Absorption costing which is also called as full costing, treats the costs of all

manufacturing components (direct material, direct labor, variable overhead, and fixed overhead)
as inventoriable, or product, costs in accordance with GAAP. Under absorption costing, costs
incurred in the nonmanufacturing areas of the organization are considered period costs and are
expensed in a manner that properly matches them with revenues. In addition, absorption costing
presents expenses on an income statement according to their functional classifications. A
functional classification is a group of costs that were all incurred for the same principal purpose.
Functional classifications generally include cost of goods sold, selling expense, and administrative
expense. In contrast, variable costing which is also known as direct costing, is a cost
accumulation method that includes only direct material, direct labor, and variable overhead as
product costs. This method treats manufacturing overhead (FOH) as a period cost. Like
absorption costing, variable costing treats costs incurred in the organization’s selling and
administrative areas as period costs. Variable costing income statements typically present
expenses according to cost behavior (variable and fixed), although expenses can also be
presented by functional classifications within the behavioral categories.
2. Whether absorption costing income is more or less than variable costing income depends
on the relationship of production to sales. In all cases, to determine the effect on income, it
must be assumed that variances from standard are immaterial and that unit product costs
are constant over time.

 If production (inventory) equals sales, absorption costing income will equal variable
costing income.
 If production (inventory) is more than sales, absorption costing income is greater than
variable costing income. This result occurs because some fixed manufacturing
overhead cost is deferred as part of inventory cost on the balance sheet under absorption
costing, whereas the total amount of fixed manufacturing overhead cost is expensed as a
period cost under variable costing.
 If production (inventory) is less than sales, income under absorption costing is less
than income under variable costing. In this case, absorption costing expenses all of
the current period fixed manufacturing overhead costs and releases some fixed
manufacturing overhead cost from the beginning inventory where it had been deferred
from a prior period.
3. For me, I think absorption costing would be a better choice for costing since it may provide
a fuller picture of a product’s cost by including fixed manufacturing overhead costs. A proponent
of this method would argue that it is most effective. This is because, simply enough, all the
possible costs are included, unlike variable costing method which ignores the fixed
manufacturing overhead costs, thus, understating a product’s overall cost. Absorption costing
method also gives a company or organization a more accurate view of the products importance
from an economic standpoint. Lastly, it is also the method required by GAAP to be used for
external reporting.
Case 3-70

1.

Direct Material $ 94 x 20000 (units)* $1,880,000

Direct Labor $16 x 20,000 320,000
Overhead $80 x 20,000 1,600,000
Selling Cost $7 x 20,000 140,000
TOTAL VARIABLE COST $3,940,000

*20000 units was used since each unit uses 1 direct labor hour for production.

Total unit variable cost:

Total Variable Cost: $3,940,000 = $197/ variable cost per unit

Number of units ordered 20,000

Garner should accept the order since the cost per variable unit of the said order ($197) is lower
than the cost of the unit ($212), thus, generating an income of $300,000 for the order ($15 – the
difference of the actual cost and the cost per variable unit X 20,000 units).

2. The correlation coefficient describes the influence of the independent variable (cost drivers) to
dependent variable (cost). For the direct materials usage, it can be seen that it has a 90%
correlation with the actual cost which is quite high. For overhead costs, it can be seen that it has a
quite low correlation of 75%. For the selling costs, it can be seen that it has an 86% correlation with
the actual cost which is also quite high. Lastly, for the direct labor usage, it can be seen that it has
a 92% correlation with the actual cost which is the highest correlation among the costs. Since the
higher correlation means that it is a better cost driver than the other, it can be deducted that the
direct labor usage is the most suitable of being the independent variable. This measure helped us
to see that the direct labor hours was the most suitable choice of being the cost driver in
requirement number one since it has the most significant influence in the cost of the unit.
3.
Direct Material $ 94 x 20000 (units) $1,880,000
Direct Labor $16 x 20,000 320,000
Overhead
X1 – Direct Labor Hours $85 x 20,000 (units) 1,700,000
X2 – Number of Setups $5000 x 12 60,000
X3 – Engineering Hours $300 x 600 180,000
Variable Selling Cost $7 x 20,000 140,000
TOTAL VARIABLE COST $4,280,000

Total unit variable cost:

Total Variable Cost: $4,280,000 = $214/ variable cost per unit

Number of units ordered 20,000

Garner should reject this special order since the cost per variable unit of the said order ($214) is
greater than the cost of the unit ($212), thus, it will lead us to a loss of $40,000 ($2 – the difference
the cost per variable unit and the actual cost X 20,000 units).