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Income Measurement and Reporting:

Variable and Absorption Costing

1 (C) Ghanendra Fago( M Phil, MBA)


Concept of Product Cost
 The cost of making a product is called product cost.
 It is also known as manufacturing cost.
 Product costs are taken for inventory valuation.
 So product costs are sometimes called inventory cost as well.
 Inventorial costs are all costs of product that are regarded as assets
when they are incurred and then become costs of goods sold when
the product is sold.
 Product cost affects the value of inventory and the profit differs.
 Raw material cost is an example of a product cost.

2 (C) Ghanendra Fago( M Phil, MBA)


Period Cost
 The costs that are indifferent to the level of production are period
cost.
 Period costs do not change with the change in production volume.
 Rather, these costs are incurred either for sales activity or with the
passage of time
 Period cost are not taken for inventory valuation.
 All period costs are deducted from the revenues of the same period.
 Office and administrative and department costs, and marketing
department costs are good examples of period costs.

3 (C) Ghanendra Fago( M Phil, MBA)


Product Costing
The process of determining cost of production. There two
method of determining cost of product for accounting
purposes:They are:
(a) Absorption costing and
(b)Variable costing

4 (C) Ghanendra Fago( M Phil, MBA)


Variable Costing
 It is also called marginal costing, direct costing, Contribution
margin format.
 Variable costing includes only variable production costs in product
costs.
 Fixed manufacturing overhead is treated as a period cost and is
charged against income each period.
 Cost of production per unit
Direct materials xx
Direct labours xx
Variable overheads xx
Cost of goods manufactured xx.

5 (C) Ghanendra Fago( M Phil, MBA)


Absorption Costing
 Also called traditional costing, conventional costing, full costing
 It treats all production costs as product costs, regardless of whether they are
variable or fixed.
 Under this costing, a portion of fixed manufacturing overhead is allocated to
each unit of product.
 Cost of production per unit includes
Direct materials xx
Direct labours xx
Variable overheads xx
Fixed Overhead (Fixed overhead/Normal capacity) xx
Cost of goods manufactured xx

6 (C) Ghanendra Fago( M Phil, MBA)


Under Variable Costing Under Absorption Costing
Product Costs Product Costs
Direct Material Direct Material
Direct Labour Direct Labour
Variable Manufacturing Costs Variable Manufacturing Costs
Period Costs Fixed manufacturing Costs
Fixed manufacturing costs Period Costs
General & administrative costs General & Administrative Costs
Selling & distribution costs Selling & Distribution Costs

(C) Ghanendra Fago( M Phil,


7
MBA)
Illustration
The Boley Company produces a single product. The cost characteristics of the product and of the
manufacturing plant are given below:
Number of units produced each year 6,000
Variable costs per unit:
Direct materials $2
Direct labor 4
Variable manufacturing overhead 1
Variable selling and administrative expense 3
Fixed cost per year:
Manufacturing overhead $ 30,000
Selling and administrative expense 10,000
Required:
1. Compute the, cost of a unit of product under absorption costing.
2. Compute the cost of a unit of product under direct costing

8 (C) Ghanendra Fago( M Phil, MBA)


Absorption
Absorption Costing Costing Vs. Direct Costing
Direct materials $2
Direct labor 4
Variable overhead 1
Total variable production cost 7
Fixed overhead ($30,000 ÷ 6,000 units of product) 5
Total cost per unit $12

Direct Costing
Direct materials $2
Direct labor 4
Variable overhead 1
Total cost per unit $7

9 (C) Ghanendra Fago( M Phil, MBA)


Explanation
 Under the absorption costing method, notice that all production costs, variable
and fixed, have been added to the cost of units produced during the period.
 Thus, if the company sells a unit of product and absorption costing is being used, then
$12 (consisting of $7 variable cost and $5 fixed cost) will be deducted on the income
statement as cost of goods sold.
 Similarly, any unsold units will be carried as inventory on the balance sheet at $12 each.
 Under the direct costing method, notice that only the variable production costs
have been added to the cost of units produced during the period. Thus, if the company
sells a unit of product, only $7 will be deducted as cost of goods sold, and unsold units
will be carried in the balance sheet inventory account at only $7 each.

10 (C) Ghanendra Fago( M Phil, MBA)


Capacity Concepts
Installed capacity - Maximum units that can be produced.
Normal capacity - Average production level, that is normally below the maximum
capacity
Actual capacity - Actual production, it may be more or less than normal capacity
Fixed overhead per unit - Fixed overhead/Normal capacity
Under/Over Absorption Of Fixed Manufacturing Overhead
 Fixed manufacturing cost is considered as constant cost which is unaffected due to change into
production units. The increase or decrease in production volume does not affect the total fixed cost.
Thus, fixed manufacturing overhead is allocated to product cost based on normal level activities.
 It is determined on the basis of normal capacity level of production.The differences between normal
capacity and actual production create over absorption or under absorption of fixed manufacturing
overhead.

11 (C) Ghanendra Fago( M Phil, MBA)


The Controversy over Fixed Overhead Cost

 Probably no subject in all of managerial accounting has created as much controversy among accountants as has
direct costing. The controversy isn't over whether costs should be separated as between variable and fixed in
matters relating to planning and control. Rather, the controversy is over the theoretical justification for excluding
fixed overhead costs from the cost of units produced and therefore from inventory.
 Advocates of direct costing argue that fixed overhead costs relate to the capacity to produce rather than to the
actual production of units of product in a given year. That is, they argue that costs for facilities and equipment,
insurance, supervisory salaries, and the like, represent costs of being ready to produce and therefore will be
incurred regardless of whether any actual production takes place during the year. For this reason, advocates of
direct costing feel that such costs should be charged against the period rather than against the product.
 Advocates of absorption costing argue, on the other hand, that so far as product costing is concerned; it makes no
difference whether a manufacturing cost is variable or fixed. They argue that fixed overhead costs such as
depreciation and insurance are just as essential to the production process as are the variable costs, and therefore
cannot be ignored in costing units of product. They argue that to be fully costed, each unit of product must bear
an equitable portion of all manufacturing costs.
 Although this difference in the handling of fixed overhead might seem slight, it can have a substantial impact on
both the clarity and the usefulness of statement data.

12 (C) Ghanendra Fago( M Phil, MBA)


Income statement under variable costing
Particulars Details Amount
Sales revenue (Sales units  SPPU) 
Less: Variable cost of goods sold:
Direct material @ . . .  production units 
Direct labour @ . . .  production units 
Variable Overhead @ . .  production units 
Total variable manufacturing costs 
Add: Opening stock @ . . . 
Cost of goods available for sales 
Less: Closing stock @ . . . 
Variable cost of goods sold 
Gross contribution margin 
Less: Non-manufacturing variable costs @ . . Sales 
Net contribution margin 
Less: Fixed costs
Manufacturing 
Non-manufacturing  
13 (C) Ghanendra Fago( M Phil, MBA)
Net Income before tax 
Income Statement Under Variable Costing
Particulars Details Amount
Sales revenue (Sales units  SPPU) 
Less: Variable cost of goods sold:
Direct material @ . . .  production units 
Direct labour @ . . .  production units 
Variable Overhead @ . . .  production units 
Total variable manufacturing costs 
Add: Opening stock @ . . . 
Cost of goods available for sales 
Less: Closing stock @ . . . 
Variable manufacturing cost of goods sold 
Add: Non-manufacturing variable costs @ . . .  Sales 
Total variable costs of sales 
Net Contribution margin 
Less: Fixed manufacturing cost 
Fixed non-manufacturing cost  
Net Income before tax 
(C) Ghanendra Fago( M Phil,
14
MBA)
Absorption Costing Under Income Statement
Particulars Details Amount
Sales revenue (Sales units  SPPU) 
Less: Manufacturing cost of goods sold:
Direct materials @ . . .  production units x
Direct labour @ . . .  production units x
Variable overhead @ . . .  production units x
Fixed manufacturing overhead @ . production units x
Cost of goods manufactured 
Add: Opening stock @ . . . x
Cost of goods available for sale 

Less: Closing stock @ . . . x


Cost of goods sold 
Gross margin before adjustments xxxxx
Less: Under absorption of fixed manufacturing overhead 
Add: Over absorption of fixed manufacturing overhead () 
Gross margin after adjustments 
Less: Variable non manufacturing @ . . . X sales 
Fixed non manufacturing costs  xxxx
Net income before tax 
(C) Ghanendra Fago( M Phil,
15
MBA)
Reconciliation statement
Particulars Details Difference

Net profit as per variable costing xxxxxxx


Less: Net profit as per absorption costing xxxxxxx
DIFFERENCE IN PROFIT Xxxxxx
Opening stock in units xxxxxxx
Less: Closing stock in units xxxxxxx
Difference in stock xxxxxx

Fixed manufacturing cost per unit xxx

DIFFERENCE IN PROFIT xxxxx


(DIFF. STOCK X FIXED COST PER UNIT)

(C) Ghanendra Fago( M Phil,


16
MBA)
Illustration
Diamond manufacturing company showed the following results for three years.
Particulars Year I Year 2 Year 3
Normal capacity in units 10,000 10,000 10,000
Actual production units 16,000 10,000 12,000
Actual sales in units 12,000 10,000 15,000
Selling price per unit Rs. 20 Rs. 20 Rs. 20
Direct materials cost per unit 5 5 5
Direct labour cost per unit 3 3 3
Variable overhead cost per unit 2 2 2
Variable selling and administrative cost per unit 1 1 1
Fixed manufacturing overhead Rs. 50,000 Rs.50,000 Rs.50,000
Fixed selling and Administrative costs 10,000 10,000 10,000
Required: Income statement under absorption costing and variable costing for three
years

17 (C) Ghanendra Fago( M Phil, MBA)


Absorption Vs Variable Costing
1. Production Equals Sale
 When production equals sales, inventories do not change.

 If inventories do not change, then there is no change in the fixed manufacturing


overhead costs in inventories under absorption costing.
 Therefore, under both costing methods all of the current fixed manufacturing
overhead will flow through to the income statement as an expense.
 In the case of absorption costing it will be part of cost of goods sold. In the case
of variable costing, it will be a period expense.

18 (C) Ghanendra Fago( M Phil, MBA)


2. Production Exceeds Sales (Inventories Increase)
• When production exceeds sales, inventories grow.
• If inventories grow, then some of the current fixed manufacturing
overhead costs will be deferred in inventories under absorption
costing.
• Since all of the current fixed manufacturing overhead costs are
expensed under variable costing, the net operating income
reported under absorption costing will be greater than the net
operating income reported under variable costing.

19 (C) Ghanendra Fago( M Phil, MBA)


Sales Exceed Production (Inventories Decrease)
 When sales exceed production, inventories shrink.

 If inventories decrease, then some of the fixed manufacturing overhead costs that
had been deferred in inventories in previous periods will be released to the
income statement as part of cost of goods sold as well as all of the current fixed
manufacturing overhead costs.
 Since only the current fixed manufacturing overhead costs are expensed under
variable costing, the net operating income reported under absorption costing will
be less than the net operating income reported under variable costing.

20 (C) Ghanendra Fago( M Phil, MBA)


Long-term Differences In Income
 Over an extended period of time, the cumulative net operating income
figures reported under absorption costing and variable costing will be about
the same.
 They will differ only by the amount of fixed manufacturing overhead cost in
ending inventories under absorption costing.
 Cumulative net operating income figures will be identical whenever ending
inventories are reduced to zero
Changes In Production Volume
 Variable costing net operating income is not affected by changes in production
volume.
 On the other hand, absorption costing net operating income is affected by
changes in production volume.
 For any given level of sales, net operating income under absorption costing
will increase as the level of output increases and hence inventories increase.

21 (C) Ghanendra Fago( M Phil, MBA)


Use of Absorption Vs. Variable costing
 Accountants and managers have been arguing for decades
concerning the relative merits of absorption and variable costing.
In practice, absorption costing is used far more than variable
costing even for internal reports. The reasons for this are not
entirely clear, although the perception that absorption costing is
required for external reporting undoubtedly plays a key role.
 Argument for absorption costing
 Advocates of absorption costing argue that all manufacturing costs
must be assigned to units of product so as to properly match costs
with revenues.
 They argue that fixed manufacturing overhead costs are essential
to the production process and must be included when costing
units of product, regardless of how the cost behaves.

22 (C) Ghanendra Fago( M Phil, MBA)


Argument for Variable Costing
Advocates of variable costing argue that fixed manufacturing overhead costs are
incurred in order to have the capacity to produce. Moreover, they will be
incurred regardless of whether anything is actually produced. Since these costs
are not caused by any particular unit of product and are incurred to provide
capacity for a particular period, the matching principle would dictate that fixed
manufacturing overhead costs must be expensed in the current period.

23 (C) Ghanendra Fago( M Phil, MBA)


Advantages of Variable Costing
More useful for CVP analysis. Variable costing statements provide data that are
immediately useful for CVP analysis since they categorize costs on the basis of their
behavior. In contrast, it is often difficult to rework absorption costing data so that
they can be used in CVP analysis and in decisions.
Income is not affected by changes in production volume. Under absorption
costing, reported net operating income is affected by changes in production since
fixed costs are spread across more or fewer units. This can distort income and may
even result in income moving in an opposite direction from sales. This does not
occur under variable costing.

24 (C) Ghanendra Fago( M Phil, MBA)


Avoids misunderstandings concerning unit product costs.
Absorption costing unit product costs can be easily misinterpreted as
variable costs since they are stated on a per unit basis. Such a
misperception can lead to serious errors in making decisions. Variable
costing avoids this problem since unit costs include only variable costs.
Fixed costs are more visible. The impact of fixed costs on profits is
emphasized because the total amount of such costs for the period
appears separately and is highlighted in the income statement rather
than being buried in cost of goods sold and ending inventory.
Understandability. Managers should find it easier to understand
variable costing reports because data are organized by behavior and
because variable costing is much closer to cash flow.
Facilitates in Control:. Variable costing ties in with cost control methods
such as flexible budgets.

25 (C) Ghanendra Fago( M Phil, MBA)


CASE 1: The Directorium Manufacturing Company produced: 80,000
units of new products during 1990 and sold 60,000 units at Rs. 50 each.
The cost for 1990 were as follows:
Direct materials Rs.200,000
Direct labour Rs.160,000
Variable Manufacturing Overhead Rs.320,000
Fixed Manufacturing overhead Rs.440,000
V. Selling/administrative expenses Rs.80,000
F. Selling and administrative expensesRs. 280,000
There was no ending work in process inventory.
Required:
a) Income statements for the year 1990 using (i) direct costing method (ii)
Absorption costing method
b) Give the reasons for differences in reported net income or net loss in
requirement a (i) and a (ii).

26 (C) Ghanendra Fago( M Phil, MBA)


Income Statement Under Contribution Margin Approach
Particulars Amount Amount
Sales revenue @ Rs.50 each Rs.3,000,000
Less: Variable manufacturing cost of goods sold:
Direct materials @ 2.5 each 200,000
Direct labour @ 2 each 160,000
Variable manufacturing overhead @ 4 each 320,000
Total variable manufacturing costs 680,000
Add: Opening stock @ 8.5 each Nil
Cost of goods available for sales 680,000
Less: Closing stock @ 8.5 each (20,000 units) 170,000 510,000
Gross contribution margin 2,490,000
Less: Variable selling and administrative 80,000
Net contribution margin 2,410,000
Less: Fixed costs:
Manufacturing 440,000
Selling and administrative 280,000 720,000
Net income 1,690,000

(C) Ghanendra Fago( M Phil,


27
MBA)
Income Statement Under Absorption Costing
Particulars Amount Amount
Sales revenue @ Rs.50 each Rs.3000,00
0
Less: Manufacturing cost of goods sold:
Direct materials @ 2.5 each 200,000
Direct labour @ 2 each 160,000
Variable manufacturing overhead @ 4 each 320,000
Fixed manufacturing overhead @ 5.5 each 440,000
Total manufacturing costs 11,20,000
Add: Opening stock @ 14 each Nil
1120,000
Less: Closing stock @ 14 each 280,000 840,000
Gross margin 21,60,000
Less: Non-manufacturing costs:
Variable selling and administrative expenses 80,000
Fixed selling and administrative expenses 280,000 360,000
Net income 1800,000

(C) Ghanendra Fago( M Phil,


28
MBA)
Reconciliation Statement

Particulars Details Difference

Net profit as per variable costing 16,90,000

Less: Net profit as per absorption costing 18,00,000

Difference in profit 110,000

Opening stock in units 0

Less: Closing stock in units 20,000


Difference in stock 20,000

Fixed manufacturing cost per unit 5.5

Difference in profit (Diff. stock x fixed cost per unit) 110,000

29 (C) Ghanendra Fago( M Phil, MBA)