Variable costing & absorption costing

1. Topics to be covered
• Variable Costing
• Absorption Costing

2. Comparison Between
Variable Costing & Absorption Costing

3. Variable Costing
Absorption Costing
This would usually 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.
Absorption costing treats all manufacturing costs as product
costs, regardless of whether they are variable or fixed.

4. Variable Costing—An Example
A company that produces light recreational aircraft. Data concerning
the company’s operations appear below:
Per Aircraft Per Month
Selling price. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $100,000
Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $19,000
Direct labor. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . …. $5,000
Variable manufacturing overhead . . . . . . . . . . . . . . . . $1,000
Fixed manufacturing overhead . . . . . . . . . . . . . . . . . . $70,000
Variable selling and administrative expenses. . . . . . . $10,000
Fixed selling and administrative expenses. . . . . . . . . $20,000
January February March
Beginning inventory . . . . . . . . . . . . . . . . . . . . . . . 0 0 1
Units produced . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 2 4
Units sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 1 5
Ending inventory . . . . . . . . . . . . . . . . . . . . . . . . . . 0 1 0

5. Variable Costing Unit Product Cost
Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $19,000
Direct labor. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
Variable manufacturing overhead . . . . . . . . . . . . . . . . . . . . . . 1,000
Variable costing unit product cost . . . . . . . . . . . . . . . . . . . . . . $25,000
Variable Costing Cost of Goods Sold
January February March
Variable production cost (a). . . . . . . . . $25,000 $25,000 $25,000
Units sold (b) . . . . . . . . . . . . . . . . . . . . . 1 1 5
Variable cost of goods sold (a) × (b). . . $25,000 $25,000 $125,000
Selling and Administrative Expenses
January February March
Variable selling and administrative expense
(@ $10,000 per unit sold). . . . . . . . . . . . . . . $10,000 $10,000 $50,000
Fixed selling and administrative expense . . . . 20,000 20,000 20,000
Total selling and administrative expense . . . . . $30,000 $30,000 $70,000

6. Variable Costing Contribution Format Income Statements
January February March
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $100,000 $100,000 $500,000
Variable expenses:
Variable cost of goods sold. . . . . . . . . . . . 25,000 25,000 125,000
Variable selling and administrative
expense . . . . . . . . . . . . . . . . . . . . . . . . 10,000 10,000 50,000
Total variable expenses . . . . . . . . . . . . . . . 35,000 35,000 175,000
Contribution margin . . . . . . . . . . . . . . . . . 65,000 65,000 325,000
Fixed expenses:
Fixed manufacturing overhead . . . . .. 70,000 70,000 70,000
Fixed selling and administrative expense. . . 20,000 20,000 20,000
Total fi xed expenses . . . . . . . . . . . . . . . . . 90,000 90,000 90,000
Net operating income (loss). . . . . . . . . . $ (25,000) $ (25,000) $235,000

7. INCOME STATEMENT OF ABSORPTION
COSTING
Absorption costing uses a gross margin income statement,
which starts with revenues and subtracts cost of goods sold
to derive gross margin, then subtracts non-manufacturing
costs to derive operating income. Gross margin income
statements separate manufacturing costs from non-
manufacturing costs.

8. Review Problem :
Dexter Corporation produces and sells a single product, a wooden hand loom for
weaving small items such as scarves. Selected cost and operating data relating to the
product for two years are given below:
Selling price per unit . . . . . . . . . . . . . . . . . . . . . . $50
Manufacturing costs:
Variable per unit produced:
Direct materials . . . . . . . . . . . . . . . . . . . . . . $11
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . $6
Variable manufacturing overhead . . . . . . . . . $3
Fixed manufacturing overhead per year . . . . . . $120,000
Selling and administrative expenses:
Variable per unit sold . . . . . . . . . . . . . . . . . . . . $4
Fixed per year . . . . . . . . . . . . . . . . . . . . . . . . . $70,000
Year 1 Year 2
Units in beginning inventory . . . . . . . . . . . 0 2,000
Units produced during the year . . . . . . . . 10,000 6,000
Units sold during the year . . . . . . . . . . . . 8,000 8,000
Units in ending inventory . . . . . . . . . . . . . 2,000 0

9. Required
1. Assume the company uses absorption costing.
a. Compute the unit product cost in each year.
b. Prepare an income statement for each year.
Solution
1. a. Under absorption costing, all manufacturing costs, variable and fixed, are included
in unit product costs:
Year 1
Year 2
Direct materials . . . . . . . . . . . . . . . . . . . . . . . $11 $11
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . 6 6
Variable manufacturing overhead . . . . . . . . . . 3 3
Fixed manufacturing overhead
($120,000 4 10,000 units) . . . . . . . . . . . . . 12
($120,000 4 6,000 units) . . . . . . . . . . . . . . 20
Absorption costing unit product cost . . . . . . . $32 $40

10. b. The absorption costing income statements follow :
Sales (8,000 units 3 $50 per unit) . . . . . . . . . . . . . . . . . . . . . $400,000 $400,000
Cost of goods sold (8,000 units 3 $32 per unit);
(2,000 units 3 $32 per unit) 1
(6,000 units 3 $40 per unit) . . . . . . . . . . . . . . . . . . . . . . . . 256,000 304,000
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144,000 96,000
Selling and administrative expenses
(8,000 units 3 $4 per unit 1 $70,000) . . . . . . . . . . . . . . . . 102,000 102,000
Net operating income (loss) . . . . . . . . . . . . . . . . . . . . . . . . . $ 42,000 $(6,000)
Year 1 Year 2

11. Reconciling The Differences In Net Operating
Income Under Variable Costing And Absorption
Costing
• Income reported under variable costing and absorption costing
are different.
• It is only the different value of inventory under the two costing
income statements that changes the amount of the net income.
• As the size of inventory increases or decreases during the year,
the reported income differs under variable and absorption
costing.

12. • This results from the fixed overheads that are included in the inventory
valuation under absorption costing but are expended immediately under
variable costing.
• Under absorption costing this period's factory overheads are postponed to
the next year whereas under variable costing it is expended during the
same year.

13. Comparative Income Effects- Absorption
Costing &Variable Costing
Relation between
Production and Sales for
the Period
Effects on Inventories Relation between the
Absorption & Variable
Costing net income
Units Produced = Units Sold No change in inventories Absorption costing net
operating income = Variable
costing net operating income
Units Produced > Units Sold Inventories Increase Absorption costing net
operating income > Variable
costing net operating income
Units Produced < Units Sold Inventories decrease Absorption costing net
operating income < Variable
costing net operating income

14. Net income will tend to be higher under AC since fixed manufacturing
overhead cost will be deferred inventory costing.
Net income will be tend to be lower under AC since fixed manufacturing
overhead cost will be released in inventory under absorption costing.

15. Example
Company prepares variable costing income statement for the use of internal
management and absorption costing income statement for the use of
external parties like creditors, banks, tax authorities etc. The company
manufactures a product that is sold for $80. The variable and fixed cost data
is given below:
• Direct materials: $30.00
• Direct labor:$19.00
Factory over head:
• Variable cost: $6.00
• Fixed cost ($45,000/9000 units): $5.00

16. Marketing, general and administrative:
• Variable cost (per unit sold): $4.00
• Fixed cost (per month): $28,000
During the month of June, 9,000 units were produced and 7,500 units were
sold. The opening inventory was 2,000 units.
Required:
• Reconcile the variable costing and absorption costing net operating
incomes.

17. Solution:
Computation of units in ending inventory

18. Income Statement
• Absorption Costing

19. Variable Costing

20. Reconciliation of net operating income:

21. TOPICS
Uses & Limitations of Absorption Costing
Uses & Limitations of Variable Costing

22. Uses of Absorption Costing & Variable Costing
Absorption Costing:
External financial reports
Variable Costing:
Internal financial reports

23. Example

24. Absorption Costing
Advantages :
1. Increase profit
2. Fuller picture of a product’s cost
3. Accounting tools
4. GAAP Compliant
5. Accounts for all production costs
6. Smaller companies
Disadvantages
1. Mislead when analyzing profitability.
2. Not as useful for internal decision-making purposes
3. Doesn't Help Improve Operational Efficiency
4. Not Useful for Comparison of Product Lines
5. Need of computation of unit fixed cost
6. Profit is not easily calculated

25. Variable Costing
Advantages :
1. Surplus income
2. Clearer picture of the actual incremental cost
3. Determine contribution margin ratios
4. Break-even points
5. Prevents inflating profit
6. Easy to understand and use
7. No need of computation of unit fixed cost
8. Profit is calculated easily
Disadvantages :
1. Show less profit
2. External reporting purpose.
3. Not accepted by GAPP