Module 4 Absorption and Variable Costing Notes

MANUEL L.
QUEZON UNIVERSITY
Integrated Review 2
Management Advisory Services
Rogienel L. Reyes, CPA
_____________________________________________________________________________________________
Module 4 – Absorption and Variable Costing R. L. REYES
I. Definition of Terms
 Absorption/Full Costing – Costing that considers fixed manufacturing overhead to be a product cost.
 Variable/Direct Costing – Costing that considers all fixed manufacturing overhead as a period cost rather
than as a product cost.
II. Product costs and Period Costs

Particular Product Costs Period Costs
Elements Manufacturing costs (direct materials, Nonmanufacturing costs (selling and
direct labor and factory overhead administrative expenses)
Relation to inventory Inventoriale costs Non-inventoriable costs
Treatment Capitalized when incurred and expensed Expensed in full when incurred
when product are sold
III. Absorption Costing versus Variable Costing
 Cost classification
Absorption Costing Variable Costing
Direct materials
Direct labor Product costs
Product costs
Variable manufacturing overhead
Fixed manufacturing overhead
Variable selling & administrative expenses Period costs
Period costs
Fixed selling & administrative expenses
 Differences between absorption costing and variable costing

Particular Absorption Costing Variable Costing
Cost segregation According to function (manufacturing, According to behavior (fixed and
selling and administrative costs) variable costs)
Cost of inventory Includes both variable and fixed Includes only variable manufacturing
manufacturing costs. costs.
Fixed factory overhead Product cost Period cost
Income statement Gross margin format Contribution margin format
Compliance with GAAP Complies with IFRS/GAAP Need not comply with IFRS/GAAP
Reporting External report Internal report
Profit variation Profit varies with production Profit varies with sales
Use Financial reporting Management accounting
 Profit under absorption costing and variable costing

Production & Sales Effect on Inventory Income Difference
Production = Sales No change in inventory level Absorption = Variable
Production > Sales Inventory level increases Absorption > Variable
Production < Sales Inventory level decreases Absorption < Variable
 Income statement format

Absorption Costing Variable Costing
Sales P xx Sales P xx
Less: Cost of goods sold xx Less: Variable costs xx
Gross margin xx Contribution margin xx
Less: Selling & administrative expenses xx Less: Fixed costs xx
Profit P xx Profit P xx
 Reconciliation of income difference

MAS Notes – Module 4 Page 1 of 3
CASE 1: Fixed cost per unit is constant for prior and current period. No beginning inventory or production in
previous year equals production in current year
Difference in income = Fixed overhead cost per unit × Change in inventory level
CASE 2: Fixed cost per unit not constant for prior and current period. With beginning inventory and
production in previous year is different from production in current year.
Difference in income = Fixed overhead cost in ending inventory – Fixed overhead cost in beginning
inventory
Production > Sales Production < Sales
Absorption costing income P xx Absorption costing income P xx
Less: Income difference xx Add: Income difference xx
Variable costing income P xx Variable costing income P xx
Variable costing income P xx Variable costing income P xx
Add: Income difference xx Less: Income difference xx
Absorption costing income P xx Absorption costing income P xx
 Illustration of income measurement under absorption and variable costing

Hardy Corporation uses the FIFO method to track inventory. The records for Hardy include the following
information. For simplicity, assume that the amounts given are both the budgeted amounts and the actual
amounts and thus, there were no variances.
Inventory Year 1 Year 2
Beginning balance, in units -0- 4,000
Production 12,000 12,000
Units sold (8,000) (14,000)
Ending balance, in units 4,000 2,000
Other information
Sales P16,800 P29,400
Variable manufacturing costs 10,800 10,800
Fixed manufacturing costs 6,000 6,000
Variable selling and administrative costs 2,400 4,200
Fixed selling and administrative costs 3,500 3,500
Required: (1) Which method would profit be higher in Year 1? Absorption costing
(2) Which method would profit be higher in Year 2? Variable costing
(3) How much is the difference in income for Year 1? P2,000
(4) How much is the difference in income for Year 2? P1,000
(5) Prepare the income statements for Year 1 and Year 2 using both approaches.
(6) Prepare reconciliation of income of absorption costing and variable costing.
Hardy Corporation
Income Statement
For the Years Ended Year 1 and Year 2
Year 1 Year 2
Absorption Sales 16,800 29,400
Costing Less: Cost of goods sold __________11,200 __________19,600
Gross margin 5,600 9,800
Less: Selling & administrative expenses ___________5,900 ___________7,700
Profit ___________(300) ___________2,100
Variable Sales 16,800 29,400

Costing Less: Variable costs ___________9,600 __________16,800
Contribution margin 7,200 12,600
Less: Fixed costs __________9,500 ___________9,500
Profit _________(2,300) ___________3,100
MAS Notes –Module 4 Page 2 of 3

 Reconciliation of absorption costing income and variable costing income
Softy Company uses FIFO method to account its inventory movement. Production data showed the following
for Year 1 and Year 2 of operation:
Year 1 Year 2
Inventory level (units) 10,000 5,000
Units produced 250,000 200,000
Units sold 240,000 205,000
Variable factory overhead P1,250,000 P1,000,000
Fixed factory overhead P1,000,000 P1,000,000
Income difference 40,000? 15,000?
Required: (1) If the company earned P20,000 profit in Year 1 using absorption costing, how much is its
profit/loss under variable costing? (P20,000) loss
(2) If the company earned P20,000 profit in Year 1 using variable costing, how much is its
profit/loss under absorption costing? P60,000 profit
(3) If the company suffered P10,000 loss in Year 2 using absorption costing, how much is its
profit/loss under variable costing? P5,000 profit
(2) If the company suffered P10,000 loss in Year 1 using variable costing, how much is its profit/loss
under absorption costing? (P25,000) loss
 Activity level approaches used in computation of overhead rates
 Throughput costing
Throughput costing is an inventory costing method that places only variable direct material in inventoriable cost.
All other costs are treated as costs of the period. The objective of theory of constraints is to increase throughput
contribution while decreasing investment and operating costs. Throughput contribution is revenues minus the
direct materials cost of goods sold.
MAS Notes –Module 4 Page 3 of 3

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MANUEL L.

II. Product costs and Period Costs

III. Absorption Costing versus Variable Costing

 Differences between absorption costing and variable costing

 Profit under absorption costing and variable costing

 Income statement format

 Reconciliation of income difference

 Illustration of income measurement under absorption and variable costing

Variable Sales 16,800 29,400

MAS Notes –Module 4 Page 2 of 3

 Activity level approaches used in computation of overhead rates

MAS Notes –Module 4 Page 3 of 3

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