Absorption and Variable Costing

ABSORPTION COSTING INCOME STATEMENT

Direct collections earned by a company for selling its products to customers. The carrying value of goods sold which is the sum of Variable manufacturing costs and Fixed manufacturing costs. These are costs to produce the cost of goods that are sold. This measures the money from goods after subtracting the cost incurred to produce the inventories sold.

Also known as Selling, general, and administrative expenses that are necessary in doing business to reach-out customers and maintain records as well as introducing the products to them. It is the Net amount of income generated after considering the effect of Operating expenses. Profit if Gross profit is higher than expenses while Loss when Expense is greater than Gross profit.

ABSORPTION COSTING INCOME STATEMENT

• Sold units x Selling Price
• Sold units x Product Cost
• Sales Revenue – Gross Profit
• Sold Units x Variable Selling, General and Administrative cost per unit;
• Produced units x Fixed Selling, General and Administrative cost per unit (The sum of 1&2 above is the total Operating Expenses)
• Gross Profit – Operating Expenses

ABSORPTION COSTING INCOME STATEMENT

Sold Units x Product Cost

DIRECT MATERIALS

These are actual physical items that is built into products. For example, cost of wood used to create table.

DIRECT LABOR

These are Labor involved in producing the Goods.

VARIABLE MANUFACTURING OVERHEAD

Term used to describe fluctuating costs used to manufacture a product. As production output increases or decreases. For example, production supplies

FIXED MANUFACTURING OVERHEAD

These are production costs that do not change even while the volume of production increases or decreases. For example, Factory rent monthly.

WHAT IS PRODUCT COST ?

This is the actual cost of product that does not include any mark-up. It is also called as “inventoriable cost” that means costs used to make the product and getting it ready in order to sell the product. For Absorption Costing, the product costs are Direct Materials, Direct Labor, Variable Manufacturing Overhead and Fixed Manufacturing Overhead. Product Cost is apportioned between sold and unsold units. Note that under the Absorption costing treats fixed factory overhead as a product cost.

ABSORPTION COSTING INCOME STATEMENT

Period Cost

VARIABLE SELLING, GENERAL, AND ADMINISTRATIVE EXPENSES

These are necessary expenses that changes whenever sales changes; however, they are cost incurred other than producing the units. For example, Sales Commission.

FIXED SELLING, GENERAL, AND ADMINISTRATIVE EXPENSES

These are necessary expenses that do not change within the relevant range; however, they are cost incurred other than producing the units. For example, Salary and Wages of Security department

WHAT IS PERIOD COST ?

These costs are necessary for business operations aside from costs incurred in producing the product. It is not related to the production of inventory instead; they are expenses used to support the continuance of Production Department. It may be Variable or Fixed. Examples of period costs are audit fees, sales fees, rent of the office building, CEO Salary, Marketing expenses, Advertising Expenses, Security of the different Offices, Information Technology support team etc.

VARIABLE COSTING INCOME STATEMENT

Direct collections earned by a company for selling its products to customers. Costs that change whenever volume changes. These includes Variable Manufacturing and Variable Selling, General and Administrative expense. Measures the profitability of a product or the revenue that is left after covering fixed Cost. It represents the sales revenue that is not consumed by variable costs and so contributes to the coverage of Fixed Costs Unlike Absorption costing, ALL fixed costs whether used in manufacturing or not is treated as expense under Variable Costing It is the Net amount of income generated after deducting Fixed Costs. Profit if Contribution Margin is higher than Fixed Costs while Loss when Fixed Costs are greater than Contribution Margin.

VARIABLE COSTING INCOME STATEMENT

• Sold units x Selling Price
• Sold units x Variable Cost per unit.
• Sales Revenue – Variable Cost
• Produced units x Fixed Manufacturing cost per unit.
• Produced units x Fixed Selling, General, and Administrative per unit. The total of 1 & 2 is the Total Fixed costs.
• Contribution Margin – Fixed Costs

VARIABLE COSTING INCOME STATEMENT

VARIABLE MANUFACTURING COST includes the following:

• Direct Materials
• VARIABLE MANUFACTURING COST
• Direct Labor
• Variable Manufacturing Overhead
• VARIABLE SELLING, GENERAL, AND ADMINISTRATIVE EXPENSE

There are two (2) categories of VARIABLE COST: Variable Manufacturing Cost (which is composed of Direct materials, Direct Labor and Variable Manufacturing Overhead); and the Variable Selling, General, and Administrative expenses. Note that Variable Manufacturing Cost encompasses Variable Manufacturing Overhead.

VARIABLE COSTING INCOME STATEMENT

Since Variable Cost can be broken down into Variable Manufacturing cost and Variable Selling, General, and Administrative Expense, the expanded format of Variable Costing income statement would be:

Manufacturing Margin has the same concept with Gross Profit of Absorption Costing where it represents the difference between how much it costs to create something, known as Product Cost and for how much they sell the product.

IMPORTANT TO NOTE! Variable Selling, General, and Administrative Expenses are still categorized as Period cost. Only the Variable Manufacturing Costs (Direct Materials, Direct Labor, and Variable Manufacturing Overhead) are product costs. Fixed costs in Variable Costing method are always treated as Product cost based on units produced regardless of how much are the sold units.

Comprehensive Illustration During December 2023, ABC, Inc. produced and sold 2,000 units of Product A with selling price of $50.00 per unit and costs as follows: Materials $ 12,000 Labor 6,600 Total Manufacturing Overhead (50% Variable) 8,000 Total Manufacturing Costs 26,600 Selling, General, and Administrative costs incurred during the month were: Variable SGA Expenses Fixed SGA Expenses

$ 6,000 4,000 10,000

What is the product cost for Absorption Costing? Answer: 13.3 What is the product cost for Variable Costing? Answer: 11.3 What is the Variable Cost per unit for purposes of computing Contribution Margin? Answer: 14.3 What is the Operating income under Absorption Costing? Answer: $63,400 What is the Operating income under Variable Costing? Answer: $63,400 SOLUTION:

Units produced is equal to Units sold for this problem. These are the total costs of Variable and Fixed Manufacturing. Fixed manufacturing is a product cost for Absorption Costing

Total Manufacturing Overhead is composed of Variable and Fixed Manufacturing Costs. Variable manufacturing cost is based on Units Sold, which is 2,000 while Fixed Manufacturing cost is based on units produced, which is 2,000 as well. For Variable Costing, it is always based on Units sold. For this problem, units sold is 2,000. For Variable Costing, only Variable Manufacturing Costs are inventoriable. Fixed Manufacturing Costs should not be included as product cost under Variable Costing that is why we multiply 8,000 by 50% because the other 50% is the amount for Fixed Manufacturing Cost.

Again, notice that if we’re talking about Variable Costing, Variable Costs are based on Units sold and not on Units Produced These are the total Variable Costs that changes whenever the volume of units sold changes. Only Materials, Labor, and Variable Manufacturing Overhead are product costs, however, for the purpose of computing Contribution Margin, we must consider the effect of Variable Selling, General, and Administrative Expenses.

Sold units x Selling Price Sold units

x Product Cost for Absorption Costing

Whether Variable or Fixed Selling, General, and Administrative Expenses, they are both considered as Operating expenses under Absorption Costing Sold units x Selling Price Sold units

x Product Cost for Variable Costing

Variable Selling, General, and Administrative Expenses are not product cost. These costs are still period costs under the Variable Costing; however, they are considered to calculate the Contribution Margin.

Unlike Absorption Costing, under Variable Costing, Fixed Costs whether Manufacturing or Selling, General, and Administrative are all considered Outright Expense. Variable Costing method argues that Fixed Costs should be expensed outright because they are incurred anyway regardless of how many units are sold.

IMPORTANT NOTE!

1. Selling, General, and administrative costs, whether Variable or Fixed, is always treated as PERIOD COSTS under both Absorption Costing and Variable Costing systems. 2. Depreciation Expense is not always a Period Cost. Also, It is not always a Product Cost. It depends on what the company depreciate. If we depreciate equipment or machine that is used in producing the units, then it should be classified as Product Cost. On the other hand, if the equipment or machine is used aside from producing a unit, such as computer for accounting office or CCTVs for security, then we classify the depreciation as Period Cost. 3. Absorption Costing is also called Full Costing. 4. Absorption Costing is used for external reporting purposes. 5. Conversion Cost is the sum of Direct Labor and Manufacturing Overhead. 6. Prime Cost is the sum of Direct Materials and Direct Labor. 7. If units produced is equal to units sold, the income under Variable Costing and Absorption Costing should be the same.

In the previous Comprehensive Illustration, Units produced is the same with Units sold. In this next Comprehensive Illustration, what if Units produced is not equal to Units sold.

Comprehensive Illustration #2: During December 2023, ABC, Inc. produced 2,000 units and sold 1,000 units of Product A with selling price of $50.00 per unit and costs as follows: Materials $ 12,000 Labor 6,600 Total Manufacturing Overhead (50% Variable) 8,000 Total Manufacturing Costs 26,600 Selling, General, and Administrative costs incurred during the month were: Variable SGA Expenses Fixed SGA Expenses

$ 6,000 4,000 10,000

What is the product cost for Absorption Costing? Answer: 24.6 What is the product cost for Variable Costing? Answer: 22.6 What is the Variable Cost per unit for purposes of computing Contribution Margin? Answer: 28.6 What is the Operating income under Absorption Costing? Answer: $ 15,400 What is the Operating income under Variable Costing? Answer: $ 13,400 Variable Manufacturing Costs are based on Units sold.

If Units Produced is different from Units Sold, then Fixed Manufacturing Overhead should be based in Units produced.

Notice that the product cost for absorption costing uses both Units produced and Units Sold, unlike variable costing that uses Units sold.

Units Produced Units Sold Fixed Manufacturing Cost per unit RECONCILIATION OF ABSORPTION COSTING INCOME and VARIABLE COSTING INCOME Variable and Absorption Costing method of accounting may result to different amount of operating income because they have different treatment of Fixed manufacturing overhead. If Produced units is greater than Sold units: This means that there is an increase in inventory. Fixed Overhead expensed under absorption costing Is less than fixed overhead expensed under variable costing.

NOTE!

There’s no need for reconciliation if Units produced is equal with Units sold because they will have the same amount of operating income.

(Sold Units – Produced Units) X

If Produced units is less than Sold units:

Fixed Manufacturing Cost per unit

This means that there is a decrease in inventory. Fixed Overhead expensed under absorption costing Is more than Fixed overhead expensed under variable costing.

Fixed Manufacturing (Sold Units – Produced Units) X Cost per unit ABSORPTION COSTING

ADVANTAGES

• Complies with International Accounting Standards 2 (Inventories)
• Recognizes that Selling price must cover all costs.
• Better cost control
• Meet requirements of external reporting
• Facilitates more accurate inventory valuation than Variable Costing.

DISADVANTAGES

• Not helpful for analysis to improve operational and financial efficiency.
• Can inflate company’s profitability because fixed factory overhead is not deducted from revenue unless all produced products are sold.
• Profits can be manipulated by changing production levels.
• Base assumptions on overheads are volume-based.

VARIABLE COSTING

1. Easier to compute and more understandable.

2. Amounts computed can be used in Cost-Volume- Profit Analysis.

3. More Compatible with Standard cost accounting system.

4. Useful in decision-making for manager because Variable costs are Segregated from Fixed Costs.

5. Per-unit cost is easily determined.

1. Difficult segregation of Variable and Fixed costs during Mixed Cost.

2. Matching Principle is violated.

3. Inventory cost is undervalued because Fixed Manufacturing cost is treated as outright expense.

4. Can lead to sub-optimal decision-making.

5. Ineffective for long-term pricing because it does not account for fixed factory overhead as product cost.