ABSORPTION VERSUS VARIABLE COSTING

When units produced are less than units sold, net income
Product vs. Period Costs under absorption costing will show lower net income than
variable costing because fixed manufacturing overhead
Product costs are costs that are a necessary and integral part cost in beginning inventory is charged to the current year
of producing the finished product. income under absorption costing.
Product costs do not become expenses until the company
sells the finished goods inventory. When units produced and sold are the same, net income
Period costs are costs that are matched with the revenue will be equal under the two costing approaches because
of a specific time period rather than included as part of the there is no increase in ending inventory, and therefore
cost of a salable product. no deferral of fixed overhead costs to future periods
Period costs include selling and administrative expenses through the ending inventory.
and companies deduct them from revenues in the period
in which they are incurred. Decision-Making Concerns

Absorption Costing For external reporting purposes, companies must report

financial information using GAAP, which requires that
Costing method that includes all manufacturing costs absorption costing be used for the costing of inventory.
(direct materials, direct labor and both variable and
fixed manufacturing overhead) in the cost of a unit of Some companies have recognized that net income
product. calculated using GAAP does not highlight differences
between variable and fixed costs and may lead to poor
Treats fixed manufacturing overhead as a product
business decisions. Therefore, some companies use
cost.
variable costing for internal reporting purposes.
Also called Full Costing and Conventional Costing.

Variable Costing Potential Advantages of Variable Costing

Costing method that includes only variable Variable costing has several potential advantages relative
manufacturing costs (direct materials, direct labor, to absorption costing:
and variable manufacturing overhead) in the cost of a
unit of product. Net income computed under variable costing is
Treats fixed manufacturing overhead as a period cost. unaffected by changes in production levels.
Also called Direct Costing.
The use of variable costing is consistent with cost-
Summary of Differences volume-profit analysis and incremental analysis.

Absorption costing Variable costing Net income computed under variable costing is
Cost Seldom segregates Costs are closely tied to changes in sales and provides a more
segregation costs into variable segregated into
and fixed costs. variable and fixed. failure.
Cost of Cost of inventory Cost of inventory
Inventory includes all the includes only the The presentation of fixed and variable cost
manufacturing variable components on the variable costing income
costs; materials, manufacturing statement makes it easier to identify these costs and
labor, variable costs; materials, results.
factory overhead, labor and variable
and fixed factory factory overhead. Reconciliation of Income under Absorption Costing and
overhead. Variable Costing
Treatment of Fixed factory Fixed factory
Fixed factory overhead is treated overhead is Basic Formula:
overhead as product cost. treated as period
cost.
Income Distinguishes Distinguishes
Statement between production between variable Where:
and other costs. and fixed costs. Inventory = Ending Inventory Beginning Inventory
Note: Units Sold
Selling and administrative expenses are period costs
under both absorption and variable costing. Alternative Formula:
Companies use the cost-volume-profit format in
preparing a variable costing income statement. Income, Absorption costing Pxxx
Add: FFOH in beginning inventory xxx
Difference in Net Income Under Absorption and Variable Total Pxxx
Costing: Less: FFOH in ending inventory (xxx)
Income, Variable costing Pxxx
When units produced exceed units sold, net income under
absorption costing will show a higher net income than - - END - -
variable costing since fixed overhead costs are deferred to
a future period as part of the ending inventory cost.
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 ABSORPTION VS. VARIABLE COSTING

THEORY

1. The costing procedure that treats fixed manufacturing costs as period costs is
a. Full costing c. Variable costing
b. Absorption costing d. Conventional costing

2. Another name for variable costing is

a. Full costing c. Job order costing
b. Direct costing d. Fixed costing

3. Under variable costing, which of the following are costs that can be inventoried?
a. Variable selling and administrative expense c. Fixed manufacturing overhead
b. Variable manufacturing overhead d. Fixed selling and administrative expense

4. If a firm uses variable costing, fixed manufacturing overhead will be included

a. Only on the balance sheet c. On both the balance sheet and income statement
b. Only on the income statement d. On neither the balance sheet nor income statement

5. Under variable costing

a. All product costs are variable c. All product costs are fixed
b. All period costs are variable d. Product costs are both fixed and variable

6. A basic tenet of variable costing is that period costs should be currently expensed. What is the rationale behind
this procedure?
a. Period costs are uncontrollable and should not be charged to a specific product
b. Period costs are generally immaterial in amount and the cost of assigning the amounts to specific
products would outweigh the benefits
c. Allocation of period costs is arbitrary at best and could lead to erroneous decision by management
d. Because period costs will occur whether or not production occurs, it is improper to allocate these costs
to production and defer a current cost of doing business

7. In an income statement prepared as an internal report using the variable costing method, fixed manufacturing
overhead would
a. Not be used
b. Be used in the computation of operating income but not in the computation of the contribution margin
c. Be used in the computation of the contribution margin
d. Be treated the same as variable manufacturing overhead

8. The FASB requires which of the following to be used in preparation of external financial statements?
a. Variable costing c. Activity-based costing
b. Standard costing d. Absorption costing

9. Another name for absorption costing is

a. Full or conventional costing c. Job order costing
b. Direct costing d. Fixed costing

10. If a firm uses absorption costing, fixed manufacturing overhead will be included
a. Only on the balance sheet c. On both the balance sheet and income statement
b. Only on the income statement d. On neither the balance sheet nor income statement

11. If a firm produces more units than it sells, absorption costing, relative to variable costing, will result in
a. Higher income and assets c. Lower income but higher assets
b. Higher income but lower assets d. Lower income and assets

12. An ending inventory valuation on an absorption costing balance sheet would

a. Sometimes be less than the ending inventory valuation under variable costing
b. Always be less than the ending inventory valuation under variable costing
c. Always be the same as the ending inventory valuation under variable costing
d. Always be greater than or equal to the ending inventory valuation under variable costing

13. Profit under absorption costing may differ from profit determined under variable costing. How is this difference
calculated?
a. Change in the quantity of all units in inventory times the relevant fixed costs per unit
b. Change in the quantity of all units produced times the relevant fixed costs per unit
c. Change in the quantity of all units in inventory times the relevant variable cost per unit
d. Change in the quantity of all units produced times the relevant variable cost per unit

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 14. What factor, related to manufacturing costs, causes the difference in net earnings computed using absorption
costing and net earnings computed using variable costing?
a. Absorption costing considers all costs in the determination of net earnings, whereas variable costing
considers fixed costs to be period costs
b. Absorption costing allocates fixed overhead costs between cost of goods sold and inventories, and
variable costing considers all fixed costs to be period costs
c. Absorption costing "inventories" all direct costs, but variable costing considers direct costs to be period
costs
d. Absorption costing "inventories" all fixed costs for the period in ending finished goods inventory, but
variable costing expenses all fixed costs

15. The difference between the reported income under absorption and variable costing is attributable to the
difference in the
a. Income statement formats c. Treatment of variable manufacturing overhead
b. Treatment of fixed manufacturing overhead d. Treatment of variable selling, general, and
administrative expenses

16. Absorption costing differs from variable costing in all of the following except
a. Treatment of fixed manufacturing overhead c. Acceptability for external reporting
b. Treatment of variable production costs d. Arrangement of the income statement

17. Under absorption costing, if sales remain constant from period 1 to period 2, the company will report a larger
income in period 2 when
a. Period 2 production exceeds period 1 production
b. Period 1 production exceeds period 2 production
c. Variable production costs are larger in period 2 than period 1
d. Fixed production costs are larger in period 2 than period 1

18. When inventories increase from one period to the next and all other factors remain constant, income under
direct costing:
a. Will be irrelevant for decision making c. Leads to smaller federal income tax payments
b. Will be smaller than under absorption costing d. Will be greater than under absorption costing

TRUE OR FALSE

___ 1. Under variable costing, only variable production costs are treated as product costs.
___ 2. Under variable costing, variable selling and administrative costs are included in product costs.
___ 3. Absorption costing treats all manufacturing costs as product costs.
___ 4. In the preparation of financial statements using variable costing, fixed manufacturing overhead is treated as a
period cost.
___ 5. Absorption costing treats fixed manufacturing overhead as a period cost.
___ 6. When the number of units in work in process and finished goods inventories increase, absorption costing net
operating income will typically be greater than variable costing net operating income.
___ 7. Net operating income computed using absorption costing will always be greater than net operating income
computed using variable costing.
___ 8. When reconciling variable costing and absorption costing net operating income, fixed manufacturing overhead
costs released from inventory under absorption costing should be added to variable costing net operating income
to arrive at the absorption costing net operating income.
___ 9. When production exceeds sales for the period, absorption costing net operating income will exceed variable costing
net operating income.
___ 10. Under variable costing it may be possible to report a profit even if the company sells less than the break-even
volume of sales.

PROBLEMS

1. June Company, which has only one product, has provided the following data concerning its most recent month
of operations:
Selling price ............................................................ P129

Units in beginning inventory .................................. 500

Units produced....................................................... 3,600
Units sold................................................................ 3,800
Units in ending inventory....................................... 300

Variable costs per unit:

Direct materials .................................................. P13
Direct labor......................................................... P59
Variable manufacturing overhead...................... P4
Variable selling and administrative .................... P8

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 Fixed costs:
Fixed manufacturing overhead .......................... P97,200
Fixed selling and administrative ......................... P64,600

The company produces the same number of units every month, although the sales in units vary from month to
month. The company's variable costs per unit and total fixed costs have been constant from month to month.

Question 1: What is the unit product cost for the month under variable costing?
a. P 76 c. P 84
b. P 103 d. P 111

Question 2: What is the unit product cost for the month under absorption costing?
a. P 84 c. P 103
b. P 76 d. P 111

Question 3: What is the net operating income for the month under variable costing?
a. P 3,800 c. P 9,200
b. P 24,400 d. P 8,100

Question 4: What is the net operating income for the month under absorption costing?
a. P 8,100 c. P 3,800
b. P 9,200 d. P 24,400

2. Christopher Corporation produces a single product that sells for P7.00 per unit. Standard capacity is 100,000 units
per year; 100,000 units were produced, and 80,000 units were sold during the year. Manufacturing costs and selling
and administrative expenses are presented below. There were no variances from the standard variable costs. Any
under- or overapplied overhead is written off directly at year-end as an adjustment to cost of goods sold.
Fixed costs Variable costs
Direct material P0 P1.50 per unit produced
Direct labor 0 1.00 per unit produced
Manufacturing overhead P150,000 0.50 per unit produced
Selling & Administration expense 80,000 0.50 per unit sold

The company had no inventory at the beginning of the year.

Question 1: In presenting inventory on the balance sheet at December 31, the unit cost under absorption costing
is
a. P2.50 c. P3.50
b. P3.00 d. P4.50

Question 2: What is the net income under variable costing?

a. P50,000 c. P90,000
b. P80,000 d. P120,000

Question 3: What is the net income under absorption costing?

a. P50,000 c. P90,000
b. P80,000 d. P120,000

3. The following information was extracted from the first-year absorption-based accounting records of Paolo
Corporation
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

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 Question 1: What is Cost of Goods Sold for first year?
a. P80,000 c. P48,000
b. P90,000 d. None of the above

Question 2: If it had used variable costing in its first year of operations, how much income (loss) before income
taxes would it have reported?
a. (P6,000) c. P26,000
b. P54,000 d. P2,000

Question 3: Based on variable costing, if it had sold 12,001 units instead of 12,000, its income before income
taxes would have been
a. P9.50 higher c. P8.50 higher
b. P11.00 higher d. P8.33 higher

4. Johanna Company, which has only one product, has provided the following data concerning its most recent month
of operations:
Selling price ............................................................ P112

Units in beginning inventory .................................. 500

Units produced....................................................... 2,600
Units sold ............................................................... 3,000
Units in ending inventory....................................... 100

Variable costs per unit:

Direct materials .................................................. P13
Direct labor......................................................... P49
Variable manufacturing overhead...................... P6
Variable selling and administrative .................... P10

Fixed costs:
Fixed manufacturing overhead .......................... P80,600
Fixed selling and administrative ......................... P15,000

The company produces the same number of units every month, although the sales in units vary from month to
month. The company's variable costs per unit and total fixed costs have been constant from month to month.

What is the unit product cost for the month under variable costing?
What is the unit product cost for the month under absorption costing?
Compute the net income for the month using the variable costing method.
Compute the net income for the month using the absorption costing method.
Reconcile the variable costing and absorption costing net operating incomes for the month.

This document is strictly private and confidential and should not be shared or distributed to a third party. Any violation gives Pinnacle the right to seek legal recourse.

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