PRODUCT COSTING ‘This chapter aims that the student be able to: Know what is variable costing as against absorption costing. Understand the rationale of using variable costing internally for management planning and control. Differentiate inventory valuation under variable (direct) costing as against absorption (full) costing [dentify costs included in the product cost under variable costing, Know how fixed overhead costs are deferred in inventory under absorption costing. Know why fixed overhead costs are charged to period costs when incurred and not part of Product costs. Prepare an income statement under variable costing (Contribution Margin approach). Prepare an income statement under absorption costing or full costing approach. Lea how to reconcile the net income under variable costing and absorption costing methods. * Know the proper treatment of volume variance under absorption costing when sales and production in a period differs. re Introduction Income is one of the many important measures used to evaluate the performance of both segments and the company as a whole. ‘That is why managers strive to make their performances look good by making decisions that would increase income. But the question is “how income be correctly measured?" Normally, accountants and managers make judgment when measuring income and one of the most important factor is choosing the appropriate method in calculating product cost or activity costs. When managers realized that product costing would affect their evaluation (income aspect), they started to pay attention on the determination of product costs. Cost accounting used to determine product costs by adding all manufacturing costs as inventoriable costs and charged to revenues when sold as "cost of goods sold" under the so- called absorption (full) costing method. Absorption costing method costs the products with all ‘manufacturing costs regardless of whether the manufacturing cost is variable or fixed. Since absorption costing includes variable and fixed manufacturing costs in costing the product, this cannot be used to prepare a segment income reporting under contribution margin which is one of the best measures in evaluating the performance of a segment. An alternative costing method was suggested, for intemal purposes only, called variable costing. Variable (Direct) Costing Method Variable costing recognizes that the cost of the product must include only those production costs that vary directly with the volume of production. Fixed manufacturingChapter 3 Product Costing I overhead is not treated as a product cost rather it is treated as a period cost and charged the entire fixed manufacturing overhead for the period against revenues for that period. Variable costing method differs from absorption costing method only in one conceptual aspect, the treatment of the fixed factory overhead. Fixed factory overhead is excluded from the cost of products under variable costing method but included under absorption costing method. Difference between the two methods could be presented as follows: Balance sheet Income statement Under Absorption Costing Method (COST OF MANUFACTURING Direct Materials |__| Initially etait Becomes Direct Labor Applied to, Boods | expense as goods Variable Mfg, OH Inventory aera are sold as Fixed Mig OH |] “Product Cost” “cocs” — Under Variable costing Method COST OF MANUFACTURING Direct Materials | Initially " ‘Becomes Direct Labor a] Applied to |_ 80088 |) expense as goods are Variable Mfg, OH. Inventory aresold | soldas “COGS” “Product Cost”. becomes Fixed Mfg, OH ; Expense as |_——_Charged immediately "incurred to revenues (petiod costs) Variable costing method treats that fixed factory overhead must not be inventoried, as it claims under worst case of no production in a given period would result in an inventory cost equal to the fixed factory overhead even with zero units on hand. Fixed factory overhead is treated as an expired cost to be immediately charged to revenue as incurred, while absorption costing treats fixed factory overhead as an unexpired costs to be held back as inventory and charged to revenue later as goods were sold. To illustrate, consider the following information for Variety Manufacturing Corporation in its first year of operation in 2022: Units produced 25,000 Units sold 18,000 Unit selling price P100 Variable manufacturing costs P40 per unit produced Variable selling expenses 8 per unit sold Fixed manufacturing costs 540,000 Fixed administrative expenses P200,000 ‘Assume that the actual production is the same with the normal operating level for the year. Income statements under the two methods will be presented as follows:Chapter 3 Product Costing Variety Manufacturing Company Income Statement (Absorption Costing) For the Year Ended December 31, 2022 Sales (18,000 x P10) 1,800,000 Less: Cost of goods sold (18,000 x P61.60) 1,108,800 Gross profit P 691,200 Less: Selling & administrative costs Variable (18,000 x P8) 144,000 Fixed 200,000 __344,000 Net income 347,200 The cost of goods sold is P61.60 ( P40 variable manufacturing costs plus the fixed manufacturing costs of P540,000 / 25,000 = P21.60). The cost of ending inventory will be 431,200 (P61.60 x 7,000 units unsold). Variety Manufacturing Company Income Statement (Variable Costing) For the Year Ended December 31, 2022 Sales (18,000 x P100) 1,800,000 Less: Variable costs Variable cost of goods sold (18,000 x P40) P720,000 Variable selling & administrative costs (18,000 x P8) 144,000 __864,000 Contribution margin P 936,000 Less: Fixed costs Fixed manufacturing costs 540,000 Fixed selling é administrative costs 200,000 __740,000 Net income P196,000 The income statement under variable costing separates variable costs and fixed costs and showed a contribution margin amount instead of gross profit as shown under absorption costing. The cost of ending inventory is P280,000 (P40 x P7,000). Note further that fixed manufacturing costs were all charged to expense. The net income in two methods differ by 151,200 which is the difference in the cost of ending inventory, P151,200 (P431,200 ~ P280,000), This comprised the fixed factory overhead in ending inventory, (7,000 x P21.60) The net income in the two methods can be reconciled as follows: 2022 Variable Costing Net Income 196,000 + Fixed manufacturing costs deferred at 12/31/22 under absorption costing (7,000 x P21.60) 151,200 2022 Absorption Costing Net Income 347,200 2022 Absorption Costing Net Income 347,200 + Fixed manufacturing costs deferred at 12/31/22 under absorption costing (7,000 x P21.60) 151,200 2022 Absorption Costing Net Income 196,000Chapter 3 Product Costing 53 Some typical observations could be developed regarding variable costing and absorption costing methods regarding sales and production of units. They are: > When production and sales are equal, the same net income will be realized regardless of the method used. The reason is that when production and sales are equal, there is no fixed overhead cost that has been deferred to inventory and all manufacturing costs ‘were released from inventory as cost of goods sold. > When sales exceeds production, the net income reported under the absorption costing, will generally be less than the net income reported under the variable costing. The reason is that when more units is sold than produced, inventories will decrease and fixed overhead costs that were previously deferred in inventory under absorption costing are released, plus the current fixed overhead costs were charged against income for the current year. While under variable costing, only fixed overhead costs of the current year have been charged against revenues. > When production exceeds sales, the net income reported under absorption costing will generally be greater than the net income reported under variable costing. The reason is that when more units is produced than sold, part of the fixed overhead costs of the current period are deferred in inventory to the next period under absorption costing. Only that portion of the fixed overhead costs of the sold units is charged against income for the year. While under variable costing, all of the fixed overhead costs for the year were charged immediately against income as a period cost. Income Statement Presentation using Standard Costing. Companies using standard costing could use variable costing method or absorption costing. The only difference is that in absorption costing method, production volume variance appears whenever actual production deviates from the expected volume of production, which was used in computing the pre-determined fixed factory overhead rate. ‘Assume the following information: rect material cost P130 Direct labor 150 Variable FOH on Standard Variable Cost per unit 3.00 Fixed factory overhead is budgeted at P150,000 at a production level of 150,000 units. Selling price 5,00 per unit. Budgeted and actual fixed selling and administrative expenses 65,000 per year. Variable selling expenses is 5% of peso sales.(Ghapier 3 Product Costing Actual quantities in units are: Year: Year2 Beginning inventory : 30,000 Production 170000 140,000 Sales 140,000 160,000 Ending inventory 30,000 10,000 Assume further that there are no variances from the standard variable manufacturing: costs, and the fixed manufacturing overhead incurred is exactly P150,000 per year. Prepare the following: 1. Income statements for Year 1 and Year 2 under absorption costing. 2. Income statements for Year 1 and Year 2 under variable costing. 3, Show a reconciliation of the difference in operating income for Year 1 and Year 2, and the two years as a whole. SOLUTIONS: Standard cost = Variable cost + Fixed overhead rate = P3000 «+ «=P 1 = PAO Fixed Overhead rate = Budgeted fixed overhead / Expected volume of production = P150,000 / 150,000 units = P1.00 Variable Costing method (in thousands) Yearl | Year2 Sales, 140,000 and 160,000 units P700 P3800 Less, Variable Expenses: Variable mfg. Cost of goods sold: Beg. Inventory, at Standard Variable costs, P3 POO P90 ‘Add, variable cost of goods manufactured, at| 510 420 standard Available for sale 510 510 Less, Ending inventory, at standard ,P3 90 30. Variable cost of goods sold 420 480 Variable selling & administrative expenses 35 40 Total variable costs 455 520 Contribution Margin m5| 280 Less, Fixed Expenses: Fixed factory overhead 150 150 Fixed selling & administrative expenses & 6, Total fixed expenses 25 215 Operating Income 30 a3 Product Costing Ending inventory: Year 1 30,000 units x P3.00 Year 2 10,000 units x P 3.00 90,000 30,000 Absorption Costing method ( in thousands) Year1 Year 2 Sales, 140,000 and 160,000 units P700| _P800 Less, Cost of goods sold: Beg, Inventory, at standard (variable & Fixed), | POO! P120 Pa ‘Add, Cost of goods manufactured, at{ 680 360 standard, Pa ‘Available for sale 680 680 ‘Less, Ending inventory, at standard ,P4 120 40 Cost of goods sold, at standard 560 640) Gross Profit, at standard 140 160 Production Volume Variance 20F 10U Gross Profit at actual P160 P150 Less, Operating expenses: Selling & administrative expenses 100) 105 Operating Income 60 5 When using standard costs, all production costs must be stated at standard. A production volume variance appears whenever actual production deviates from the expected volume of production used in computing the fixed overhead rate under absorption costing. This production volume will be adjusted to the cost of goods sold at standard to get the cost of goods sold at actual. Itis important to note that: > When expected production volume and actual production volume are the same, there is no production volume variance. > When actual volume is less than expected volume, the production volume variance is unfavorable because usage of facilities is less than expected and fixed overhead is under- applied. > When actual volume is more than expected volume, the production volume variance is favorable because usage of facilities is more than expected and fixed overhead is over- applied. Computation of production volume variance based on expected volume of production of 150,000 units. Year 1 (170,000 - 150,000) x P1.00 = P20,000 Favorable Year 2 (140,000 - 150,000) x P1.00 = _10,000 Unfavorable ‘Two years combined 10.000 Favorable(Chapter 3 Product Costing Reconciliation of Variable Costing and Absorption Costing Notice the differences in their operating income for each year. This difference can be quickly explained by multiplying the fixed factory ovethead rate by the difference in the ending inventories and the beginning inventories for both years, Therefore, we can say that if production equals sales in all periods, the operating income in both methods will be the same. Pro forma reconciliation: Absorption to Variable costing Net income per Absorption costing Prox + Fixed overhead in beginning inventory xx - Fixed overhead in ending inventory (ox) = Net income per Variable costing Pox Variable costing to Absorption Net income per Variable Costing Prox - Fixed overhead in beginning inventory (xxx) + Fixed overhead in ending inventory _x0«x = Net income per Absorption costing, Ex Year1 sc) 0 £30) B30 a ( reo leS Year2 Pas, 30 pi 10 Bk