Variable costing

Absorption costing: Absorption costing treats all manufacturing cost as product cost
regardless of whether they are variable or fixed. Under absorption costing, we add:
1) Direct materials
2) Direct labor
3) Both variable and fixed MOH
It is also called full cost method
Variable costing: Under variable costing, only those costs that vary with output are
treated as product cost. This would usually include direct materials, direct labor, and the
variable portion of MOH. Fixed MOH is not treated as a product cost under this method.
It is regarded as period cost. It is sometimes called direct costing or marginal costing.
Selling and administrative expenses: Selling and administrative expenses are never
treated as product cost, regardless of the costing method.
Reconciliation of variable costing with absorption costing income: Under absorption,
costing some fixed MOH is capitalized in inventories (i.e. product cost) rather than
currently expensed on the income statement.
For example- In February 2 aircraft were produced and each carried with it $35000
(700002) in FMOH. If we sell only one aircraft then this $35000 is going to be shown as
part of cost-of-goods sold but $ 35000 would have been in the balance sheet as part of
finished goods inventory.
In contrast, under variable costing all of the $70000 FMOH appeared on the income
statement as a period expense.

In general, when the units produced exceed unit sales and hence inventories increase.
Net operating income is higher under absorption costing than under variable costing.
Because some of the FMOH is deferred.
In contrast, when the unit sales exceed unit produced and hence inventories decrease
unit operating unit operating income lower under absorption costing than under
variable costing.

When, unit produced = unit sold; No change in inventories.

Advantages of Variable costing:
1) CVP analysis.
2) Profit for a period is not affected by changes in inventory.

3) Unit product costs are variable. But it is a combination of both fixed and variable
cost.
Lean production:
Goods are produced to customers orders and the goal is to ultimate FG inventories.
Activity based costing
Activity costing is costing method

That is designed to provide managers with cost information for strategic and other
decision that potentially affect capacity and therefore "fixed" as well as "variable
cost".
It is a supplement to the usual costing system.
It is designed to be use for internal decision-making.

Non-manufacturing cost and activity based costing:

In traditional costing only manufacturing cost are assigned to products. Selling &
Administrative expenses are treated as period expenses. But many of these
nonmanufacturing costs are also part of the costs of producing, selling, distributing and
servicing product. E.g. Commission paid, shipping, repair, warranty etc
In activity based costing, products assigned all of overhead cost- nonmanufacturing as
well as manufacturing that we can trace to the product.
Manufacturing cost and activity based costing:
In traditional costing all manufacturing costs are assigned to the products- even
manufacturing costs that are not caused by the product.
Activity costing does not assign two types of MOH to products1) Organization sustaining factory security guards salary, plant controllers salary
and the cost of supplies used by the plant manager's secretary.
2) Cost of idle capacity.
Activity: In activity based costing, an activity is any event that causes the consumption
of overhead resources.
Activity cost pool: An activity cost pool is a bucket in which costs are accumulated that
relate to a single activity measure in the ABC system.

An activity measure in an allocation base in an activity based costing system. Cost

driver is also used refer to an activity measure because the activity measure should drive
the cost being allocated.
Two common activity measures are:
1. Transaction drivers Simple counts of the number of times an activity occurs.
2. Duration drivers Amount of time required to perform an activity.
Activity based costing defines five levels of activity
1.
2.
3.
4.
5.

Unit
Batch
Product
Customer
Organization sustaining activities

Unit: Is performed each time a unit is produced. The cost of unit level activities
should be proportional to the number of units produced. E.g. providing power.

Batch level activities are performed each time a batch is handled or processed.
Regardless of how many units in the batch. E.g. placing purchase order, selling up
equipment, arranging for shipment to customers.
Cost of the batch level depends on the number of batches processed rather than
number of units produced.

Product level activities: Relate to specific product regardless of how many

batches are run or how many units are produced.
a. Designing a product
b. Advertising a product
c. Maintaining product manager and staff

Customer level activities: Relate to specific customers. E.g. Sales calls, catalog
mailing, general technical support.

Organization sustaining activities: Heating factory, providing computer

network, arranging for loan, preparing annual report.

Steps to follow in ABC system

a. Defining activity, activity cost pool and activity measure
b. Assign overhead cost to activity cost pool
c. Calculate activity ratio
d. Assign overhead cost to cost object
e. Prepare management report