Absorption vs Variable Costing

Variable vs Absorption Costing

• Full or absorption costing allocates all manufacturing costs to the product.
• Variable costing considers only direct materials, direct labor, and variable manufacturing overheads as product costs.
• Fixed manufacturing overheads are period costs under variable costing

Absorption Costing

• Includes all manufacturing costs (direct materials, direct labor, variable and fixed factory overhead) in the unit cost.
• Fixed factory overhead is treated as a product cost.

Variable Costing

• Includes only the variable manufacturing costs (direct materials, direct labor, and variable overhead) in the cost of a product
• Fixed factory overhead is treated as a period cost.

Period Costs

• Costs expensed in the current time period, regardless of production or sales volumes.
• Not included in inventory valuation.
• Reduce current income fully.

Product Costs

• Costs included in product cost calculation and allocated between sold and unsold units.
• Are inventoriable, unsold units are part of inventory cost.
• Reduce current income to the sold units, and unsold units are treated as assets.

Premium Products Corporation Example (January 1996)

• Premium Products Corp. makes "Fix-it," a polyurethane sealant.
• Selling price is Php20 per unit.
• Production: 30,000 units, Sales: 20,000 units, Beginning inventory: zero.
• Variable unit costs in manufacturing are Php9 (direct materials Php5, direct labor Php3, variable overhead Php1).
• Selling and administrative expenses: Php2.
• Fixed costs include Php120,000 in manufacturing overhead and Php15,000 in selling/administrative expenses.
• Unit cost differences (Php4) arise between absorption and variable costing because of how fixed costs are treated.
• Absorption costing reports Php40,000 higher income versus variable costing (Php85,000 vs Php45,000).
• Ending inventories differ by Php40,000 ($130,000 and $90,000 under absorption and variable costing respectively).
• Absorption costing defers Php40,000 of fixed overhead to a future period as a product cost, due to different accounting of fixed costs.

Income Effects Summary

Rationale for Costing Methods

• Variable costing rationale focuses on fixed manufacturing costs as necessary for productive facilities, not direct production costs.
• Absorption costing includes fixed manufacturing overhead in inventory, considering it essential to prepare products for sale.
• Variable costing is acceptable, but only for internal managerial purposes.

Multiple Choice Notes

• Full costing is another term for absorption costing.
• If production exceeds sales, absorption costing results in higher income and assets than variable costing.
• Fixed manufacturing overhead is found in work-in-process, finished goods inventory, and cost of goods sold under absorption, but not period costs.
• With constant sales under absorption costing, higher period 2 income results from production exceeding period 1 production.
• Ending inventory valuation is typically greater or equal to variable costing's valuation under absorption costing.
• Absorption and variable costing differ in the treatment of fixed manufacturing overhead and acceptability for external reporting.
• Contribution margin is not associated with absorption costing.
• Unabsorbed fixed overhead are fixed manufacturing costs not allocated to produced units in an absorption costing system.
• Profit differences between costing methods is calculated by the change in inventory quantity times the relevant fixed costs per unit.
• The difference between net earnings under absorption and variable costing is due to how fixed overhead costs are handled.
• Absorption costing classifies costs by functional group.
• Depreciation on office equipment is a general and administrative expense in a functional classification.
• Absorption costing classifies costs by both functional group and behavior.
• Variable manufacturing overhead can be inventoried under variable costing.
• Process costing, job order costing, and standard costing can be used with variable costing.
• Direct costing is another term for variable costing.
• Fixed manufacturing overhead is included only on the income statement if a firm uses variable costing.
• product costs are both fixed and variable under variable costing
• A favorable volume variance increases net income under absorption costing but has no effect under variable costing.
• Income differences are attributable to the treatment of fixed manufacturing overhead under absorption and variable costing.
• On a variable costing income statement, subtracting total fixed costs from the contribution margin equals income before income taxes.
• Variable indirect manufacturing costs are treated as product costs in variable costing.
• A key principle of variable costing is that period costs should be immediately expensed.
• Only variable production costs are treated as product costs under variable costing.
• A disadvantage of direct (variable) costing is that fixed manufacturing overhead is necessary for production.
• The term contribution margin appears in an income statement prepared as an internal report when using variable costing.
• Variable costing excels at analyzing profitability, CVP relationships, and minimizing inventory effects on net income.
• In the variable costing income statement, total contribution margin separates variable and fixed costs.
• If sales rise, net income with variable costing will increase more than with absorption costing.

Rome Ortiz Corporation Key Facts

• Sold 48,000 and manufactured 51,000 units
• Selling price was P25 per unit.
• Direct Material: 3.00 per unit
• Direct Labor: 2.50 per unit
• Variable Manufacturing Overhead :1.80 per unit
• Fixed Manufacturing Overhead: 4.00 per unit (based on an estimate of 50,000 units)
• Variable Selling Expenses: 0.25 per unit
• Fixed SG&A Expense: P75,000 per year

Langley Corporation Calculations

• Under absorption costing, standard production cost per unit: P11.30.
• Volume variance under absorption costing: P4,000 U.
• Under variable costing, standard production cost per unit: P7.30. Based on variable costing, income before income taxes: P562,600.

Ford Company Key Facts

• Sales in Units: 5,000
• Production in Units: 8,000
• Direct labor: P3 per unit
• Direct material: P5 per unit
• Variable overhead: 1 per unit
• Fixed overhead: P100,000
• Net income (absorption method): 30,000
• Sales price per unit: P40

Ford Company Calculations

• If Ford Company used variable costing, income before income taxes would have been (P7,500)
• Selling, General, and Administrative Expense incurred by Ford Company would be undetermined from given information.
• If Ford Company were using variable costing, the value of the ending inventory would be P24,000

Clinton Corporation Key Facts

• Units Produced: 10,000
• Units Sold: 7,000
• Direct material: P8
• Direct labor: P9
• Manufacturing Overhead: P3
• SG&A: P4
• Manufacturing Overhead :P70,000
• SG&A: P30,000

Clinton Corporation Calculations

• Based on absorption costing, income will be higher than it would be under variable costing, but exact difference cannot be determined.
• Based on absorption costing, Cost of Goods Manufactured for the first year would be P300,000.
• Based on absorption costing, period costs will Clinton Corporation deduct? will be undetermined from the information given.

More Calculations

• A firm reported its contribution margin was equal to 40 percent of sales and that its net income amounted to 10 percent of sales,. Its fixed costs for the year were P60,000, so sales are undetermined from the information given
• At its present level of operations, a small manufacturing firm has total variable costs equal to 75 percent of sales and total fixed costs equal to 15 percent of sales. Based on variable costing, if sales change by P1.00, income will change by P0.25.

Enigma Corporation Key Facts

• Total fixed costs incurred: P100,000
• Total variable costs incurred: 50,000
• Total period costs incurred: 70,000
• Total variable period costs incurred: 30,000
• Units produced: 20,000
• Units sold: 12,000
• Unit sales price: P12

Enigma Corporation Calculations

• Cost of Goods Sold is missing information
• If Enigma Corporation had used variable costing in its first year of operations, missing information.
• Based on variable costing, if Enigma Corporation had sold 12,001 units instead of 12,000, its income before income taxes would have been P8.33 higher.

King Corporation Key Facts

• SG&A - P2 per unit
• Production - P4 per unit
• SGA - P14,000
• Total Production - 20,000.

King Corporation Calculations

• If it uses absorption rather than variable costing, the absorption costing income would be P4,800 larger.
• At this level of activity assuming it had an income of P30,000 using variable costing, The sales price per unit equals to P18.80
• it would deduct period costs of undetermined information.
• the company would end the current year with a finished goods inventory of undetermined information.

Self Test Notes

• Variable costing can be used for internal reporting
• The income statement under variable costing does not include overhead volume variance.
• When variable costing is used, the income statement is usually prepared using a contribution margin format
• Adoption of just-in-time (JIT) production system is the most effective at resolving this problem
• variable selling and administrative costs are not product costs
• Fixed factory costs not allocated to units produced are the Unabsorbed fixed overhead costs in an absorption costing system
• inclusion of fixed factory overhead in product costs is the primary difference between variable and absorption costing,
• Absorption costing net income exceeds variable costing net income when units produced are greater than units sold.
• Inventoried fixed costs in the beginning and ending inventories and any deferred over- or underapplied fixed factory overhead computes net earnings
• Change in the quantity of all units in inventory times the relevant fixed costs per unit, is how to calculate the net profit
• absorption costing affects the income under the following methods
• sales exceed production: Variable-costing income will usually exceed absorption costing income
• higher than absorption net income when more units are sold than produced: is the Variable costing net income
• Selling and administrative fixed expenses had decreased, is a true statement.
• cost is incurred is when : fixed manufacturing overhead is recognized as an expense
• P100,00 is the value of ending inventory : Sharapova Corporation

Roy Co.

• P5.10; P3.80 are the unit costs under: absorption and variable costing methods, respectively
• The absorption-costing income exceeded variable-costing income by P8,000: is the difference in reported income
• P 60,000 :Fixed overhead deferred as product cost.
• P52,500 : income, Variable costing