Chapter 7

Variable Costing and Absorption Costing

Introduction:
The inventory costing choices relate to which manufacturing costs are treated as inventoriable or
product costs. For manufacturing companies, the two most common methods are absorption
costing and variable costing.

Specific Objectives:

At the end of the lesson, the students should be able to:

Learn the concepts and application of variable costing vs. absorption costing

Duration: 3 hours (Lecture/Discussion/Problem Solving)

Lesson Proper

Absorption Costing or Full Costing.- a product costing method that includes all the
manufacturing costs in the cost of a unit of a product.

Variable Costing -a product costing method that includes only the variable manufacturing costs
in the cost of a unit of a product.

Product Cost Components

Absorption Costing Variable Costing
Direct materials Direct Materials
+ Direct labor + Direct Labor
+ Variable FOH +Variable FOH
+ Fixed FOH Product Cost
Product Cost ===========
===========

Distinctions Between Absorption and Variable Costing

Absorption Costing Variable Costing
1) Cost segregation Seldom segregates costs into Costs are segregated into
variable and fixed costs variable and fixed
2) Cost of inventory Includes all the Includes only the variable
manufacturing costs manufacturing costs
3) Treatment of fixed Treated as product cost Treated as period cost
factory overhead
4) Income statement Distinguishes between Distinguishes between
production and other costs: variable and fixed costs:
Sales xx Sales xx
Less CGS xx Less Variable Costs xx
 Gross Profit xx Contribution margin xx
Less S & G Expenses xx Less fixed costs xx
Profit xx Profit xx
5) 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 in sales and production in the long run. However, both
methods give substantially the same results since sales cannot
continually exceed production, nor production can continually exceed
sales.

Difference in Net Income undet Absorption Costing and Variable Costing

a) Production equals sales
When production equals sales, there is no change in inventory. Fixed overhead
expensed under absorption costing equals fixed overhead expensed under variable
costing. Therefore, absorption costing income equals variable costing income.

b) Production is greater than sales

When production is greater than sales, there is an increase in inventory. Fixed
overhead expensed under absorption costing is less than fixed overhead expensed
under variable costing. Therefore, absorption costing income is greater than
variable costing income.

c) Production is less than sales

When production is less than sales, there is a decrease in inventory. Fixed overhead
expensed under absorption costing is greater than fixed overhead expensed under
variable costing. Therefore, absorption costing income is less than variable
costing income.

Reconciliation of Absorption and Variable Costing Income Figures

Absorption Costing Income xx
Add Fixed Overhead in the beginning inventory xx
Total xx
Less fixed overhead in the ending inventory xx
Variable costing Income xx
==
Accounting for change in income
Change in inventory (Production less sales) xx
X Fixed Overhead cost per unit xx
Difference in income xx
==
Arguments for the use of variable costing
1) Variable costing reports are more simple and more understandable.
2) Data needed for break even and CVP analysis are readily available.
3) The problems involved in allocating fixed costs are eliminated.
4) Variable costing is more compatible with the standard costing 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 variable and fixed might be difficult, especially with mixed
costs.
2) The matching principle is violated by using variable costing, which excludes fixed
overhead from product costs and charges the same as 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.

Illustrative Example:
During the year 2020, Wood Corp’s production was equal to its normal capacity of 1,000 units. It
sold 900 units at P50 per unit.

The following costs were incurred during the year:

Total Cost Cost per unit
Direct materials 12,000 12
Direct Labor 10,000 10
Variable factory overhead 8,000 8
Fixed factory overhead 6,000 6
Variable selling and administrative 4,500 5*
Fixed selling and administrative 3,000 3

*Variable selling and administrative cost per unit= P4,500/900 units sold

1) Product cost per unit:

Absorption Variable
Direct materials 12 12
Direct Labor 10 10
Variable factory overhead 8 8
Fixed factory overhead 6 -
Product cost per unit 36 30
== ==

Note: Under both costing methods, selling and administrative costs are treated as period
costs.

2) Income under absorption costing:

Sales (900 units x P50) 45,000
Less cost of goods sold (900 units x 36) 32,400
Gross income 12,600
Less Selling and admistrative exp.:
 Variable (900 x 5) 4,500
Fixed 3,000 7,500
Income-absorption costing 5,100
====

3) Income under variable costing:

Sales (900 x P50) 45,000
Less Variable costs:
Cost of goods sold (P30 x 900) 27,000
Selling and adm. (900 x 5) 4,500 31,500
Contribution margin 13,500
Less fixed costs:
Factory overhead 6,000
Selling & adm. 3,000 9,000
Income-variable costing 4,500
=====

4) Computation of and accounting for difference in net income:

Absorption costing income 5,100
Variable costing income 4,500
Difference 600
====

Difference is accounted as follows:

Change in inventory (1,000- 900) 100
X Fixed overhead cost per unit x6
Difference in income 600
===

Activity
Discussion of exercises/problems in Ch. 10, Strategic Cost Management, 2021 edition, Ma. Elenita
B.Cabrera