ABSORPTION AND VARIABLE COSTING

ABSORPTION COSTING
A costing method that includes all manufacturing costs - direct materials, direct labor, variable and
fixed manufacturing overhead – in the cost of a unit of product. It treats fixed manufacturing overhead
(Fixed FOH) as a product cost. It is also known as full costing.

VARIABLE COSTING
A costing method that includes only variable manufacturing costs – direct materials, direct labor and
variable manufacturing overhead – in the cost of unit s product. It treats Fixed FOH as a period cost.
It is also known as direct costing.

PRODUCT COST PERIOD COST

An inventoriable cost that is subject to allocation A cost that is charged as expense against
between sold and unsold units. Current income is income, regardless of the sales performance. No
reduced only by the amount allocated to the sold allocation is necessary so current income is
units. reduced by the full amount.

Point of difference ABSORPTION VARIABLE

Inventories – Product cost. It is expensed in the Period costs. It is expensed when
treatment of FIXED period when the units to which such FIXED FOH is incurred.
FOH FIXED FOH relates are sold.
Rationale Advocates of this costing method Advocates of this costing method
believe that all manufacturing costs – argue that fixed manufacturing costs
variable and fixed – are essential to are incurred in order to have the
the production process and should capacity to produce output in a given
not be ignored when determining period. Thus, FIXED FOH having no
product costs. future service potential should be
charged against the period and not
included in the product cost.
Is this acceptable to Yes No
financial reporting
and tax purposes?
Income statement It distinguishes between production It distinguishes between variable and
and other costs. Appropriate fixed costs. All variable costs are first
production costs are first deducted deducted from revenue to arrive at the
from sales to arrive at gross profit, contribution margin, and the fixed
and then other costs are deducted to costs are deducted to obtain income.
obtain income.
Cost segregation Segregates cost according to Segregates costs according to
function. behavior.
● Manufacturing
● Selling ↑ Production ↓ Production
● Administrative VC in total ↑ ↓
VC per unit CONSTANT CONSTANT
FC in total CONSTANT CONSTANT
FC per unit ↓ ↑
 Mixed Cost ↑ ↓
in total
Mixed Cost ↓ ↑
per unit

Production = Sales, Income, Absorption = Income, Variable

no change in
inventory
Production > Sales Income, Absorption > Income, Variable
Production < Sales Income, Absorption < Income, Variable

POINT OF RECONCILIATION:
Income, Absorption Costing Pxxx
Fixed FOH in beginning inventory xxx
Total xxx
Fixed FOH in ending inventory (xxx)
Income, Variable Costing P xxx

Variable costing Absorption costing Throughput costing Super absorption

(Super variable costing
costing)
Operating costs:
Direct materials PRODUCT COST PRODUCT COST PRODUCT COST PRODUCT COST
Direct labor PRODUCT COST PRODUCT COST PERIOD COST PRODUCT COST
Factory overhead:
● Variable PRODUCT COST PRODUCT COST PERIOD COST PRODUCT COST
● Fixed PERIOD COST PRODUCT COST PERIOD COST PRODUCT COST
Selling and admin.
● Variable PERIOD COST PERIOD COST PERIOD COST PRODUCT COST
● Fixed PERIOD COST PERIOD COST PERIOD COST PRODUCT COST
(Provided it is value
adding)
Use in decision making Profitability analysis External reporting Theory of constraints Life cycle costing
Income statement
presentation: Sales X Sales X Sales X
VC: Manufacturing: COGS:
Man. (X) Variable (X) Direct mats (X)
Non-man (X) Fixed (X) Throughput
CM X Gross profit X CM X
FC: Non-man: Period costs:
Man. (X) Variable (X) Direct labor (X)
Non-man (X) Fixed (X) Variable FOH (X)
Net income X Net income X Fixed FOH (X)
Variable S&A (X)
Fixed S&A (X)
Net income X

If there is budgeted capacity or denominator level given in the problem, consider the following:
1. Compute for the fixed manufacturing costs to be expensed (Excluding adjustments for
variances):

Fixed manufacturing costs XX

÷ Budgeted capacity or denominator level XX
 Fixed manufacturing cost per unit X
X unit sold XX
Fixed manufacturing cost - EXPENSE XX

2. Compute for the fixed manufacturing costs to be included as part of ending inventory:

Production XX
Sold (XX)
Increase/(Decrease) in inventory XX/(XX)
X Fixed manufacturing cost per unit X
Fixed manufacturing cost – ENDING INVENTORY (ACNI > VCNI) XX
Fixed manufacturing cost – ENDING INVENTORY (ACNI < VCNI) (XX)

3. Compute the production volume variance:

Budgeted capacity or denominator level XX

Production (XX)
Unfavorable/(Favorable) XX/(XX)
X Fixed manufacturing cost per unit X
Production volume variance XX

Problem 1
ABS Company operated at a normal capacity of P 1,000 units in the year 2021. The company sold
80% of these units at a price of P 12 per unit.

Manufacturing: Unit cost

Materials P 1,500 1.5
Labor 1,000 1
Variable Factory Overhead 500 0.5
Fixed Factory Overhead 2,000 2
Selling and Administrative:
Variable 1,500
Fixed 800

1. Inventory cost per unit under absorption and variable costing

Solution:
AC VC
Direct materials 1.5 1.5
Direct labor 1 1
Variable manufacturing overhead 0.5 0.5
Fixed manufacturing overhead 2
Inventoriable cost per unit 5 3

2. Cost of ending inventory under absorption and variable costing

Solution:

ABSORPTION COSTING VARIABLE COSTING

 Production 1,000 Production 1,000
Sold (800) Sold (800)
Increase/(Decrease) in inventory 200 Increase/(Decrease) in inventory 200
Inventoriable cost per unit P5 Inventoriable cost per unit P3
Ending inventory P1,000 Ending inventory P600

Ending inventory – AC 1,000

Ending inventory – VC (600)
Change in the net income (ACNI > VCNI) P400

OR

Production 1,000
Sold (800)
Increase/(Decrease) in inventory 200
X Fixed manufacturing cost per unit P2
Change in the net income P400

ABSORPTION COSTING VARIABLE COSTING

Sales (800 x P12) 9,600 Sales (800 x P12) 9,600

Manufacturing: Variable costs:
Variable (800 x P3) (2,400) Manufacturing cost (800 x P3) (2,400)
Fixed (800 x P2) (1,600) Non-manufacturing cost (1,500)
Contribution margin 5,700
Fixed Costs:
Manufacturing cost (1,000 x P2) (2,000)
Gross profit 5,600 Non-manufacturing cost (800)
Non-manufacturing costs: Net income 2,900
Variable (1,500)
Fixed (800)
Net income 3,300

Net income – AC 3,300

Net income – VC (2,900)
Change in the net income (ACNI > VCNI) P400

Problem 2
CBN Company makes state-of-the-art pillows. Each pillow sells for P 2,000 each. Data for 2021’s
operations are as follows:

Units:
Beginning Inventory 5
Production 80
Ending Inventory 15
Variable Costs:
Direct Materials P 24,000
Direct Labor 16,000
 Factory Overhead 8,000
Selling and administrative 4,000
Fixed Costs:
Factory Overhead P 20,000
Selling and administrative 2,000

Required:
1. Prepare income statements for both costing methods

Solution:

ABSORPTION COSTING VARIABLE COSTING

Sales (70 x P2,000) 140,000 Sales (70 x P2,000) 140,000

Manufacturing: Variable costs:
Variable (70 x P600) (42,000) Manufacturing cost (70 x P600) (42,000)
Fixed (70 x P250) (17,500) Non-manufacturing cost (4,000)
Contribution margin 94,000
Fixed Costs:
Gross profit 80,500 Manufacturing cost (80 x P250) (20,000)
Non-manufacturing costs: Non-manufacturing cost (2,000)
Variable (4,000) Net income 72,000
Fixed (2,000)
Net income 74,500

Problem 3
The following information is taken from the books of GMA Company, which uses FIFO for inventory
cost flow:

Inventory (in units) 2020 2021

Beginning inventory -none- ???
Production 10,000 units 9,000 units
Ending inventory 3,500 units 1,000 units
=6,500 =3,500
Sales (P2/unit) ??? ???
Variable manufacturing costs (P0.75/unit) P7,500 P6,750
Fixed manufacturing costs 5,000 5,400
Selling and administrative costs (50% variable) 4,500 7,500

Required:
1. Determine 2020 profit under the two costing methods
2. Reconcile the two income figures in No.1
3. Determine 2021 profit under the two costing methods
4. Reconcile the two income figures in No.3

Solution:

ABSORPTION COSTING 2020 VARIABLE COSTING 2020

 Sales (6,500 x P2) 13,000 Sales (6,500 x P2) 13,000
Manufacturing: Variable costs:
Variable (6,500 x P0.75) (4,875) Manufacturing cost (6,500 x P0.75) (4,875)
Fixed (6,500 x P0.50) (3,250) Non-manufacturing cost (2,250)
Contribution margin 5,875
Fixed Costs:
Gross profit 4,875 Manufacturing cost (10,000 x P0.50) (5,000)
Non-manufacturing costs: Non-manufacturing cost (2,250)
Variable (2,250) Net loss (1,375)
Fixed (2,250)
Net income 375

Net income – AC 375

Net loss – VC 1,375
Change in the net income (ACNI > VCNI) [375 – (1,375)] P1,750

ABSORPTION COSTING VARIABLE COSTING

Production 10,000 Production 10,000

Sold (6,500) Sold (6,500)
Increase/(Decrease) in inventory 3,500 Increase/(Decrease) in inventory 3,500
Inventoriable cost per unit P1.25 Inventoriable cost per unit P0.75
Ending inventory P4,375 Ending inventory P2,625

Ending inventory – AC 4,375

Ending inventory – VC (2,625)
Change in the net income (ACNI > VCNI) P1,750

OR

Production 10,000
Sold (6,500)
Increase/(Decrease) in inventory 3,500
X Fixed manufacturing cost per unit P0.50
Change in the net income P1,750

ABSORPTION COSTING 2021 VARIABLE COSTING 2021

Sales (11,500 x P2) 23,000 Sales (11,500 x P2) 23,000

Manufacturing: Variable costs:
Variable (11,500 x P0.75) (8,625) Manufacturing cost (11,500 x P0.75) (8,625)
Fixed: Non-manufacturing cost (3,750)
12/31/20 3,500 P0.50 (1,750) Contribution margin 10,625
1/1/21 8,000 0.60 (4,800) Fixed Costs:
Sold 11,500 Manufacturing cost (5,400)
Non-manufacturing cost (3,750)
 Gross profit 7,875 Net income 1,475
Non-manufacturing costs:
Variable (3,750)
Fixed (3,750)
Net income 325

Ending inventory – AC (1,000 x P0.6) 600

Ending inventory – VC (3,500 x P0.5) (1,750)
Change in the net income (ACNI > VCNI) P(1,150)

OR

Production (9,000 X P0.6) 5,400

Sold :
12/31/20 3,500 P0.5 (1,750)
1/1/21 8,000 0.6 (4,800)
Sold 11,500

Change in the net income (ACNI > VCNI) P(1,150)

PROBLEM 4
The following information was provided to you by Halili Co.
Budgeted capacity 150,000
Actual production 120,000
Sales in units 100,000
Beginning inventory -
Fixed manufacturing overhead P150,000
Variable manufacturing costs P6/unit
Selling price per unit P10/unit
Fixed selling and administrative expense P30,000
Variable selling and administrative expense P0.50

The company applies fixed overhead based on budgeted capacity.

1. Compute the finished goods inventory under absorption costing (assume the variance is
insignificant)
2. Compute the finished goods inventory under absorption costing (assume the variance is
significant)
3. Compute the finished goods inventory under variable costing
4. Compute the operating income under absorption costing
5. Compute the operating income under variable costing

Solution:
ABSORPTION COSTING ABSORPTION COSTING VARIABLE COSTING
(Insignificant variance) (Significant variance)
 VMC P6 VMC P6 VMC P6
Applied Fixed OH: Actual Fixed OH: Applied Fixed OH: -
(P150,000/150,000) 1 (P150,000/120,000) 1.25 Inventoriable cost
Inventoriable cost Inventoriable cost per unit P6
per unit P7 per unit P7.25 Ending inventory
Ending inventory Ending inventory (BI + P – S) 20,000
(BI + P – S) 20,000 (BI + P – S) 20,000 FG inventory P120,000
FG inventory P140,000 FG inventory P145,000

ABSORPTION COSTING ABSORPTION COSTING VARIABLE COSTING

(Insignificant variance) (Significant variance)

Sales (100,000 X P10) 1,000,000 Sales (100,000 X P10) 1,000,000 Sales (100,000 X P10) 1,000,000
Manufacturing: Manufacturing: VC:
Variable (100,000 X Variable (100,000 X Man. (100,000 X P6) (600,000)
P6) (600,000) P6) (600,000) Non-man (100,000 X
Fixed (100,000 X P1) (100,000) Fixed (100,000 X P1) (100,000) P0.50) (50,000)
Underapplied OH Underapplied OH CM 350,000
(120,000 X *P0.25) **(30,000) (100,000 X P0.25) (25,000) FC:
Gross profit 270,000 Gross profit 275,000 Man. (150,000)
Non-man (30,000)
Non-man: Non-man:
Net income 170,000
Variable (100,000 X Variable (100,000 X
P0.50) (50,000) P0.50) (50,000)
Fixed (30,000) Fixed (30,000)
Net income 190,000 Net income 195,000

Actual overhead per unit (P150,000/120,000) P1.25

Applied overhead per unit (P150,000/150,000) (1)
Underapplied overhead per unit P0.25

Budgeted capacity 150,000

Actual production (120,000)
Balance 30,000
Applied overhead per unit (P150,000/150,000) P1
Production volume variance - underapplied P30,000

Alternative solution for absorption costing:

Sales (100,000 X P10) 1,000,000
Manufacturing:
Variable (100,000 X P6) (600,000)
Fixed [100,000 X (P150,000/120,000)] (125,000)
Gross profit 275,000
Non-man:
Variable (100,000 X P0.50) (50,000)
Fixed (30,000)
Net income – with significant variance 195,000
Underapplied:
Production 120,000
Sales (100,000)
Increase in inventory 20,000
Underapplied overhead per unit P0.25 (5,000)

Net income – insignificant variance 190,000