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ACCT 403

Cost Accounting

Absorption and Variable Costing Techniques


Lecturer
Teddy Ossei Kwakye, PhD
Department of Accounting
tokwakye@ug.edu.gh
Learning Outcomes/Objectives
LO 1 Explain the purpose of costing technique and describe the
constituents of costing techniques.
LO 2 Explain the differences between absorption and variable costing
techniques and their importance to management in organizations.
LO 3 Value inventory and prepare income statements using absorption
and variable costing costing techniques.
LO 4 Discuss the effect of production on absorption and variable costing
income and reconcile the net income obtained from absorption
costing with net income from variable costing.

acct403/teddyok/2018-19/Bsc Slide 2
Costing Techniques (slide 1 of 3) LO1

» Costing technique refers to the various approaches organizations use to


determine the product cost of their goods or services.
– Aids decision-making and assists in cost reduction and control.
» It involves
– Cost accumulation approach to product costing
▪ Determining which manufacturing costs to be recorded and included as part of the
product cost.
– Cost presentation approach to product costing
▪ Focuses on how costs are shown on external financial statements and internal
management reports.

acct403/teddyok/2018-19/Bsc Slide 3
Costing Techniques (slide 2 of 3) LO1

» Main costing techniques


– Absorption (or full) costing
▪ Product cost consists of both fixed and variable production cost.
– Variable (or marginal) costing
▪ Product Cost consists of only variable production cost.
» Both techniques
– use the same basic data, accumulate and assign variable manufacturing costs in
the same way and can be used in any product costing methods.
– But differ in how they structure and process the data for costing products,
specifically, in their treatment of fixed manufacturing overheads.

acct403/teddyok/2018-19/Bsc Slide 4
Costing Techniques (slide 3 of 3) LO1

» Fixed manufacturing overhead will be expensed under both product


costing techniques eventually over different periods. However,
– Fixed overhead is expensed immediately, as it is incurred (i.e., period cost), when
using variable costing technique.
– When using absorption costing techniques, fixed overhead is kept in inventory
until the manufactured goods are sold.

acct403/teddyok/2018-19/Bsc Slide 5
Absorption Costing (slide 1 of 3) LO2

» Absorption (or full or total or conventional) costing charges products with all
manufacturing (or production) costs, regardless of whether the costs are fixed
or variable.
– Cost per unit of a product or service consists of all four types of manufacturing costs –
direct material, direct labour, variable manufacturing overhead, and fixed manufacturing
overhead costs.
– The valuation of inventories and work-in-progress contains both fixed and variable cost
elements.
» Absorption costing classify and presents costs by management function.
– Expenses are presented on income statement according to their functional classification
– production, selling, general and administrative expenses etc.
– Financial accounting employs full costing in presenting external financial reports.

acct403/teddyok/2018-19/Bsc Slide 6
Absorption Costing (slide 2 of 3) LO2

acct403/teddyok/2018-19/Bsc Slide 7
Absorption Costing (slide 3 of 3) LO2

Arguments for absorption costing


» Conforms with accrual concept.
» Inventory valuation complies with accounting standards, IAS 2.
» Avoids the illusion that fixed cost has nothing to do with production
– avoid the separation of product cost into fixed and variable.
» Inefficient utilization of production cost are revealed through the
analysis of over or under absorbed (applied) overheads.
» Cost plus pricing ensures all costs are covered.

acct403/teddyok/2018-19/Bsc Slide 8
Variable Costing (slide 1 of 3) LO2

» Variable (or marginal or direct) costing technique charges only variable


manufacturing costs to cost units.
– Fixed manufacturing overhead costs are excluded from inventory or product
costs and are treated as period cost, expensed as they are incurred.
– Cost of a unit of product or service consists of the three variable manufacturing
costs – direct material, direct labor, and variable manufacturing overhead.
» Basis of cost classification for variable costing is cost behaviour.
– Expenses are presented on income statement mainly according to cost
behaviour, although they may also be presented by functional classification
within the behavioural categories.

acct403/teddyok/2018-19/Bsc Slide 9
Variable Costing (slide 2 of 3) LO2

acct403/teddyok/2018-19/Bsc Slide 10
Variable Costing (slide 3 of 3) LO3

Arguments for variable costing


» It prevents arbitrary allocation of indirect cost.
» Under/over absorption of overhead cannot arise or entirely avoided.
» No attempt is made to relate fixed cost to product.
» No fictitious profit arise as a result of fixed cost being capitalized on
inventory.

acct403/teddyok/2018-19/Bsc Slide 11
Product cost Determination (slide 1 of 3) LO3

Absorption Variable
Costing Costing

Direct Materials
Product
Product
Direct Labor
Costs
Costs
Variable Manufacturing Overhead

Fixed Manufacturing Overhead


Period
Period
Variable Selling and Administrative Expenses
Costs
Costs
Fixed Selling and Administrative Expenses

acct403/teddyok/2018-19/Bsc Slide 12
Product Cost Determination (slide 2 of 3) LO3

Example In 2017, 20,000 units of the product


» ABF Ltd produces a single product were sold during the year at a price
with the following information of GH¢30 each. ABF had 2,000 units
available for year end 2016: in beginning inventory with cost per
unit of GH¢12 (25% fixed).
a. Prepare the income statement
for ABF at the end of 2017 using
i. Absorption costing technique
ii. Variable costing technique
b. Reconcile the net profit
obtained under each technique.
acct403/teddyok/2018-19/Bsc Slide 13
Product Cost Determination (slide 3 of 3) LO3

Solution
Cost per unit for production and ending inventory Cost per unit for beginning inventory

acct403/teddyok/2018-19/Bsc Slide 14
Income Statement Presentation Format (slide 1 of 1) LO3

Variable Costing Income Statement


Sales xxx
Less variable expenses:
Beginning inventory xx
Add COGM xx
Goods available for sale xx
Less ending inventory xx
Variable cost of goods sold xx
Variable non production expense xx xx
Contribution margin xx
Less fixed expenses:
Manufacturing overhead xx
Non production overheads xx xx
Net operating income xx

acct403/teddyok/2018-19/Bsc Slide 15
Absorption and Variable Costing Income (slide 1 of 7) LO4

Effect of changes in production on net income


» Changes in production have implication on net income under absorption
costing techniques
» Net income is not affected by changes in production using variable costing,
but net income under absorption costing is affected by changes in production.
» The effects of the production on income under the costing techniques are
based these assumptions:
– that unit costs are constant over time; and
– that any fixed cost variances from standard are written off when incurred rather than
being prorated to inventory balances.

acct403/teddyok/2018-19/Bsc Slide 16
Absorption and Variable Costing Income (slide 2 of 7) LO4

Production units equal to sales units


» Net operating income under absorption costing is the same as that
under variable costing.
» Inventory will neither increase nor decrease, i.e., there is no beginning
or ending inventory.
» Same fixed cost carried forward as expense in beginning inventory
valuation will be deducted in closing inventory valuation in the cost of
production.

acct403/teddyok/2018-19/Bsc Slide 17
Absorption and Variable Costing Income (slide 3 of 7) LO4

Production units exceed sales units


» Net operating income under absorption costing is higher than variable
costing net operating income.
» Inventory is increasing, i.e., there is ending inventory.
» Under absorption costing, fixed manufacturing overheads is being
deferred into inventory and held as an asset (ending inventory).
» Greater amount of fixed manufacturing overheads in ending inventory is
deducted from the cost of sales expense for the period.

acct403/teddyok/2018-19/Bsc Slide 18
Absorption and Variable Costing Income (slide 4 of 7) LO4

Production units less than sales units


» Absorption costing net operating income is less than variable costing net
operating income.
» Inventory is reducing, i.e., beginning inventory exists.
» Greater amount of fixed manufacturing overheads is brought forward
from previous period as expense in beginning inventory valuation.
» Fixed manufacturing overheads charged as expense in the previous
period under variable costing is now being released from inventory into
the current period as expense under absorption costing.

acct403/teddyok/2018-19/Bsc Slide 19
Absorption and Variable Costing Income (slide 5 of 7) LO4

acct403/teddyok/2018-19/Bsc Slide 20
Product Cost Determination (slide 2 of 3) LO3

Example In 2017, 20,000 units of the product


» ABF Ltd produces a single product were sold during the year at a price
with the following information of GH¢30 each. ABF had 2,000 units
available for year end 2016: in beginning inventory with cost per
unit of GH¢12 (25% fixed).
a. Prepare the income statement
for ABF at the end of 2017 using
i. Absorption costing technique
ii. Variable costing technique
b. Reconcile the net profit
obtained under each technique.
acct403/teddyok/2018-19/Bsc Slide 21
Absorption and Variable Costing Income (slide 6 of 7) LO4

Solution

acct403/teddyok/2018-19/Bsc Slide 22
Absorption and Variable Costing Income (slide 7 of 7) LO4

Solution
Variable Costing
Sales (20,000 × GH¢30) 600,000
Less variable expenses:
Beginning inventory (2,000 x GH¢9) 18,000
Add COGM (25,000 × GH¢10) 250,000
Goods available for sale 268,000
Less ending inventory (7,000 × GH¢10) 70,000
Variable cost of goods sold 198,000
Variable selling & administrative
expenses (20,000 × GH¢3) 60,000 258,000
Contribution margin 342,000
Less fixed expenses:
Manufacturing overhead 150,000
Selling & administrative expenses 100,000 250,000
Net operating income 92,000

acct403/teddyok/2018-19/Bsc Slide 23
Reconciling Absorption and Variable Costing Net LO4
Income (slide 1 of 2)
Variable costing net operating income xxx

Add : Differences in valuation of ending inventory (Ending


inventory units × fixed cost per unit) xxx

Less : Differences in valuation of beginning inventory


(beginning inventory units x fixed cost per unit) xxx

Absorption costing net operating income xxx

acct403/teddyok/2018-19/Bsc Slide 24
Reconciling Absorption and Variable Costing Net LO4
Income (slide 2 of 2)
Solution

Variable costing net operating income 92,000

Add : Differences in valuation of ending


inventory (7,000 units × GH¢6 per unit) 42,000

Less : Differences in valuation of beginning


inventory (2,000 units × GH¢3 per unit) 6,000

Absorption costing net operating income 128,000

acct403/teddyok/2018-19/Bsc Slide 25
End of Lessons