MANAGEMENT ADVISORY SERVICES
PRODUCT COSTING
ABSORPTION COSTING (also called full costing, conventional costing)
– costing method that includes all manufacturing costs (direct materials, direct labor, and both
variable and fixed manufacturing overhead) in the cost of a unit of product. It treats fixed
manufacturing overhead as a product cost.
VARIABLE COSTING (also called direct costing)
– costing method that includes only variable manufacturing costs (direct materials, direct
labor, and variable manufacturing overhead) in the cost of a unit of product. It treats fixed
manufacturing overhead as a period cost.
DISTINCTIONS BETWEEN PERIOD COSTS AND PRODUCT COSTS:
PERIOD COST PRODUCT COST
1. Refers to an item charged against 1. Refers to an item included in product
current revenue on the basis of time costing which is apportioned between
period regardless of the difference the sold and unsold units.
between production and sales volume.
2. Does not form part of the cost of 2. The portion of the cost, which has been
inventory. allocated to the unsold units, becomes
part of the inventory.
3. Diminishes current income by that
3. Diminishes income for the current period portion thereof identified with the sold
by its full amount. units only with the remainder being
deferred to the next accounting period
as part of the cost
of ending inventory.
PRINCIPAL DIFFERENCES BETWEEN VARIABLE AND CONVENTIONAL ABSORPTION
COSTING:
ABSORPTION COSTING VARIABLE COSTING
Seldom segregates costs into Costs are segregated into variable
1. Cost segregation
variable and fixed costs and fixed
Cost of inventory includes all the Cost of inventory includes only
manufacturing costs: materials, the variable manufacturing costs:
2. Cost of Inventory
labor, variable factory overhead, materials, labor, and variable
and fixed factory overhead factory overhead
3. Treatment of
Fixed factory overhead is treated Fixed factory overhead is treated
fixed factory
as product cost. as period cost.
overhead
Distinguishes between variable
Distinguishes between production
4. Income and fixed costs.
and other costs.
statement
Net income between the two methods may differ from each other
because of the difference in the amount of fixed overhead costs
recognized as expense during an accounting period. This is due to
5. Net income variations between sales and production. In the long run, however,
both methods give substantially the same results since sales cannot
continuously exceed production, nor production can continually exceed
sales.
DIFFERENCE IN NET INCOME UNDER ABSORPTION AND VARIABLE COSTING:
Variable and absorption costing methods of accounting for fixed manufacturing overhead result
in different levels of net income in most cases. The differences are timing differences, i.e.,
when to recognize the fixed manufacturing overhead as an expense. In variable costing, it is
expensed during the period when the fixed overhead is incurred, while in absorption costing, it
is expensed in the period when the units to which such fixed overhead has been related are
sold.
Production Equals Sales:
When production is equal to sales, there is no change in inventory. Fixed overhead expensed
under absorption costing equals fixed overhead expensed under variable costing. Therefore,
absorption costing income equals variable costing income.
Production is Greater Than Sales
When production is greater than sales, there is an increase in inventory. Fixed overhead
expensed under absorption costing is less than fixed overhead expensed under variable costing.
Therefore, absorption income is greater than variable costing.
Production is Less Than Sales
When production is less than sales, there is decrease in inventory. Fixed overhead expensed
under absorption is greater than fixed overhead expensed under variable costing. Therefore,
absorption income is less than variable costing income.
ARGUMENTS FOR THE USE OF VARIABLE COSTING
1. Variable costing reports are simpler and more understandable.
2. Data needed for break-even and cost-volume-profit analyses are readily available.
3. The problems involved in allocating fixed costs are eliminated.
4. Variable costing is more compatible with the standard cost accounting system.
5. Variable costing reports provide useful information for pricing decisions and other
decision- making problems encountered by management.
ARGUMENTS AGAINST VARIABLE COSTING
1. Segregation of costs into fixed and variable might be difficult, particularly in the case of
mixed costs.
2. The matching principle is violated by using variable costing which excludes fixed overhead
from product costs and charges the same to period costs regardless of production and sales.
3. 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 fixed overhead
in the computation of product cost.
THROUGHPUT COSTING (or SUPERVARIABLE COSTING)
An extreme form of variable costing in which only direct material costs are included as
inventoriable costs. All other costs are costs of the period in which they are incurred.
Throughput margin = Revenue – Direct material cost of the goods sold
