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VARIABLE VS. ABSORPTION COSTING; HOW MANAGEMENT

DECISIONS AFFECTED BY THE COSTING METHOD CHOSEN

ACCT 2200 Principles of Accounting II

Variable costing:
Tool for management

Variable costing vs. absorption costing

1.

Classification of costs under variable & absorption costing

2.

Comparison between variable & absorption costing:

a.

Unit product cost

b.

Income statement

3.

Illustration I: The effect of fluctuating sales

4.

Comparative income effects

5.

Illustration II: The effect of fluctuating production

6.

Advantages of variable costing

1. Classification of costs under absorption & variable

costing
a.

b.

Absorption costing
i.

A costing method that treats ALL manufacturing costs as product costs

ii.

Doesnt look at whether they are fixed or variable

iii.

Unit cost = DM, DL and both variable & fixed OH

iv.

Required for external financial reports & tax reporting

Variable costing
i.

Only those manufacturing costs that vary with output are treated as
product costs

ii.

Unit cost = DM, DL and only variable portion of OH

iii.

Fixed OH not treated as product cost, but like period cost, i.e., expensed
entirely each period and excluded from product costs

1. Classification of costs under absorption & variable

4
costing
c. Variable costing & absorption costing are alternative methods of
determining unit product costs
d.

Both have impact on:

i.

Inventory valuations (balance sheet);

ii.

Net income (income statement)

1. Classification of costs under absorption & variable

costing
Absorption
Costing

Product costs

Period costs

Variable
Costing
Direct materials
Direct labor
Variable manufacturing OH
overhead
Fixed manufacturing OH
overhead
Selling and administrative
expenses

Product costs

Period costs

2. Comparison between absorption & variable costing

a. Unit Cost Comparison

Unit product costs differ between variable and absorption costing.

EXAMPLE: Harvey Company produces a single product.

Number of units produced annually

25,000

Variable costs per unit:

DM, DL & variable OH

$10

Selling & administrative expense

$3

Fixed costs per year:

Fixed OH

$150,000

Fixed selling & administrative expense

$100,000

Unit product costs are computed as follows:

DM, DL & variable OH

Fixed manufacturing overhead ($150,000 25,000 units)
Total unit product cost

Absorption

Variable

Costing

Costing

$10

$10

6
$16

-0$10

S&A expenses are always treated as period costs; they are not treated as product costs under either
costing method.

2. Comparison between absorption & variable costing

b. Income Statement Comparison

Harvey Company had no beginning inventory, produced 25,000 units, and sold 20,000
units last year.
Absorption costing
Sales (20,000 units x $30) $600,000
Less cost of goods sold:
Beginning inventory $
-0Add COGM (25,000 units x $16)
400,000
Goods available for sale 400,000
Less ending inventory (5,000 units x $16) 80,000
Gross margin
280,000
Less selling & admin. expense
(20,000 units x $3 + $100,000)
160,000
Net income $120,000

320,000

2. Comparison between absorption & variable costing

b. Income Statement Comparison (continued)
Variable costing
Sales (20,000 units x $30)
$600,000
Less variable expenses:
Variable cost of goods sold:
Beginning inventory $
-0Add variable manufacturing costs
(25,000 units x $10)
250,000
Goods available for sale 250,000
Less ending inventory (5,000 x $10) 50,000
Variable cost of goods sold
200,000
Variable selling & admin.
(20,000 units x $3)
60,000
260,000
Contribution margin
340,000
Less fixed expenses:
Fixed manufacturing overhead
150,000
Fixed selling & admin. Expense
100,000
Net income
$ 90,000

250,000

2. Comparison between absorption & variable costing

b. Income Statement Comparison (continued)

Cost of

Ending

Goods Sold

Inventory

Absorption costing
Variable manufacturing costs
(20,000 x $10)

$200,000

(5,000 x $10)

$50,000

Fixed manufacturing overhead

(20,000 x $6)
(5,000 x $6)
Total

120,000

30,000

$320,000

$80,000

Variable costing
Variable manufacturing costs
(20,000 x $10)

$200,000

(5,000 x $10)
Total

$200,000

$50,000
$50,000

2. Comparison between absorption & variable costing

b. Income Statement Comparison (continued)
RECONCILIATION OF NET INCOMES:
Variable costing net income

$90,000

Add: Fixed manufacturing overhead

cost deferred in inventory under
absorption costing (5,000 units x $6)
Absorption costing net income

30,000
$120,000

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2. Comparison between absorption & variable costing

b. Income Statement Comparison (continued)

Questions:
i.

Which method gives higher ending WIP and FG inventory,

variable or absorption costing?

ii.

Which method gives higher COGS?

iii.

Which method gives higher net income?

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3. Illustration I: The effect of fluctuating sales

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Holland Company produces a single product.

Number of units produced annually

5,000

Variable costs per unit:

DM, DL & variable OH

$5

Selling & administrative expense

$1

Fixed costs per year:

Fixed manufacturing overhead

$15,000

Fixed selling & admin. Expense

$21,000

Unit product costs are computed as follows:

Absorption
Costing

Variable

Costing

Direct materials, direct labor, and

variable manufacturing overhead

$5

$5

Fixed manufacturing overhead

($15,000 5,000 units)
Total unit product cost $8

-0-

$5

Income statements using both costing methods over a three-year period are provided on the following transparency. (Note
the computation of the variable cost of goods sold on the variable costing income statements. The method used is simpler
than the method used in the previous example.)

3. Illustration I: The effect of fluctuating sales

Year 1

Year 2

Year 3

Units in beginning inventory

Units produced
Units sold

5,000

5,000

-0- -0- 1,000

5,000

4,000

5,000

6,000

Units in ending inventory -0- 1,000

-0-

Absorption costing
Sales (@ $15)

$75,000 $60,000 $90,000

Less variable expenses:

Beginning inventory (@ $8)
Add COGM (@ $8)

-040,000

Less ending inventory (@ $8)

Gross margin
Less selling & admin.

8,000

40,000 40,000 40,000

Goods available for sale

Cost of goods sold

-0-

-0-

40,000
8,000

40,000 32,000 48,000

35,000

28,000

42,000

26,000 25,000 27,000

Net income $ 9,000 $ 3,000 15,000

48,000
-0-

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3. Illustration I: The effect of fluctuating sales

Year 1

Year 2

Year 3

Units in beginning inventory

Units produced
Units sold

5,000

5,000

-0- -0- 1,000

5,000

4,000

5,000

6,000

Units in ending inventory -0- 1,000

-0-

Variable costing
Sales (@ $15)

$75,000 $60,000 $90,000

Less variable expenses:

Variable COGS (@ $5)

25,000

Variable SG&A expenses (@ $1)

Total variable expenses
Contribution margin

20,000

5,000
30,000

4,000
24,000

30,000
6,000
36,000

45,000 36,000 54,000

Less fixed expenses:

Fixed manufacturing OH
Fixed SG&A expenses
Total fixed expenses

15,000

15,000

21,000 21,000 21,000

36,000 36,000 36,000

Net income $ 9,000 $

-0-

$18,000

15,000

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3. Illustration I: The effect of fluctuating sales

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RECONCILIATION OF NET INCOME (fluctuating sales):

Variable costing net income

Year 1

Year 2

Year 3

$9,000

$18,000

-0-

Add: Fixed manufacturing overhead

cost deferred in inventory under
absorption costing (1,000 units x $3)

3,000

Deduct: Fixed manufacturing overhead

cost released from inventory under
absorption costing (1,000 units x $3)
(3,000)
Absorption costing net income

$9,000

$3,000

$15,000

4. Comparative income effects

Relation Between
Relation Between

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Variable and Absorption

Production and Sales

Costing Net Incomes

Production = Sales Absorption costing NI =

(No change in inventory)

Variable costing NI

Production > Sales Absorption costing NI >

(Inventory increases)

Variable costing NI *

Production < Sales Absorption costing NI <

(Inventory decreases)

Variable costing NI #

* Net income will tend to be higher under absorption costing since fixed manufacturing overhead cost will
be deferred in inventory under absorption costing.
#Net income will tend to be lower under absorption costing since fixed manufacturing overhead cost will be
released from inventory under absorption costing.

4. Comparative income effects

Question: Is net income always more volatile under variable costing?
Given the production level, changes in sales volume cause changes in net
income; this is true under both variable and absorption costing; but net
income is more volatile under variable costing than under absorption
costing.
Question: Does net income change with production level under variable
costing?
Given the sales volume, changes in production level cause changes in net
income; net income is more volatile under absorption costing

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5. Illustration II: The effect of fluctuating production

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Suppose all of the facts are the same as in the previous example of Holland Company except that
production and sales are as follows:
Year 1

Year 2

Year 3

-0-

-0-

1,000

Units in beginning inventory

Units produced
Units sold
Units in ending inventory

5,000

6,000

5,000
-0-

4,000

5,000
1,000

5,000
-0-

Unit product costs are computed as follows:

Year 1

Year 2

Year 3

$5.00

$5.00

$5.00

Absorption costing
DM, DL & variable OH
Fixed manufacturing overhead
($15,000 5,000 units)

3.00

($15,000 6,000 units)

($15,000 4,000 units)
Unit product cost

2.50

3.75

$8.00

$7.50

$8.75

5. Illustration II: The effect of fluctuating production

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Year 1

Year 2

Year 3

$75,000

$75,000

$75,000

-0-

-0-

7,500

Add COGM

40,000

45,000

35,000

Goods available for sale

40,000

45,000

42,500

Absorption costing
Sales (@ $15)
Less cost of goods sold:
Beginning inventory

Less ending inventory

Cost of goods sold
Gross margin
Less selling & admin
Net income

-0-

7,500

-0-

40,000

37,500

42,500

35,000

37,500

32,500

26,000

26,000

26,000

$ 9,000

$11,500

$6,500

5. Illustration II: The effect of fluctuating production

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Suppose all of the facts are the same as in the previous example of Holland Company except that
production and sales are as follows:
Year 1

Year 2

Year 3

-0-

-0-

1,000

Units in beginning inventory

Units produced
Units sold
Units in ending inventory

5,000
5,000
-0-

6,000
5,000
1,000

4,000
5,000
-0-

Unit product costs are computed as follows:

Year 1

Year 2

Year 3

$5.00

$5.00

$5.00

$5.00

$5.00

$5.00

Variable costing
DM, DL & variable OH
Unit product cost

5. Illustration II: The effect of fluctuating production

Year 1

Year 2

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Year 3

Variable costing
Sales (@ $15)

$75,000

$75,000

$75,000

25,000

25,000

25,000

5,000

5,000

5,000

Less variable expenses:

Variable COGS (@ $5)
Variable selling & admin.
expenses (@ $1)
Total variable expenses

30,000

30,000

30,000

Contribution margin

45,000

45,000

45,000

Less fixed expenses:

Fixed manufacturing overhead

15,000

15,000

15,000

Fixed selling & admin. expense

21,000

21,000

21,000

Total fixed expenses

Net income

36,000

36,000

36,000

$ 9,000

$ 9,000

$ 9,000

5. Illustration II: The effect of fluctuating production

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RECONCILIATION OF NET INCOME (fluctuating production):

Variable costing net income

$9,000

Year 1

Year 2

Year 3

$9,000

$ 9,000

Add: Fixed manufacturing overhead

cost deferred in inventory under
absorption costing (1,000 units x $2.50)

2,500

Deduct: Fixed manufacturing overhead

cost released from inventory under
absorption costing (1,000 units x $2.50)
Absorption costing net income

$9,000

$11,500

(2,500)
$6,500

6. Advantages of variable costing

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a.

Variable costing is easy to use with CVP analysis.

b.

With variable costing, changes in levels of inventories do not affect net income.

c.

Absorption costing unit product costs may be misinterpreted by managers as variable

costs.

d.

In variable costing, fixed costs are highlighted rather than buried in cost of goods sold
and inventories.

e.

Variable costing is easier to use in controlling costs as will be discussed in later chapters.

f.

Variable costing net income is closer to net cash flow than absorption costing net income.

But, variable costing is usually not considered acceptable for external financial reports.
If absorption costing must be used for mandatory external reports, is it worth the trouble to
maintain a different costing system for internal reports?