Absorption Costing Gclass

ABSORPTION COSTING
A costing method that includes all manufacturing costs – direct labor, variable and fixed manufacturing
overhead – in the cost of a unit of product. It treats fixed manufacturing overhead (Fixed FOH) as a
product cost. Absorption costing is also known as full costing.
VARIABLE COSTING
A costing method that includes only variable manufacturing costs – direct labor, and variable
manufacturing overhead – in the cost of unit of product. It treats Fixed FOH as a period cost. Variable
costing is also called direct costing.
PRODUCT vs. PERIOD COST

A product cost is an inventoriable cost that is subject to allocation between sold and unsold units.
Current income is reduced only by the amount allocated to the sod units.
UNSOLD UNITS → Asset (as Inventory)

PRODUCT COST
SOLD UNITS → Expense (as Cost of Goods Sold)
A period cost is a cost that is charged as expense against income, regardless of the sales performance.
No allocation is necessary so current income is reduced by the full amount.
PERIOD COST → SOLD UNITS FULLY EXPENSED I the period incurred
ABSORPTION vs. VARIABLE COSTING
Inventories
Under variable costing, Fixed FOH is treated as a prior cost; while under absorption costing, it is treated
as a product cost. Because of this, the peso amount f inventories under variable costing is always smaller
than inventories under absorption costing.
Rationale
Advocates of variable costing argue that fixed manufacturing costs are incurred in order to have the
capacity to produce output in a given period. These costs are incurred whether or not the capacity is
actually used to make output. Thus, Fixed FOH, having no future service, should be charged against the
period and not included in the product cost.
Advocates of absorption costing believe that all manufacturing costs – variable and fixed – are essential
to the production process and should not be ignored when determining product costs.
Acceptability
Since treating Fixed FOH as an inventoriable cost is consistent with accounting standards, only
absorption costing is acceptable for financial reporting and tax purposes. Variables costing, which
violates the matching principle, is not acceptable for financial reporting nor for tax purposes.
NOTE: Matching principle is an accounting principle that calls for the recognition of expense only when
related units have been already sold.
Income Statement
An income statement prepared under absorption costing distinguishes between production and other
costs. Appropriate production costs are first deducted from sales to arrive to gross profit, and then other
costs are deducted to obtain income.
Under variable costing, the income statement distinguishes between variable and fixed costs. All
variables costs are first deducted from revenue to arrive at the contribution margin, and fixed costs are
deducted to obtain income.
Income Computation
Income computed by variable costing may differ from income computed by absorption costing because
of the difference in the amount of Fixed FOH recognized as expense during an accounting period. This is
also caused by the difference between production and sales volume. In the long run, however, both
methods would yield the same results since sales cannot continuously exceed production, nor
production can continuously exceed sales.
RECONCILIATION OF INOME UNDER ABSORPTION and VARIABLE COSTING

 The cause of the difference between the income computed under absorption and variable
costing is primarily a timing difference - - when to recognize the Fixed FOH as an expense.
 In variable costing, it is expensed when Fixed FOH is incurred, while in absorption costing, it is
expensed in the period when the units to which such Fixed FOH relates are sold.
 The relationship between production and sales generally indicate the following income patterns:
1. When production is equal to sales, there is no change in inventory. Fixed FOH expensed under
absorption costing equals Fixed FOH expensed under variable costing.
PRODUCTION = SALES → Income, Absorption = Income, Variable
2. When production is greater than sales, there is an increase in inventory. Fixed FOH expensed
under absorption costing is less than Fixed FOH expensed under variable costing. Therefore,
absorption income is greater than variable income.
PRODUCTION¿ SALES → Income, Absorption > Income, Variable
3. When production is less than sales, there is a decrease in inventory. Fixed FOH expensed
under absorption costing is greater than Fixed FOH expensed under variable costing. Therefore,
absorption income is less than variable income.
PRODUCTION < SALES → Income, Absorption < Income, Variable
 POINT OF RECONCILLATION:
Income, Absorption costing P xxx

Add: Fixed FOH in beginning inventory xxx
Total P xxx or:∆ Income = ∆ Inventory x Fixed FOH per
unit
Less: Fixed FOH in ending inventory (xxx)
Income, Variable costing P xxx
ADVANTAGES OF USING VARIABLE COSTING

1. Variable costing reports are simpler and more understandable.
2. The problems involved in allocating fixed costs are eliminated.
4. Variable costing is more compatible with the standard cost accounting system.
3. Data needed for break-even and cost-volume-profit analyses are readily available.
5. Variable costing reports provide useful information for pricing decisions and other decision-
making problems encountered by management.
DISADVANTAGES OF USING VARIABLE COSTING
1. This costing is not I accordance with GAAP; hence, it is not acceptable for external reporting.
2. Segregation of costs into fixed and variable might be difficult.
3. The matching principle is violated by using variable costing, with excludes fixed FOH rom
product costs and charges the same as period costs regardless of production and sales.
4. With variable ratio are understated because of the exclusion of Fixed FOH in the computation
of product cost.
EXERCISES: ABSORPTION and VARIABLE COSTING
Problem 1: ABS Company operated at a normal capacity of 1,000 units in the year 2014. The company
sold 80% of these units at a price of P12 per unit. Manufacturing costs incurred the year are as follows:
Manufacturing: Per Unit

Materials P1,500 1.50
Labor 1,000 1.00
Variable Factory Overhead 500 0.50
Fixed Factory Overhead 2,000 2.00
Selling and Administrative
Variable P1,500 expensed
Fixed 800 expensed
Required:
1. Inventory cost per unit under absorption and variable costing.
2. Cost of ending inventory under absorption and variable costing.
Problem 2: CBN Company makes state-of-the-art pillows. Each pillow sells for P2,000 each. Data for
2014’s operations are as follows:
Units:
Beginning Inventory 5
Production 80
Ending Inventory 15
Variable Costs:
Direct Materials P24,000
Direct Labor 16,000
Factory Overhead 8,000
Selling and Administrative 4,000
Fixed Costs:
Factory Overhead P20,000
Selling and Administrative 2,000
Required:
1. Prepare income statements under both absorption and variable costing.
2. Provide computations explaining the differences in income between the two costing methods.
Solution Guide to Requirement No. 2
CBN COMPANY
Income Statement
For the period of 2014
Absorption Costing Variable Costing
Sales P Sales P
Less: Cost of Sales Less: Variable cost
Gross profit P Contribution margin P
Less: Expenses Less: Fixed cost
Net Income P Profit P
Problem 3. The following information are taken from the books OF GMA Company, which assumes first–
in first–out (FIFO) for inventory cost flow:
Inventory (in units) 2014 2015

Beginning inventory -None- ???
Production 10,000 units 9,000 units
Ending inventory 3,500 units 1,000 units
Sales (P 2/units) ??? ???

Variable manufacturing costs (0.75/unit) P7,500 P6,750
Fixed manufacturing costs P5,000 P5,000
Selling and administrative costs (50% variable) P4,500 P7,500
Required:
1. Determine 2014 profit under variable and absorption costing
2. Reconcile the two income figures in No. 1.
3. Determine 2015 profit under variable and absorption costing.
4. Reconcile the two income figures in No. 3.

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ABSORPTION COSTING

PRODUCT vs. PERIOD COST

UNSOLD UNITS → Asset (as Inventory)

PERIOD COST → SOLD UNITS FULLY EXPENSED I the period incurred

ABSORPTION vs. VARIABLE COSTING

RECONCILIATION OF INOME UNDER ABSORPTION and VARIABLE COSTING

Income, Absorption costing P xxx

ADVANTAGES OF USING VARIABLE COSTING

EXERCISES: ABSORPTION and VARIABLE COSTING

Manufacturing: Per Unit

Solution Guide to Requirement No. 2

Less: Cost of Sales Less: Variable cost

Gross profit P Contribution margin P

Less: Expenses Less: Fixed cost

Net Income P Profit P

Inventory (in units) 2014 2015

Sales (P 2/units) ??? ???

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