MAS – 03: ABSORPTION & VARIABLE COSTING

ABSORTION COSTING – is a costing method that includes all manufacturing costs (direct materials, direct labor, variable an fixed factory overhead) in the cost of a unit of
product. It treats fixed factory overhead (FFOH) as a product cost. Absorption costing is also called as full costing.

VARIABLE COSTING – is a 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 FFOH as a period cost. Variable costing is also called direct costing.

PRODUCT vs. PERIOD COST

A product cost is an inventoriable cost that is subject to allocation between sold and unsold units. Current income is reduced only by the amount allocated to the
sold units. Consider the following allocation:

Unsold Units Assets (as Inventory)

Product Cost

Sold Units Expense (as Cost of Goods Sold)

A period cost is a cost that is charged as expense against income, regardless of the sales performance. No allocation is necessary: current income is reduced by
the full amount of the period cost.

Period Cost Fully Expensed in the period incurred, regardless of sales

ABSORPTION vs. VARIABLE COSTING

a. RATIONALE
Supporters of variable costing argue that FFOH costs are incurred whether or not production occurs. Having no future service potential, FFOH costs should
be fully expensed in the same period incurred.
Supporters of absorption costing believe that all manufacturing cost (variable and fixed) are necessary for production to take place and hence should not be
ignored in determining product costs.

b. INVENTORIES
Since FFOH costs are simply expensed (i.e., period cost) under the variable costing, the peso amount of inventories under variable costing is always lower
than the peso amount of inventories under absorption costing.

c. ACCEPTABILITY
Since treating FFOH as part of inventory cost is consistent with accounting standards, only absorption is acceptable for financial reporting and tax purposes.
Variable costing, which violates the matching principle, is acceptable only for internal use by management.
NOTE: Matching principle is an accounting principle that calls for the recognition of expense by matching it with the related revenue in the same accounting
period. It supports the treatment of cost of sales as expense only when related units have been sold.

d. INCOME STATEMENT
Under absorption costing, the income statement distinguishes between production and other costs. Production costs pertaining to sold units are first
deducted from sales to arrive at the gross profit, and then other costs and expenses are deducted to obtain net income.
Under variable costing, the income statement distinguishes between variable and fixed costs. All variable costs are first deducted from sales to arrive at
the contribution margin, and then fixed costs are deducted to obtain profit.

e. INCOME COMPUTATION
Income between variable costing and absorption costing may differ because of the amount of FFOH recognized as expense during a period, caused by the
difference between production and sales.
In the long run, however, both methods would yield the same income since sales cannot continuously exceed sales. (NOTE: the term “income” in this
context, like in many accounting literatures, is liberally used to mean “profit”)

RECONCILIATION OF INCOME UNDER ABSORPTION COSTING & VARIABLE COSTING

Under variable costing, FFOH costs are fully expensed as incurred (regardless of sales), while under absorption costing, FFOH costs are expensed when related
units are sold. Consider the following patterns:
 Pattern No. 1: When production equals sales, there is no change in inventory. FFOH expensed under absorption costing equals FFOH expensed under
variable costing.
PRODUCTION = SALES Income (Absorption) = Income (Variable)
 Pattern No. 2: When production is greater than sales, there is an increase in inventory. FFOH expensed under absorption costing is less than FFOH
expensed under variable costing. Therefore, absorption income greater than variable income.

PRODUCTION > SALES Income (Absorption) > Income (Variable)

 Pattern No. 3: When production is less than sales, there is a decrease in inventory. FFOH expensed under absorption costing is greater than FFOH
expensed under variable costing.

PRODUCTION < SALES Income (Absorption) < Income (Variable)

 Basic Formula:

Δ Income = Δ Inventory x unit FFOH

Where:
Δ Inventory = Ending Inventory – Beginning Inventory
Δ Inventory = Units Produced – Units Sold
 Alternative Formula:
Income, Absorption costing Pxxx
Add: FFOH in beginning inventory xxx
Total Pxxx
Less: FFOH in ending inventory (xxx)
Income, Variable costing Pxxx

ADVANTAGES OF USING VARIABLE COSTING

1. Variable costing reports are simpler and more understandable.
2. The problems involved in allocating fixed costs are eliminated.
3. Data needed for break-even and cost-volume-profit analyses are readily available.
4. Variable costing is more compatible with standard cost accounting system.
5. Variable costing reports provide useful information for pricing decisions and other operational problems encountered by management.
DISADVANTAGES OF USING VARIABLE COSTING
1. Variable costing is not in accordance with GAAP; hence, it is not acceptable for external reporting.
2. Segregation of costs into fixed and variable might be difficult.
3. The matching principle is violated by using variable costing, which excludes FFOH from product costs and charges the same as period costs regardless of
production and sales.
4. With variable costing, inventory costs and other accounts, such as working capital, current ratio, and acid-test ratio are understated because of the exclusion of
FFOH in the computation of product costs.

EXCERSES: ABSORPTION and VARIABLE COSTING

1) Adriel Company makes state-of-the-art toy car. Each toy car sells for P1,000 each. Data for 2018’s operations are as follows:
Units: Variable Costs:
Beginning Inventory 5 Direct Materials P18,000
Production 60 Direct Labor 12,000
Ending Inventory 15 Factory Overhead 6,000
Selling and Administrative 2,000
Fixed Costs:
Factory Overhead P15,000
Selling and Administrative 1,000
Required:
1. Determine the inventory cost per unit under:
A. Absorption costing
B. Variable costing
2. Determine the cost of ending inventory under:
A. Absorption costing
B. Variable costing
3. Prepare income statements under absorption costing and variable coting.
4. How much is the difference in income between the two costing methods?
5. What causes the difference in income between the two costing methods?

2) The following information are taken from the books of Bea Company, Which assumes first-in, first-out (FIFO) for inventory cost flow:
Inventory (in units) 2017 2018
Beginning inventory None ???
Production 10,000 units 9,000 units
Ending inventory 3,500 units 1,000 units

Sales (P2 per unit) ??? ???

Variable manufacturing costs (P0.75 per unit) P7,500 P6,750
Fixed manufacturing costs P5,000 P5,400
Selling and administrative costs P4,500 P7,500
Required:
1. Determine 2017 profit under variable and absorption costing.
2. Reconcile the two profit figures in 2017.
3. Determine 2018 profit under variable and absorption costing.
4. Reconcile the two profit figures in 2018.
 WRAP-UP EXERCISES (TRUE OR FALSE; MULTIPLE-CHOICE)
1. Which of the following costs is treated differently under absorption and variable costing?
a. Direct labor c. Fixed manufacturing overhead
b. Raw materials d. Variable manufacturing overhead

2. Under absorption costing, fixed manufacturing overhead costs are best described as
a. Direct period costs c. Direct product costs
b. Indirect period costs d. Indirect product costs

3. Under variable costing, fixed manufacturing overhead costs are best described as
a. Direct period costs c. Direct product costs
b. Indirect period costs d. indirect product costs

4. Under variable costing, all product costs are variable.

5. Under variable costing, all variable costs are treated as product costs.

6. Assuming there are FFOH costs, the cost of inventory under absorption costing is characteristically higher than the cost of inventory under variable costing.

Items 7 to 9 are based on the following information

White Company manufactures a single product. Unit variable production costs are P20 and fixed production costs are P150,000. White uses a normal activity of
10,000 units. White began the year with no inventory, produced 12,000 units, and sold 7,500 units.
7. What is the unit product cost under variable costing?
a. P20.00 c. P35.00
b. P32.50 d. P40.00

8. What is the unit product cost under absorption costing?

a. P20.00 c. P35.00
b. P32.50 d. P40.00

9. What is the volume (capacity) variance under absorption costing?

a. P24,000 unfavorable c. P30,000 unfavorable
b. P24,000 favorable d. P30,000 favorable
NOTE: volume variance = (actual production – normal production) x unit FFOH

10. There is no volume or capacity variance under variable costing.

11. If production is higher than sales, then absorption costing income is expected to be
a. Lower than variable costing income c. Equal to variable costing income
b. Higher than variable costing income d. Incomparable with variable costing income

12. Black Company produced 10,000 units and sold 9,000 units. Fixed manufacturing overhead costs were P20,000, and variable manufacturing overhead costs were P3 per
unit. Which of the following best describes the profit under the absorption costing method?
a. P2,000 more than profit under variable costing method
b. P5,000 more than profit under variable costing method
c. P2,000 less than profit under variable costing method
d. P5,000 less than profit under variable costing method

13. Green Company has an operating income of P50,000 under direct costing. Beginning and ending inventories were 13,000 units and 18,000 units, respectively. If the fixed
factory overhead application rate is P2 per unit, then what is the operating income under the absorption costing?
a. P70,000 c. P50,000
b. P60,000 d. P40,000

14. Violet Company had 16,000 units in its beginning inventory. The company’s variable production costs were P6 per unit and its fixed manufacturing overhead costs were
P4 per unit. The company’s net income for the year was P24,000 lower under adsorption costing than it was under variable costing. How many units does the company have
in its ending inventory?
a. 22,000 units c. 6,000 units
b. 10,000 units d. 4,000 units

15. Pink Co. had a net income of P85,500 using variable costing and net income of P90,000 using absorption costing. Total fixed manufacturing overhead cost was P150,000,
and production was 100,000 units. How did the inventory level change during the year?
a. 3,000 units increase c. 3,000 units decrease
b. 4,500 units increase d. 4,500 units decrease

16. Under a just-in-time (JIT) production environment, income under absorption costing tends to be equal with income under variable costing.

17. Variable costing income fluctuates with production and does not react to changes in sales.

18. Variable costing is unacceptable for

a. Financial reporting c. Cost-volume-profit analysis
b. Transfer pricing d. Short-term decision making