Management Advisory Services: Variable and Absorption Costing

Batangas CPA Review

Center
“Committed to your CPA review needs”
RLCAPUNO, CPA, LLB
RVJCLAVERIA, CPA
A. Overview of Variable and Absorption Costing
At least two methods can be used by manufacturing firms to value units of product for accounting
purposes-absorption costing and variable costing. These methods differ only in how they treat fixed
manufacturing overhead costs.
1. Variable Costing. Variable costing treats only those costs of production that varies with output as
product costs. Ordinarily, direct materials, direct labor and variable manufacturing overhead costs
would be included in product costs under variable costing. Fixed manufacturing overhead is treated as
a period cost and is charged off against revenue each period.
2. Absorption Costing. Absorption costing treats all costs of production as product costs regardless of
whether they are variable or fixed in nature. Under the absorption costing method, a portion of fixed
manufacturing overhead is allocated to each unit of product.

B. Comparison of Absorption and Variable Costing

When comparing absorption costing and variable costing income statements, a number of points should be
noted:
1. Deferral of fixed manufacturing costs under absorption costing. Under the absorption costing method,
if inventories increase, the portion of the fixed manufacturing overhead costs of the current period is
deferred to future periods through the inventory account. When the units are later taken out of
inventory and sold, the deferred costs flow through to the income statement.
2. Difference in inventories under the two methods. Under variable costing, only the variable
manufacturing costs are included in inventory. Under absorption costing, both variable and fixed
manufacturing costs are included in inventory.
3. Suitability for CVP analysis. The absorption costing income statement is not well suited for providing
data for CVP computations since it makes no distinction between fixed and variable costs. In contrast,
the variable costing method classifies costs by behavior and is very useful in setting-up CVP
computations.

C. Extended Comparison of Income Data

1. Production equals sales (no change in inventories). When production equals sales, there is no change
in inventories. If there is no change in inventories, then there is no change in the fixed manufacturing
overhead cost in inventories under absorption costing. Therefore, under both costing methods all of
the current fixed manufacturing overhead will flow through to the income statement and be charged
against income.
2. Production exceeds sales (inventories increase). When production exceeds sales, inventories grow. If
inventories grow, then some of the current fixed manufacturing overhead costs will be deferred in
inventories under absorption costing. Since all of the current fixed manufacturing overhead costs are
expensed under variable costing, the net income reported under absorption costing will be greater
than the net income reported under variable costing.
3. Sales exceed production (inventories decrease). When sales exceed production, inventories shrink. If
inventories decrease, then some of the fixed manufacturing overhead costs that had been deferred in
inventories in previous periods will be released to the income statement as a charge against income as
well as of the current fixed manufacturing overhead costs. Since only the current fixed manufacturing
overhead costs are expensed under variable costing, the net income reported under absorption costing
will be less than the net income reported under variable costing.
4. Long-term differences in income. Over an extended period of time, the cumulative net income figures
under absorption costing and variable costing will be about the same; they will differ only by the
amount of fixed manufacturing overhead cost in ending inventories under absorption costing.
Cumulative net income figures will be identical whenever ending inventories are reduced to zero.
5. Changes in production volume. Variable costing income is not affected by changes in production
volume. Absorption costing income is affected by changes in production volume. For any given level of
sales, net income under absorption costing will increase as the level of output increases and hence
inventories increase.

D. Advantages of the Contribution Approach

There are a number of advantages to using variable costing (and contribution approach) in internal
reports and analysis.
1. More useful for CVP analysis
2. Income is not affected by changes in production volume
3. Avoids misunderstandings concerning unit of product costs
4. Fixed costs are more visible.
5. Understandability
6. Control id facilitated
7. Incremental analysis is more straight-forward

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Additional Discussion

A. Variable versus Absorption Costing

Profit centers are evaluated based on income (revenues minus expenses). However, how the income is
measured is important for evaluation purposes. Two ways of calculating income are:
1. Variable costing: assigns only variable manufacturing costs to the product (direct materials, direct labor,
and variable manufacturing overhead).
2. Full or absorption costing: assigns all manufacturing costs to the product (direct materials, direct labor,
variable manufacturing overhead, and fixed manufacturing overhead).

Absorption costing is required for external financial reporting and income tax purposes.
Variable costing is used for internal reporting to management because it provides information that is useful
for planning, control, and decision making.

Product and period costs under absorption and variable costing are summarized below:

Absorption Costing Variable Costing

Product costs: direct materials (DM) direct materials (DM)

direct labor (DL) direct labor (DL)
variable overhead (VOH) variable overhead (VOH)
fixed overhead (FOH)

Period costs: variable selling expenses fixed overhead (FOH)

fixed selling expenses variable selling expenses
variable administrative expenses fixed selling expenses
fixed administrative expenses variable administrative expenses
fixed administrative expenses

B. Inventory Valuation
The main difference between the two methods relates to how fixed manufacturing overhead is recorded.
 When using absorption costing, fixed manufacturing overhead is considered a product cost, included in
inventory and expensed when the inventory is sold.
 When using variable costing, fixed manufacturing overhead is considered a period cost so thus is not
included in inventory but is expensed in the period it is incurred.
The ending finished goods inventory values for absorption and variable costing will differ by the amount of
fixed manufacturing costs included in ending inventory.

C. Income Statements Using Variable and Absorption Costing

Under absorption costing, costs are classified by function as:
1. manufacturing costs (both fixed and variable)
2. selling and administrative costs (both fixed and variable)
The format used when costs are classified by function for absorption costing is:
Sales
– Cost of goods sold (Manufacturing costs)
Gross margin
– Selling and administrative expenses
Net income
When variable costing is used, costs are classified by behavior as:
1. variable costs
 variable manufacturing
 variable selling and administrative
2. fixed costs
 fixed manufacturing
 fixed selling and administrative

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The format used for a variable-costing income statement follows:

Sales
– Variable expenses:
Variable cost of goods sold
Variable selling and administrative
Contribution margin
– Fixed expenses:
Fixed overhead
Fixed selling and administrative
Net income

D. Production, Sales, and Income Relationships

When sales equal production, income is the same under variable and absorption costing.
Production, sales, and income relationships are summarized below:
If Then
Production > Sales Absorption net income > Variable net income
Production < Sales Absorption net income < Variable net income
Production = Sales Absorption net income = Variable net income
The difference between absorption-costing income and variable-costing income results from differences in the
timing of the recognition of fixed manufacturing overhead costs as an expense. Variable costing always
recognizes the period’s fixed overhead as an expense.
Absorption costing recognizes as an expense only the fixed overhead attached to the units sold.
The difference in incomes can be calculated as the change in the number of units in inventory multiplied by
the fixed overhead rate per unit.
Absorption-costing Variable-costing Fixed overhead Change in total units
– = ×
income income rate in inventory
Absorption-costing Variable-costing Fixed overhead
income
–
income
=
rate × (Units produced – Units

LET’S REVIEW
Theory
1. In its first year of operations, Magna Manufacturers had the following costs when it produced 100,000
and sold 80,000 units of its only product:
Manufacturing costs Fixed P180,000
Variable 160,000
Selling and admin.costs Fixed 90,000
Variable 40,000

How much lower would Magna’s net income be if it used variable costing instead of full absorption
costing?
a. P36,000
b. P54,000
c. P68,000
d. P94,000

2. Using the variable costing method, which of the following costs are assigned to inventory?
Variable selling and Variable factory
administrative costs overhead costs
a. Yes Yes
b. Yes No
c. No No
d. No Yes

3. At the end of Killo Co.’s first year of operations, 1,000 units of inventory remained on hand. Variable
and fixed manufacturing costs per unit were P90 and P20, respectively. If Killo uses absorption costing
rather than variable (direct) costing, the result would be a higher pretax income of
a. P0
b. P20,000
c. P70,000
d. P90,000

4. A manufacturing company prepares income statements using both absorption and variable costing
methods. At the end of a period actual sales revenues, total gross profit, and total contribution margin
approximated budgeted figures, whereas net income was substantially greater than the budgeted
amount. There was no beginning or ending inventories. The most likely explanation of the net income
increase is that, compared to budget, actual
a. Manufacturing fixed costs had increased.
b. Selling and administrative fixed expenses had decreased.
c. Sales prices and variable costs had increased proportionately.

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d. Sales prices had declined proportionately less than variable costs.
5. A single-product company prepares income statements using both absorption and variable costing
methods. Manufacturing overhead cost applied per unit produced in 2003 was the same as in 2002.
The 2003 variable costing statement reported a profit whereas the 2003 absorption costing statement
reported a loss. The difference in reported income could be explained by units produced in 2003 being
a. Less than units sold in 2003.
b. Less than the activity level used for allocating overhead to the product.
c. In excess of the activity level used for allocating overhead to the product.
d. In excess of units sold in 2003.

6. Net income under absorption costing is gross profit less

a. cost of goods sold.
b. fixed manufacturing overhead and fixed selling and administrative expenses.
c. fixed manufacturing overhead and variable manufacturing overhead.
d. variable selling and administrative expenses and fixed selling and administrative expenses.

7. Net income under variable costing is contribution margin less

a. cost of goods sold.
b. fixed manufacturing overhead and fixed selling and administrative expenses.
c. fixed manufacturing overhead and variable manufacturing overhead.
d. variable selling and administrative expenses and fixed selling and administrative expenses.

8. The manufacturing cost per unit for absorption costing is

a. usually, but not always, higher than manufacturing cost per unit for variable costing.
b. usually, but not always, lower than manufacturing cost per unit for variable costing.
c. always higher than manufacturing cost per unit for variable costing.
d. always lower than manufacturing cost per unit for variable costing.

9. The one primary difference between variable and absorption costing is that under
a. variable costing, companies charge the fixed manufacturing overhead as an expense in the current
period.
b. absorption costing, companies charge the fixed manufacturing overhead as an expense in the
current period.
c. variable costing, companies charge the variable manufacturing overhead as an expense in the
current period.
d. absorption costing, companies charge the variable manufacturing overhead as an expense in the
current period.

10. Net income under absorption costing is higher than net income under variable costing
a. when units produced exceed units sold.
b. when units produced equal units sold.
c. when units produced are less than units sold.
d. regardless of the relationship between units produced and units sold.

11. Some fixed manufacturing overhead costs of the current period are deferred to future periods under
a. absorption costing.
b. variable costing.
c. both absorption and variable costing.
d. neither absorption nor variable costing.

12. When production exceeds sales,

a. some fixed manufacturing overhead costs are deferred until a future period under absorption
costing.
b. some fixed manufacturing overhead costs are deferred until a future period under variable costing.
c. variable and fixed manufacturing overhead costs are deferred until a future period under
absorption costing.
b. variable and fixed manufacturing overhead costs are deferred until a future period under variable
costing.

13. When production exceeds sales,

a. ending inventory under variable costing will exceed ending inventory under absorption costing.
b. ending inventory under absorption costing will exceed ending inventory under variable costing.
c. ending inventory under absorption costing will be equal to ending inventory under variable
costing.
d. ending inventory under absorption costing may exceed, be equal to, or be less than ending
inventory under variable costing.

14. Management may be tempted to overproduce when using

a. variable costing, in order to increase net income.
b. variable costing, in order to decrease net income.
c. absorption costing, in order to increase net income.
d. absorption costing, in order to decrease net income.

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15. If a division manager’s compensation is based upon the division’s net income, the manager may
decide to meet the net income targets by increasing production when using
a. variable costing, in order to increase net income.
b. variable costing, in order to decrease net income.
c. absorption costing, in order to increase net income.
d. absorption costing, in order to decrease net income.

16. Which of the following is a potential advantage of variable costing relative to absorption costing?
a. Net income is affected by changes in production levels.
b. The use of variable costing is consistent with cost-volume-profit analysis.
c. Net income computed under variable costing is not closely tied to changes in sales levels.
d. More than one of the above.

17. Companies that use just-in-time processing techniques will

a. have greater differences between absorption and variable costing net income.
b. have smaller differences between absorption and variable costing net income.
c. not be able to use absorption costing.
d. not be able to use variable costing.

Problems
1. Esmana Company produced 50,000 units during its first year of operations and sold 47,000 at P20 per
unit. The company chose practical activity – at 50,000 units – to compute its predetermined overhead
rate. Manufacturing costs are as follows:
Direct materials P300,000
Direct labor 87,500
Expected and actual variable overhead 150,000
Expected and actual fixed overhead 250,000
a. Calculate the unit cost and the cost of finished goods inventory under absorption costing.
b. Calculate the unit cost and the cost of finished goods inventory under variable costing
c. What is the peso amount that would be used to report the cost of finished goods inventory to
external parties.

2. Espiritu Company manufactures a single product. The following costs were incurred during the
company’s first year of operations.
Variable cost per unit
Production
Direct materials 12
Direct labor 8
Variable manufacturing overhead 4
Variable selling and administrative 3
Fixed cost per year
Fixed manufacturing overhead P64,000
Fixed selling and administrative expenses 50,000

During the year, the company produced 16,000 units and sold 12,000 units. The selling price of the
company’s product is P35 per unit.
Compute the following:
a. Unit product cost, cost of finished goods and operating income under variable costing
b. Unit product cost, cost of finished goods and operating income under absorption costing

3. Information taken from Mendoza Company’s records for the most recent year is as follows:
Direct material used 290,000
Direct labor 100,000
Variable manufacturing OH 50,000
Fixed manufacturing OH 80,000
Variable selling and administrative costs 40,000
Fixed selling and administrative costs 20,000
Compute the inventoriable costs assuming the company uses
a. Variable costing
b. Absorption costing

4. Panopio Company manufactures diving masks with a standard variable cost of P25. The masks sell for
P34. Budgeted fixed overhead for the most recent year was P792,000. Actual production was equal to
planned production.

Under each of the following conditions, state (a) whether income is higher under variable or
absorption costing and (b) the amount of the difference in reported income under the two methods.
Treat each condition as an independent case.
Production Sales
1 90,000 95,000
2 110,000 108,000
3 79,200 79,200

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5. Colang Company began operations on January 1 to produce a single product. It used a standard
absorption costing system with a planned production volume of 100,000 units. During its first year of
operations, no variances were incurred and there were no fixed selling and administrative. Inventory
on December 31 was 20,000 units, and net income for the year was P240,000. If Blanco had used
variable costing, it net income would have been P220,000. Compute the breakeven point in units.

6. During its first year of operations, Aquino, Inc., produced 27,000 units of its product. Unit sales were
26,400. Fixed overhead was applied at P0.75 per unit produced. Fixed overhead was underapplied by
P3,000. 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 9on absorption costing basis).
Sales (26,400 units @ P12) 316,800
Less: COGS 161,400
Gross margin 155,400
Less: Selling and administrative expenses (all fixed) 120,000
Operating income 35,400
Required:
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. Prepare a variable costing income statement. Reconcile the difference between the two income
figures.

7. Manguiat Company has just completed its first year of operations. The unit costs on a normal costing
basis are as follows:

Manufacturing cost (per unit)

Direct materials (2 lb at P30) 60
Direct labor (1.5 hr at P100) 150
Variable overhead (1.5 hr at P40) 60
Fixed overhead (1.5 hr at P30) 45
Total 315

Selling and administrative costs:

Variable P50/unit
Fixed P1,230,000

During the year, the company had the following activity:

Units produced 24,000
Units sold 22,300
Unit selling price P440
Direct labor hours 36,000

Actual fixed overhead was P12,000 less than budgeted fixed overhead. Budgeted variable overhead
was P5,000 less than the actual variable overhead. The company used an expected actual activity
level of 36,000 direct labor hours to compute the predetermined overhead rates. Any overhead
variances are closed to cost of goods sold.
Required:
a. Compute the unit cost using (a) absorption costing and (b) variable costing
b. Compute the operating income using (a) absorption costing and (b) variable costing
c. Reconcile the difference between the two incomes.

8. The following information pertains to AliCorporation:

Beginning inventory 1,000 units
Ending inventory 6,000 units
Direct labor per unit P40
Direct materials per unit 20
Variable overhead per unit 10
Fixed overhead per unit 30
Variable selling and admin. costs per unit 6
Fixed selling and admin. costs per unit 14

Required
a. What is the value of the ending inventory using the absorption costing method?
b. Absorption costing income would be ____ variable costing income.
c. What is the value of the ending inventory using the variable costing method?

9. Corsat Company has the following information for 2011:

Selling price P190 per unit
Variable production costs P52 per unit produced
Variable selling and admin. expenses P18 per unit sold
Fixed production costs P240,000
Fixed selling and admin. expenses P180,000
Units produced 12,000
Units sold 7,000
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There were no beginning inventories.

Required
a. What is the value of ending inventory for Sanders using the absorption costing method?
b. What is the income for Sanders using the absorption costing method?
c. What is the cost of ending inventory for Sanders using the variable costing method?
d. What is the income for Eastwood using the variable costing method?

10. De Torres Company incurred the following costs in manufacturing desk calculators:

Direct materials P18

Indirect materials (variable) 3
Direct labor 9
Indirect labor (variable) 7
Other variable factory overhead 13
Fixed factory overhead 34
Variable selling expenses 26
Fixed selling expenses 12

During the period, the company produced and sold 2,000 units.

Required:
a. What is the inventory cost per unit using absorption costing?
b. What is the inventory cost per unit using variable costing?

11. Aguilar Company reported the following units of production and sales for June and July 2011:
Units
Month Produced Sold
Income
June 2011 100,000 90,000
under
July 2011 100,000 105,000
absorption
costing for June was P40,000; income under variable costing for July was P50,000. Fixed costs were
P600,000 for each month.
Required:
a. How much was income for July using absorption costing?
b. How much was income for June using variable costing?

12. Varias Corporation has the following information for January, February, and March 2011:

January February March

Units produced 10,000 10,000 10,000
Units sold 7,000 8,500 10,500

Production costs per unit (based on 10,000 units) are as follows:

Direct materials P12
Direct labor 8
Variable factory overhead 6
Fixed factory overhead 4 There were no beginning inventories
for Variable selling and admin. expenses 10 January 2011, and all units were sold
for Fixed selling and admin. expenses 4 P50. Costs are stable over the three
months.

Required:
a. What is the February ending inventory for Steele Corporation using the absorption costing method?
b. What is the January ending inventory for Steele Corporation using the variable costing method?
c. What is the March ending inventory for Steele Corporation using the variable costing method?
d. What is the February contribution margin for Steele Corporation using the variable costing method?

13. The following information pertains to Barairo Corporation:

Beginning inventory 0 units

Ending inventory 5,000 units
Direct labor per unit P20
Direct materials per unit 16
Variable overhead per unit 4
Fixed overhead per unit 10
Variable selling costs per unit 12
Fixed selling costs per unit 16
Required:
a. What is the value of ending inventory using the variable costing method?
b. Absorption costing income would be ____ the variable costing income.

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c. What is the value of ending inventory using the absorption costing method?

14. Carlos Company produced 30,000 units and sold 28,000 units in 2011. Beginning inventory was zero.
During the period, the following costs were incurred:

Indirect labor (variable) P 60,000

Indirect materials (variable) 30,000
Other variable overhead 90,000
Fixed manufacturing overhead 180,000
Fixed administrative expenses 150,000
Fixed selling expenses 120,000
Variable selling expenses, per unit 40
Direct labor, per unit 80
Direct materials, per unit 20

Required: Compute the dollar amount of ending inventory using:

A. Absorption costing
B. Variable costing

15. During the most recent year, Manaois Corp. had the following data:
Beginning inventory in units -
Units produced 15,400
Units sold (P125 per unit) 8,200
Variable costs per unit:
Direct materials P 13
Direct labor P 16
Variable overhead P 8
Fixed costs:
Fixed overhead per unit produced P 23
Fixed selling and administrative P 185,000
Required:
a. How many units are in ending inventory?
b. Using absorption costing, calculate the per-unit product cost. What is the value of ending inventory?
c. Using variable costing, calculate the per-unit product cost. What is the value of ending inventory?
d. Prepare an income statement using absorption costing.
e. Prepare an income statement using variable costing.

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