Variable & Absorption

Costing
Managerial Accounting, ADA

Instructor
Mehriban Ahmadova
Variable vs Absorption Costing
• Absorption costing “absorbs” all of the costs used in manufacturing and
includes fixed manufacturing overhead as product costs.
• Absorption costing is in accordance with GAAP because the product cost
includes fixed overhead.
• Variable costing considers the variable overhead costs and does not consider
fixed overhead as part of a product’s costs.
• It is not in accordance with GAAP because fixed overhead is treated as a period
cost and is not included in the cost of the product.

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Overview of Variable and Absorption Costing
Variable Costing
• Product Costs:
• Direct Materials
• Direct Labor
• Variable Manufacturing Overhead
• Period Costs:
• Fixed Manufacturing Overhead
• Variable Selling and Administrative Expenses
• Fixed Selling and Administrative Expenses
Overview of Variable and Absorption Costing 2

Absorption Costing
• Product Costs:
• Direct Materials
• Direct Labor
• Variable Manufacturing Overhead
• Fixed Manufacturing Overhead
• Period Costs:
• Variable Selling and Administrative Expenses
• Fixed Selling and Administrative Expenses
Quick Check 1
Which method will produce the highest values for work in process and
finished goods inventories?
a. Absorption costing.
b. Variable costing.
c. They produce the same values for these inventories.
d. It depends.
Quick Check 1a
Which method will produce the highest values for work in process and
finished goods inventories?
a. Answer: Absorption costing.
b. Variable costing.
c. They produce the same values for these inventories.
d. It depends.
Unit Cost Computations 1

Harvey Company produces a single product with

the following information available:
Number of units produced annually 25,000
Variable costs per unit:
Direct materials, direct labor, and $ 10
variable manufacturing overhead
Selling and administrative expenses $ 3
Fixed costs per year:
Manufacturing overhead $ 150,000
Selling and administrative expenses $ 100,000
Unit Cost Computations 2

• Unit product cost is determined as follows:

Absorption Variable
Costing Costing
Direct materials, direct labor, and variable
manufacturing overhead $ 10 $ 10
Fixed mfg. overhead ($150,000 ÷ 25,000 units) 6 -
Unit product cost $ 16 $ 10

• 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.
Variable and Absorption Costing Income
Statements
• Let’s 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 let’s compute net operating income using

both absorption and variable costing.
 Variable Costing Contribution Format Income
Statement
• Variable cost of goods sold,
$200,000 (20,000 × $10):
Variable manufacturing costs
only.
• Fixed manufacturing overhead,
$150,000: All fixed
manufacturing overhead is
expensed.
 Absorption Costing Income Statement
• Cost of goods sold (20,000 × $16): Unit product cost

• Fixed manufacturing overhead deferred in inventory is

5,000 units × $6 = $30,000.
Comparing the Two Methods 1

Cost of Ending Period

Goods Sold Inventory Expense Total
Absorption costing
Variable mfg. expenses $ 200,000 $ 50,000 $ - $ 250,000
Fixed mfg. expenses 120,000 30,000 - 150,000
$ 320,000 $ 80,000 $ - $ 400,000
Variable costing
Variable mfg. expenses $ 200,000 $ 50,000 $ - $ 250,000
Fixed mfg. expenses - - 150,000 150,000
$ 200,000 $ 50,000 $ 150,000 $ 400,000
Comparing the Two Methods 2

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
Extended Comparisons of Income Data
Harvey Company – Year 2
Number of units produced 25,000
Number of units sold 30,000
Units in beginning inventory 5,000
Unit sales price $ 30
Variable costs per unit:
Direct materials, direct labor, and variable mfg. overhead $ 10
Selling & administrative expenses $ 3
Fixed costs per year:
Manufacturing overhead $150,000
Selling & administrative expenses $100,000
Unit Cost Computations
Absorption Variable
Costing Costing
Direct materials, direct labor, and variable
mfg. overhead $ 10 $ 10
Fixed mfg. overhead ($150,000 ÷ 25,000 units) 6 -
Unit product cost $ 16 $ 10

Since the variable costs per unit, total fixed costs, and
the number of units produced remained unchanged,
the unit cost computations also remain unchanged.
Variable Costing 1

• Variable cost of goods sold (30,000 × $10): Variable

manufacturing costs only.
• Fixed manufacturing overhead $150,000: All fixed
manufacturing overhead is expensed.
Variable Costing 2

Variable Costing
Sales (30,000 × $30) $900,000
Less variable expenses:
Variable cost of goods sold (30,000 × $10) $300,000
Variable selling and administrative expenses (30,000 × $3) 90,000
Total variable expenses 390,000
Contribution margin 510,000
Less fixed expenses:
Fixed manufacturing overhead $150,000
Fixed selling and administrative expenses 100,000 250,000
Net operating income $260,000
Absorption Costing
• Cost of goods sold (30,000 × $16): Unit product cost.
Absorption Costing

Sales (30,000 × $ 30) $900,000

Cost of goods sold (30,000 × $16) 480,000

Gross margin 420,000
Less selling and administrative expenses:

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.
Reconciling the Difference 1

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
Reconciling the Difference 2

Costing Method 1st Period 2nd Period Total

Absorption $120,000 $230,000 $350,000

Variable 90,000 260,000 350,000

Finished goods inventory with absorption
costing and variable costing
• Assume a company has fixed overhead of $12,000 and manufactures 10,000
units. Direct materials cost is $3 per unit, direct labor is $15 per unit, and the
variable manufacturing overhead is $7 per unit.

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Income statement with absorption costing and
variable costing
• Income statement with absorption costing and variable costing: all inventory
sold, no finished goods inventory
• Assume each unit is sold for $33 each.

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COGS and ending inventory with absorption
costing and variable costing
• 8,000 units sold and 2,000 units in ending inventory.

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Net income under absorption and variable
costing
• 8,000 units sold and 2,000 units in ending inventory

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Outdoor Nation’s income statement:
Multi-year effect of inventory changes

Absorption Costing Variable Costing

Outdoor Nation’s reconciliation of net incomes
Variable Costing: advantages and disadvantages
• Advantages:
• More useful for CVP analysis
• Income is not affected by changes in production volume
• Understandability
• Fixed costs are more visible
• Margins are less distorted
• Disadvantages:
• Unacceptable for Financial reporting and Tax reporting

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Absorption Costing: advantages and
disadvantages
• Advantages:
• Product cost
• Acceptable for Financial and Tax reporting
• Disadvantages:
• Difficulty in understanding

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Your Turn: Comparing Variable and Absorption
Methods 7.2

A company expects to manufacture 7,000 units. Its direct

material costs are $10 per unit, direct labor is $9 per unit, and
variable overhead is $3 per unit. The fixed overhead is estimated
at $49,000. How much would each unit cost under both the
variable method and the absorption method?
Your Turn: Comparing Variable and Absorption
Methods 7.2 (solution)

The variable cost per unit is $22 (the total of direct material,
direct labor, and variable overhead).
The absorption cost per unit is the variable cost ($22) plus the
per-unit cost of $7 ($49,000/7,000 units) for the fixed overhead,
for a total of $29.
Sample Exercise 7.3
Using this information from Planters, Inc., what is the cost per unit under
both variable and absorption costing?
Sample Exercise
7.3 solution Per-Unit Cost per Variable Costing
Direct materials $240
Direct labor 280
Variable manufacturing overhead 100
Total cost per unit: variable $620

Per-Unit Cost per Absorption Costing

Fixed overhead per unit $1,200,000 $120 per Unit
Units produced 10,000 Units

Direct materials $240

Direct labor 280
Variable manufacturing overhead 100
Fixed manufacturing overhead 120
Total cost per unit: absorption $740
Sample Problem 7.4
PA3. A local picnic table manufacturer has budgeted overhead costs (Table 1):
They are considering adapting ABC costing and have estimated the cost drivers for each
pool (Table 2)
Recent success has yielded an order for 1,000 tables. Assume direct labor costs per hour of
$20. Determine how much the job would cost given the activities shown in Table 3
 Sample Problem 7.4 solution
Estimated
Overhead Cost Driver Activity Rate
Purchasing $70,000 Orders 700 $100.00
Handling materials 33,350 Material moves 1,334 25.00
Machine setups 70,500 Machine setups 15,000 4.70
Inspections 25,500 Number of inspections 5,000 5.10
Utilities 45,000 Square feet 180,000 0.25

The job will cost:

Activity Rate Assigned
Direct materials $112,700 $112,700
Direct labor 106,000 106,000
Number of purchase orders 60 100 6,000
Number of machine setups 100 4.7 470
Number of inspections 450 5.1 2,295
Number of square feet occupied 8,000 0.25 2,000
Total order cost $249,465
Sample Problem 7.6

Using this information from Outdoor Grills, what is the cost per
unit under both variable and absorption costing?
Sample Problem 7.6 (Solution)

Per-Unit Cost per Variable Costing

Direct materials $110
Direct labor 150
Variable manufacturing overhead 75
Total cost per unit: variable $335

Per-Unit Cost per Absorption Costing

Fixed overhead per unit 2,700,000 30.00 per unit
Units produced 90,000

Direct materials $110

Direct labor 150
Variable manufacturing overhead 75
Fixed manufacturing overhead 30
Total cost per unit: absorption $365
Sample Problem 7.7

Grainger Company produces only one product and sells that product for $100 per unit. Cost
information for the product is:
Direct Material $15 per Unit
Direct Labor $25 per Unit
Variable Overhead $5 per Unit
Fixed Overhead $34,000
Selling expenses are $4 per unit and are all variable. Administrative expenses of $20,000 are all
fixed. Grainger produced 5,000 units; sold 4,000; and had no beginning inventory.
A. Compute net income under
I. absorption costing
II. variable costing
B. Reconcile the difference between the income under absorption and variable costing.