STRATEGIC COST MANAGEMENT

Absorption vs. Variable Costing

Absorption Costing

Absorption costing (also called the full costing) treats all costs of production as product costs, regardless of whether they are variable
or fixed. Since no distinction is made between variable and fixed costs, absorption costing is not well suited for CVP computations. Under
absorption costing, the cost of a unit of product consists of direct materials, direct labor, and both variable and fixed overhead. Variable and
fixed selling and administrative expenses are treated as period costs and are deducted from revenue as incurred.

Supporters of absorption costing believe that all manufacturing costs – variable and fixed – are necessary ingredients for production
to take place and should not be ignored in determining product costs.

Variable Costing

Variable costing (also called direct costing) treats only those costs of production which vary with output as product costs. This
method is called variable costing because it only includes “variable” manufacturing costs in determining the total cost of a product. This
approach is compatible with the contribution approach income statement and supports CVP analysis because of its emphasis on separating
variable and fixed costs. The cost of a unit of product consists of direct materials, direct labor, and variable overhead. Fixed manufacturing
overhead, and both variable and fixed selling and administrative expenses are treated as period costs and deducted from revenue as
incurred.

Supporters of variable costing argue that FFOH costs are incurred in order to have the capacity to produce units in a given period.
These costs are incurred whether or not the capacity is actually used to make output. Thus, FFOH, having no future substantial service
potential, should be charged against the period and not included in the product cost.

Advantages of Using Variable Costing:

1. Reports are simpler and more understandable.

2. The problems involved in allocating fixed costs are eliminated.
3. Data needed for break-even and cost-volume-profit analyses are readily available.
4. More compatible with the standard cost accounting system.
5. Reports provide useful information for pricing decisions and other decision-making problems encountered by management.

Disadvantages of Using Variable Costing:

1. Not in 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.
4. Inventory costs and other related accounts, such as working capital, current ratio, and acid-test ratio are understated because of the
exclusion of FFOH in the computation of product cost.

Reconciliation of Income under Absorption and Variable Costing

 The difference between the absorption costing income and variable costing income is primarily a timing difference – when to
recognize the FFOH as an expense.
 In variable costing, it is expensed when FFOH is incurred, while in absorption costing, it is expensed in the period when the related
units are sold.
 The relationship between production and sales generally indicate the following income patterns:

 When production is equal to sales, there is no change in inventory. FFOH expensed under absorption costing equals FFOH
expensed under variable costing.
 When production is greater than sales, there is an increase in inventory. FFOH expensed under absorption costing is less
than FFOH expensed under variable costing. Therefore, absorption income is greater than variable income.
 When production is less than sales, there is a decrease in inventory. FFOH expensed under absorption costing is greater
than FFOH expensed under variable costing. Therefore, absorption income is less than variable income.

 POINT OF RECONCILIATION:

Profit/Loss using Absorption Costing P xxx

Add: Fixed FOH in Beginning Inventory xxx
Total P xxx
Less: Fixed FOH in Ending Inventory xxx
Profit/Loss using Variable Costing P xxx

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Illustration: Absorption vs. Variable Costing

Warriors Corporation produces a single product. The following is a cost structure applied to its first year of operations.

Selling price P 15 per unit

Variable selling and administrative costs P2 per unit
Direct materials P2 per unit
Direct labor P1.50 per unit
Variable FOH P0.50 per unit
Fixed selling and administrative costs P14,000
Fixed FOH P20,000

During the first year, Warriors Corporation manufactured 5,000 units and sold 3,800. There was no beginning or ending work-in-process
inventory.

Required:
1. Compute for the product cost per unit under absorption costing.
2. Compute for the product cost per unit under variable costing.
3. Prepare an income statement using absorption costing.
4. Prepare an income statement using variable costing.
5. Show why the two costing methods give different profit/loss amounts.
6. Reconcile the two profit/loss figures.

Throughput costing – is a technique that assigns only the unit-level spending amounts for direct costs as the cost of products or services. In
this case, direct material is the only item that qualifies as a throughput cost.

Illustration:

Krell Corporation, which uses throughput costing, began operations at the start of the current year 2015. Planned and actual production
equaled 40,000 units, and sales totaled 35,000 units at P80 per unit. Cost data for 2015 were as follows:

Direct materials (per unit) P 20

Conversion cost:
Direct labor 215,000
Variable manufacturing overhead 340,000
Fixed manufacturing overhead 528,000
Selling and administrative costs:
Variable (per unit) 8
Fixed 220,000

The company classifies direct materials as a throughput cost.

Required:
1. Compute the cost of the company's year-end inventory.
2. Prepare Krell's income statement for the year.

EXERCISES

TRUE OR FALSE

1. Absorption costing is commonly used for external reporting.

2. Absorption costing conforms with generally accepted accounting principles.
3. The Bureau of Internal Revenue allows the use of both variable and absorption costing.
4. Sales minus cost of goods sold is referred to as variable contribution margin.
5. If production exceeds sales, absorption costing net income exceeds variable costing net income.
6. If sales exceed production, absorption costing net income is less than variable costing net income.
7. Under variable costing, all product costs are variable.
8. Under variable costing, all variable expenses are treated as product costs.
9. Variable costing income fluctuates with production and does not react to changes in sales.
10. Variable costing violates matching principle.
11. Variable costing is consistent with contribution reporting and cost-volume-profit analysis.
12. Absorption costing must be used for external financial reporting.
13. A number of companies use both absorption costing and variable costing.
14. Variable costing is consistent with contribution reporting and cost-volume-profit analysis.
15. A number of companies use both absorption costing and variable costing.

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 16. Under a just-in-time (JIT) production environment, income under absorption costing tends to be equal with income under variable
costing.
17. There is no capacity or volume variance under s standard variable costing system.
18. Variable costing is not permitted for income tax purposes, but it is widely accepted for external financial reports.
19. A basic concept of the contribution approach and variable costing is that fixed costs are not important in an organization.
20. Variable costing is better suited to cost-volume-profit calculations than absorption costing.

PROBLEM-SOLVING

Problem 1

Chucky Company operated at a normal capacity of 1,000 units in the year 2016. The company sold 80% of these units at a price of P12 per
unit. Manufacturing costs incurred during the year are as follows:

Manufacturing:
Materials P 1,500
Labor 1,000
Variable Factory Overhead 500
Fixed Factory Overhead 2,000
Selling and Administrative Expenses
Variable P 1,200
Fixed 800

Required: Compute for the following:

1. Inventory cost per unit under absorption and variable costing.
2. Cost of ending inventory under absorption and variable costing.

Problem 2

Gregor Company makes state-of-the-art pajamas. Each pajama sells for P1,000 each. Data for 2016’s operation are as follows:
Units:
Beginning Inventory 5
Production 80
Ending Inventory 15
Variable Costs:
Direct Materials P 24,000
Direct Labor 16,000
Factory Overhead 8,000
Selling and Administrative 4,000
Fixed Costs:
Factory Overhead P 20,000
Selling and Administrative 2,000

Required:
1. Compute for the net income under both absorption and variable costing.
2. Provide computation explaining the difference in income between the two costing methods.

Problem 3

The following information is available for Ford Company for its first year of operations:

Sales in units 5,000

Production in units 8,000
Manufacturing costs:
Direct labor P3 per unit
Direct material 5 per unit
Variable overhead 1 per unit
Fixed overhead P100,000
Net income (absorption method) P30,000
Sales price per unit P40

Required:
1. If Ford Company had used variable costing, what amount of income before income taxes would it have reported?
2. What was the total amount of Selling and administrative expense incurred by Ford Company?
3. If Ford Company were using variable costing, what would it show as the value of ending inventory?

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Problem 4

The following information has been extracted from the financial records of Clinton Corporation for its first year of operations:

Units produced 10,000

Units sold 7,000
Variable costs per unit:
Direct material P8
Direct labor 9
Manufacturing overhead 3
SG&A 4
Fixed costs:
Manufacturing overhead P70,000
SG&A 30,000

Required:

1. How much is the difference in net income if Clinton Corporation used absorption costing instead of variable costing?
2. Based on absorption costing, the Cost of Goods Manufactured for Clinton Corporation's first year would be
3. Based on absorption costing, what amount of period costs will Clinton Corporation deduct?

Problem 5

The following information was extracted from the first year absorption-based accounting records of Enigma Corporation

Total fixed costs incurred P100,000

Total variable costs incurred 50,000
Total period costs incurred 70,000
Total variable period costs incurred 30,000
Units produced 20,000
Units sold 12,000
Unit sales price P12

Required:

1. What is Cost of Goods Sold for Enigma Corporation's first year?

2. If Enigma Corporation had used variable costing in its first year of operations, how much income (loss) before income taxes would it
have reported?
3. Based on variable costing, if Enigma had sold 12,001 units instead of 12,000, its income before income taxes would have been

Problem 6

Abdi Company, which has only one product, has provided the following data concerning its most recent month of operations:

Selling price .................................................................... P81

Units in beginning inventory ........................................... 0

Units produced ............................................................... 7,300
Units sold ........................................................................ 7,000
Units in ending inventory ................................................ 300

Variable costs per unit:

Direct materials .......................................................... P20

Direct labor ................................................................. P30
Variable manufacturing overhead ............................. P7
Variable selling and administrative ........................... P11

Fixed costs:
Fixed manufacturing overhead .................................. P65,700
Fixed selling and administrative ................................ P21,000

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Required: Determine the following:
1. Unit product cost for the month under variable costing?
2. Unit product cost for the month under absorption costing?
3. Total contribution margin for the month under the variable costing approach is:
4. Total gross margin for the month under the absorption costing approach is:
5. Total period cost for the month under the variable costing approach?
6. Total period cost for the month under the absorption costing approach?
7. Net operating income for the month under variable costing?
8. Net operating income for the month under absorption costing?

Problem 7

McCoy Corporation manufactures a computer monitor. Shown below is McCoy's cost structure:

Variable cost per Total fixed cost for the

monitor year
Manufacturing cost ........................................ P75.20 P912,000
Selling and administrative ............................. P14.60 P456,000

In its first year of operations, McCoy produced 100,000 monitors but only sold 95,000. McCoy's gross margin in this first year was
P2,629,600. McCoy's contribution margin in this first year was P2,109,000.

Required:
1. Under the variable costing method, what is McCoy's net operating income for its first year?
Under the absorption costing method, what is McCoy's net operating income for its first year?

Problem 8

The following information is taken from the books of Renz Company, which assumes first-in, first-out (FIFO) for inventory cost flow:
2013 2014
Beginning inventory None ?
Production 10,000 units 9,000 units
Ending inventory 3,500 units 1,000 units

Sales (P2 per unit) ? ?

Variable manufacturing costs (P0.75/unit) P 7,500 P 6,750
Fixed manufacturing costs 5,000 5,400
Selling and administrative costs (50% variable) 4,500 7,500

Required:
1. Determine the 2013 profit under absorption and variable costing.
2. Reconcile the two income figures in No. 1.
3. Determine the 2014 profit under absorption and variable costing.
4. Reconcile the two income figures in No. 3.

Problem 9

Coastal Corporation, which uses throughput costing, began operations at the start of the current year. Planned and actual production equaled
20,000 units, and sales totaled 17,500 units at P95 per unit. Cost data for the year were as follows:

Direct materials (per unit) P 18

Conversion cost:
Direct labor 160,000
Variable manufacturing overhead 280,000
Fixed manufacturing overhead 340,000
Selling and administrative costs (total) 430,000

The company classifies direct materials as a throughput cost.

Required:
1. Compute the company's total cost for the year.
2. How much of this cost would be held in year-end inventory under throughput costing?
3. How much of the company's total cost for the year would appear on the period's income statement under throughput costing?
4. Compute the year's throughput-costing net income.

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 MULTIPLE-CHOICE

1. Under variable costing, fixed manufacturing overhead is:

A. expensed immediately when incurred.
B. never expensed.
C. applied directly to Finished-Goods Inventory.
D. applied directly to Work-in-Process Inventory.
E. treated in the same manner as variable manufacturing overhead.

2. All of the following are inventoried under variable costing except:

A. direct materials D. fixed manufacturing overhead
B. direct labor E. items "C" and "D" above
C. variable manufacturing overhead

3. All of the following are expensed under variable costing except:

A. variable manufacturing overhead D. fixed selling and administrative costs
B. fixed manufacturing overhead E. items "C" and "D" above
C. variable selling and administrative costs

4. All of the following costs are inventoried under absorption costing except:
A. direct materials D. fixed manufacturing overhead
B. direct labor E. fixed administrative salaries
C. variable manufacturing overhead

5. All of the following are inventoried under absorption costing except:

A. direct labor D. sales commissions
B. raw materials used in production E. machine lubricant used in production
C. utilities cost consumed in manufacturing

6. The underlying difference between absorption costing and variable costing lies in the treatment of:
A. direct labor D. variable selling and administrative expenses
B. variable manufacturing overhead E. fixed selling and administrative expenses
C. fixed manufacturing overhead

7. Which of the following costs would be treated differently under absorption costing and variable costing?
Variable Fixed
Direct Manufacturing Administrative
Labor Overhead Expenses
A. Yes No Yes
B. Yes Yes Yes
C. No Yes No
D. No No Yes
E. No No No

8. Lone Star has computed the following unit costs for the year just ended:
Direct material used P 12
Direct labor 18
Variable manufacturing overhead 25
Fixed manufacturing overhead 29
Variable selling and administrative cost 10
Fixed selling and administrative cost 17

Under variable costing, each unit of the company's inventory would be carried at:
A. P35 B. P55 C. P65 D. P84

9. Prescott Corporation has computed the following unit costs for the year just ended:
Direct material used P 18
Direct labor 27
Variable manufacturing overhead 30
Fixed manufacturing overhead 32
Variable selling and administrative cost 9
Fixed selling and administrative cost 17

Under absorption costing, each unit of the company's inventory would be carried at:
A. P75 B. P107 C. P116 D. P133

10. Santa Fe Corporation has computed the following unit costs for the year just ended:
Direct material used P 25
Direct labor 19
Variable manufacturing overhead 35
Fixed manufacturing overhead 40

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 Variable selling and administrative cost 17
Fixed selling and administrative cost 32

Which of the following choices correctly depicts the per-unit cost of inventory under variable costing and
absorption costing?
Variable Absorption
Costing Costing
A. P79 P119
B. P79 P151
C. P96 P119
D. P96 P151

11. Delaware has computed the following unit costs for the year just ended:
Variable manufacturing cost P 85
Fixed manufacturing cost 20
Variable selling and administrative cost 18
Fixed selling and administrative cost 11

Which of the following choices correctly depicts the per-unit cost of inventory under variable costing and
absorption costing?
A. Variable, p85; absorption, p105 C. Variable, p103; absorption, p105
B. Variable, p85; absorption, p116 D. Variable, p103; absorption, p116

Use the following to answer questions 12 and 13:

Indiana Company incurred the following costs during the past year when planned production and actual
production each totaled 20,000 units:

Direct materials used P 280,000

Direct labor 120,000
Variable manufacturing overhead 160,000
Fixed manufacturing overhead 100,000
Variable selling and administrative costs 60,000
Fixed selling and administrative costs 90,000

12. If Indiana uses variable costing, the total inventoriable costs for the year would be:
A. P400,000 B. P460,000 C. P560,000 D. P620,000

13. The per-unit inventoriable cost under absorption costing is:

A. P9.50 B. P25.00 C. P28.00 D. P33.00

14. Consider the following comments about absorption- and variable-costing income statements:
I. A variable-costing income statement discloses a firm's contribution margin.
II. Cost of goods sold on an absorption-costing income statement includes fixed costs.
III. The amount of variable selling and administrative cost is the same on absorption- and variable-costing
income statements.

Which of the above statements is (are) true?

A. I only B. II only C. I and II D. I, II, and III

Use the following data for questions 15 through 17:

15. Roberts, which began business at the start of the current year, had the following data:
Planned and actual production 40,000 units
Sales 37,000 units at P15/unit
Production costs:
Variable P4/unit
Fixed P260,000
Selling and administrative costs:
Variable P1/unit
Fixed P32,000

The gross margin that the company would disclose on an absorption-costing income statement is:
A. P97,500 B. P147,000 C. P166,500 D. P370,000

16. The contribution margin that the company would disclose on an absorption-costing income statement is:
A. P -0- B. P147,000 C. P166,500 D. P370,000

17. The contribution margin that the company would disclose on a variable-costing income statement is:

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 A. P97,500 B. P147,000 C. P166,500 D. P370,000

18. Chicago began business at the start of the current year. The company planned to produce 25,000 units, and
actual production conformed to expectations. Sales totaled 22,000 units at P30 each. Costs incurred were:

Fixed manufacturing overhead P 150,000

Fixed selling and administrative cost 100,000
Variable manufacturing cost per unit 8
Variable selling and administrative cost per unit 2

If there were no variances, the company's absorption-costing net income would be:
A. P190,000 B. P202,000 C. P208,000 D. P220,000

19. Madison began business at the start of the current year. The company planned to produce 30,000 units, and
actual production conformed to expectations. Sales totaled 28,000 units at P32 each. Costs incurred were:
Fixed manufacturing overhead P 150,000
Fixed selling and administrative cost 90,000
Variable manufacturing cost per unit 11
Variable selling and administrative cost per unit 2

If there were no variances, the company's variable-costing net income would be:
A. P270,000 B. P292,000 C. P308,000 D. P532,000

20. The following data relate to Lobo Corporation for the year just ended:
Sales revenue P 750,000
Cost of goods sold:
Variable portion 370,000
Fixed portion 110,000
Variable selling and administrative cost 50,000
Fixed selling and administrative cost 75,000

Which of the following statements is correct?

A. Lobo’s variable-costing income statement would reveal a gross margin of P270,000.
B. Lobo’s variable costing income statement would reveal a contribution margin of P330,000.
C. Lobo’s absorption-costing income statement would reveal a contribution margin of P330,000.
D. Lobo’s absorption costing income statement would reveal a gross margin of P330,000.

Use the following to answer questions 21 and 22:

Franz began business at the start of this year and had the following costs: variable manufacturing cost per unit,
P9; fixed manufacturing costs, P60,000; variable selling and administrative costs per unit, P2; and fixed selling
and administrative costs, P220,000. The company sells its units for P45 each. Additional data follow.

Planned production in units 10,000

Actual production in units 10,000
Number of units sold 8,500

There were no variances.

21. The net income (loss) under absorption costing is:

A. P(7,500) B. P9,000 C. P15,000 D. P18,000

22. The net income (loss) under variable costing is:

A. P(7,500) B. P9,000 C. P15,000 D. P18,000

23. Income reported under absorption costing and variable costing is:
A. always the same
B. typically different
C. always higher under absorption costing
D. always higher under variable costing

24. Gomez's inventory increased during the year. On the basis of this information, income reported under absorption
costing:
A. will be the same as that reported under variable costing.
B. will be higher than that reported under variable costing.
C. will be lower than that reported under variable costing.
D. will differ from that reported under variable costing, the direction of which cannot be determined from the
information given.

25. Which of the following conditions would cause absorption-costing net income to be lower than variable-costing net
income?

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 A. Units sold exceeded units produced C. Units sold were less than units produced
B. Units sold equaled units produced D. Selling expenses increased

26. Which of the following situations would cause variable-costing net income to be lower than absorption-costing net
income?
A. Units sold equaled 39,000 and units produced equaled 42,000.
B. Units sold and units produced were both 42,000.
C. Units sold equaled 55,000 and units produced equaled 49,000.
D. Sales prices decreased by p7 per unit during the accounting period.

27. Consider the following statements about absorption- and variable-costing net income:
I. Yearly income reported under absorption costing will differ from income reported under variable costing if
production and sales volumes differ.
II. Long-run, total income reported under absorption costing will often be close to that reported under variable
costing.
III. Differences in income under absorption and variable costing can often be reconciled by multiplying the
change in inventory (in units) by the variable manufacturing overhead cost per unit.

Which of the above statements is (are) true?

A. I only B. II only C. III only D. I and II

28. Which of the following formulas can often reconcile the difference between absorption- and variable-costing net
income?
A. Change in inventory units x predetermined variable-overhead rate per unit.
B. Change in inventory units ÷ predetermined variable-overhead rate per unit.
C. Change in inventory units x predetermined fixed-overhead rate per unit.
D. Change in inventory units ÷ predetermined fixed-overhead rate per unit.

29. Monex reported P65,000 of net income for the year by using absorption costing. The company had no beginning
inventory, planned and actual production of 20,000 units, and sales of 18,000 units. Standard variable
manufacturing costs were P20 per unit, and total budgeted fixed manufacturing overhead was P100,000. If there
were no variances, net income under variable costing would be:
A. P15,000 B. P55,000 C. P65,000 D. P75,000

30. Canyon reported P106,000 of net income for the year by using variable costing. The company had no beginning
inventory, planned and actual production of 50,000 units, and sales of 47,000 units. Standard variable
manufacturing costs were P15 per unit, and total budgeted fixed manufacturing overhead was P150,000. If there
were no variances, net income under absorption costing would be:
A. P52,000 B. P97,000 C. P106,000 D. P115,000

31. Consider the following statements about absorption costing and variable costing:
I. Variable costing is consistent with contribution reporting and cost-volume-profit analysis.
II. Absorption costing must be used for external financial reporting.
III. A number of companies use both absorption costing and variable costing.

Which of the above statements is (are) true?

A. I only B. II only C. I and II D. I, II, and III

32. Consider the following statements about absorption costing and variable costing:
I. Variable costing is consistent with contribution reporting and cost-volume-profit analysis.
II. Variable costing must be used for external financial reporting.
III. A number of companies use both absorption costing and variable costing.

Which of the above statements is (are) true?

A. I only B. III only C. I and II D. I and III

33. For external-reporting purposes, generally accepted accounting principles require that net income be based on:
A. absorption costing B. variable costing C. direct costing D. semi-variable costing

34. The fixed-overhead volume variance under variable costing:

A. coincides with the fixed manufacturing overhead that was applied to production.
B. is deducted on the income statement.
C. does not exist.
D. will equal the fixed-overhead budget variance.

35. Which of the following differs between absorption costing and variable costing?
A. The number of units produced. C. Sales revenues.
B. The fixed-overhead volume variance. D. The treatment of variable manufacturing overhead.

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