MANAGEMENT ADVISORY SERVICES

TOPIC 2: VARIABLE AND ABSORPTION COSTING

OVERVIEW
 Includes all costs, whether variable or fixed costs, related to production.
 Also known as Full Costing or Conventional Costing
Absorption Costing
 External Reporting for long-run decisions – benefit from the advantages of both
methods
 Includes the variable costs directly incurred in production such as Direct Materials,
Direct Labor, and Variable Overhead.
Variable Costing
 Also known as Direct Costing
 Internal Reporting for short-run decisions and performance evaluation
 All manufacturing cost as well as non-manufacturing cost as long as it is value added
Super Absorption Costing are product cost.
 Life Cycle Costing
 Throughput costing has only Raw Materials as product cost and treats all other cost
as period cost.
Super Variable Costing  Wages paid to labor is directly related to daily attendance and not on units produced,
hence it should be treated as period cost.
 Theory of Constraints

DISTINCTION BETWEEN PRODUCT COST AND PERIOD COST

 Inventoried when incurred and will be only against the revenues only at the point of sale.
 Supported the Matching Principle “Associating Cause and Effect”
Product
Cost Note: Product costs are often treated as inventory and are referred to as inventoriable costs because
these costs are used to value the inventory. When products are sold, the product costs become part of
costs of goods sold as shown in the income statement.
 Treated an outright expense the moment it is incurred regardless of the relationship between the
production and sales units.
 The use of variable costing helps eliminate the manipulation of net income by treating fixed overhead
as period cost.
Period Cost
 Supported the Matching Principle “Immediate Recognition”
 Other examples of period costs include marketing expenses, rent (not directly tied to a production
facility), and office depreciation. Also, interest expense on a company's debt would be classified as a
period cost

INVENTORY COSTS BETWEEN VARIABLE COSTING AND ABSORPTION COSTING

1. As to treatment of the various operating income

Variable Absorption Throughput Super Absorption
Operating Costs
Costing Costing Costing Costing
a. Direct Materials Product Cost Product Cost Product Cost Product Cost
b. Direct Labor Product Cost Product Cost Period Cost Product Cost
c. Factory Overhead
Variable Product Cost Product Cost Period Cost Product Cost
Fixed Period Cost Product Cost Period Cost Product Cost
d. Selling and Administrative Expenses
Variable Period Cost Period Cost Period Cost Product Cost
Fixed Period Cost Period Cost Period Cost It is value adding

2. As to net income and inventory levels

Relationship between
Production Net
Inventories
and Sales Income
If production and sales units are the same, it means the same fixed
overhead was deducted against revenues, therefore the net income
P=S AC = VC BE = BB
should be the same. The inventory end will be the same level with
the beginning inventory.

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 Relationship between
If production exceeds sales, fewer fixed overhead was deducted
under absorption costing and more were deducted under variable
P>S AC > VC BE > BB
costing, hence absorption costing income would be higher. Since
production exceeded sales units, ending inventory units will increase
If production is less that sales, more fixed overhead was deducted
under absorption costing and fewer were deducted under variable
P<S AC < VC BE < BB costing. Hence absorption costing income would be lower. Since
production was less than sales, the additional units sold came from
beginning balance hence, lower ending inventory units.

3. As to cost segregation
Variable Costing  According to behavior
Absorption Costing  According to function

Costing of Inventories
Variable Costing Only variable manufacturing costs
Absorption Costing All manufacturing Costs
Throughput Costing Only raw materials
Super Absorption Costing All manufacturing costs & non-manufacturing cost

4. As to presentation of income statement

Variable Costing Contribution Margin Income Approach
Absorption Costing Conventional Income Statement
Throughput Contribution Income Statement

Throughput Costing Period cost under Throughput costing includes Direct Labor, Overhead both variable and
fixed, and all Selling and Administrative expense. For Throughput costing, period costs
are all based on units produced

Contribution Margin Income Conventional Income Throughput Contribution Income

Approach Statement Statement

Revenue XX Revenue XX Revenue XX

Less: Variable Cost (XX) Less: COGS (XX) Less: Direct Materials Cost of
Contribution Margin XX Gross Profit XX Goods Sold (XX)
Less: Fixed Cost (XX) Less: OPEX (XX) Throughput Contribution
Net Income XX Net Income XX Margin XX
Less: All Period Cost (XX)
Net Income XX

REVENUE DRIVER
Variable Costing Absorption Costing
What are the effects on cost-volume- Driven by: Driven by:
profit for a given level of fixed costs UNIT LEVEL OF SALES
and a given contribution margin per UNIT LEVEL OF SALES UNIT LEVEL OF PRODUCTION
unit? CHOSEN DENOMINATOR LEVEL

Performance Issues as Absorption Costing

 Managers may seek to manipulate income by producing too many units.
 Production beyond demand will increase the amount of inventory on hand.
 This will result in more fixed costs being capitalized as inventory.
 That will leave a smaller amount of fixed costs to be expensed during the period.
 Profit increases, and potentially, so does a manager’s bonus

Inventories and Costing Methods

 One way to prevent the unnecessary buildup of inventory for bonus purposes is to base manager's bonuses on profit
calculated using variable costing.
 Drawback: complicated system of producing two inventory figures-one for external reporting and the other for bonus
calculations.

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Other Manipulation Schemes beyond Simple Production
 Deciding to manufacture products that absorb the highest amount of fixed costs, regardless of demand ("cherry-
picking")
 Accepting an order to increase production, even though another plant in the same firm is better suited to handle that
order
 Deferring maintenance (Example: Training for employees)

Management Countermeasures for Fixed Cost Manipulation Schemes

 Focus on careful budgeting and inventory planning to reduce management's freedom to build up excess inventory.
 Incorporate a "carrying charge" for inventory in the internal accounting system.
 Change the period to evaluate performance. Instead of quarterly or annual horizon, evaluate the manager over a
three-to-five-year period.
 Include nonfinancial as well as financial variables in the measures of performance evaluation.

NATURE AND TREATMENT OF FIXED FACTORY OVERHEAD COSTS

Variable Costing – assumes that fixed overhead is incurred regardless of production, hence it must be treated as an outright
expense.
Absorption Costing – dictates that fixed overhead is essential in the production process. It is impossible to produce without
overhead, hence it is inventoriable.

Four different capacity levels are used to compute the budgeted fixed manufacturing cost rate. They are:
 The level of capacity based on producing at full efficiency all the time
 This measure of capacity does not allow for plant maintenance, shutdowns,
Theoretical
TRADITIONAL interruptions, or any other factors.
Capacity
 Theoretical capacity may be achieved for short periods of time, but it cannot be
sustained. Theoretical capacity represents an ideal goal of capacity utilization.
 the level of capacity that reduces theoretical capacity by considering
Practical
unavoidable operating interruptions
Capacity
 Example: Scheduled Maintenance or holidays
 The level of capacity utilization that satisfies average customer demand over a
TIME FRAME
Normal Capacity period of time
 Includes seasonal, cyclical, and trend factors
Master – Budget  The level of capacity that managers expect for the current year.
Capacity

CAPACITY LEVEL – basis of allocating overhead; denominator level.

With the challenges imposed in allocation overhead to the units produced, alternative cost methods were developed to control
cost and easily allocate overhead. Actual costs system together with the alternative costs systems are presented below:
A cost accounting system that uses actual cost or
NO actual rates, and actual quantities or hours used in AP X AQ – Materials,
Actual Cost System
VARIANCE production to determine the cost of specific Labor, Overhead
products.
A costing method under which a company
AP X AQ – Materials,
measures the actual costs of direct materials and
Labor
Normal Cost System direct labor, but uses predetermined factory
SP X AQ - Overhead
overhead rates to measure the factory overhead
(Applied Overhead)
cost for a period.
A costing method used to track production costs.
Extended Normal Cost Extended normal costing determines the cost of
SP X AQ – Materials,
System production using budgeted costs of the inputs used
Labor, Overhead
(Flexible Budget) in production multiplied by the actual quantity of the
inputs that were used in production.
A standard costing system is a tool for planning
Standard Cost System SP X SQ – Materials,
budgets, managing and controlling costs, and
(Static Budget) Labor, Overhead
evaluating cost management performance.

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 ACTUAL COST NORMAL COST FLEXIBLE BUDGET STATIC BUDGET AP – ACTUAL PRICE
Materials AP * AQ AP * AQ SP * AQ SP * SQ AQ – ACTUAL QUANTITY
Labor AP * AH AP * AH SP * AH SP * SH SP – STANDARD PRICE
FOH AP * AQ SP * AQ SP * AQ SP * SQ SQ – STANDARD QUANTITY

RECONCILIATION OF OPERATING INCOME UNDER VARIABLE COSTING AND ABSORPTION COSTING

ACTUAL AND NORMAL COST SYSTEM WITH INSIGNIFICANT VARIANCE

Net Income – Variable Costing XXX

Add: Fixed Cost in Ending Inventory XXX
Less: Fixed Cost in Beginning Inventory XXX
Net Income in Absorption Costing XXX

NORMAL COST SYSTEM WITH VARIANCE IS SIGNIFICANT

Net Income – Variable Costing XXX

Add: Fixed Cost in Ending Inventory XXX
Less: Fixed Cost in Beginning Inventory XXX
Add/Deduct any Over (Under) applied Overhead XXX
Net Income in Absorption Costing XXX

RECONCILING CONTRIBUTION MARGIN AND GROSS PROFIT

Contribution Margin XXX

Add: Variable Selling and Administrative Expenses XXX
Less: Fixed Overhead based on units sold XXX
Gross Profit XXX