Absorption & Variable Costing

(Go through the reference books for details)

 Introduction (Managerial Accounting, Garrison, 10th edition, p. 280)
Two general approaches are used for costing products for the purposes of valuing inventories and cost
of goods sold, one approach is absorption costing and another is variable costing. Absorption costing is
generally used for external financial reports and variable costing is preferred by some managers for
internal decision making and must be used when an income statement is prepared in the contribution
format. Absorption costing and variable costing produce different figures for net operating income, and
the difference can be quite large.

 Absorption Costing (Managerial Accounting, Garrison, 10th edition, p. 280)

Absorption costing treats all costs of production as product costs, regardless of whether they are
variable or fixed. The cost of unit of product under the absorption costing method therefore consists of
direct materials, direct labor, and both variable and fixed overhead. Thus, absorption costing allocates a
portion of fixed manufacturing overhead cost to each unit of product, along with the variable
manufacturing costs. Because absorption costing includes all costs of production as product costs, it is
frequently referred to as the full cost method.

Under the absorption costing:

1. Product costs = Direct Materials + Direct Labor + Variable Manufacturing Overhead + Fixed
Manufacturing Overhead
2. Period Costs = Variable Selling and Administrative Expenses + Fixed Selling and Administrative
Expenses

 Variable Costing (Managerial Accounting, Garrison, 10th edition, p. 280)

Under the variable costing, only those costs of production 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 charged off in its entirely against revenue 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
overhead cost. Variable costing is sometimes referred to as direct costing or marginal costing.

Under the variable costing:

1. Product costs = Direct Materials + Direct Labor + Variable Manufacturing Overhead
2. Period Costs = Fixed Manufacturing Overhead + Variable Selling and Administrative Expenses +
Fixed Selling and Administrative Expenses

1
Unit Cost Computation and Net Operating Income determination (Garrison, p. 281)
The following are the information of Boley Company relating a single product.

Units in beginning inventory 0

Number of units produced each year 6000
Units Sold 5000
Units in ending inventory 1000
Selling Price per unit Tk. 20
Variable cost per unit

Direct Materials Tk. 2

Direct Labor Tk. 4

Variable Manufacturing Overhead Tk. 1

Variable Selling and Administrative Expenses Tk. 3

Fixed Cost Per year:

Fixed manufacturing overhead Tk. 30000

Fixed selling and administrative Expenses Tk. 10000

Required:

1. Compute unit product cost under absorption costing and variable costing
2. Compute net operating income under absorption costing and variable costing
3. Reconcile the absorption costing and variable costing net operating income

 Solution to Illustration
Req. 1
Absorption Costing Variable Costing
Direct Materials Tk. 2 Tk. 2
Direct Labor Tk. 4 Tk. 4
Variable Manufacturing Overhead Tk. 1 Tk. 1
Total variable product cost Tk. 7 Tk. 7
Fixed manufacturing overhead (Tk. 30000÷6000) Tk. 5 0
Unit product cost Tk. 12 Tk. 7

2
Req. 2
Absorption Costing Taka Taka
Sales (5000 unit x Tk. 20) 100000
Less, Cost of good sold:
Beginning inventory 0
Add, Cost of good manufactured (6000 x 12) 72000
Cost of good available for sale 72000
Less, Ending inventory (1000 x 12) 12000
Cost of good sold 60000
Gross Margin 40000
Less, Selling and Administrative expenses:
Variable Selling and Administrative expenses (5000 x 3) 15000
Fixed Selling and Administrative expenses 10000
Total Selling and Administrative expenses 25000
Net Operating Income 15000

Variable Costing
Sales (5000 unit x Tk. 20) 100000
Less, Variable expenses:
Variable Cost of good sold:
Beginning inventory 0
Add, Variable manufacturing cost (6000 x 7) 42000
Cost of good available for sale 42000
Less, Ending inventory (1000 x 7) 7000
Variable Cost of good sold 35000
Variable Selling and Administrative expenses (5000 x 3) 15000
Total Variable expenses 50000
Contribution Margin 50000
Less, Fixed Expenses:
Fixed Manufacturing overhead 30000
Fixed Selling and Administrative expenses 10000
Total Fixed expenses 40000
Net Operating Income 10000

Req. 3
Variable costing net operating income Tk. 10000

Add fixed manufacturing overhead costs deferred in inventory under absorption costing

(1000 units x Tk. 5) 5000

Absorption costing net operating income Tk. 15000

3
Effect of Change in Inventory on Net Operating Income (Garrison, p. 287)

Relationship between Effect on Inventories Relationship between Absorption and

Production and Sales Variable costing net operating income

Production = Sales No change in inventories Absorption costing net operating income =

Variable costing net operating income

Production > Sales Inventories increase Absorption costing net operating income >
Variable costing net operating income

Production < Sales Inventories decrease Absorption costing net operating income <
Variable costing net operating income

 Effect of Change in Production on Net Operating Income (Garrison, p. 288)

1. Variable costing
Net operating income is not affected by changes in production under variable costing. A change in
production has no impact on net income when variable costing is used.

2. Absorption Costing
Net operating income is affected by changes in production under absorption costing. Under absorption
costing net operating income goes up with increase in production and goes down with the drop in
production. Net operating income goes up and down between 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 the absorption costing method as a result of changes in
inventory.

Advantages of Variable Costing and the Contribution Approach (p. 295)

1. The data that are required for CVP analysis can be taken directly from a contribution margin format
income statement. These data are not available on a conventional income statement based on
absorption costing
2. Under variable costing, the net operating income for a period is not affected by changes in
inventories
3. Managers often assume that unit product costs are variable costs. This is a problem under
absorption costing.
4. The impact of fixed costs on profits is emphasized under the variable costing.
5. Variable costing data make it easier to estimate the profitability of products, customers, and other
segments of the business.
6. Variable costing ties in with cost control methods such as standard costs and flexible budgets
7. Variable costing net operating income is closer to net cash flow than absorption costing net
operating income

4
 Problem 1
Dexter Company produces and sells a single product. Selected cost and operating data relating to the
product for two years are given below:

Selling Price per unit Tk. 50

Manufacturing Costs:

Variable cost for per unit produced:

Direct Materials 11

Direct Labor 6

Variable Overhead 3

Fixed Cost per year 120000

Selling and Administrative costs:

Variable per unit sold 5

Fixed per year 70000

Year 1 Year 2

Units in beginning inventory 0 2000

Units produced during the year 10000 6000

Units sold during the year 8000 8000

Units in ending inventory 2000 0

Required
1. Assume that the company uses absorption costing
a. Compute the unit product cost in each year
b. Prepare an income statement for each year
2. Assume that the company uses Variable costing
a. Compute the unit product cost in each year
b. Prepare an income statement for each year
3. Reconcile the variable costing and absorption costing net operating incomes
4. Show the effect on total net operating income after two years

5
 Problem 2

Maxwell Company manufactures and sells a single product. The following costs were incurred during
the company’s first year of operation:
Variable cost for per unit produced:

Direct Materials Tk. 18

Direct Labor 7

Variable Overhead 2

Variable selling and administrative 5

Fixed Cost per year:

Fixed manufacturing overhead 160000

Fixed selling and administrative expenses` 110000

During the year, the company produced 20000 units and sold 16000 units. The selling price of the
company’s product is Tk. 50 per unit.

Required
1. Assume that the company uses absorption costing
c. Compute the unit product cost
d. Prepare an income statement for the year
2. Assume that the company uses Variable costing
c. Compute the unit product cost
d. Prepare an income statement for the year
3. Reconcile the variable costing and absorption costing net operating incomes

 Problem 3
Taka Taka
Sales (40000 unit x Tk. 33.75) 1350000
Less, Cost of good sold:
Beginning inventory 0
Add, Cost of good manufactured (50000 x 21) 1050000
Cost of good available for sale 1050000
Less, Ending inventory (10000 x 21) 210000
Cost of good sold 840000
Gross Margin 510000
Less, Selling and Administrative expenses 420000
Net Operating Income 90000

6
The company’s selling and administrative expenses consist of Tk. 300000 per year in fixed expenses
and Tk. 3 per unit sold in variable expenses. The company’s Tk. 21 unit product cost given above is
computed as follows:
Direct Materials Tk. 10

Direct Labor 4

Variable manufacturing overhead 2

Fixed manufacturing overhead (Tk. 250000÷50000 Units) 5

Unit product cost Tk. 21

Required
1. Redo the income statement using variable costing
2. Reconcile the variable costing and absorption costing net operating incomes

Problem 4
Shastri Bicycle produces an inexpensive bicycle for use on the city’s crowded streets that it sells for
Tk. 500. Selected data for the company’ operations last year follow:

Units in beginning inventory 0

Units produced during the year 10000

Units sold during the year 8000

Units in ending inventory 2000

Variable cost for per unit produced:

Direct Materials Tk. 120

Direct Labor 140

Variable Manufacturing Overhead 50

Variable Selling and Administrative 20

Fixed Costs:
Fixed Manufacturing overhead Tk. 600000

Fixed Selling and Administrative 400000

Required
1. Compute the unit product cost for one bicycle under absorption costing and variable costing
2. Prepare an income statement using absorption costing

7
 Absorption & Variable Costing

 Solution to the Problem 1 (Garrison, p. 297)

Req. 1 (a) Calculation of unit product cost under absorption costing

Year 1 Year 2
Direct Materials Tk. 11 Tk. 11
Direct Labor 6 6
Variable Manufacturing Overhead 3 3
Total variable product cost Tk. 20 Tk. 20
Fixed manufacturing overhead
(Tk. 120000 ÷ 10000 Units) 12
(Tk. 120000 ÷ 6000 Units) 20
Unit product cost Tk. 32 Tk. 40

Req. 1 (b) Income Statement under absorption costing

Year 1 Year 2
Sales (8000 unit x Tk. 50) Tk. 400000 Tk. 400000
Less, Cost of good sold:
Beginning inventory Tk. 0 Tk. 64000
Add, Cost of good manufactured
(10000 units x Tk. 32) 320000
(6000 units x Tk. 40) 240000
Cost of good available for sale 320000 304000
Less, Ending inventory
(2000 units x Tk. 32) 64000
(0 units) 0
Cost of good sold 256000 304000
Gross Margin 144000 96000
Less, Selling and Administrative expenses:
Variable Selling & Administrative @ Tk. 5 40000 40000
Fixed Selling & Administrative 70000 70000
Total Selling & Administrative expense 110000 110000
Net Operating Income 34000 (14000)

8
Req. 2 (a) Calculation of unit product cost under Variable costing

Year 1 Year 2
Direct Materials Tk. 11 Tk. 11
Direct Labor 6 6
Variable Manufacturing Overhead 3 3
Total variable product cost Tk. 20 Tk. 20

Req. 2 (b) Income Statement under variable costing

Year 1 Year 2
Sales (8000 unit x Tk. 50) Tk. 400000 Tk. 400000
Less, Cost of Variable expenses:
Variable cost of good sold
(8000 unit x Tk. 20) Tk. 160000 Tk. 160000
Variable selling and administrative
(8000 unit x Tk. 5) 40000 40000
200000 200000
Contribution Margin 200000 200000
Less, Fixed Expenses:
Fixed manufacturing overhead 120000 120000
Fixed selling and administrative exp. 70000 70000
190000 190000
10000 10000

Req. 3 The reconciliation of the variable and absorption costing net operating income

Year 1 Year 2

Variable costing net operating income Tk. 10000 Tk. 10000

Add fixed manufacturing overhead costs deferred in inventory under

absorption costing (2000 units x Tk. 12)
24000

Deduct fixed manufacturing overhead costs released from inventory under

absorption costing (2000 units x Tk. 12)
(24000)

Absorption costing net operating income 34000 (14000)

Req. 4 The effect on total net operating income after two years

9
 Costing method 1st Period 2nd Period Total

Absorption costing Tk. 34000 (Tk. 14000) Tk. 20000

Variable costing 10000 10000 20000

Solution to Problem 2 (Garrison, p. 300)

Req. 1 (a) Calculation of unit product cost under absorption costing

Direct Materials Tk. 18
Direct Labor 7
Variable Manufacturing Overhead 2
Total variable product cost Tk. 27
Fixed manufacturing overhead (Tk. 160000 ÷ 20000 Units) 8
Unit product cost Tk. 35

Req. 1 (b) Income Statement under absorption costing

Sales (16000 unit x Tk. 50) Tk. 800000
Less, Cost of good sold:
Beginning inventory Tk. 0
Add, Cost of good manufactured (20000 units x Tk. 35) 700000
Cost of good available for sale 700000
Less, Ending inventory (4000 units x Tk. 35) 140000
Cost of good sold 560000
Gross Margin 240000
Less, Selling and Administrative expenses:
Variable Selling & Administrative (16000 units x Tk. 5) 80000
Fixed Selling & Administrative 110000
Total Selling & Administrative expense 190000
Net Operating Income 50000

Req. 2 (a) Calculation of unit product cost under Variable costing

Direct Materials Tk. 18
Direct Labor 7
Variable Manufacturing Overhead 2
Total variable product cost Tk. 27

10
Req. 2 (b) Income Statement under variable costing
Sales (16000 unit x Tk. 50) Tk. 800000
Less, Cost of Variable expenses:
Variable cost of good sold (16000 unit x Tk. 27) Tk. 432000
Variable selling and administrative (16000 unit x Tk. 5) 80000
512000
Contribution Margin 288000
Less, Fixed Expenses:
Fixed manufacturing overhead 160000
Fixed selling and administrative exp. 110000
270000
18000

Req. 3 The reconciliation of the variable and absorption costing net operating income
Variable costing net operating income Tk. 18000

Add fixed manufacturing overhead costs deferred in inventory under absorption costing
(4000 units x Tk. 8)
32000

Absorption costing net operating income 50000

 Solution to Problem 3 (Garrison, p. 300)

Req. 1 Calculation of unit product cost under Variable costing

Direct Materials Tk. 10

Direct Labor 4
Variable Manufacturing Overhead 2
Total variable product cost Tk. 16

Sales (40000 unit x Tk. 33.75) Tk. 1350000

Less, Cost of Variable expenses:
Variable cost of good sold (40000 unit x Tk. 16) Tk. 640000
Variable selling and administrative (40000 unit x Tk. 3) 120000
760000
Contribution Margin 590000
Less, Fixed Expenses:
Fixed manufacturing overhead 250000
Fixed selling and administrative exp. 300000
550000
40000

11
Req. 2 The reconciliation of the variable and absorption costing net operating income

Variable costing net operating income Tk. 40000

Add fixed manufacturing overhead costs deferred in inventory under absorption costing
(10000 units x Tk. 5)
50000

Absorption costing net operating income 90000

Solution to Problem 4 (Garrison, p. 301)

Req. 1 Calculation of unit product cost under absorption costing and variable costing

Absorption Variable
Costing Costing
Direct Materials Tk. 120 Tk. 120
Direct Labor 140 140
Variable Manufacturing Overhead 50 50
Total variable product cost Tk. 310 Tk. 310
Fixed manufacturing overhead (Tk. 600000 ÷ 10000 Units) 60
Unit product cost Tk. 370 Tk. 310

Req. 2 Income Statement under absorption costing

Sales (8000 unit x Tk. 500) Tk. 4000000

Less, Cost of good sold:
Beginning inventory Tk. 0
Add, Cost of good manufactured (10000 units x Tk. 370) 3700000
Cost of good available for sale 3700000
Less, Ending inventory (2000 units x Tk. 370) 740000
Cost of good sold 2960000
Gross Margin 1040000
Less, Selling and Administrative expenses:
Variable Selling & Administrative (8000 units x Tk. 20) 160000
Fixed Selling & Administrative 400000
Total Selling & Administrative expense 560000
Net Operating Income 480000

12
Solution to Problem 5 (Garrison, p. 302)
Req. 1 Calculation of unit product cost under Variable costing

Direct Materials Tk. 8

Direct Labor 10
Variable Manufacturing Overhead 2
Total variable product cost Tk. 20

Income statement under for each year in the contribution format using variable costing

Variable costing Year 1 Year 2

Sales @ Tk. 50 Tk. 1000000 Tk. 1500000
Less, Cost of Variable expenses:
Variable cost of good sold @ Tk. 20 Tk. 400000 Tk. 600000
Variable selling and administrative @ Tk. 3 60000 90000
460000 690000
Contribution Margin 540000 810000
Less, Fixed Expenses:
Fixed manufacturing overhead 350000 350000
Fixed selling and administrative exp. 250000 250000
600000 600000
(60000) 210000

Req. 2 The reconciliation of the variable and absorption costing net operating income

Year 1 Year 2

Variable costing net operating income Tk. (60000) Tk. 210000

Add fixed manufacturing overhead costs deferred in inventory under

absorption costing (5000 units x Tk. 14)
70000

Deduct fixed manufacturing overhead costs released from inventory under

absorption costing (5000 units x Tk. 14)
(70000)

Absorption costing net operating income 10000 140000

Req. 3 The effect on total net operating income after two years

13
 Costing method 1st Period 2nd Period Total

Absorption costing Tk. 10000 Tk. 140000 Tk. 150000

Variable costing (60000) 210000 150000

Solution to Problem 6 (Garrison, p. 304)

Req. 1 Calculation of unit product cost under absorption costing and variable costing
Absorption Variable
Costing Costing
Direct Materials Tk. 86 Tk. 86
Variable Manufacturing Overhead 4 4
Total variable product cost Tk. 90 Tk. 90
Fixed manufacturing overhead (Tk. 240000 ÷ 4000 Units) 60
Unit product cost Tk. 150 Tk. 90

Req. 2(a) Income Statement under absorption costing

Sales (3200 unit x Tk. 250) Tk. 800000

Less, Cost of good sold:
Beginning inventory Tk. 0
Add, Cost of good manufactured (4000 units x Tk. 150) 600000
Cost of good available for sale 600000
Less, Ending inventory (800 units x Tk. 150) 120000
Cost of good sold 480000
Gross Margin 320000
Less, Selling and Administrative expenses:
Variable Selling & Administrative (Tk. 800000 x 15%) 120000
Fixed Selling & Administrative 160000
Total Selling & Administrative expense 280000
Net Operating Income 40000

Req. 2(b) Income Statement under variable costing

14
 Sales (3200 unit x Tk. 250) Tk. 800000
Less, Cost of Variable expenses:
Variable cost of good sold (3200 unit x Tk. 90) Tk. 288000
Variable selling and administrative (Tk. 800000 x 15%) 120000
408000
Contribution Margin 392000
Less, Fixed Expenses:
Fixed manufacturing overhead 240000
Fixed selling and administrative exp. 160000
400000
(8000)

Req. 3 The reconciliation of the variable and absorption costing net operating income
Variable costing net operating income Tk. (8000)

Add fixed manufacturing overhead costs deferred in inventory under absorption costing
(800 units x Tk. 60)
48000

Absorption costing net operating income 40000

Problem 5
During Denton Company’s first two years of operations, the company reported net operating income as
follows (absorption costing basis)
Year 1 Year 2
Sales (at Tk. 50) Tk. 100000 Tk. 150000
Less, Cost of good sold:
Beginning inventory 0 170000
Add, Cost of good manufactured (at Tk. 34 per unit) 850000 850000
Cost of good available for sale 850000 1020000
Less, Ending inventory (at Tk. 34 per unit) 170000 0
Cost of good sold 680000 102000
Gross Margin 320000 480000
Less, Selling and Administrative expenses 310000
.340000
Net Operating Income 10000 140000

The company’s selling and administrative expenses consist of Tk. 250000 per year in fixed expenses
and Tk. 3 per unit sold in variable expenses. The company’s Tk. 34 unit product cost given above is
computed as follows:

Direct Materials Tk. 8

15
 Direct Labor 10

Variable manufacturing overhead 2

Fixed manufacturing overhead (Tk. 350000÷25000 Units) 14

Unit product cost Tk. 34

Production and cost data for two years are given below:
Year 1 Year 2

Units produced during the year 25000 25000

Units sold during the year 20000 30000

Required

1. Prepare an income statement for each year in the contribution format using variable costing
2. Reconcile the variable costing and absorption costing net operating incomes for each year
3. Show the effect on total net operating income after two years

Problem 6

Advance Products, Inc. has just organized a new division to manufacture and sell specially designed
tables using select hardwoods for personal computers. The company’s new plant is highly automated
and thus requires high monthly fixed costs, as shown in the schedule below:

Selling Price per unit Tk. 250

Manufacturing Costs:

Variable cost for per unit produced:

Direct Materials 86

Variable Manufacturing Overhead 4

Fixed Manufacturing Overhead (Total) 240000

Selling and Administrative costs:

Variable 15% of sales

Fixed (Total) 160000

16
Advance Products regards all of its workers as full-time employees. Furthermore, production is highly
automated. Accordingly, the company has included in its fixed manufacturing overhead all of its labor
costs. During the month of operations, the following activity was recorded:

Units produced 4000

Units sold 3200

Required
1. Compute the unit product cost under:
a. Absorption costing
b. Variable costing
2. Prepare income statement for the month using:
a. Absorption costing
b. Variable costing
3. Reconcile the variable costing and absorption costing net operating incomes

17