Ateneo de Zamboanga University

School of Management and Accountancy

Accountancy Department
School Year 2021-22

Course Code: COSMAN2 Semester: 1st

Course Title: Strategic Cost Management Session: 1
Instructor: _____________________________________ Week No.: 3

LEARNING PACKET NO. 3

Product Costing Methods

INTENDED LEARNING OUTCOME:

At the end of this learning unit, the learners shall:

1. Describe the context of usage of full (absorption) and direct (variable) costing methods.
2. Distinguish the difference in reporting and calculating profit and inventory under the two
methods.
3. Investigate the cause of difference in income between the two methods and reconcile the
same.

I. CONCEPT NOTES

Review of the Relevant Classification of Costs

As to Function
1. Manufacturing Costs – all costs incurred in the factory to convert raw materials into
finished goods.
a. Direct Materials – raw materials cost that becomes integral part of the finished
product and that can be conveniently and economically assigned to specific units
manufactured.
b. Direct Labor – all labor costs related to time spent on products that can be
conveniently and economically assigned to specific units manufactured.
c. Manufacturing Overhead – all other costs incurred in the factory aside from direct
materials and direct labor.
2. Non-Manufacturing Costs – all costs which are not incurred in transforming materials to
finished goods.
a. Selling/Marketing/Distribution Costs – all costs associated with marketing or selling
a product.
b. General and Administrative Costs – all executive, organizational and clerical costs
associated with the general management of the organization rather than with
manufacturing, marketing or selling.

As to Behavior
1. Variable Costs – costs which change in total amount directly in proportion to the change in
the activity level but remain constant on a per unit basis within the relevant range and time
period under consideration.
 2. Fixed Costs – costs for which the total amount remain constant but changes inversely to
the change in activity level on a per unit basis within the relevant range and time period
under consideration.

As to Timing of Recognition as Expense

1. Product Costs – costs that “attach” or cling to the units that are produced and are reported
as assets until the goods are sold.
2. Period Costs – costs that are recognized as expense in the income statement on the period
in which the cost was incurred.

Distinctions Between Period Costs and Product Costs

PERIOD COSTS PRODUCT COSTS

1. Refers to an item charged against
1. Refers to an item included in
current revenue or treated as expense
determining the cost of the product
on the basis of time period regardless
allocated between sold and unsold
of the difference between production
units.
and sales volume.
2. The portion of the cost, which has
2. Does not form part of the cost of
been allocated to the unsold units,
inventory.
becomes part of the inventory.
3. Diminishes current income by that
portion thereof identified with the
3. Diminishes income for the current sold units only with the remainder
period by its full amount. being deferred to the next accounting
period as part of the cost of ending
inventory.

Nature of Absorption and Variable Costing Methods

Definitions

ABSORPTION COSTING (also called full costing, conventional costing) – costing method that includes all
cost elements of production (direct materials, direct labor, and both variable and fixed manufacturing
overhead) in the cost of a unit of product. It treats fixed manufacturing overhead as a product cost.

VARIABLE COSTING (also called direct costing) – costing method that includes only variable
manufacturing costs (direct materials, direct labor, and variable manufacturing overhead) in the cost of a
unit of product. It treats fixed manufacturing overhead as a period cost.

Differences Between Absorption and Variable Costing

ABSORPTION COSTING VARIABLE COSTING
Cost segregation Seldom segregates costs into Costs are segregated into
variable and fixed costs variable and fixed
Cost of Inventory Cost of inventory includes all Cost of inventory includes
the manufacturing costs: only the variable
materials, labor, variable manufacturing costs:
factory overhead, and fixed materials, labor, and variable
factory overhead factory overhead
Treatment of fixed factory overhead Fixed factory overhead is Fixed factory overhead is
treated as product cost treated as period cost

Income statement Distinguishes between Distinguishes between

production and other costs. variable and fixed costs.
Net income Net income between the two methods may differ from each
other because of the difference in the amount of fixed overhead
costs recognized as expense during an accounting period. This
is due to variations between sales and production. In the long
run, however, both methods give substantially the same results
since sales cannot continuously exceed production, nor
production can continually exceed sales.
Notes:
1. Cost of inventory under Absorption Costing is ALWAYS HIGHER than under Variable Costing.

Cost Treatment Under Both Methods

Absorption Costing Cost Element Variable Costing

Direct Materials

Direct Labor
Product Cost
Product Cost Variable Manufacturing Overhead

Fixed Manufacturing Overhead

Marketing/Selling/ Distribution Costs Period Cost

Period Cost
General and Administrative Costs

Review: How do we determine Fixed Manufacturing Overhead ( Per Unit ) ?

Predetermined OH Rate = Budgeted OH Cost at a Specified Activity Level / Volume of Specified Activity
Level

What happens if the budgeted capacity used to determine the predetermined FOH rate and the actual
capacity is not the same ?
There is Volume Variance
Favorable Volume Variance ( Decrease in Cost of Budgeted Capacity < Actual Units Produced/Actual
Goods Sold )/ Also Called Overapplied Overhead Capacity
Unfavorable Volume Variance ( Increase in Cost of Budgeted Capacity >Actual Units Produced/Actual
Goods Sold ) / Also Called Underapplied OH Capacity

Accounting and Reporting of Costs and Income Under Absorption and Variable Costing

Accounting of Manufacturing Costs

Absorption Costing Cost Element Variable Costing

Direct Materials Cost of Goods Sold

Cost of Goods Sold
d
ts Sol
ni
Product Cost U
Un

Direct
it s

Labor
So

Un
ld

so
ldFinished Goods Inventor
Un
Product Cost its
Variable Manufacturing Overhead
its
Un

Expense (Period Cost)

d
sol

Finished Goods Inventory Fixed Manufacturing Overhead

Un

Unit Cost Per Unit Computation

Absorption Costing:
Unit cost of inventory = Direct materials per unit + Direct labor per unit + Variable factory overhead per
unit + Applied factory overhead per unit

Variable Costing:
Unit cost of inventory = Direct materials per unit + Direct labor per unit + Variable factory overhead per
unit

Income Statement Presentation

Absorption Costing – Conventional Income Statement Format (Functional Income Statement)

Variable Costing – Contribution Margin Income Statement

Contribution Margin Income Statement – an income statement format that highlights cost behavior
patterns.
Contribution Margin – the amount of revenue that is left to the company after all variable costs
(manufacturing and non-manufacturing) were deducted, and that amount of revenue used to recover the
amount of fixed cost before profit is determined.

Conventional Income Statement Contribution Margin Income Statement

 Sales XXX Sales XXX
Cost of Goods Sold (XXX) Variable Cost
Gross Profit XXX Manufacturing XXX
Operating Expenses Non-Manufacturing XXX (XXX)
Selling XXX Contribution Margin XXX
Administrative XXX (XXX) Fixed Cost (XXX)
Net Income XXX Net Income XXX

Differences in Income under Absorption and Variable Costing Methods

Variable and absorption costing methods of accounting for fixed manufacturing overhead result in
different levels of net income in most cases. The differences are timing differences, i.e., when to
recognize the fixed manufacturing overhead as an expense. In variable costing, is expensed during the
period when the fixed overhead is incurred, while in absorption costing, it is expensed in the period when
the units to which such fixed overhead has been related are sold.

Production = Sales Beg. Inventory = End Inventory NI, AC = NI, VC

Production > Sales Beg. Inventory < End Inventory NI, AC > NI, VC
Production < Sales Beg. Inventory > End Inventory NI, AC < NI, VC

Reconciliation of Differences in Net Income

Net Income, Absorption Costing XXX
Add: Fixed Overhead in Beg. Inventory XXX
Total XXX
Less: Fixed Overhead in End Inventory XXX
Net Income, Absorption Costing XXX

Alternate Computation:
Net Income, Absorption Costing XXX
∓ Change in Fixed Factory Overhead in the Inventory* XXX
Net Income, Absorption Costing XXX

*Change in Fixed FOH in the Inventory = (Beg. Inventory – End Inventory) X Applied Fixed FOH per unit

Sample Problem with Solution

Smart Screen Corporation manufactures and sells 32 -inch television sets and uses standard costing. Actual
data relating to January and February 2019 are as follows:

January February
Unit Data
Beginning inventory 0 300
Production 1,000 800
Sales 700 800
Variable costs
Manufacturing cost per unit produced P 900 P 900
Operating (marketing) cost per unit sold 600 600
Fixed Costs
Manufacturing Costs 400,000 400,000
Operating (marketing costs) 140,000 140,000
The selling price per unit is P2,500. The budgeted level of production used to calculate the budgeted fixed
manufacturing cost per unit is 1,000 units. There are no price, efficiency, or spending variances. Any
production-volume variance is written off to cost of goods sold in the month in which it occurs.

Instruction:
1. Prepare income statements for Smart Screen in January and February under (a) variable costing
and (b) absorption costing.

Solution:

JANUARY

Variable Costing

Sales P 2,500 X 700 P1,750,000

Variable Cost
Manufacturing P900 X 700 (630,000)
Non-Manufacturing P600 X 700 (420,000)
Contribution Margin 700,000
Fixed Cost 400,000 + 140,000 (540,000)
Net Income P 160,000

Absorption Costing

Variable Manufacturing Costs P 900

Fixed Manufacturing Cost Allocated per Unit 400
( P400,000 / 1,000 units)
Manufacturing cost per unit 1,300

Sales P 2,500 X 700 P 1,750,000

Cost of Goods Sold P 1,300 X 700 (910,000)
Gross Profit 840,000
Operating Expenses
Variable Marketing P600 X 700 (420,000)
Expense
Fixed Marketing (140,000)
Expense
Net Income P 280,000

FEBRUARY

Variable Costing

Sales P 2,500 X 800 P2,000,000

Variable Cost
Manufacturing P900 X 800 (720,000)
Non-Manufacturing P600 X 800 (480,000)
Contribution Margin 800,000
Fixed Cost 400,000 + 140,000 (540,000)
Net Income P 260,000
Absorption Costing

Variable Manufacturing Costs P 900

Fixed Manufacturing Cost Allocated per Unit 400
( P400,000 / 1,000 units)
Manufacturing cost per unit 1,300

Sales P 2,500 X 800 P 2,000,000

Cost of Goods Sold P 1,300 X 800 (1,040,000)
Volume Variance 200 X 400 (80,000)
Gross Profit 880,000
Operating Expenses
Variable Marketing P600 X 800 (480,000)
Expense
Fixed Marketing (140,000)
Expense
Net Income P 260,000

2. Explain the difference in operating income for January and February under variable costing and
absorption costing.

January

Net Income, Absorption Costing P 280,000

Add: Fixed Overhead in Beg. Inventory 0
Total 280,000
Less: Fixed Overhead in End Inventory 120,000
Net Income, Absorption Costing P 160,000

February
Net Income, Absorption Costing P 160,000
Add: Fixed Overhead in Beg. Inventory 120,000
Total 280,000
Less: Fixed Overhead in End Inventory 120,000
Net Income, Absorption Costing P 260,000

Arguments For and Against the Use of Variable Costing

Arguments FOR Variable Costing:

1. Variable costing reports are simpler and more understandable.
2. Data needed for break-even and cost-volume-profit analyses are readily available.
3. The problems involved in allocating fixed costs are eliminated.
4. Variable costing is more compatible with the standard cost accounting system.
5. Variable costing reports provide useful information for pricing decisions and other decision-making
problems encountered by management.

Arguments AGAINST Variable Costing:

1. Segregation of costs into fixed and variable might be difficult, particularly in the case of mixed costs.
2. The matching principle is violated by using variable costing which excludes fixed overhead from
product costs and charges the same to period costs regardless of production and sales.
 3. With variable costing, inventory costs and other related accounts, such as working capital, current
ratio, and acid-test ratio are understated because of the exclusion of fixed overhead in the
computation of product cost.

II. CHECKING FOR UNDERSTANDING

PROBLEM 1. Morgana Company operated at normal capacity of 20,000 units in the year 2012. The
company sold 80% of these units at a price of P30 per unit. Manufacturing cost incurred during the year is
as follows:
Variable cost per unit:
Materials P4
Labor 6
Factory overhead 2
Selling and administrative 5
Fixed costs – Total:
Factory overhead P160,000
Selling and administrative 40,000
REQUIRED:
1. Product cost per unit (or inventoriable cost per unit) under absorption and variable costing.
2. Cost of ending inventory under absorption and variable costing.
3. Operating income under absorption and variable costing.

PROBLEM 2. Helaena Corporation developed the following standard unit cost at 100% of its normal
production capacity, which is 20,000 units per year:
Ingredients used P 12,220
Direct Labor 5,720
Variable overhead 7,060
Fixed overhead 5,000
Variable selling expenses 2,700
Fixed selling and administrative expenses 5,300
Total actual costs P 38,000

The product is sold for P16 per unit. Variable commercial expenses are P2 per unit sold, and fixed
commercial expenses total P60,000 for the period. During the year, 20,800 units were produced and 19,000
units were sold. There is no work in process beginning or ending inventories, and finished goods inventory
is maintained at standard cost, which has not changed from the preceding year. In the current year, there is
a net favorable variable cost variance in the amount of P2,000. All standard cost variances are written off to
cost of goods sold at the end of the period.

REQUIRED:
1. What was the actual production cost per liter under variable costing? Under absorption costing?
2. What was cost of goods under variable costing? Under absorption costing?
3. What was the value of ending inventory under variable costing? Under absorption costing?
4. How much fixed cost was charged to expense under variable costing? Under absorption costing?
5. Prepare an income statement on the absorption costing basis.
6. Prepare an income statement on the variable costing basis.
7. Compute and reconcile the difference in operating income for the current year under absorption
costing and variable costing.

PROBLEM 3. Lorrea Company was organized just a year ago. The results of the company’s first year of
operations are shown below (absorption costing basis):
 Lorrea Company
Income Statement
Sales (2,000 units) P 135,000
Less: Cost of goods sold/Variable cost:
Beginning Inventory P 0
Cost of Goods Manufactured 105,000
Goods Available for Sale P 105,000
Ending Inventory 21,000 84,000
Gross Margin 51,000
Less: Selling and Administrative expenses 42,000
Net Income P 9,000

The company’s selling and administrative expenses consist of P32,000 per year in fixed expenses and P5
per unit sold in variable expenses. The company’s unit product cost is computed as follows:

Variable manufacturing cost P 32

Fixed manufacturing overhead (based on normal capacity of 2,500 units) 10
Unit product cost P 42

REQUIRED:
1. Redo the company’s income statement in the contribution format using variable costing.
2. Reconcile any difference between the net income figure on your variable costing income statement
and the net income figure on the absorption costing income statement above.

PROBLEM 4. The following annual flexible budget has been prepared for use in making decisions relating
to Product X.
100,000 units 150,000 units 200,000 units
Sales volume P 800,000 P1,200,000 P1,600,000
Manufacturing costs:
Variable P 300,000 P 450,000 P 600,000
Fixed 200,000 200,000 200,000
P 500,000 P 650,000 P 800,000
Selling and other expenses:
Variable P 200,000 P 300,000 P 400,000
Fixed 160,000 160,000 160,000
P 360,000 P 460,000 P 560,000
Income (loss) (P 60,000) P 90,000 P 240,000

The 200,000 unit budget has been adopted and will be used for allocating fixed manufacturing costs to
units of Product X. At the end of the first six months the following information is available:
Units
Production completed 120,000
Sales 60,000

All costs are budgeted and incurred uniformly throughout the year and all costs incurred coincide with the
budget. Over- and underapplied fixed manufacturing costs are deferred until year-end. Annual sales have
the following seasonal pattern:
Portion of Annual Sales
First quarter 10%
Second quarter 20%
Third quarter 30%
Fourth quarter 40%
 100%

REQUIRED:
Compute for the:
a. Reported net income (or loss) for the first six months under absorption costing
b. Reported net income (or loss) for the first six months under direct costing

PROBLEM 5. During its first year of operations, Sugar Ray Company produced 55,000 jars of hand cream
based on a formula containing 10 percent glycolic acid. Unit sales were 53,500 jars. Fixed overhead was
applied at P0.50 per unit produced. Fixed overhead was underapplied by P10,000. This fixed overhead
variance was closed to Cost of Goods Sold. There was no variable overhead variance. The results of the
year's- operations are as follows (on an absorption costing basis):
Sales (53,500 units @ P8.50) P 454,750
Less: Cost of Goods Sold (170,500)
Gross Margin P 284,250
Less: Selling and Administrative (all fixed) (120,000)
Net Income P 164,250

REQUIRED:
1. Give the cost of the firm's ending inventory under absorption costing. What is the cost of the ending
inventory under variable costing?
2. Compute the income under variable costing. Reconcile the difference between the two income
figures.

PROBLEM 6. A manufacturing company employs variable costing for internal reporting and analysis
purposes. However, it converts its records to absorption costing for external reporting. The accounting
department always reconciles the two operating income figures to assure that no errors have occurred in
the conversion. Financial data for the year are presented below. The fixed manufacturing overhead cost per
unit was based on the planned level of production of 480,000 units.

Budgeted and Actual Levels for Sales and Production

Budget Actual
Sales (in units) 495,000 510,000
Production (in units) 480,000 500,000

Standard Unit Manufacturing Costs

Variable Costing Absorption Costing
Variable costs P 10.00 P 10.00
Fixed Manufacturing overhead 0 6.00
Total unit manufacturing costs P 10.00 P 16.00

REQUIRED: The difference between variable costing and absorption costing operating profit.

PROBLEM 7. Els Company had net income for the first 10 months of the current year of P2.00,000. They
used a standard costing system, and there were no variances through October 31. One hundred thousand
units were manufactured during the period, and 100,000 units were sold. Fixed manufacturing overhead
was P2M over the 10-month period. There are no selling and administrative expenses for Els Company. All
variances are disposed of at year-end by, an adjustment to cost of goods sold. Both variable and fixed costs
are expected to continue at the same rates for the balance of the year (i.e., fixed costs at P200,000 per
month and variable costs at the same variable cost per unit). There were 10,000 units in inventory on
October 31. Eighteen thousand units are to be produced and 22,000 units are to be sold in total over the
last two months of the current year. Assume the standard unit variable cost is the same in the current year
as in the previous year.

REQUIRED:
1. If operations proceed as described, will net income be higher under variable or absorption costing
for the current year in total?
2. If operations proceed as described, what will net income for the year in total be under: a. variable
costing; and b. absorption costing? Ignore income tax.

III. ANALYSIS AND INTEGRATION

1. Based on your analysis of the answers in some of the activities above, how do fixed manufacturing
overhead costs shift from one period to another under the absorption costing?
2. What observations have you made on the difference in income reported absorption costing and
variable costing when the units produced differ from units sold? What causes such difference?

IV. INDEPENDENT LEARNING

Submit your answer to the case below through the Schoology assignment box assigned by the instructor.
You may submit scanned or digital copy of your answer. BE HONEST!

CASE 1. “Now this doesn’t make any sense at all,” said Lace Manuel, financial vice president for A-Team, Inc.
“Our sales have been steadily rising over the last several months, but profits have been going in the
opposite direction. In September we finally hit P2,000,000 in sales, but the bottom line for that month
drops off to a P100,000 loss. Why aren’t profits more closely correlated with sales?”

The statements to which Ms. Manuel was referring are shown below:
JULY AUGUST SEPTEMBER
Sales (@P25) P 1,750,000 P 1,875,000 P 2,000,000
Less: Cost of Goods Sold
Beginning inventory 80,000 320,000 400,000
Cost applied to production:
Variable manufacturing costs 765,000 720,000 540,000
Fixed Manufacturing overhead 595,000 560,000 420,000
Cost of Goods Manufactured 1,360,000 1,280,000 960,000

Goods available for sale 1,440,000 1,600,000 1,360,000

Less ending inventory 320,000 400,000 80,000
Cost of Goods Sold 1,120,000 1,200,000 1,280,000
Underapplied or (overapplied) fixed overhead cost (35,000) 0 140,000
Adjusted cost of goods sold 1,085,000 1,200,000 1,420,000
Gross Margin 665,000 675,000 580,000
Less selling and administrative expenses 620,000 650,000 680,000
Net income (loss) P 45,000 P 25,000 P (100,000)

Jasper Culajara, a new graduate from a state university who has just been hired by A-Team, has stated Ms.
Manuel that the contribution approach, with variable costing, is a much better way to report it data to
management. Sales and production data for the last quarter follow:
JULY AUGUST SEPTEMBER
Production in units 85,000 80,000 60,000
Sales in units 70,000 75,000 80,000
Additional information about the company's operations is given below:
a. Five thousand units were in inventory on July 1.
b. Fixed manufacturing overhead costs total P1,680,000 per quarter and are incurred evenly
throughout the quarter. This fixed manufacturing overhead cost is applied to units of product on
the basis of a budgeted production volume of 80,000 units per month.
c. Variable selling and administrative expenses are P6 per unit sold. The remainder of the selling and
administrative expenses on the statements above are fixed.
d. Work in process inventories are insignificant and can be ignored.

“I know production is somewhat out of step with sales,” said Ralph Cresmundo, the company's controller.
"But we had to build inventory early in the quarter in anticipation of a strike in September. Since the union
settled without a strike, we then had to cut back production in September in order to work off the excess
inventories. The income statements you have are completely accurate."

REQUIRED:
1. Prepare a contribution margin income statement for each month using variable costing.
2. Reconcile the variable costing and absorption costing net income (loss) figures for each month.
3. Assume that the company had decided to introduce JIT inventory methods at the beginning of
September. (Sales and production during July and August were as shown above.)
a. How many units would have been produced during September under JIT?
b. How much would have been the company’s profit under absorption costing during
September? Prepare a traditional income statement for this.
c. Starting with the next quarter (October - December) would you expect any difference
between the income reported under absorption costing and under variable costing? Explain
why there would or would not be any difference.