LESSON 3 PRODUCT COSTING

In this lesson, the learner will be able to:

1. Differentiate Absorption costing from variable costing
2. Prepare Contribution margin income statement
3. Compute Cost under absoption to variable costing and vice versa

ABSORPTION & VARIABLE COSTING

Absorption Costing -is a costing method that includes all manufacturing costs-----direct
(Full costing) materials, direct labor, variable and fixed factory overhead---in the cost of a unit of product.
It treats fixed factory overhead (FFOH) as a product cost.

Variable Costing -is a method that includes only variable manufacturing costs-------direct
(Direct costing) materials, direct labor, and variable overhead-----in the cost of a unit of product.
It treats FFOH as a period cost.

PRODUCT vs. PERIOD cost

A product cost is an inventoriable cost that is subject to allocation between sold and unsold units. Current income is reduced only by the
amount allocated to the sold units. Consider the following allocation:

Unsold units (asset--- Inventory)

Product Cost Sold units ( Expense----- cost of goods sold)

A period cost is a cost that is charged as expense against income, regardless of sales performance. No Allocation is necessary; current
income is reduced by the full amount of the period cost.

Fully Expensed in the period incurred, regardless of sales

Period Cost
ABSORPTION vs. VARIABLE COSTING

1 RATIONALE

Supporters of variable costing argue that FFOH cost are incurred whether or not production occurs. Having no future service potential,
FFOH costs should be expensed in the same period incurred.

Supporters for absorption costing believe that all manufacturing costs----variable and fixed---- are necessary for production to take place
and hence should not be ignored in determining product costs.

2. INVENTORIES

Variable < Absorption

3. ACCEPTABILITY

Since treating FFOH as part of inventory cost is consistent with accounting standards, only absorption costing is acceptable for financial
reporting and tax purposes. Variable costing , which violates the “matching principle” is acceptable only for internal use by management.

NOTE: Matching principle is an accounting principle that calls for the recognition of expense by matching it with the related revenue in the
same accounting period. It supports the treatment of cost of sales as expense only when related units are sold.

4. INCOME STATEMENT

Under absorption costing, the income statement distinguishes between production and other costs. Production costs pertaining to sold
units are first deducted from sales to arrive at the gross profit, and then other costs and expenses are deducted to obtain net income.

Under variable costing, the income statement distinguishes between variable and fixed costs. All variable costs are first deducted from
sales to arrive at the contribution margin, and then fixed costs are deducted to obtain profit.

5. INCOME COMPUTATION

Income between variable costing and absorption may differ because of the amount of FFOH recognized as expense during a period,
caused by the difference between production and sales.

In the long run, however, both methods would yield the same income since sales cannot continuously exceed production, nor production
can continuously exceed sales.
RECONCILIATION OF INCOME UNDER ABSORPTION COSTING AND VARIABLE COSTING
Under variable costing, FFOH costs are fully expensed as incurred (regardless of sales), while under asorption costing, FFOH costs are
expensed when related units are sold. Consider the following patterns:

1. Production = Sales Income (Absorption) = Income (Vanable)

2. Production > Sales Income (Absorption) > Income (Vanable)

3. Production < Sales Income (Absorption) < Income (Vanable)

Basic Formula: ^Income = ^ Inventory x unit FFOH

Where:
^Inventory= Ending Inventory – Beginning Inventory
^Inventory= Units Produced - Units Sold

Alternative formula:
Income, Absorption costing
Add back: FFOH in beginning Inventory
Total
Less: FFOH in ending inventory
Income, Variable costing

ADVANTAGES OF USING VARIABLE COSTING

1. Variable costing reports are simpler and more understandable.
2. The problems involved in allocating fixed are eliminated.
3. Data needed for breakeven and cost-volume profit 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 operational problems encountered by management.

DISADVANTAGES OF USING VARIABLE COSTING

1. Variable 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 safes.
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.
EXAMPLE:
A. AAA Company makes state-of-the- art toy car. Each toy car sells for P 1,000 each. Data for 2024's operations are as follows:

Units: Variable Costs:

Beginning Inventory 5 Direct Materials 18,000
Production 60 Direct labor 12,000
Ending Inventory 15 Factory Overhead 6,000
Selling and Administrative 2,000
Fixed Costs:
Factory Overhead 15,000
Selling and Administrative 1,000
REQUIRED:
1. Determine the inventory cost per unit under:
A) Absorption costing
B) Variable costing
Total Cost Absorption Per unit Variable Per unit
DM 18,000 /60 U P300 P300
DL 12,000/60 U 200 200
VFOH 6,000/ 60 U 100 100
FFOH 15,000/ 60 U= 250 N/A
TOTAL 51,000 P850 P600

2. Determine the total cost of ending inventory under:

A) Absorption costing 15 U X P850= 12,750
B) Variable costing 15 U X P600= 9,000

3. Prepare income statements under

A) Absorption costing
B) Variable costing

Absorption Costing Variable Costing

NET SALES 50 U X P1,000 P50,000 NET SALES 50 U X P1,000 P50,000
LESS: COGS 50 U X 850 (42,500) LESS: VARIABLE COST 32,000
50 U X P600= 30,000 + 2,000
2,000 / 60=
GROSS PROFIT P7,500 CONTRIBUTION MARGIN P18,000
LESS: OPEX (3,000) LESS: FIXED COST -16,000
NET INCOME P4,500 NET INCOME P2,000

4. how much is the difference in income between the 2 costing methods

NI, absorption P4,500
NI, Variable 2,000
Difference P2,500 / 250= 10 UNITS
Income, Absorption costing 4,500
Add: FFOH in beginning Inventory 5U x 250 +1,250
Total
Less: FFOH in ending inventory 15U x 250 -3,750
Income, Variable costing 2,000

5. What causes the difference in income between the 2 costing methods?

Production > Sales
60> 45

B. The following information are taken from the books of BBB Company, which assumes (FIFO) for inventory cost flow:
2023 2024
Beginning Inventory None ? 3,500 units
Production 10,000 units 9,000 units
Ending Inventory 3,500 units 1,000 units
6,500 units 11,500 units
Sales P2 per unit ? ?
Variable manufacturing costs (P0.75 per unit) 7,500 6,750
Fixed manufacturing costs 5,000/ 10,000 units= 0.50 per unit 5,000 5,400
5,400/ 9,000 units= 0.60 per unit
Selling and administrative costs (50% variable) 4,500 7,500
REQUIRED:
1. Determine 2023 profit under variable and absorption costing.
2. Reconcile the two profit figures in 2023.
3. Determine 2024 profit under variable and absorption costing.
4. Reconcile the two profit figures in 2024.9
2023
Absorption Costing Variable Costing
Net Sales P2 x 6,500 u P13,000 Net Sales P13,000
Less: Cost of goods sold P1.25 x 6,500 u 8,125 Less: Variable Cost (P.75 x 6500)+2250 7,125
Gross Profit P4,875 Contribution Margin P5,875
Less: Operating Expenses 4,500 Less: Fixed Cost 7,250
Net Income (Net Loss) P375 Net Income (loss) P(1,375)

Income, Absorption costing 375

Add: FFOH in beginning Inventory 0
Total
Less: FFOH in ending inventory 3,500 x 0.50 -1,750
Loss, Variable costing (1,375)
 2024
Absorption Costing Variable Costing
Net Sales P2 x 11,500 u P23,000 Net Sales P23,000
Less: Cost of goods sold 15,175 Less: Variable Cost P0.75 x 11,500 12,375
1.25 x 3,500 u + + 3,750
1.35 x 8,000 u
Gross Profit P7,825 Contribution Margin P10,625
Less: Operating Expenses 7,500 Less: Fixed Cost 9,150
Net Income (Net Loss) P325 Net Income (loss) P1,475

Income, Absorption costing P325

Add: FFOH in beginning Inventory 0.50 x 3,500u 1,750
Total
Less: FFOH in ending inventory 0.60 x 1,000 u (600)
Income, Variable costing P1,475

Throughput costing: Finally, under throughput costing, only direct materials are recorded as inventory costs while all other manufacturing
costs (including direct labor and variable factory overhead) are expensed as period costs. Selling and administrative costs are expensed
as period costs as well.

The comparison of the absorption, variable, and throughput costing methods is summarized in the table below:

ABSORPTION COSTING VARIABLE COSTING THROUGHPUT COSTING

EXTERNAL REPORTING ACCOUNTING NOT NOT
STANDARDS
INTERNAL REPORTING USED TO SAVE COSTS USED TO EVALUATE USED FOR SHORT TERM CAPACITY
PERFORMANCE AND FOR DECISIONS
DECISION-MAKING
INVENTORY COSTS DIRECT MATERIALS DIRECT MATERIALS DIRECT MATERIALS
DIRECT LABOR DIRECT LABOR
VARIABLE FOH VARIABLE FOH
FIXED FOH
PERIOD COSTS SELLING AND ADMIN FIXED FOH DIRECT LABOR
EXPENSES SELLING AND ADMIN EXPENSES VARIABLE FOH
FIXED FOH
SELLING AND ADMIN EXPENSES
 ASSIGNMENT 3
MULTIPLE CHOICES
1. Under absorption costing, fixed manufacturing overhead costs
(A) are deferred in inventory when production exceeds sales.
(B) are always treated as period costs.
(C) are released from inventory when production exceeds sales.
(D) are always treated the same as in variable costing.

2. When juxtaposing absorption costing against variable costing, which of the following assertions is not accurate?
(A) In instances where sales volume surpasses production volume, variable costing tends to yield greater operating profit.
(B) Operating profit under absorption costing is contingent upon both sales volume and production volume.
(C) Absorption costing facilitates the short-term augmentation of operating profits through increasing inventories.
(D) A manager assessed based on variable costing operating profit might be inclined to escalate production towards the
period's conclusion to garner a more advantageous evaluation.

3. Four managers are talking about absorption and variable costing on the respective segments they lead:
Hanni “Variable costing is the preferred method for external financial reporting as it provides a clearer picture of product costs
and profitability.”
Haerin "Variable costing treats fixed manufacturing overhead costs as period costs, meaning they are expensed in the period
incurred rather than being allocated to units produced."
Hyein "Absorption costing distinguishes costs between cost of goods sold and operating expenses, making it more effective for
understanding cost behavior as variable or fixed.”
Danielle "Absorption costing complies with generally accepted accounting principles (GAAP) for external financial reporting, while
variable costing does not.

Who do you think are the managers that need re-training in management accounting techniques?
(A) Haerin and Danielle
(B) Hanni and Hyein
(C) Hanni and Haerin
(D) Hyein and Danielle

4. Consider the following equation for company i at year t:

What does x i,t represent?

(A) Contribution Margin
(B) Fixed Costs
(C) Net Income
(D) Variable Costs

5. The amount of income under absorption costing will be more than the amount of income under variable costing when
units manufactured:
a. exceed units sold
b. equal units sold
c. are less than units sold
d. are equal to or greater than units sold
PROBLEM SOLVING
1. Dongpyo, the management accountant of Mirae Company, intends to transform the income statement of the entity into
something that the managers can use in analyzing the entity’s variable and fixed cost components. Recently issued financial
statements show P800,000 sales and P120,000 total operating expenses with a net income of P80,000. Normal operations dictate
70% of cost of goods sold as variable, and that 60% of operating expenses are fixed. From the information, Dongpyo would report a
contribution margin of _________________

2. Lumina Enterprises manufactured 700 units of The Light (TL), a new product, during the year. At normal capacity, TL’s variable
and fixed manufacturing costs per unit were P60 and P20 respectively. The inventory of TL on December 31 consisted of 200
units. There was no inventory of TL on January 1. What would be the change in the peso amount of inventory on December
31 if variable costing was used instead of absorption costing? _____________

3. Gehlee Company manufactures Unis, a notebook designed for college students. Currently, Gehlee sells the notebooks at P40
per unit. Normal annual production is 8,000 units. During the year, Gehlee enjoyed net income of P30,000 reported in its recently
issued financial statements. Gehlee sold 5,000 notebooks during the year. Manufacturing costs include direct labor of P3 per
unit, direct materials of P5 per unit, variable manufacturing overhead of P1 per unit, and total fixed overhead of P100,000. The
management requires an income determination report that separates variable and fixed cost components of cost of goods sold
and operating expenses. From this information, the variable costing income statement will report net income (loss) of __________

4. Kathryn Company that produces a single product has provided the following data concerning its most recent month of
operations:
Selling price .....................................................P79
Units in beginning inventory ...........................-
Units produced ................................................6,600
Units sold .........................................................6,300
Units in ending inventory ................................300
Variable costs per unit:
Direct materials ...............................................P14
Direct labor ......................................................P30
Variable manufacturing overhead ....................P4
Variable selling and administrative .................P8
Fixed costs:
Fixed manufacturing overhead ........................P46,200
Fixed selling and administrative ......................P88,200

What is the total period cost for the month under the variable costing approach? ____________

5. Jun Company produces a single product. Last year, the company’s net operating income computed using absorption costing method
was P6,400 and its operating income computed using variable costing method was P9,100. The company’s unit product cost was P17
under variable costing and P20 under absorption costing. If the ending inventory consisted of 2,100 units, the beginning inventory in units
must have been: ___________