Week 3 Absorption Variable

Absorption
and
Variable Costing
Week 3
6/24/2020 Hermie T. Bola

Absorption Vs. Variable Costing
Absorption or Full Costing Variable or Direct Costing
• Product costs • Product costs
– Direct material – Direct material
– Direct labor – Direct labor
– Variable mfg. overhead – Variable mfg. overhead
– Fixed mfg. overhead
• Period costs • Period Costs
– Selling – Fixed mfg. overhead
– General – Selling
– Administrative – General
6/24/2020 Hermie T. Bola – Administrative
Differences
Absorption costing Variable costing
• Fixed manufacturing overhead
• Fixed manufacturing overhead is is a period cost
a product cost • Variable operating expenses are
subtracted from product
contribution margin to equal
contribution margin

Income Statement
Absorption Costing
Product Costs
Direct Material
Sales Direct Labor
Less: Cost of Goods Sold Fixed and Variable
Mfg. Overhead
Gross Profit
Less: Operating Expenses
Net Income Period Costs
Selling, General,
Administrative
Variable Costing or Contribution Margin
Income Statement
Direct Material
Sales Direct Labor
Less: Variable Cost of Goods Sold Variable Mfg. Overhead
Product Contribution Margin
Variable Selling and
Less: Variable Operating Expenses General Administrative
Contribution Margin
Less: Fixed Mfg. Overhead
Fixed Mfg. Overhead
Less: Fixed Operating Expenses
Net Income Fixed Selling and
General Administrative
Difference in Income
Absorption Vs. Variable
• No change in inventory level

Absorption Income = Variable Income
• Increase in inventory level

Absorption Income > Variable Income
• Decrease in inventory level

Absorption Income < Variable Income
Problem:
AMCAR Corporation produces a single product. The following is a cost structure
applied to its first year of operations.
Sales price P15 per unit
Variable costs:
SG&A P2 per unit
Production P4 per unit
Fixed costs (total cost incurred for the year):
SG&A P14,000
Production P20,000
During the first year, AMCAR Corporation manufactured 5,000 units and sold 3,800.
There was no beginning or ending work-in-process inventory.
a. How much income before income taxes would be reported if AMCAR uses absorption costing?
b. How much income before income taxes would be reported if variable costing was used?
c. Show why the two costing methods give different income amounts.
A. Income under absorption costing is:
Sales (P15x3,800) P57,000

COGS (3,800x (P4 + P20,000/5,000) 30,400
Gross Margin P26,600
Operating Expenses
Variable Selling Expense( P2x 3,800) P 7,600
Fixed Selling Expense 14,000 (21,600)
Absorption income before income taxes P 5,000
B. Income under variable costing:

Contribution Margin per Unit (SP - VProd.Cost – VSGA) = P15 - P4 - P2 = P9
´ Vol. sold 3,800
Contribution Margin P34,200
Less: FC - Production (20,000)
SG&A (14,000)
Variable costing income before income taxes P 200
C. Reason for difference in income:
Fixed costs expensed under absorp. costing
COGS 3,800 ´ P20,000/5,000 units P15,200
Fixed SG&A 14,000
Total P29,200
Fixed costs expensed under variable costing
Fixed SG&A P14,000
Fixed Production 20,000
Total FC P34,000
Difference in FC expensed under two methods P 4,800
Estimating Cost Behavior
Fixed Cost Behavior Variable Cost Behavior
P P
Activity Activity
Unit Cost Varies with Volume Unit Cost Rate is Constant

Mixed Cost
Total Costs
P Cost contains both
Variable Costs a variable and

fixed
component
Fixed amount
Number of Units Produced
Mixed Cost contains both a variable and fixed component.

Total Costs = Fixed Amount + (Variable Cost Per Unit x Number of Units)
6/24/2020 Total Costs = Fixed Costs + Variable Costs
Hermie T. Bola
Account Analysis
Engineering Approach
Interviews
The (High-Low) Two-Point Method
Scatter-Diagram Method
Regression

High-Low (Two-Point) Method
The high-low (two-point) method is a widely used, method of

estimating the components of a mixed cost.
• Actual cost observations

• Considers only two data points
• highest and lowest levels of activity
• Disregard outliers when analyzing mixed cos
Approach: This method uses two past levels of activity and the amounts
of the cost incurred at those levels; more specifically, the highest and
lowest levels of activity.
Separating Mixed Costs
Formula for a straight line

y = a + bX
y = total cost
a = fixed portion of total cost
b = variable cost
X = activity base to which y is related
Month Utility Costs Units Produced
January P 5,000 400
February 6,000 800
March 9,000 1,200
April 10,000 1,600
May 15,000 2,000
Variable cost change in cost

component
of mixed cost change in activity

High! Y = a + b (X)
Variable Cost = (P 15,000 – P 5,000) / (2,000 – 400)

= P 10,000 /1,600
= P 6.25 per unit
Fixed Costs = P 15,000 – (P6.25 x 2,000)

= P 2,500
The cost formula using the high-low method is:
P 15,000 = P 2,500 + P 6.25 (2,000)

Low! Y = a + b (X)
Variable Cost = (P 15,000 – P 5,000) / (2,000 – 400)

= P 10,000 /1,600
= P 6.25 per unit
Fixed Costs = P 5,000 – (P6.25 x 400)

= P 2,500
The cost formula using the high-low method is:
P 5,000 = P 2,500 + P 6.25 ( 400 )

Regression Method
Regression analysis (or just regression) is a

more sophisticated method for estimating the
fixed and variable components of a mixed cost.
Regression uses cost and volume data from prior periods

to yield an equation of the form y = a + bx.
The appendix covers regression in more detail.

Scatter-Diagram Method
The scatter-diagram (or graphical) method requires

cost and volume data from prior periods, and drives
an equation (cost prediction formula) based on those
data.
Weakness: The placement and slope of the line

are matters of judgment; the manager “eyeballs” the
data and fits the line visually.

Scatter-Diagram Method
Utility Cost
P16,000
x
12,000
x
x
8,000 Analyst can fit line
based on experience
x
4,000 x
0
400 800 1,200 1,600 2,000
6/24/2020 Hermie
Units T. Bola
Produced
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Absorption

6/24/2020 Hermie T. Bola

6/24/2020 Hermie T. Bola

• No change in inventory level

• Increase in inventory level

• Decrease in inventory level

Sales (P15x3,800) P57,000

B. Income under variable costing:

Fixed Cost Behavior Variable Cost Behavior

Unit Cost Varies with Volume Unit Cost Rate is Constant

6/24/2020 Hermie T. Bola

Variable Costs a variable and

Number of Units Produced

Mixed Cost contains both a variable and fixed component.

6/24/2020 Hermie T. Bola

The high-low (two-point) method is a widely used, method of

• Actual cost observations

Formula for a straight line

Variable cost change in cost

6/24/2020 Hermie T. Bola

Variable Cost = (P 15,000 – P 5,000) / (2,000 – 400)

Fixed Costs = P 15,000 – (P6.25 x 2,000)

The cost formula using the high-low method is:

P 15,000 = P 2,500 + P 6.25 (2,000)

Variable Cost = (P 15,000 – P 5,000) / (2,000 – 400)

Fixed Costs = P 5,000 – (P6.25 x 400)

The cost formula using the high-low method is:

P 5,000 = P 2,500 + P 6.25 ( 400 )

Regression analysis (or just regression) is a

Regression uses cost and volume data from prior periods

6/24/2020 Hermie T. Bola

The scatter-diagram (or graphical) method requires

Weakness: The placement and slope of the line

6/24/2020 Hermie T. Bola

6/24/2020 Hermie T. Bola

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