The main difference between the variable costing method and the absorption costing

method is the treatment of FIXED MANUFACTURING OVERHEAD.

• In absorption costing, fixed manufacturing overhead is part of product costs. With that,
fixed manufacturing overhead related to unsold products becomes part of finished goods
inventory and will only be charged against revenue at this point of sale. Thus, in
comparison with variable costing, there is a “deferred fixed overhead” cost not charged
against revenue until products are sold.
• In variable costing, all fixed manufacturing overhead is charged and matched against
sales, thereby all fixed overhead is deducted to sales. There is no deferral of fixed
overhead in relation to inventory, thus providing a more precise measurement of income
on the premise that whatever the level of production and sale, we will still be incurring
these fixed overhead costs.
VARIABLE COSTING
PROBLEM 1
Mela Ltd. Produces novelty products which they sell to party stores for $125 per unit.
Recently they began producing a new product. The following cost and sales data is available
for the first three months of operations:

Beginning inventory 0

Units produced 10,000

Units sold 9,000

Manufacturing costs

Fixed overhead (total) $155,000

Variable overhead (per unit) $4

Direct Labour(per unit) $16

Direct materials (per unit) $40

Fixed selling & admin (total) $218,000

Variable selling & admin (per unit) $5

Step 1- Calculate the per-unit variable manufacturing cost
Direct materials per unit $ 40.00
Direct labour per unit $16.00
Variable manufacturing per unit $ 4.00
Total $60.00
Step 2 – Prepare a variable cost income statement

Mela Ltd.
Income Statement (Variable Costing)
Quarter Ended March 31
Sales revenue ($125* 9,000 units) $1, 125,000
Variable Cost of goods sold
Opening inventory 0
Variable manufacturing costs 600,000
Cost of goods available for sale 600,000
Ending inventory (60,000)
Variable Cost of goods sold 540,000
Variable selling &admin expense 45,000 585,000
Contribution margin 540,000
Fixed selling &admin expense 218,000
Fixed manufacturing costs 155,000
Operating Income $167,000
Problem 2
ZKB company manufactures a unique device that is used by internet users to boost Wi-Fi
signals. The following data relates to the first month of operation:
Beginning inventory: 0 units
Units produced: 40,000 units
Units sold: 35,000 units
Selling price: $120 per unit
Marketing and administrative expenses:
Variable marketing and administrative expenses per unit: $4
Fixed marketing and administrative expenses per month: $1,120,000
Manufacturing costs:
Direct materials cost per unit: $30
Direct labor cost per unit: $14
Variable manufacturing overhead cost per unit: $4
Fixed manufacturing overhead cost per month: $1,280,000

Required:

1. Calculate unit product cost and prepare income statement under variable costing system

and absorption costing system.
2. Prepare income statement under two costing system.
3. Prepare a schedule to reconcile the net operating income under variable and absorption
costing system
Solution:
Calculation of unit product cost:

*$1,280,000/40,000 units

Income statements
Absorption costing
Variable costing:

Reconciliation schedule:
Problem 3
AJX company manufactures and sells a single product. Company sold the same
number of units this year as it did last year but generated different profit for two
years. The president asks for the explanation of difference in net operating income
for two years.
The income statements of two years are as follows:
Sales, production and production for two years are as follows:

Variable selling and administrative expenses of AJX are $4.00 per unit sold.

Required:

1. Calculate unit product cost for both the years under absorption costing and
direct costing (variable costing).
2. Prepare a contribution margin format income statement for two years.
3. Reconcile the net operating income figures for each year under two costing
methods.

Solution:

(1) Computation of unit product cost:

Year 1:
 Unit product cost under variable costing: $12
 Unit product cost under absorption costing: $12 + $30* = $42
1. Variable Production Cost per unit = $12
2. Fixed manufacturing overhead= ($1,200,000/40,000 units = $30)
Year 2:
1. Unit product cost under variable costing: $12
2. Unit product cost under absorption costing: $12 + $24* = $36
1. Variable Production Cost per unit = $12
2. Fixed manufacturing overhead= ($1,200,000/50,000 units = $24)
(2) Variable costing income statement:

(3) Reconciliation of net operating income:

Problem 4
Fine Producers suffered a loss for the first month of operations. Following is the income
statement of Fine Producers prepared by an accounting service providing firm.

The loss created a serious problem because company was planning to use the statement to
encourage investors to purchase the stock of the company. Some other relevant data is given
below:
Units produced during the first month: 50,000 units
Units sold during the first month: 40,000 units

Variable costs:
Direct materials: $2.00 per unit
Direct labor: $1.60 per unit
Variable manufacturing overhead: $0.40 per unit
Variable selling and administrative expenses: $1.50 per unit
Required:
 What costing method was used by the accounting firm for preparing income statement of
Fine Producers? Can an absorption costing income statement show a profit rather than
loss?
 Prepare company’s income statement using variable costing and absorption costing for
the second month if 60,000 units were sold in the second month and there were no
closing inventories.
 Reconcile the second month’s net operating income under both the costing approaches.

Solution:
(1) Costing method used by accounting firm:

The net operating loss for the first month of operation under variable costing is $10,000
and the cost to be absorbed under absorption costing system is $30,000*. It results in a
net operating profit of $20,000 (30,000 – $10,000). The computations are shown below:

Fixed manufacturing overhead/Units manufactured

= $150,000/50,000 units
= $3.00 per unit

(2) Income statements for second month:

a. Absorption costing:
Unit product cost under absorption costing: Direct materials + Direct labor + Variable
manufacturing overhead + Fixed manufacturing overhead
= $2.00 + $1.60 + $0.40 + $3.00
= $7.00

Units manufactured in second month: Units sold + Units in ending inventory – Units in
beginning inventory
= 60,000 units + 0 units – 10,000 units
= 50,000 units

b. Variable costing:
Unit product cost under variable costing: Direct materials + Direct labor + Variable
manufacturing overhead
= $2.00 + $1.60 + $0.40
= $4.00

(3) Reconciliation:

If the company sells 60,000 units in second month, the sales of the second month will be
more than production. In that case, the fixed manufacturing overhead cost deferred in
inventory in first month will be released from inventory in the second month and the net
operating income under absorption costing will be less than the net operating income
under variable costing.