Cost and management accounting-I chapter 5

2022

CHAPTER FIVE

5. Income Effect of Alternative Product Costing Methods

Learning Objectives
After completing this unit, you should be able to:
 Explain absorption costing and variable costing
 Distinguish what costs are inventoried (assigned to products) under each technique.
 Compare the two costing techniques
 Develop income statements under absorption costing and variable costing
 Reconcile Variable costing and Absorption costing net income

5.1 Introduction

Two general approaches are used in manufacturing companies for costing products for the
purposes of valuing inventories and cost of goods sold. The first approach is called abnormal
costing. Absorption costing is generally used for external financial reports and tax reporting. The
other approach, called variable costing, is preferred by some managers for internal decision
making and must be used when an income statement is prepared in the contribution margin
format. Ordinarily, absorption costing and variable costing produce different figures for net
operating income, and the difference can be quite large. In addition to showing how these two
methods differ, we will consider the arguments for and against each costing method and we will
show how management decisions can be affected by the costing method chosen.

Products costs – in the products-costing systems we have studied in chapter three and four of
this course, that manufacturing overhead is applied to work-in-process Inventory as a product
cost along with direct material and direct labor costs. When the manufactured goods are finished
(completed), these product costs flow from work-in-process inventory into finished goods
inventory. Finally, during the accounting period when the goods are sold, the product costs flow
from finished goods inventory in to cost of goods sold, and then to expense account.
Accordingly, our main concern here is how fixed and variable costs are treated in the
determination of product costs and income and the discussion is presented in detail as follows.

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5.2 Variable and Absorption Costing

Absorption costing: - treats all manufacturing costs as product costs, regardless of whether they
are variable or fixed. The cost of a unit of product under the absorption costing method consists
of direct materials, direct labor, and both variable and fixed manufacturing overhead. Thus,
absorption costing allocates a portion of fixed manufacturing overhead cost to each unit of
product, along with the variable manufacturing costs. Because all manufacturing-overhead cost
are applied to (absorbed by) manufactured goods, it is frequently referred to as traditional or full
cost method. In other words, the variable costs, such as those of direct materials, direct labors
etc., are directly charged to the products while the fixed costs are apportioned on a suitable basis
over different products manufactured during the period.
Variable Costing: - Under variable costing, only those manufacturing costs that vary with
output are treated as product costs. This would usually include direct materials, direct labor, and
the variable portion of manufacturing overhead. Fixed manufacturing overhead is not treated as a
product cost under this method. Rather, fixed manufacturing overhead is treated as a period cost
and, like selling and administrative expenses, it is expensed in its entirety each period.
Consequently, the cost of a unit of product in inventory or in cost of goods sold under the
variable costing method does not contain any fixed manufacturing overhead cost. Variable
costing is sometimes referred to as direct costing or marginal costing.

5.3 Comparison of absorption and variable costing

Having read the above details in relation to both techniques (absorption costing and variable
costing), we can list down the following differences in a summarized way as below:

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Under absorption costing Under Variable costing

Both fixed cost and variable cost are Only variable cost is considered for product
considered for product costing and inventory costing and inventory valuation.
valuation
The fixed cost is charged to cost of production. Treatment of fixed overhead is different. Fixed
Each product is to bear a reasonable share of cost is considered period cost and
fixed cost and profitability of product is thus profitability of different products is fudged by
influenced by subjective apportionment of profit volume rate.
fixed overheads.
The presentation of cost data is on Presentation of data is oriented to highlight the
conventional pattern. Net Profit of each total contribution and contribution from each
product is determined after deducting fixed product
overhead
The difference in the magnitude of opening The difference in the magnitude of opening
inventory and closing inventory affects the unit stock and closing stock does not affect the unit
cost of production. Inventory affects the unit cost of production.
cost of production due to the impact of related
to the impact of related fixed overheads.

5.3.1. Unit product cost comparison

Illustration 1
To illustrate the computation of unit product costs under both absorption and variable costing,
consider ABC Company, a small company that produces a single product and that has the
following cost structure for the year 2017:
Number of units produced each year . . . . . . . . . . . . . …. . 6,000 units
Variable costs per unit:
Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . birr 2
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Variable manufacturing overhead . . . . . . . . . . . . . . . . . . 1
Variable selling and administrative expenses . . . . . . . . . 3
Fixed costs per year:
Fixed manufacturing overhead . . . . . . . . . . . . . . . . . . . . 30,000
Fixed selling and administrative expenses . . . . . . . . . . . 10,000

Required:
1. Compute the unit product cost under absorption costing.
2. Compute the unit product cost under variable costing.

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Solution
Absorption Costing
Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . birr 2
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . …. 4
Variable manufacturing overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ... . 1
Total variable manufacturing cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Fixed manufacturing overhead (birr 30,000 /6,000 units of product) . . . . . . . . 5
Unit product cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Birr 12
Variable Costing
Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . birr 2
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Variable manufacturing overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Unit product cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Birr 7
Under the absorption costing method, all manufacturing costs; variable and fixed, are included
when determining the unit product cost. Thus, if the company sells a unit of product and
absorption costing is being used, then $12 (consisting of $7 variable cost and $5 fixed cost) will
be deducted on the income statement as cost of goods sold. Similarly, any unsold units will be
carried as inventory on the balance sheet at $12 each.
Unit product cost=unit direct materials cost+ unit direct mfg labor cost+unit variable overhead cost +unit ¿ overhe
Under the variable costing method, only the variable manufacturing costs are included in product
costs. Thus, if the company sells a unit of product, only $7 will be deducted as cost of goods
sold, and unsold units will be carried as inventory on the balance sheet at only $7 each.
Unit product cost=unit direct materials cost+ unit direct mfg labor cost+u nit variable overhead cost

5.3.2. Income statement comparison

The following points should be noted when income statements under absorption costing and
variable costing are compared:

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(1) When sales and production coincide i.e., there is neither opening stock nor closing
stock, the results under both the methods will be same.
(2) When closing stock is more than the opening stock, profit under absorption costing will
be more than the profit under variable costing. This is because, under absorption
costing, a portion of fixed overhead is charged to the closing stock and carried over to
the next instead of being charged to the current period.
(3) When closing stock is less than the opening stock, the profit shown under absorption
costing will be lower than the profit shown under variable costing. This because, under
absorption costing a portion of fixed cost relating to the previous year is changed to
current period.
Illustration 2
In preparing these statements, we use the data for ABC Company presented earlier, along with
other information about the company as given below:
Units in beginning inventory . . . . . . . . . . . . . . . . 0
Units produced. . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000
Units sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
Units in ending inventory . . . . . . . . . . . . . . . . . . . 1,000
Selling price per unit . . . . . . . . . . . . . . . . . . . . . . birr 20
Selling and administrative expenses:
Variable cost per unit . . . . . . . . . . . . . . . . . . . . . . . . birr 3
Fixed cost per year . . . . . . . . . . . . . . . . . . . . . . . . . birr 10,000

Solution
Absorption Costing
Sales (5,000 units × birr 20 per unit) . . . . . . . …….……………………………….. birr 100,000
Cost of goods sold:
Beginning inventory . . . . . . . . . . . . . . . …………………………….. . birr 0
Add cost of goods manufactured (6,000 units * birr 12 per unit)……... 72,000
Goods available for sale…………........................................................... 72,000
Less ending inventory (1,000 units * birr12 per unit) . . . . . . . ………. (12,000)
Cost of goods sold . . . . . . . . . . . . . . . . . . . …………………………………………….. (60,000)
Gross margin ........................................................................................................................40,000

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Selling and administrative expenses: (5,000 units * birr 3/unit variable & birr 10,000 fixed)….(25,000)
Net operating income . . . . . . . . . . . . . . . . ………………………...……………...… birr 15,000

Variable Costing
Sales (5,000 units x birr 20 per unit) . . . . . . . ……………………………….………. birr 100,000
Variable expenses:
Variable cost of goods sold:
Beginning inventory . . . . . . . . . . . . …………………. ………………. Birr 0
Add variable manufacturing costs (6,000 units* birr 7 per unit)………. 42,000
Goods available for sale . . . . . . . . . ………………………………… . . 42,000
Less ending inventory (1,000 units * birr 7 per unit) . . . . . . . ……..….. (7,000)
Variable cost of goods sold . . . . . . . . . ……………………….............. 35,000
Variable selling & administrative expenses (5,000 units * birr 3/unit)…....15,000 …….….. (50,000)
Contribution margin . . . . . . . . . . . . . . . . . ………………………………………….…... 50,000
Fixed expenses:
Fixed manufacturing overhead . . . . . . . …………. . 30,000
Fixed selling and administrative expenses… …....... 10,000 …………………..…...... (40,000)
Net operating income . . . . . . . . . . . . . . . ……………………………………….…….birr 10,000

Several observations should be made concerning the income statements in the above illustration.
First, the net operating incomes under the two costing methods are not the same. The net
operating income under absorption costing is higher than under variable costing by birr 5,000.
Why is this? Under absorption costing, each of the units produced during the period is assigned
birr 5 of fixed manufacturing overhead cost. This is true of the 1,000 units in ending inventory as
well as the 5,000 units that were sold. Consequently, the ending inventory under absorption
costing contains birr 5,000 of fixed manufacturing overhead and the cost of goods sold contains
birr 25,000 of fixed manufacturing overhead. In contrast, the entire birr 30,000 of fixed
manufacturing overhead is expensed under variable costing.

As a direct result, the net operating income under variable costing is birr 5,000 lower than under
absorption costing. In effect, the birr 5,000 of fixed manufacturing overhead in ending inventory
under absorption costing is deferred to the future period in which these units are sold. This birr

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5,000 of fixed manufacturing overhead cost in the ending inventory is referred to as fixed
manufacturing overhead cost deferred in inventory. In general, under absorption costing,
when inventories increase, some of the fixed manufacturing costs of the current period are
reported on the balance sheet as part of the ending inventories rather than on the income
statement as part of cost of goods sold. Generally, the difference in ending inventories is due to
the fixed overhead cost. Fixed manufacturing overhead cost at birr 5 per unit is included under
the absorption approach. This explains the difference in ending inventory and in net operating
income (1,000 units X birr 5 per unit = birr 5,000).

Note: The difference between the absorption and variable costing approaches to accounting for
fixed manufacturing costs centers on timing. That means the main controversy between the two
methods centers on what costs should be inventoried (assigned to products). Advocates of
variable costing say that fixed manufacturing costs should be expensed immediately in total,
whereas advocates of absorption costing say that fixed manufacturing costs should be charged
against revenues gradually as units of product are sold. Any units of product not sold under
absorption costing result in fixed manufacturing costs being inventoried and carried forward on
the balance sheet as assets to the next period.

Summary for comparison between absorption and variable costing income statements

Relationship between Effect on Relationship between variable and

production and sales for the ending absorption costing net operating incomes
period inventories
Production = Sales No change in Absorption costing net operating income =
inventories Variable costing net operating income
Production > Sales Inventories Absorption costing net operating income >
increase Variable costing net operating income
Production < Sales Inventories Absorption costing net operating income <
decrease Variable costing net operating income

Example: Assume that Abco-company began operation on January-1, 2001, to manufacture

hand held electronic calculator. The company used standard costing system. Cost, production,

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and sales data for the first three years of Abco-company’s operations are given in the following
table below. Comparative income statements for years 2015, 2016 and 2017 are presented below,
using both absorption and variable costing.

Data provided by ABCO Company for the three operation periods:

2015 2016 2017
Production and inventory data:
-Planned production (in units) ----------------50,000 ------------ 50,000 ---------50,000
-Finished –goods inventory
(in units), January-1---------------------- -0- --------------- - 0- ---------15,000
-Actual production (in units) -------------------50,000 ------------50,000 -------- 50,000
-Sales (in units) --------------------------------- 50,000 -------------35,000 ------- 65,000
-Finished goods inventory (in units)
December-31------------------------------------ -0- -------------- 15,000 --------- -0-
Revenue and cost data, all three years:
-Sales price per unit---------------------------------------------------------------------birr 12
- Standard manufacturing costs per unit:
Direct material-------------------------------------------------------------------birr 3
Direct labor--------------------------------------------------------------------------- 2
Variable manufacturing overhead ------------------------------------------------- 1
Total variable standard cost per unit--------------------------------------------- birr 6
Used only Fixed manufacturing overhead:
under
Absorption Budgeted annual fixed overhead = birr 150,000 = birr 3
Costing Planned annual production 50,000
Total absorption standard cost per unit---------------- birr 9
- Variable selling and administrative costs per unit------------------------------ birr 1
- Fixed selling and administrative costs per year ----------------------------- birr 25,000
- Variance-there was no variance during 2015, 2016 and 2017.

Income Statements comparison under Absorption and variable costing

ABCO- Company
Absorption-costing Income Statement
For the year ended 2015 2016 2017

Sales revenue (at birr 12 per unit) ---------------birr 600,000 ----- birr 420,000 --- birr 780,000
Less: Cost of goods sold (at standard
absorption cost of birr 9 per unit) -------------------450,000 -------- 315,000 ------ 585,000
Gross margin-------------------------------------- birr 150,000 -------- 105,000 ----- birr 195,000
Less: Selling and Administrative expenses
(do not include fixed mfg overhead):
- Variable (at birr 1 per unit) --------- 50,000 -------- 35,000 ---- 65,000

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- Fixed --------------------------------- 25,000 --------- 25,000 ----- 25,000
Net income ---------------------------- birr 75,000 -------- $45,000 ---- $105,000
ABCO-Company
Variable-costing Income Statement
For the years ended 2015 2016 2017
Sales revenue (at birr 12 per unit) ---------- birr 600,000 -------- birr 420,000 ----- birr 780,000
Less: Variable expense:
- Variable manufacturing cost
(at standard variable cost of birr 6
per unit)-------------------------------300,000 ---------- birr 210,000 ---- 390,000
-Variable selling and administrative
( at birr 1 per unit)------------------- 50,000 ---------------- 35,000 ------- 65,000
-Contribution margin-------------- birr 250,000 ---------------175,000 --- -birr 325,000
Less: Fixed expenses:
- Fixed manufacturing overhead---------150,000 -------------- 150,000 ----- 150,000
- Fixed selling and administrative
expenses-------------------------------- 25,000 --------------- 25,000 --------25,000
-Net income-------------------------- birr 75,000 -------------birr 0 birr 150,000

 Comparison of absorption and variable costing income statements

From the absorption and variable income statements given in the table above, we can
notice the following features (points).

 Absorption costing income statement

i) The cost of goods sold expense for each year is determined by multiplying the
year’s sales unit by the standard absorption manufacturing cost per unit of birr 9.
Included in the birr 9 cost per unit is the predetermined fixed manufacturing-
overhead cost of birr 3 per unit.
ii) In Abco-company’s absorption-costing income statements, the only period
expenses are selling and administrative expenses. There is no deduction of fixed-
overhead costs as a lump-sum period expense at the bottom of each income
statement. As mentioned above, fixed manufacturing-overhead costs are included
in cost of goods sold on these absorption costing income statements.
 Variable costing income statement

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i) Notice that the format of the statement is different from the format used in
absorption costing in that the variable costing method is attempted to highlight
the separation of variable and fixed costs.
ii) In this, the manufacturing expenses subtracted from sales revenue each year
include only the variable costs, which amount to $6 per unit.
iii) The fixed manufacturing overhead is subtracted as a lump-sum period expense
at the bottom of each year’s income statement.

5.4 Effect of Changes in Production on Net Operating Income

Variable Costing: Net operating income is not affected by changes in production under variable
costing. In short, a change in production has no impact on net operating income when variable
costing is used.

Absorption Costing: Net operating income is affected by changes in production under absorption
costing. Note particularly that net operating income goes up and down between these two years
even though the same number of units is sold in each year. The reason for this effect can be
traced to fixed manufacturing overhead costs that shift between periods under absorption costing
as a result of changes in inventory.

Absorption costing Variable costing

- Fixed manufacturing overhead is treated - Management finds easy to understand
the same as the other product costs: direct - Consistent with the
materials and direct labor cost-volume-profit/CVP analysis
- Consistent with the long run pricing - Profit for period not affected by changes in
decisions that must cover full costs fixed manufacturing costs
- External reporting and income tax laws - Impact of fixed costs on profit emphasized
require absorption costing

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