Management Accounting Concepts & Techniques for Planning & Control

Jazz
ABSORPTION AND VARIABLE COSTING

ABSORPTION COSTING - is a costing method that includes all manufacturing costs (direct materials,
direct labor, variable and fixed manufacturing overhead) in the cost of a unit of product.
It treats fixed manufacturing overhead as a product cost. It is also known 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 fixed manufacturing overhead as a period cost. It is also known as direct costing.

DISTINCTIONS BETWEEN PERIOD COSTS AND PRODUCT COSTS:

PERIOD COSTS PRODUCT COSTS

1. Refers to an item charged against current 1. Refers to an item included in product
revenue on the basis of time period costing which is apportioned between the
regardless of the difference between sold and unsold units.
production and sales volume.
2. Does not form part of the cost of inventory. 2. The portion of the cost, which has been
allocated to the unsold units, becomes part
of the inventory.
3. Diminishes income for the current period by 3. Diminishes current income by that portion
its full amount. thereof identified with the sold units only
with the remainder being deferred to the
next accounting period as part of the cost of
ending inventory.

DIFFERENCES BETWEEN VARIABLE AND ABSORPTION COSTING

ABSORPTION COSTING VARIABLE COSTING

1. Rationale All manufacturing costs FFOH costs are incurred in
(variable and fixed) are order to have capacity to
necessary for production to produce units. These costs are
take plane and hence should incurred whether or not
not be ignored in determining production occurs. Thus, FFOH
products costs. costs, having no future service
potential, should be fully
expensed in the same period
incurred.
2. Cost Segregation Seldom segregates costs into Costs are segregated into
variable and fixed costs. variable and fixed.
3. Cost of inventory Cost of inventory includes all Costs of inventory include only
the manufacturing costs: the variable manufacturing
materials, labor, factory costs: materials, labor and
overhead variable factory overhead.
4. Treatment of fixed factory Fixed factory overhead is Fixed factory overhead is
overhead treated as product cost. treated as period cost.
5. Income statement Distinguishes between Distinguishes between variable
production and other costs. and fixed costs.
6. Acceptability Acceptable for financial Acceptable only for internal
reporting and tax purposes use by management because it
since it is consistent with violates the “matching
accounting standards. principle”.
7. 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 between sales and production. In the long run,
however, both methods give substantially the same results since
sales cannot continuously exceed production, nor production can
continually exceed sales.

DIFFERENCE IN NET INCOME UNDER ABSORPTION AND VARIABLE COSTING

- Timing differences on the recognition of fixed manufacturing overhead as an expense.

Production equals Sales

When production is equal to sales, there is no change in inventory. Fixed overhead expense under absorption
costing equals fixed overhead expense under variable costing. Therefore, absorption costing income equals
variable costing income.

PRODUCTION = SALES INCOME UNDER AC = INCOME UNDER VC

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Management Accounting Concepts & Techniques for Planning & Control
Jazz

Production is greater than Sales

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

PRODUCTION > SALES INCOME UNDER AC > INCOME UNDER VC

Production is less than Sales

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

PRODUCTION < SALES INCOME UNDER AC < INCOME UNDER VC

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 the standard cost accounting system.
5. Variable costing reports provide useful information for pricing decisions and other decision-making
problems encountered by management.

Disadvantages of Using Variable Costing

1. This 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 related accounts, such as working capital, current ratio,
and acid-test ratio are understated because of the exclusion of FFOH in the computation of product cost.

RECONCILIATION OF DIRECT COSTING TO ABSORPTION COSTING NET INCOME

Net income- direct costing xxx

Add: Fixed cost in ending inventory xxx
Less: Fixed cost in beginning inventory xxx
Net income- absorption costing xxx

Exercises:
1. Sosyalista Company began its operations in 2011, during which it produced 210,000 quarts of olive oil. In
2011, it sold 190,000 quarts. Cost incurred during the year were as follows:

Ingredients used P244,400

Direct labor 114,400
Variable Overhead 187,200
Fixed overhead 105,000
Variable selling expenses 47,500
Fixed selling and administrative expenses 112,000
Total actual costs P810,500

a. What was the actual production cost per quart under variable costing? Under absorption costing?
b. What was the cost of goods sold for 2011 under variable costing? Under absorption costing?
c. What was the value of ending inventory under variable costing? Under absorption costing?
d. How much fixed cost was charged to expense in 2011 under variable costing? Under absorption
costing?

2. Mafeeling Company produces and sells a single product. The following costs relate to its production and
sales:
Variable costs per unit:
Materials P9
Labor 10
Manufacturing overhead 5
Selling and administrative expenses 3

Fixed costs per year:

Manufacturing overhead P150,000
Selling and administrative expenses 400,000

During the last year, 25,000 units were produced and 22,000 units were sold. The Finished Goods
Inventory account at the end of the year shows a balance of P72,000 for the 3,000 unsold units.

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Management Accounting Concepts & Techniques for Planning & Control
Jazz
a. Is the company using absorption costing or variable costing to cost units?
b. Assume that the company wishes to prepare financial statements for the year to issue to its
stockholders.
1. Is the P72,000 figure for Finished Goods inventory the correct amount to use on these
statements for external reporting purposes? Explain.
2. At what peso amounts should the 3,000 units be carried in the inventory for external reporting
purposes?

3. During its first year of operations, Buko Pie Company produced 55,000 jars of hand cream based on a
formula containing 10 percent glycolic acid. Unit sales were 53,500 jars. Fixed overhead was applied at
P0.50 per unit produced. Fixed overhead was underapplied by P10,000. This fixed overhead variance was
closed to Cost of Goods Sold. There was no variable overhead variance. The results of the year’s operations
are as follows (on an absorption costing basis):

Sales (53,500 units @P8.50) P454,750

Less: Cost of goods sold (170,500)
Gross margin P284,250
Less: Selling and administrative (all fixed) (120,000)
Net income P164,250

a. Give the cost of the firm’s ending inventory under absorption costing. What is the cost of the ending
inventory under variable costing?
b. Compute the income under variable costing. Reconcile the difference between the two income
figures.

4. CPA Corporation, which uses throughput costing, began operations at the start of the current year. Planned
and actual production equaled 20,000 units, and sales totaled 17,500 units at P95 per unit. Cost data for the
year were as follows:
Direct materials (per unit) P 18
Conversion cost:
Direct labor 160,000
Variable manufacturing overhead 280,000
Fixed manufacturing overhead 340,000
Selling and administrative costs (total) 430,000

The company classifies direct materials as a throughput cost.

Required:
A. Compute the company's total cost for the year.
B. How much of this cost would be held in year-end inventory under (1) absorption costing, (2) variable
costing, and (3) throughput costing?
C. How much of the company's total cost for the year would appear on the period's income statement under
(1) absorption costing, (2) variable costing, and (3) throughput costing?
D. Compute the year's throughput-costing net income.

5. CPA, Inc., began business at the start of the current year and maintains its accounting records on an
absorption-cost basis. The following selected information appeared on the company's income statement and
end-of-year balance sheet:

Income-statement data:
Sales revenues (35,000 units x P22) P770,000
Gross margin 210,000
Total sales and administrative expenses 160,000
Balance-sheet data:
Ending finished-goods inventory (12,000 units) 192,000

CPA achieved its planned production level for the year. The company's fixed manufacturing overhead totaled
P141,000, and the firm paid a 10% commission based on gross sales pesos to its sales force.

Required:
A. How many units did CPA plan to produce during the year.
B. How much fixed manufacturing overhead did the company apply to each unit produced?
C. Compute CPA's cost of goods sold.
D. How much variable cost did the company attach to each unit manufactured?