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Variable and Absorption

Costing
Management and Cost Accounting in South Africa. Colin Drury et
al. Cengage, 2022. (1st Edition) ISBN: 978 1 4737 7393 6
Chapter 2,3,4,7,9

Prepared By: Reuben Davids

Themes and learning objectives

1. Explain the differences between variable costing and absorption costing

2. Provide arguments for and against variable costing
3. Provide arguments for and against absorption costing
4. Calculate the cost per unit under variable and absorption costing
5. Explain why Budgeted overheads should be preferred to actual overheads
6. Calculate and explain the accounting treatment of under / over recovery of overheads
7. Compile a statement of comprehensive income using both the variable and absorption costing methods
8. Reconcile the profits between the variable and absorption costing methods
9. Understand the implications of using a FIFO and WA valuation methods

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First, let’s recap….

What do the following cost terms mean?

• Product Cost
• Period Cost
• Manufacturing Cost
• Non-Manufacturing Cost
• Fixed Cost
• Variable Cost
• Traditional Costing
• Conversion Costs
• Prime Costs

Chapter 4
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First, let’s recap….

Product Cost = DL + DM + MOH

Manufacturing Costs

Variable Manufacturing O/H

MOH
Fixed Manufacturing O/H

Product Cost = DL + DM + V.MOH + FMOH

Chapter 2
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First, let’s recap….

Direct Costs are easy to identify with a product and similarly, easy to allocate to the product, often referred to as
‘direct cost tracing”.
Allocating indirect costs requires some more work, often called “cost allocations”.
“cost allocations” – is assigning costs when the quantity of resources consumed cannot be directly measured.

Fixed Manufacturing Overheads can be assigned to cost objects through a predetermined overhead rate.

Chapter 4
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LO 1 - 3
Explain the differences between
variable costing and absorption
costing

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What is the Direct and Absorption costing system?

Product Costs
Variable Costing System are:
Also referred to as a “Direct” or “Marginal” costing system. DM + DL +
VmOH
Only allocates variable manufacturing overheads to products.
ALL FIXED costs are written off as period costs.
Sales – Cost of Sales = Contribution

Absorption Costing System Product Costs

Also referred to as a “full” costing system are:
Assigns both fixed and variable manufacturing overheads to products. DM + DL +
Absorbs fixed Manufacturing overheads to products through POR. VmOH + FmOH
ALL NON-MANUFACTURING costs are treated as period costs.
Sales – Costs of Sales = Gross Profit

Chapter 7
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Difference between Direct and Absorption costing system

What is the difference between:

Cost Accountants Financial Accountants

Chapter 1
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Difference between Direct and Absorption costing system

IAS2 – Inventories, describes the cost of inventories as:

“The cost of inventories shall comprise all costs of purchase, costs of
conversion and other costs associated with bringing the inventories to its
location and condition for sale.

Costs of conversion includes direct costs such as direct labour. They also
include a systematic allocation of fixed and variable production overheads
that are incurred in converting materials into finished goods.
This means, absorption costing is in line with the requirements of financial reporting.
Financial reporting requires product costs to include all manufacturing costs.

Chapter 7
Prepared By: Reuben Davids

Difference between Direct and Absorption costing system

Conversely, divisional managers in organizations do not have control over fixed costs e.g.
factory costs.
This makes variable costing more ideal as direct costs are a lot more controllable, it therefore assists
with internal reporting.

Absorption Costing Variable Costing

External Reporting Internal Reporting

Chapter 7
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Difference between Direct and Absorption costing system

Arguments in favor of direct costing.

Gives more relevant information for decision making.
The analysis of fixed and variable costs are highlighted.
Management expects frequent profit statements and variable costing removes the distortion of profits
when inventory significantly varies.
Avoids fixed costs being capitalized into unsaleable inventories.

Arguments in favor of absorption costing.

Fixed Overheads are essential for production and should be considered.
Consistent with IAS2 and external financial reporting requirements.
Ensures that fixed costs are covered in product pricing.
Variable costing charges the full fixed costs in a period against the sales in that period, absorption
costing avoids “fictitious losses” being reported if units were not sold in a period. As fixed costs are only
expensed in cost of sales when the item is sold.

Prepared By: Reuben Davids

Chapter 7

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LO 4
Calculate the cost per unit under
variable and absorption costing

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Calculate the cost per unit under variable and absorption costing

Class Example 1

Suppose a company produces Product A .

The following information is available for the year:

• Direct materials cost per unit for Product A: R10

• Direct labour cost per unit for Product A: R5
• Variable manufacturing overhead cost per unit for Product A: R2.50
• Fixed manufacturing overhead cost for the year: R100,000
• Budgeted number of goods produced: 10,000

Determine the cost of company A using a variable and absorption costing system.

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Calculate the cost per unit under variable and absorption costing

Class Example 1 Answer Variable Absorption

Direct Materials

Direct Labour

Variable Manufacturing O/H

Fixed Manufacturing O/H

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LO 5 - 6
Budgeted vs Actual Overheads
Over & Under recovery of
overheads

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Explain why Budgeted overheads should be preferred to actual overheads

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

• Using actual overheads and activity levels delays product costing until end of
accounting period
• Actual OH expenses like rent, maintenance, supervisor salaries and activity
levels are known only at year-end.
• Delayed OH rates hinder monthly profit calculations, inventory valuations, and
pricing

Chapter 4
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Explain why Budgeted overheads should be preferred to actual overheads

• Immediate Decision-Making: Budgeted overhead rates facilitate instant cost allocation, pricing
decisions, and cost planning at the start of the reporting period, eliminating the need to wait for
actual overhead data.

• Early Implementation: Companies adopt a budgeted overhead rate at the outset of a reporting
period, derived from projected overhead costs and activity levels, ensuring proactive financial
planning.

• Comparison and Correction: At the accounting period's end, actual manufacturing overheads and
absorbed overheads are compared. Any variances between the two are rectified in the accounting
records to accurately reflect the actual overhead expenditure

Chapter 4 Paragraph 10!

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What happens at year end when we KNOW

what the actual overheads are?

It is unlikely that an allocated overhead rate based on

budgets would be the same as the actual rate due to:

Actual Overhead cost differs from the

budgeted overhead cost (numerator) & The actual activity level may be different from
the budgeted activity level (denominator)

Chapter 4
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What happens at year end when we

KNOW what the actual overheads are?

• Overheads allocated based on budgeted rates may not match actual incurred overheads.
• Under-absorption occurs when actual activity or expenditure < budgeted.
• Over-absorption occurs when actual activity or expenditure > budgeted.
• Accounting standards recommend treating under- or over-recovery as period cost adjustments.
• Under-recovery is expensed in the current period, while over-recovery reduces expenses for the period.

Chapter 4
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Calculate and explain the accounting treatment of under / over recovery of overheads

Class Example 4 - Calculate over/under absorbed manufacturing overhead costs

A company produces and sells a single product. The company uses an absorption costing system to calculate its product
cost and profit. At the beginning of the year, the company estimates that it will incur R500,000 in manufacturing
overhead costs and produce 10,000 units of the product.
During the year, the company incurs R525,000 in manufacturing overhead costs and produces 11,000 units of the
product.

• Determine the predetermine overhead rate:

• Calculate the total amount of overheads absorbed: In the absorption
Actual production * Predetermined Overhead Rate income statement,
over-absorption
• Compare the absorbed overheads to should be recorded
actual overheads Absorbed = as
Actual =
• Compute over/under absorbed overheads
Absorbed more than the actual overheads expense Thus R25 000 – -absorbed O/H __________.

Chapter 10
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Calculate and explain the accounting treatment of under / over recovery of overheads
Class Example 5 - Calculate over/under absorbed manufacturing overhead costs

A company has 3 production departments for which you have been given the following information:

1. Departmental overhead rates based on budgeted costs and activity

Machining Assembly Finishing Total
Budgeted manufacturing Overheads R 50 380 R 62 472 R 16 332 R 129 184
Budgeted Activity (DM, DL and DL Hours) 32 000 32 000 4 000
Overhead Rate R 1,57 R 1,95 R 4,08

2. Actual Information Machining Assembly Finishing

Actual manufacturing Overheads R 43 528 R 65 891 R 15 750
Actual Machine hours 32 650
Actual Direct Labour Hours 31 040 3 925

Calculate the over or under absorption value that will appear in the absorption income statement.

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Calculate and explain the accounting treatment of under / over recovery of overheads
Class Example 5 - Calculate over/under absorbed manufacturing overhead costs

Calculate the over or under absorption value that will appear in the absorption income statement.

Machining Assembly Finishing

1. Determine the Predetermined Overhead Rate R 1,57 R 1,95 R 4,08

2. Amount of overheads absorbed

R51 403 R60 598 R16 026
4. Actual Overheads R 43 528 R 65 891 R 15 750
4. Over/(Under) Recovery

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LO 7 - 8
Compile a Variable and Absorption
Costing Statement and Reconcile
the Difference in Profits

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Statement of Profit and Loss based on Variable Costing

Units
Sales

Sales R -

Cost of Sales: VARIABLE MANUFACTURING COSTS R -

Opening Inventory R -
Production

Direct Material R - Only VARIABLE

Units

Direct Labour R -
Variable Manufacturing O/H R - costs
Closing Inventory R -

Other Variable Costs R -

Selling and distribution R -

Contribution With this method we calculate R -

CONTRIBUTION
ALL fixed costs

Fixed Costs R -
Fixed Manufacturing Overheads R -
Fixed Selling Costs R -

Net Profit R -

Chapter 7
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Statement of Profit and Loss based on Absorption Costing

Units
Sales

Sales Sales Units x Selling Price R -

Less: Cost of Sales (all manufacturing costs) (R -)
Opening Inventory Opening Inventory Units x Prior Year Product Costs R -

Direct Material Material price x units R -

Production Units

Direct Labour Labour cost per unit x budgeted units R -

Variable Manufacturing O.H VmOH Rate Per Unit x units R - Includes DM
Fixed Manufacturing O.H FmOH Rate (POR) x Actual Units R - + DL + VOH
and FOH at
Less: Closing Inventory Product Costs x Closing Units R -
the POR
(Over)/Under Recovery R -

Gross Profit With this method we calculate R -

a GROSS PROFIT.
Both fixed and

Less: ALL NON-MANUFACTURING COSTS (R -)

variable

Selling/Marketing/Distribution costs - Variable Sales units x V.NonMoh per unit R -

Selling/Marketing/Distribution costs - Fixed R -
Administrative Costs R -

Net Profit/Loss R -

Chapter 7
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Effect on the income statement

There will likely be a difference in the net profit in the SPLOCI because the two systems regard
product costs differently.

Regardless of the costing method used, the fixed manufacturing overheads would remain the same for the period,
however, the timing in which it is recognized on the income statement differs.
In absorption costing the $ amount of fixed manufacturing overheads recognised depends on the number of
goods sold.
Under the Variable costing system, fixed manufacturing overheads are recognised in the income statement as they
are incurred, because they are all expensed (period costs) in the period.

Ultimately The key difference between absorption costing and

variable costing methods pertains mainly to allocation of
manufacturing costs and its effect on reporting of net income.
Chapter 7
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Reconcile the net profits between the variable and absorption costing methods

Class Example 2 - Determine the net profit under the Variable and Absorption costing system.

Company XYZ has the following data for the year ended 31 December 20x3
Units produced during the year 10 000
Units sold during the year @R 300 each 8 000
Variable costs per unit:
Direct Materials R 50
Direct Labour R 100
Variable Overheads R 50
Fixed Costs
Fixed overhead per unit produced (total FOH R250 000) R 25
Fixed Selling and Administration Costs R 100 000

Chapter 7
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Reconcile the net profits between the variable and absorption costing methods
Class Example 2

VARIABLE COSTING ABSORPTION COSTING

Sales R 2 400 000 Sales R 2 400 000

Less Cost Of Sales Less Cost Of Sales

Opening Inventory R 0 Opening Inventory R 0

+Produced +Produced
Direct Labour R 500 000 Direct Labour R 500 000
Direct Material R 1 000 000 Direct Material R 1 000 000
Variable Manufacturing Overheads R 500 000 Variable Manufacturing Overheads R 500 000
Fixed M.OH
-Closing Inventory -Closing Inventory

Contribution Gross Profit

Less Fixed Costs Less Fixed Costs

-Fixed Selling and Administration -R 100 000 -Fixed Selling and Administration -R 100 000
-Fixed Manufacturing Overheads

Net Profit Net Profit

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Reconcile the net profits between the variable and absorption costing methods
Class Example 2

Why is there a R50 000 Where is the 50 000 currently if not When will the R50 000 be recognised in
difference in the profit? recognised in the Absorption costing the income statement under the
income statement? absorption costing system?

Chapter 7
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Reconcile the net profits between the variable and absorption costing methods

Scenario Reason
Production = Sales There's no inventory remaining, all fixed
manufacturing overhead costs are expensed
in the period, aligning the net profit
Absorption compared to Variable net profit will be: outcomes in both costing systems.

Increased closing inventory, locking up more fixed

Production > Sales manufacturing overheads in inventory for the
subsequent accounting period.
Absorption compared to Variable net profit will be: Consequently, less cost of sales is incurred,
resulting in higher net profit for absorption
costing compared to variable costing.

Production < Sales Reduced closing inventory, leading to more

fixed manufacturing overheads being
expensed in c.o.s, higher cost of sales under
Absorption compared to Variable net profit will be: absorption costing translates to a lower net
profit compared to variable costing

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Reconcile the net profits between the variable and absorption costing methods

Scenario Reason
Production = Sales There's no inventory remaining, all fixed

Absorption compared to Variable net profit will be:

Self-Study
EQUAL
manufacturing overhead costs are expensed
in the period, aligning the net profit
outcomes in both costing systems.

Increased closing inventory, locking up more fixed

Production > Sales
Class Example 3
Absorption compared to Variable net profit will be:
manufacturing overheads in inventory for the
subsequent accounting period.
MORE Consequently, less cost of sales is incurred,
in Block Pack 1 resulting in higher net profit for absorption
costing compared to variable costing.

Production < Sales Reduced closing inventory, leading to more

fixed manufacturing overheads being
expensed in c.o.s, higher cost of sales under
Absorption compared to Variable net profit will be: LESS absorption costing translates to a lower net
profit compared to variable costing
Chapter 7
Prepared by: Reuben Davids

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Reconcile the profits between the variable and absorption costing methods

The difference in direct and absorption costing profits can be reconciled with the
difference between the opening and closing inventory values of the two systems.

Memo Format

Absorption Costing Profit R -

Opening Inventory opening units * POR (opening inventory) R -

Closing Inventory closing units * POR (closing inventory) R -

Variable Costing Profit R -

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Reconcile the profits between the variable and absorption costing methods

The difference in direct and absorption costing profits can be reconciled with the
difference between the opening and closing inventory values of the two systems.

Memo Format Class Example 2

Absorption Costing Profit

Opening Inventory

Closing Inventory

Variable Costing Profit

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LO 9
Compile a Variable and Absorption
Costing Statement and Reconcile
the Difference in Profits

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Understand the implications of using a FIFO and WA valuation

methods

FIRST In FIRST OUT Weighted Average Method

Assumes items of inventory Cost of inventory is determined from the

purchased/produced first are sold first. weighted average of inventory at the
beginning of the period and inventory
Closing Inventory will be valued at the current bought/produced during the period.
period cost as all opening inventory and its Total Cost Total Units
associated costs are deemed SOLD off.. Opening Inventory R - Units
Current Manufacturing Costs R - Units
Total cost of closing inventory R - Units

÷
Total weighted average cost per unit R -

Chapter 9: paragraph 5
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CLASS EXAMPLE 6

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Class Example 6 Required

Variable Costs R
Direct Materials R 3,50 a) Prepare an income
Direct Manufacturing Labour R 1,60 statement assuming the
Indirect Manufacturing Costs R 0,90
Direct Marketing Expenses R 0,80 company operates a variable
Indirect Marketing Expense R 1,60 costing system.
R 8,40

Selling Price Per Unit b) Prepare an income

R 17,00
Fixed Costs Budget
statement assuming the
company operates a
Direct Manufacturing Costs R 330 000
Indirect Manufacturing Costs R 1 870 000 absorption costing system.
Direct Marketing Costs R 2 100 000
Indirect Marketing Costs R 3 400 000 c) Reconcile the Variable and
R 7 700 000
Absorption Costing Profit
Budgeted Production (Units) 1 100 000
Opening Inventory -
Actual Sales (Units) 1 000 000
Actual Production (Units) 1 200 000

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Class Example 6 Required

a) Prepare an income statement assuming the company operates a variable costing

system.

b) Prepare an income statement assuming the company operates a absorption costing

system.
c) Reconcile the Variable and Absorption Costing Profit

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VARIABLE COSTING STATEMENT - Class Example 6

Calculations

Sales R17 * 1000 000 R 17 000 000

Less: Cost of Sales -R 6 000 000

Opening Inventory R -
Production
Direct Material R3,5 * 1200 000 R 4 200 000
Direct Labour R1,6 * 1200 000 R 1 920 000
Variable Manufacturing O.H R0,9 * 1200 000 R 1 080 000
Less: Closing Inventory (R3,5+1,6+0,9) * (1200 000 -1000 000) -R 1 200 000

Less: Variable Marketing Expenses -R 2 400 000

-Direct Marketing R0,8 * 1000 000 R 800 000
-Indirect Marketing R1,6 * 1000 000 R 1 600 000

Contribution R 8 600 000

Less: ALL FIXED COSTS -R 7 700 000

Fixed Manufacturing O.H R330 000 + R1870 000 R 2 200 000
Fixed Marketing Costs R2100 000 + R3400 000 R 5 500 000

Net Profit/Loss R 900 000

ABSORPTION COSTING STATEMENT - Class Example 6

CALCULATIONS
Sales
Less: Cost of Sales
Opening Inventory

Direct Material
Direct Labour
Variable Manufacturing O.H
Fixed Manufacturing O.H

Less: Closing Inventory

(Over)/Under Recovery

Gross Profit

Less: ALL NON MANUFACTURING COSTS

Selling/Marketing/Distribution costs - Variable
Selling/Marketing/Distribution costs - Fixed
Administrative Costs

Net Profit/Loss

Reconcilation of Variable to Absorption Costing Profit

Variable Costing Profit

Opening Inventory
Closing Inventory

Absorption Costing Profit

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Themes and learning objectives

1. Explain the differences between variable costing and absorption costing

2. Provide arguments for and against variable costing
3. Provide arguments for and against absorption costing
4. Calculate the cost per unit under variable and absorption costing
5. Explain why Budgeted overheads should be preferred to actual overheads
6. Calculate and explain the accounting treatment of under / over recovery of overheads
7. Compile a statement of comprehensive income using both the variable and absorption costing methods
8. Reconcile the profits between the variable and absorption costing methods
9. Understand the implications of using a FIFO and WA valuation methods

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Theme
Read Chapter* Paragraph number
Cost Term Definitions Chapter 2 2-6
Product Costs Description IAS2 12 paragraph 12 and 16 Refer to IAS2 paragraphs 12 and 16
Cost Estimation Methods Chapter 3 3
Cost Assignment Chapter 4 1-8
Budgeted Overheads Chapter 4 10
Over/Under Recovery Chapter 4 11
Non-Manufacturing Overheads Chapter 4 12
Variable and absorption costing Chapter 7 1-8
FIFO and Weighted Average Chapter 9 5

*Chapters are in prescribed textbook: Colin Drury‐ Management and cost accounting in South
Africa 1st edition unless stated otherwise.
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The End

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