Three Years
Year 1 Year 2 Year 3
Together
Sales 500,000 400,000 600,000 1,500,000
Less cost of goods sold
Beginning stock - - 65,000 -
Add cost of goods manufactured (25,000*Tk. 13) 325,000 325,000 325,000 975,000
Goods available for sale 325,000 325,000 390,000 975,000
Less ending stock (5,000 units*Tk. 13) - 65,000 - -
Cost of goods sold 325,000 260,000 390,000 975,000
Gross margin 175,000 140,000 210,000 525,000
Less selling and administrative expenses 115,000 110,000 120,000 345,000
Profit 60,000 30,000 90,000 180,000

Variable Costing
Three Years
Year 1 Year 2 Year 3
Together
Sales 500,000 400,000 600,000 1,500,000
Less variable expenses
Variable cost of goods sold
Beginning stock - - 35,000 -
Add variable manufacturing costs (25,000*Tk. 7) 175,000 175,000 175,000 525,000
Goods available for sale 175,000 175,000 210,000 525,000
Less ending stock (5,000 units*Tk. 7) - 35,000 - -
Variable cost of goods sold 175,000 140,000 210,000 525,000
Variable selling and administrative expenses
25,000 200,000 20,000 160,000 30,000 240,000 75,000 600,000
(Tk. 1 per unit sold)
Contribution margin 300,000 240,000 360,000 900,000
Less Fixed expenses
Fixed manufacturing overhead 150,000 150,000 150,000 450,000
Fixed selling and administrative expenses 90,000 240,000 90,000 240,000 90,000 240,000 270,000 720,000
Profit 60,000 - 120,000 180,000

Reconciliation of variable costing and absorption costing-Profit data

Year 1 Year 2 Year 3
Variable costing profit 60,000 - 120,000
Add fixed manufacturing overhead costs deferred in stock
- 30,000 -
under absorption costing (5,000 units*Tk. 6 per unit)
Deduct fixed manufacturing overhead costs released from
- - (30,000)
stock under absorption costing (5,000 units*Tk. 6 per unit)
Absorption costing profit 60,000 (30,000) 90,000

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Relation between production Relation between absorption

Effect on Stocks
and sales for the periuod and variable costing profit
Absorption costing profit =
Production = Sales No schage in stock
Variable costing profit
Absorption costing profit >
Production > Sales Stock increase
Variable costing profit*
Absorption costing profit <
Production < Sales Stock decrease
Variable costing profit**
*Profit is higher under absorption costing since fixed manufacturing overhead cost is deferred
in stock under absorption costing as stock increase.
**Profit is lower under absorption costing, since fixed manufacturing overhead cost is released
from stock under absorption costing as stock decreases.

Understand the advantages

and disadvantages of both
variable and absorption
costing.

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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.

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. It assigns per unit fixed
manufacturing overhead costs to production.

Treating fixed manufacturing overhead as a

variable cost can:
Lead to faulty pricing decisions and faulty
keep-or-drop decisions.

Assigning per unit fixed manufacturing overhead

costs to production can:
Potentially produce positive net operating income
even when the number of units sold is less than
the breakeven point.

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External Reporting and Income Taxes

To conform to
IFRS and US GAAP
requirements, absorption costing
must be used for In many countries,
external financial reports. including US,
absorption costing must be
used when filling out
income tax returns.

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.

Consistent with
CVP analysis.
Management finds Net operating income
it more useful. is closer to
net cash flow.

Consistent with standard

costs and flexible budgeting.
Advantages

Easier to estimate profitability

of products and segments.
Impact of fixed
costs on profits
emphasized. Profit is not affected by
changes in inventories.

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Fixed manufacturing
costs must be assigned
Fixed manufacturing
to products to properly
costs are capacity costs
match revenues and
and will be incurred
costs.
even if nothing is
produced.

Absorption Variable
Costing Costing

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:
Many companies have a commitment to guarantee
workers a minimum number of paid hours.
Direct labor is usually not the constraint.
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.

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When companies use Lean Production . . .

Production
tends to equal
sales . . .

So, the difference between variable and

absorption income tends to disappear.

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