COLLEGE OF BUSINESS AND ACCOUNTANCY

COURSE DESCRIPTION:
 AC9 – Management Science

TOPIC:
 ABSORPTION AND VARIABLE COSTING

MODULE CODE:
 MS 01

LEARNING OUTCOMES:
At the end of this module, the student should be able to:
 Explain the meaning and underlying concept of variable costing.
 Prepare income statements under variable costing and absorption costing.
 Reconcile net income computed under absorption costing and net income computed
under variable costing.
 Know why the managers prefer direct costing to absorption costing.

BIBLICAL VALUES INTEGRATION:

For I know the plans I have for you,” declares the LORD, “plans to prosper you and not
to harm you, plans to give you hope and a future.
-Jeremiah 29:11

INTRODUCTION:
Planning decisions typically analysis of how alternative inventory-costing choices would
affect reported income. Reported income is considered crucial in evaluating performance of
managers.
The inventory costing choices relate to which manufacturing costs are treated as
inventoriable cost. There are three of inventory costing:
1. Absorption costing
2. Variable Costing
3. Throughput costing

BODY:
Absorption costing
- It is a method of product costing in which all manufacturing costs, fixed and variable
are treated as product inventoriable costs.
- Other terms: full, traditional, conventional, and normal costing

Variable costing
- it is a method of inventory costing in which all variable manufacturing costs are
included as inventoriable costs. All fixed manufacturing costs are excluded from
inventoriable costs, fixed manufacturing costs are instead treated as costs of the
period in which it is incurred.
- Other term: direct costing

Product cost versus Period cost

Product Cost versus Period cost
Costs incurred to produce Costs incurred outside of the
Definition
the product production activities
Allocated to: FULLY expensed
Treatment
immediately

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 1.For unsold units – will
form part of Inventory
(Asset)

2. For sold units – will form

part of the Cost of Goods
Sold (Expense)
Diminishes current income
by that portion identified
with the sold units only with Diminishes income for the
the remainder being Effect on the Net Income current period by its full
deferred to the next amount
accounting period as part
ending inventory
Direct materials Administrative Expenses
Direct labor Examples Selling Expenses
Factory overhead

Underlying concept of Variable Costing

Proponents of this product costing method maintain that the fixed part of factory overhead
is more closely related to the capacity to produce that to the production of specific units and
therefore should be charged off as expense in the period incurred.

Furthermore, the use of this system will permit construction of an income statement which
highlights the contribution margin of the product and therefore facilitates managerial
decision-making process.

Arguments against Variable costing

The use of variable costing may understate the assets (inventory) and therefore not accepted
in accounting practice particularly in the external reporting.

Advantages of using Variable Costing

1. It meets the objectives of management control systems by showing separately those
costs that can be traced to and controlled by each strategic business unit (SBU).
2. Variable costing reports are simpler and more understandable.
3. Appraisal of performance of product line or other segments of the business can be
facilitated without the need for arbitrary allocations of fixed cost.
4. Data needed for break-even and cost volume profit analysis are readily available
5. Variable costing reports provide useful information for pricing decisions and other
decision-making problems encountered by management.

Disadvantages of using Variable Costing

1. It may encourage a shortsighted approach to profit planning at the expense of the
long-run situation.
2. It tends to give the impression that variable costs are recovered first, that fixed costs
are recovered later and that finally profits are realized.
3. It is not acceptable for external reporting and tax purposes.

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 Pro-forma Condensed Statement of Profit or Loss – Variable Costing
Variable Costing
Pro-Forma Statement of Profit or Loss

Sales P xx
Less: Variable costs xx
Contribution Margin xx
Less: Fixed costs xx
Net income P xx

Pro-forma Condensed Statement of Profit or Loss – Absorption Costing

Absorption Costing
Pro-Forma Statement of Profit or Loss

Sales P xx
Less: Cost of Goods Sold xx
Gross Profit xx
Less: Administrative and Selling Expenses xx
Net income P xx

Comparison between Variable Costing and Absorption Costing

Variable Costing Absorption Costing
Supporters of VC argue that
Fixed Factory Overhead Supporters of AC believe
costs are incurred whether that all manufacturing costs
or not production occurs. – variable and fixed – are
Rationale necessary for production to
Having no future service take place and hence should
potential, FFOH should be not be ignored in
fully expensed in the same determining product costs.
period incurred.
Costs are segregated into Seldom segregates costs
Cost segregation
variable and fixed. into variable and fixed cost.
Cost of inventory includes
only the variable
manufacturing costs:
direct materials, direct labor
Cost of inventory includes
and variable factory
ALL the manufacturing
overhead
costs: direct materials,
Cost of Inventory
direct labor, variable factory
NOTE: Peso amount of
overhead and fixed factory
inventories under variable
overhead.
costing is always lower than
the peso amount of
inventories under
absorption costing.
Treatment of fixed factory
Treated as period cost Treated as product cost
overhead

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 Acceptable only for internal
reporting purposes for the
management.

It violates the matching

principle.
Acceptability of using the Acceptable for external
method reporting and tax purposes.
Matching principle is an
accounting principle that
calls for the recognition of
expense by matching it with
the related revenue in the
same
Distinguishes between Distinguishes between
Income statement
variable and fixed costs. production and other costs.
Net income between variable costing and absorption
costing may differ because of the amount of FFOH
recognized as expense during a period, caused by the
difference between production and sales.
Net income
In the long run, however, both methods would yield the
same income since sales cannot continuously exceed
production, nor production can continuously sales.

Illustration on the difference of treatment on the Operating expenses incurred.

Absorption Operating expenses Variable Costing

Costing
Direct materials
Direct labor Product Costs
Product cost
Variable manufacturing overhead
Fixed manufacturing overhead
Variable selling and administrative
Period cost Period Costs
expenses
Fixed selling and administrative expenses

Reconciliation of income
1. 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.

2. 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 the fixed overhead expensed
under variable costing. Therefore, absorption costing income is greater than variable
costing income.

The reason is fixed overhead charged against sales being a product cost under the
absorption costing is constant regardless of the level of sales while the…..

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 3. Production is Less than Sales
When production is less than sales, there is a decrease in inventory. Fixed overhead
expensed under absorption costing is greater than the fixed overhead expensed
under variable costing. Therefore, absorption costing income is less than variable
costing income.
Relationship between
Production (P) and Sales Net income
(S)
P=S AC = VC
P>S AC > VC
P<S AC < VC

Variable costing profit follows the trend in sales while absorption costing follows
production. This means that to increase profit in the variable costing system, the trigger
point is sales. An enterprise should keep on generating and creating sales to report profit.
This approach emphasizes the value of customers that is criticized by other strategists as
short-range. Under this costing system, sales would realistically higher than production
thereby creating an almost zero level of inventory. This would make the supply situation
lower than the demand and would further trigger an increase, and continuing increase, in
prices to the disadvantage of the buying public. This does not promote stability of
production. In this costing system the strategic pricing is critically influenced by the seller.

Using the absorption costing system, the trigger point is production. Management would be
encouraged to always make production greater than sales to make profit. This results to a
continuing increase in inventory leading to an oversupply situation and, eventually, industry
slowdown. It emphasizes long-term availability of resources. In this costing system, the
strategic pricing in the market is actively influenced by both the buyer and the seller. The
total maintenance cost changes because of its variable cost components.

Throughput costing
- Also known as super-variable costing
- It is a variation on variable costing in which only the direct materials form part of the
product cost. It classifies ALL the direct labor and manufacturing overhead costs as
fixed period costs.

SUMMARY/CONCLUSION:
Absorption costing is a method of product costing in which all manufacturing costs, fixed and
variable are treated as product inventoriable costs while Variable costing is a method of
inventory costing in which all variable manufacturing costs are included as inventoriable
costs.

REFERENCES:
Cabrera, M. E., Cabrera, G. A., & Cabrera, B. A. Strategic Cost Management (2021 ed.). GIC
Enterprises & Co. Inc.

Roque, R. Management Advisory Services (Latest Edition). Roque Press, Inc.

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