CHAPTER TWO:

ABSORPTION
COSTING vs
DIRECT COSTING
_____________________________________________________________________________

After studying this chapter, you will be able to:

o explain how variable costing differs from absorption costing and compute
unit product costs under each method.

o prepare income statements using both variable costing and absorption

costing.

o analyse and reconcile variable costing and absorption costing net

operating income and explain the resulting differential profit or loss.

o understand the advantages and disadvantages of both variable and

absorption costing.

o identify, describe and apply throughput costing.

Chapter 2 – Absorption Costing vs Direct Costing 33

 Cebu Pacific Air

Cebu Pacific Air entered the aviation industry on March 1996 and pioneered the “low fare, great
value” strategy. Cebu Pacific is one of the key subsidiaries of JG Summit founded by John Gokongwei
Jr, who was bestowed with an honorary doctorate in Business and Enterprise Development and was a
recipient of a Lifetime Achievement Award from the University of San Carlos.

Over the next five years, the airline company is not expecting to add any flights at Manila due to slot
constraints but aiming to grow the average seat capacity per departure from 195 seats to 280 seats.
Increasing density is a strategy of Cebu Pacific, to lower unit costs in order to maintain very low fare in
a price sensitive market while maximizing the slots at its main hub.

In order to achieve this, the company will stop operating turboprops at Manila and will double the size
of its wide body fleet and transition most of its Manila-based narrow body flights from A320s to A321s.
The airline group’s overall seat capacity has grown marginally in the last three and half years as it has
waited for the delivery of new generation aircraft.

Source:
https://centreforaviation.com/analysis/reports/cebu-
pacific-air-upgauging-drives-40-growth-at-congested-
manila-485423

Product Costs vs. Period Costs

All production and non-production costs can be classified as either product costs or period
costs. Product cost is a cost attributable or directly associated with the product as it is
produced. Such costs are involved in the purchase of goods or manufacture of products.
They are included in inventory valuation that is why it is also known as inventoriable costs.
It is considered as costs of production and such product costs are assigned to Work in
process as production occurs which will be subsequently transferred to Finished Goods as
the products are completed. Once the product is sold, the product costs are recognized as
an expense (as it is charged to Cost of Goods Sold) and matched with the related Sales for
the said period. At the point of sale, the costs are released from inventory and treated as
expenses (typically called CGS).

It diminishes current income by that portion identified with the sales volume only, the
balance of which is deferred to the next accounting period as part of ending inventory.

Chapter 2 – Absorption Costing vs Direct Costing 34

In contrast, period costs are not assigned to the product but are recognized as expense in the
period in which it is incurred.

In other words, period cost is not related to production as it cannot be assigned to the
product but rather charged to the period in which they arise. All non-production costs such
as General and Administrative Expenses as well as Selling Expenses are period costs. These
costs are matched against revenues on a time period basis. It does not form part of the cost
of inventory and it diminishes income for the current period by its full amount.

In general, the variable manufacturing cost is considered as product cost because they
change with the change in activity level. Conversely, the fixed cost is regarded as period
costs because they remain unchanged regardless of what activity level the company
operates. However, if you consider the type of product costing approach used by the
company, the breakdown of total fixed costs and expenses will vary. Under AC, the fixed
manufacturing cost or the fixed factory overhead is part of the costs of production
chargeable to the product being produced.

Hence, its period costs consist only of all the Operating Expenses or commercial expenses.
In short term decisions, period costs are not relevant as the amount will not change
regardless of what option or alternative you are going to choose.

Under DC, the total fixed costs and expenses include the fixed factory overhead or the fixed
manufacturing cost, therefore treated as period cost together with all Operating Expenses.
Shown in Figure 1 below is the composition of unit production cost under the two (2)
alternative product costing approaches.

ABSORPTION PRODUCT COSTS PERIOD COSTS

COSTING
DM DL VFO FFO VSAE FSAE

DIRECT PRODUCT COSTS PERIOD COSTS

COSTING
Figure 2.1. Breakdown of product costs and period costs under absorption costing and
variable costing

The cost assigned to unsold units or ending inventory as well as the cost assigned to Cost of
Goods Sold (CGS) will vary depending on what unit production cost is applied. The
composition of such unit production cost (UPC) will tell you whether the company is using
AC or DC.

Chapter 2 – Absorption Costing vs Direct Costing 35

Case # 1: The following data were taken from the records of Hershe Inc. in 2019:

Beginning Ending
Finished goods inventory 1,100 units 2,200 units
Cost data per unit:
Direct material P 20 P 20
Direct labor 25 25
Factory Overhead:
Variable 15 15
Fixed 12 10
P 72 P 70
==== ====
The production volume in 2018 was greater by 2,000 units compared to the 10,000 units
produced in 2019. Selling price per unit is P100. Variable Selling and Administrative
Expenses (VSAE) is P8 per unit sold while Fixed Selling and Administrative Expenses
(FSAE) is P90,000.

Based on the data presented in Case #1,

For the Year 2018 For the Year 2019

UPC under AC DM P20 + DL P25 + VFO P15 + FFO 12 DM P20 + DL P25 + VFO P15 + FFO P10
= P72 = P70

UPC under DC DM P20 + DL P25 + VFO P15 DM P20 + DL P25 + VFO P15
= P60 = P60

As you can see in Case #1, the difference in Unit Production Cost (UPC) between AC and
DC is found in the cost element Fixed Factory Overhead (FFO) of P12 per unit in 2018 and
P10 per unit in 2019. That also explains why the UPC under AC is greater than the UPC
under DC due to the inclusion of FFO in its production cost. The UPC under DC of P60
per unit is also called Variable Manufacturing Cost (VMC) per unit or Variable Production
Cost per unit.

AC DC
Total
Period Costs VSAE P87,200 + FSAE P90,000 VSAE P87,200 + FSAE90,000 + FFO P144,000
in 2018
P 177,200 P 321,200
Total
Period Costs VSAE P71,200 + FSAE P90,000 VSAE P71,200 + FSAE90,000 + FFO P100,000
in 2019
P 161,200 P 261,200

The total FFO is computed based on normal capacity. If normal capacity is not explicitly
stated in the problem, then assume that it is equal to the actual production capacity which in
Case #1 is equal to 12,000 units in 2018 and 10,000 units in 2019. You will notice that FFO
is a product cost under AC while under DC, FFO is a period cost. So the treatment or the

Chapter 2 – Absorption Costing vs Direct Costing 36

classification of FFO is the key difference between AC and DC. At this point, you can
make a comparison chart wherein you indicate the basis for comparison between product
cost and period cost.

Comparison Between AC and DC

As service or merchandising companies have no fixed manufacturing costs, these companies

do not make choices between AC and DC. Advocates of Absorption Costing (AC) believe
that all manufacturing costs whether fixed or variable are essential to the production process
and should not be ignored in determining product costs. AC is the only generally accepted
method for external reporting and for preparing Income Tax Returns (ITRs). Most
managers would prefer to use AC because their performance in any given reporting period,
at least in the short run, is influenced by the volume of production scheduled near the end of
a period. In AC, inventories include both variable factory overhead (VFO) and fixed
factory overhead (FFO). Due to the treatment of FFO, cost of inventory under DC is less
than the cost of inventory under AC.

As early as 1908, there were firms using the alternative product costing approach called
Direct Costing (DC) which is also known as variable costing or marginal costing. The term
Direct Costing is a misnomer for variable costing because variable costing does not include
all direct costs as product costs. Only variable direct manufacturing costs are included. Any
fixed direct manufacturing costs, and any direct nonmanufacturing costs, (either variable or
fixed) are excluded from product costs. Variable costing includes as product costs not only
direct manufacturing costs but also some indirect costs (variable indirect manufacturing
costs).

The essential difference between AC and DC centers on TIMING (that is, when to
recognize FFO as an expense) which is at the time the finished units are sold (under AC) or
the proper timing of the release of FFO as period costs which is at the time of incurrence
(under DC). In terms of cost segregation, DC segregates all costs (manufacturing, selling
and administrative) into fixed and variable items. In other words, DC requires the
classification of costs and expenses as either variable or fixed. This segregation is seldom
found in AC. Since variable costs have a linear relationship to output within the defined
relevant range of production, they are equal to marginal costs.

DC is usually limited to internal use by company’s management. Advocates of DC argue

that fixed factory overhead is incurred in order to have the capacity to produce output in a
given period. Such costs are incurred whether or not the capacity is actually used to make
the output. The costs have no future service potential since incurring them in the current
period does not remove the necessity to incur them in the future periods. Thus, fixed
factory overhead should be charged against the period and not included in product costs.

The merits of DC can be stated in terms of the relevance of the data provided by its
application. Some managers believe that DC provides more understandable data about
costs, volume, revenues and profits to those who do not have formal training in accounting.
Others also believe that DC helps management in their planning function because it shows a

Chapter 2 – Absorption Costing vs Direct Costing 37

clearer picture of how changes in production volume affects costs and income. Product
costs under AC include all variable costs and fixed manufacturing costs which are matched
with the Sales in the period in which the products are sold. DC however, matches only the
variable manufacturing costs at the time of sale while the fixed manufacturing costs were
reported as period costs at the time it was incurred.

Net Income under DC may differ from Net Income under AC because of variations
between production and sales volume. Over an extended period of time, the NI reported by
both costing methods will tend to be the same. The reason is that over the long run, sales
cannot continuously exceed production, nor can production
continuously exceed sales. The shorter the time period, the more that the NI will tend to
differ.

Arguments for the Use of DC:

1. DC reports are simpler and easier to understand.
2. Data needed for breakeven and CVP analysis are readily available.
3. Eliminates the problem involved in allocating fixed costs.
4. DC is more compatible with the standard cost accounting system.
5. DC reports provide useful information for pricing decisions and other decision making
problems encountered by management.

Arguments Against DC:

1. Difficulty in segregating the fixed and variable components of a mixed cost.
2. Violates the matching principle since DC excludes FFO from product costs and charges
the same to period costs regardless of production and sales.
3. With DC, inventory costs and other related accounts such as working capital, current
ratio, and acid test ratio are understated because of the exclusion of FFO in its product
costs.
When companies employ JIT, problems with NI under AC are either eliminated or become
insignificant. The erratic movement of NI under AC & the difference in NI between AC &
DC arise because of changing inventory level. Under JIT, goods are produced strictly to
customers’ orders, so inventories are largely eliminated. There is little opportunity for FFO
to be shifted between periods under AC. Thus, NI will be essentially the same whether AC
or DC is used, and the erratic movement in NI under AC will be largely eliminated.
Inasmuch as DC is used in short-range planning, it encourages a short-sighted approach to
profit planning.

DC is also criticized because no fixed manufacturing cost or fixed factory overhead is

included in Work in process or Finished Goods Inventory account. Advocates of AC
argued that both fixed and variable costs are incurred in manufacturing products. Because
the inventory amounts do not reflect the total cost of production, they do not present a
realistic inventory valuation on the statement of financial position. Adjustments can be
made to the inventory amounts to reflect absorption costs on published financial reports
while retaining the benefits of direct costing for internal decision-making purposes.

Chapter 2 – Absorption Costing vs Direct Costing 38

In 2018, the unit production cost (UPC) under DC was P60 and P72 as UPC under AC. If
P66,000 was the 2018 ending inventory under DC, the equivalent cost of 2018 ending
inventory under AC will be computed as follows:

Since AC is 120% of direct costing (P72 divided by P60), so ending inventory would
be adjusted as follows:

Ending inventory under DC P66,000 x 120% = P79,200 as ending inventory under AC

========
Or

P 66,000_ __ = 1,100 units unsold x UPC under AC P72

UPC under DC P60
= P79,200 as ending inventory under AC
========
Including or excluding fixed costs from inventories and from CGS causes Gross Profit (GP)
or Gross Margin to differ from Gross Contribution Margin (CM). Gross CM (Sales less
Variable Manufacturing Costs) is considerably greater than GP. In the Theory of
Constraints (TOC) approach, direct labor is generally considered a fixed cost for the
following reasons:
1. Even though DL workers may be paid on an hourly basis, many companies have a
commitment (sometimes enforced in labor contracts or by law) to guarantee workers a
minimum number of paid hours;
2. In TOC companies, DL is not usually the constraint (it’s either machine constraint or
policy constraint);
3. TOC emphasizes continuous improvement to maintain competitiveness. Without the
committed and enthusiastic employees, sustained continuous improvement is virtually
impossible. Managers involved in TOC are extremely reluctant to lay off employees.

TOC companies believe that direct labor is much more like a committed fixed cost than
variable cost. Hence, in the modified form of Variable Costing used in TOC companies, DL
is not included as part of product costs.

Effect of Changes in Production on Net Income

Net Income under DC is not affected by changes in production. Using DC, reported NI
moves in the same direction as Sales. Net Income under AC is affected by changes in
production. NI will increase as production increases and decrease as production decreases.
As inventories grow, FFO is deferred in inventories but as inventories shrink, FFO is
released to the income statement. These changes in NI are a major drawback of AC since a
company can increase its reported NI by simply increasing production. Fluctuations in NI
can be due to changes in inventories rather than to changes in sales.

Chapter 2 – Absorption Costing vs Direct Costing 39

EFFECT ON NET INCOME

Relationship between Relationship between

Production and Sales Effect on Inventories AC Net Income (ACNI)
for the Period and VC Net Income
(VACNI)
No change in inventories
If P = S
FFO expensed under AC is ACNI = VACNI
equal to the FFO expensed
under DC
Inventory increases;

Net income is higher under AC

If P > S since FFO is deferred in ACNI > VACNI
inventory under AC as
inventories increase.
Inventory decreases;

If P < S Net income is lower under AC

since FFO is released from ACNI < VACNI
inventory under AC as
inventories decrease.

Profit (Loss) Reconciliation

Differential profit (loss) is the difference in profit (loss) between Absorption Costing (AC)
and Direct Costing (DC). The profit or loss shown by one product costing approach may
not agree with that shown by the alternative product costing approach used by a
manufacturing company. Therefore, it becomes necessary that periodically the profit or loss
shown by AC and DC be reconciled.

Before showing the marginal income statement for Case #1, let us first determine the sales
volume for each year as follows:
2019___ 2018___
Units in FGI beginning ……………………………………. 1,100 units -0-
+ Units currently produced ………………………………..10,000 units 12,000 units
Units available for sale ……………………………………11,100 units 12,000 units
- Units in FGI end …………………………………………. (2,200 units) 1,100 units
Units sold …………………………………………………… 8,900 units 10,900 units
========= ==========
If ending inventory (EI) is greater than beginning inventory (BI), then there is increase in
inventory level. Such increase in inventory level shall be multiplied by the FFO per unit in
order to get the differential profit which is to be added to the Profit computed under DC or
Variable Costing in order to get the equivalent profit under AC. However, if EI is less than
BI, then there is decrease in inventory level which is then multiplied by the FFO per unit in

Chapter 2 – Absorption Costing vs Direct Costing 40

order to get the differential profit which is to be deducted from the Profit computed under
DC or Variable Costing.

The difference between ending inventory in units and beginning inventory in units
represents the increase (decrease) in inventory level. Such change in inventory level can
also be computed by the difference between sales volume and production volume. This
change in inventory level will be multiplied by the FFO per unit to get the differential profit.

Let us use the data in Case #1 to prepare the marginal income statement or the income
statement under DC or Variable Costing used for internal reporting and illustrated as
follows:

Hershe Inc.
Income Statement – Variable Costing
For the year ended December 31, 2018

Sales (P100 per unit x 10,900 units sold) …………………………………………. P1,090,000

Less Variable CGS ( P60 per unit x 10,900 units sold)………………. ………….. 654,000
Contribution Margin from Manufacturing or Gross CM P 436,000
Less VSAE ( P8 per unit x 10,900 units sold)………………………… 87,200
Final Contribution Margin ………………………………………………………… P 348,800
Less Total Fixed Costs and Expenses:
Fixed Factory Overhead (P12 per unit x 12,000 units) ……….. P144,000
Fixed Selling and Administrative Expenses ……………………. 90,000 234,000
Profit under DC or Variable Costing ……………………………………… P 114,800
========
The short-cut way of computing the Variable CGS is shown above. However, if you opt to
show the detailed way of presenting it, it would appear as follows:
Finished Goods Inventory beginning -0-
+ Current Production Costs 12,000 units x P60 = 720,000
Variable Cost of Goods Available for Sale P720,000
- Finished Goods Inventory end 1,100 units x P60 = 66,000
Variable Cost of Goods Sold P654,000
========
2018 was the first year of operations, so there was no beginning inventory. The differential
profit in 2018 is P13,200 which is the amount of FFO deferred in inventory. The 2018
profit under absorption costing is computed in the form of a reconciliation report:
Profit using Direct Costing or Variable Costing P 114,800
Add: FFO in Ending Inventory P12 x 1,100 units unsold = 13,200
Less: FFO in Beginning Inventory -0- 13,200
Profit using Absorption Costing P 128,000
========
The income statement under AC categorizes costs and expenses by function:
manufacturing versus non-manufacturing. All selling and administrative expenses (fixed
and variable) are reported as period costs. The profit under AC and DC can be reconciled
by determining how much FFO was deferred in, or released from, inventories during the
period. For manufacturing firms that use Lean Production, the production volume tends to

Chapter 2 – Absorption Costing vs Direct Costing 41

equal the sales volume because products are produced in response to customers’ orders,
thereby eliminating work in process inventories and finished goods inventories.

Hershe Inc.
Income Statement – Absorption Costing
For the year ended December 31, 2018

Sales (P100 per unit x 10,900 units sold) …………………………………….P1,090,000

Less Cost of Goods Sold (P72 per unit x 10,900 units sold)* 784,800
Gross Profit or Gross Margin P 305,200
Less Operating Expenses:
Variable Selling and Administrative Expenses ………… P 87,200
Fixed Selling and Administrative Expenses ……………… 90,000 177,200
Profit under AC …………………………………………………………… P 128,000
=========

The 2018 Cost of Goods Sold was computed using the short-cut way wherein the UPC
under AC amounting to P72 was multiplied by its sales volume. If instead you use the
detailed format of computing Cost of Goods Sold, then it shall be presented as follows:

Finished Goods Inventory beginning -0-

+ Current Production Costs 12,000 units x P72 = 864,000
Total Goods Available for Sale or TGAS P864,000
- Finished Goods Inventory end 1,100 units x P72 = 79,200
Cost of Goods Sold P784,800
========
To get the 2018 equivalent profit using Direct Costing or Variable Costing approach, follow
this format:

2018 Profit under Absorption Costing …………………………. P128,000

Add: FFO in Beginning Inventory -0-
Less: FFO in Ending Inventory P12 x 1,100 units unsold = (13,200)
2018 Profit under Direct Costing or Variable Costing P114,800
========
Production is greater than Sales in both 2018 and 2019, hence inventories increase. In 2018,
production exceeds sales by 1,100 units x FFO per unit @ P12 = Differential profit of
P13,200. In 2019, production exceeds sales by 1,100 units. In both years, ending inventory
is greater than beginning inventory by 1,100 units. That is why the profit under AC is
greater than the profit under DC for both years.

Hershe Inc.
Income Statement – Variable Costing
For the year ended December 31, 2019

Sales (P100 per unit x 8,900 units sold) …………………………………………. P 890,000

Less Total Variable Costs and Expenses:
Variable CGS ( P60 per unit x 8,900 units sold)……………….P534,000

Chapter 2 – Absorption Costing vs Direct Costing 42

 VSAE (P8 per unit x 8,900 units sold)…………………………… 71,200 605,200
Final Contribution Margin ……………………………………………………… P 284,800
Less Total Fixed Costs and Expenses:
Fixed Factory Overhead (P10 per unit x 10,000 units) ………. P100,000
Fixed Selling and Administrative Expenses ……………………. 90,000 190,000
Profit under DC or Variable Costing …………………………………… P 94,800
========
OR

Hershe Inc.
Income Statement – Variable Costing
For the year ended December 31, 2019

Sales (P100 per unit x 8,900 units sold*) …………………………………………. P 890,000

Less Variable CGS ( P60 per unit x 8,900 units sold)………………. ………….. 534,000
Contribution Margin from Manufacturing or Gross CM P 356,000
Less VSAE ………………………………………………………………. 71,200
Final Contribution Margin ………………………………………………………… P 284,800
Less Total Fixed Costs and Expenses:
Fixed Factory Overhead (P10 per unit x 10,000 units) ……….. P100,000
Fixed Selling and Administrative Expenses ……………………. 90,000 190,000
Profit under DC or Variable Costing ……………………………………… P 94,800
========
The Variable Cost of Goods Sold is computed based on the Unit Production Cost of P60
multiplied by the sales volume. This can also be calculated in detail as follows:
Finished Goods Inventory beginning 1,100 units x P60 = P 66,000
+ Current Production Costs 10,000 units x P60 = 600,000
Variable Cost of Goods Available for Sale P666,000
- Finished Goods Inventory end 2,200 units x P60 = 132,000
Variable Cost of Goods Sold P534,000
========

If you want to know the resulting profit using the alternative product costing approach
which is absorption costing, then use this reconciliation method:
Profit using Direct Costing or Variable Costing P 94,800
Add: FFO in Ending Inventory P10 x 2,200 units unsold = 22,000
Less: FFO in Beginning Inventory P12 x 1,100 units = (13,200) 8,800
Profit using Absorption Costing P103,600
=======

The differential profit is P8,800 which is the difference in Profit between AC and DC. So
even without preparing the income statement under AC, the bottomline figure will still be
obtained using the reconciliation method. Let us check this amount by preparing the income
statement using AC:

Chapter 2 – Absorption Costing vs Direct Costing 43

Hershe Inc.
Income Statement – Absorption Costing
For the year ended December 31, 2019

Sales (P100 per unit x 8,900 units sold*) …………………………………. P 890,000

Less Cost of Goods Sold:
Finished Goods Inventory beginning 1,100 units x P72 =P 79,200
+ Current Production Costs 10,000 units x P70 = 700,000
Total Goods Available for Sale P779,200
- Finished Goods Inventory end 2,200 units x P70 = 154,000 625,200
Gross Profit or Gross Margin P 264,800
Less Operating Expenses:
Variable Selling and Administrative Expenses ………… P 71,200
Fixed Selling and Administrative Expenses ……………… 90,000 161,200
Profit under AC …………………………………………………………… P 103,600
========
The short-cut way of computing Cost of Goods Sold is no longer applicable in 2019 because
the UPC under AC at the beginning of the year is not the same as the UPC under AC at the
end of the year. In other words, you can use the short-cut only when the UPC is the same
all throughout the year.

To get the equivalent profit using the alternative product costing approach, follow this
format:
Profit under Absorption Costing …………………………. P103,600
Add: FFO in Beginning Inventory P12 x 1,100 units = 13,200
Less: FFO in Ending Inventory P10 x 2,200 units unsold = (22,000)
Profit under Direct Costing or Variable Costing P 94,800
=======
Approaches used to reduce the negative aspects associated with using AC include:
1. Change the accounting system
• Adopt either variable or throughput costing, both of which reduce the incentives of
managers to build for inventory.
• Adopt an inventory holding charges for managers who tie up funds in inventory.

2. Extend the time period used to evaluate performance. By evaluating performance over a
longer time period (like 3 to 5 years), the incentive to take short-run actions that reduce
long-term income is lessened.

3. Include non-financial as well as financial variables in the measures used to evaluate

performance.

The company may use either theoretical capacity or normal capacity to compute the
budgeted fixed overhead rate. The theoretical capacity and practical capacity denominator-
level concepts emphasize what a plant can supply. The normal utilization and master
budget utilization concepts emphasize what customers demand for products produced by a
plant. Theoretical capacity is based on the production of output at maximum efficiency or at
100% level. Practical capacity reduces theoretical capacity for unavoidable operating

Chapter 2 – Absorption Costing vs Direct Costing 44

interruptions such as scheduled maintenance, shutdowns for holidays and other days, and
so on.

The smaller the denominator, the higher is the overhead costs capitalized for inventory
units. Thus, if the plant manager wishes to adjust plant operating income by building
inventory, master budget utilization or normal utilization would be preferred.

Conversion of Income Statement under AC to Variable Costing

1. Upon conversion:
a) Determine the FFO per unit of the base period and deduct this from the unit cost of
the beginning inventory.
b) Compute the FFO per unit for the current period and deduct it from the unit cost of
ending inventory.
c) Determine the fixed portion of Operating Expenses.

2. If the income statement to be converted to DC includes variances due to inclusion of

factory overhead based on normal capacity, they should be treated as adjustments to
factory overhead with the Spending Variance generally identified with Variable Factory
Overhead (VFO), the Volume Variance with the Fixed Factory Overhead (FFO).

Case #2:

Lexi Manufacturing Co. asked you to convert the income statement given below to conform
with the contribution margin approach or direct costing method:

Lexi Manufacturing Co.

Income Statement
For the year ended December 31, 2019

Sales 30,000 x P15 P 450,000

Less Cost of Goods Sold:
Inventory, January 1 5,000 x P8 = P 40,000
Add Current Production Cost 31,500 x P10 = 315,000
Total Goods Available for Sale P355,000
Less Inventory, December 31 6,500 x P10 = 65,000 290,000
Gross Profit or Gross Margin P 160,000
Less Operating Expenses …………………………………………….. 110,000
Net Income …………………………………………….. P 50,000
========
An analysis of costs and expenses showed the following:
Ø The 2019 production cost per unit consists of:
Direct materials ……………………………… P 3.00
Direct labor …………………………>………… 2.00
Variable factory overhead ………………….. 3.00
Fixed factory overhead ……………………… 2.00
P10.00
======

Chapter 2 – Absorption Costing vs Direct Costing 45

 Ø Fixed factory overhead in 2018 was P55,000 with production volume of 50,000 units.
Ø Operating expenses of 2019 included variable selling expenses of P3.00 per unit.

Lexi Manufacturing Co.

Income Statement – Direct Costing
For the year ended December 31, 2019

Sales 30,000 x P15 P 450,000

Less Cost of Goods Sold:
Inventory, January 1 5,000 x P6.90 = P 34,500
Add Current Production Cost 31,500 xP8.00 = 252,000
Variable Cost of Goods Available for Sale P286,500
Less Inventory, December 31 6,500 x P8.00 = 52,000 234,500
Gross Contribution Margin or CM from Manufacturing P 215,500
Less Variable Operating Expenses ……………… 30,000 x P3.00 = 90,000
Final Contribution Margin …………………………………………….. P 125,500
Less Total Fixed Costs and Expenses:
Fixed Factory Overhead ……………………………………………P 63,000
Fixed Operating Expenses ………………………………………… 20,000 83,000
Net Income under Direct Costing P 42,500
========
Reconciliation of Net Income:
Net Income under AC P 50,000
Add FFO in Beginning Inventory 5,000 units x P1.10 = 5,500
Less FFO in Ending Inventory 6,500 units x P2.00 = (13,000)
Net Income under Direct Costing P 42,500
======

Throughput Accounting (TA)

Throughput Accounting (TA) is a management accounting technique used as the

performance measure in the Theory of Constraints (TOC). It focuses on capacity utilization
and on generating more throughput. It is an important development in modern accounting
proposed by Eliyahu M. Goldratt as an alternative to traditional cost accounting that allows
managers to understand the contribution of constrained resources to the company’s overall
profitability. The fundamental assumption of TOC is that the constraint (either internal or
external to the company) limits the performance of any systems. TOC suggests the managers to
focus on how to manage those constraints in improving the overall performance of the company.

It assumes that there is always one bottleneck operation in a production process that
commands the speed with which products or services can be completed. This operation
becomes the defining issue in determining what products should be manufactured first, since
this in turn results in varying levels of profitability.

Chapter 2 – Absorption Costing vs Direct Costing 46

Throughput costing treats only Direct Materials(DM) as true variable cost and other
remaining costs as period costs to be charged in the period in which they are incurred. Only
DM costs are inventoriable costs. Direct labor costs, factory overhead (both variable and
fixed) and all operating expenses are period costs. Throughput contribution or throughput
margin is equal to revenue minus all variable direct materials cost of goods sold. It is not
used for external reporting because it gives significant different net income figures than in
AC. Hence, it has relevance only for internal uses of management.

Throughput Costing (also known as super-variable costing) puts greater emphasis on sales
as the source of Operating Profit than either absorption or variable costing. It is not based
on standard costing nor Activity Based Costing (ABC). Throughput costing puts a penalty
on producing without a corresponding sale in the same period. A manager using
throughput costing cannot increase operating profit by building for inventory as what is
possible under AC.

Throughput costing results in a lower cost of inventory compared to variable or absorption

costing. Supporters of throughput costing claim that it provides less incentive to produce for
inventory than AC or DC since inventory value is very low.

The following table illustrates three alternative rules for determining which costs are
capitalized. All three are used in managerial accounting practice. The 3 methods are AC,
VC, and TC (throughput costing). The comparison of the absorption, variable, and
throughput costing methods is summarized in the table below:

Absorption Throughput
Variable Costing
Costing Costing
External GAAP Not GAAP Not GAAP
Reporting
Internal Used to save costs Used to evaluate Used for short-
Reporting performance and term capacity
for decision decisions
making
Inventory costs Direct materials Direct materials Direct materials
Direct labor Direct labor
Variable overhead Variable overhead
Fixed overhead Variable SG&A
expenses*
Period costs SG&A expenses Fixed overhead Direct labor
(expensed when Fixed SG&A Variable overhead
incurred) expenses Fixed overhead
SG&A expenses

Chapter 2 – Absorption Costing vs Direct Costing 47

As the table indicates, non-manufacturing costs are never capitalized as part of inventory
cost.
For internal reporting purposes, survey data suggests that approximately half of
manufacturing companies use AC and approximately half use DC. Throughput costing is a
relatively recent phenomenon, and does not seem to be used extensively yet.

Problem 1 - Rinseman Statues produces a specialty statue item. The following

information has been provided:
Actual sales 300,000 units
Budgeted production 320,000 units
Selling price P34.00 per unit
Direct materials costs P9.00 per unit
Direct labor costs P3.00 per unit
Fixed manufacturing costs P5.00 per unit
Variable manufacturing OH P4.00 per unit
Variable administrative costs P2.00 per unit

a. How much is the cost per statue if absorption costing is used?

P9 + P3 + P5 + P4 = P21.00

b. How much is the cost per statue if "super-variable costing" is used?

Equal to direct materials = P9.00

c. What is the total throughput contribution or throughput margin?

300,000 (P34 - P9) = P7,500,000

Problem 2. Tick Tock produces and sells a mantel clock for P80 per unit. In 2019, 42,000
clocks were produced and 41,000 were sold. Beginning inventory consisted of 1,600 clocks.
Other information for the year includes:

Direct materials P30.00 per unit

Direct manufacturing labor P2.00 per unit
Variable OH costs P3.00 per unit
Sales commissions P5.00 per part
Fixed manufacturing costs P25.00 per unit
Administrative expenses, all fixed P15.00 per unit

a. What is the inventoriable cost using throughput costing?

P30.00 * (1,600 + 42,000 - 41,000) = P78,000

b. What is the total throughput contribution?

(P80 - P30) * 41,000 = P2,050,000

Chapter 2 – Absorption Costing vs Direct Costing 48

Exercise 2-1. Multiple Choice (Theory). Choose the best answer

1. Another name for variable costing is

a. Process costing c. Direct Costing
b. Differential costing d. Indirect costing

2. All of the following are inventoried under variable costing except:

a. Direct materials c. variable manufacturing overhead
b. Direct labor d. fixed manufacturing overhead

3. 1st statement: A concept of costing under which costs are classified as fixed or variable is
called direct costing.
2nd statement: The basic accounting principle of matching revenues, costs and expenses
is better accomplished by the use of direct costing method.
a. Only the 1st statement is true c. Both statements are true
b. Only the 2nd statement is true d. Both statements are false

4. Under absorption costing, which of the following costs would not be included in
finished goods inventory
a. Variable and fixed selling and administrative expenses
b. Conversion Cost
c. Prime Cost
d. Variable and fixed factory overhead cost

5. The underlying difference between absorption costing and variable costing lies in the
treatment of
a. Direct labor c. variable and selling expenses
b. Fixed manufacturing overhead d. variable manufacturing overhead

6. 1st statement: Often referred to as absorption costing, it is a concept wherein only the
variable manufacturing costs are assigned to the product and fixed manufacturing costs
are written off as period costs.
2nd statement: Fixed factory overhead is necessary for the production of a product, is an
argument against the use of variable costing.
a. Only the 1st statement is true c. Both statements are true
nd
b. Only the 2 statement is true d. Both statements are false

7. Under variable costing, which of the following costs would be included in finished
goods inventory?
a. Selling expenses
b. Depreciation expense of a factory equipment
c. Wages of carpenters in a furniture factory
d. Salary of the secretary of the office of the president

Chapter 2 – Absorption Costing vs Direct Costing 49

8. Consider the following comments about absorption costing and variable costing income
statement:
I – A variable costing income statement discloses a firm’s contribution margin
II – Cost of goods sold on an absorption costing income statement includes fixed
costs
III – The amount of variable selling and administrative costs is the same on
absorption costing and variable costing income statement.
Which of the following statement is true?
a. I only c. I, II and III only
b. I and II only d. None of the above

9. The amount of income under absorption costing will be more than the amount of
income under variable costing when units manufactured
a. Are equal to or greater than units sold
b. Are less than units sold
c. Exceed units sold
d. Equal to units sold

10. 1st statement: For a company that uses direct costing, the cost of a unit of product
changes because of changes in the number of units manufactured.
2nd statement: In an income statement prepared as an internal report using the variable
costing method, the term gross margin is used.
a. Only the 1st statement is true c. Both statements are true
b. Only the 2nd statement is true d. Both statements are false

11. MAS company’s inventory increased during the year. On the basis of this information,
income under absorption costing.
a. Will be less than that reported in the previous period.
b. Will differ from the reported period under variable costing, the direction of
which cannot be determined from the information given.
c. Will be lower than the reported under variable costing
d. Will be higher than the reported under variable costing

12. 1st statement: Under absorption costing the cost of finished goods includes direct
materials, direct labor and factory overhead.
2nd statement: In variable costing, the cost of products manufactured is composed of
only those manufacturing costs that increase or decrease as the volume of production
rises or falls
a. Both statements are true c. Only the 1st statement is true
b. Both statements are false d. Only the 2nd statement is false

Chapter 2 – Absorption Costing vs Direct Costing 50

13. Which of the following statements is true for a firm that uses variable costing?
a. The unit product cost changes as a result of changes in the number of units
manufactured.
b. Both variable selling costs and variable production costs are included in the
unit product cost.
c. Net income moves in the same direction as sales.
d. Net income is greatest in periods when production is highest.

14. The term "gross margin" for a manufacturing company refers to the excess of sales over
a. cost of goods sold, excluding fixed manufacturing overhead.
b. all variable costs, including variable selling and administrative expenses.
c. cost of goods sold, including fixed manufacturing overhead.
d. variable costs, excluding variable selling and administrative expenses.

15. 1st statement: The absorption costing income statement does not distinguish between
variable and fixed costs.
2nd statement: Under the variable costing income statement, deduction of the variable
cost of goods sold from salaries yields gross profit
a. Only the 1st statement is incorrect c. Both statements are incorrect
b. Only the 2nd statement is incorrect d. Neither statement is incorrect

16. 1st statement: Changes in the quantity of finished goods inventory, caused by differences
in the levels of sales and production, directly affects the amount of income from
operations under absorption costing
2nd statement: For the period during which the quantity of product manufactured equals
to the quantity sold, income from operations reported under absorption costing will be
smaller than the income from operations under variable costing.
a. Only the 1st statement is correct c. Both statements are correct
b. Only the 2nd statement is correct d. Both statements are incorrect

17. Which of the following is not true when determining the selling price of a product?
a. Both variable and absorption pricing plans should be considered, to include
several pricing alternatives
b. Variable costing is effective when determining short term pricing, but absorption
costing is generally for long term pricing policies.
c. As long as the selling price is set above the variable costs, the company will make
a profit.
d. Absorption costing should be used to determine routine pricing which includes
both fixed and variable costs.

18. Accountants prefer the variable costing method over absorption costing method for
evaluating the performance of a company because
a. By using the variable costing method, all fixed and variable costs are included in
the unit cost of the product manufactured.
b. By using absorption costing method, income could appear to be higher by
producing more inventory

Chapter 2 – Absorption Costing vs Direct Costing 51

 c. By using absorption costing method, more sales are generated
d. By using variable costing method, the cost of goods sold will be higher as more
units are manufactured and sales remain the same.

19. An allocated portion of fixed factory overhead is included in work in process inventory
under
a. Absorption costing – No; Direct costing – No
b. Absorption costing – No; direct costing – Yes
c. Absorption costing – Yes; direct costing – Yes
d. Absorption costing – Yes; direct costing – No

20. The basic assumption made in a direct costing system with respect to fixed costs is that
fixed costs are
a. A sunk cost c. A period cost
b. A product cost d. Fixed as to the total cost

21. Which of the following is more descriptive term of the type of cost accounting called
“direct costing”
a. Out of pocket costing c. Relevant Costing
b. Prime Costing d. Variable Costing

22. Why is direct costing not in accordance with GAAP?

a. Direct costing procedures are not well known in industry
b. Net earnings are always overstated when using direct costing procedures
c. Fixed manufacturing costs are assumed to be period costs
d. Direct costing ignores the concept of lower of cost or market when valuing
inventory.

23. Gross Margin is to absorption costing as _____ is to variable costing

a. Gross profit c. Income
b. Contribution margin d. Territory margin

24. These are costs that will change in per unit basis when production volume increases or
decreases within the relevant range.
a. Fixed costs c. Variable cost
b. Relevant costs d. Period Costs

Chapter 2 – Absorption Costing vs Direct Costing 52

25. The gross margin for a manufacturing company is the excess of sales over
a. Costs of goods sold, including fixed manufacturing overhead
b. Costs of goods sold, excluding fixed manufacturing overhead
c. All variable costs, including variable selling and admin expenses
d. Variable costs, excluding variable selling and admin expenses.

Exercise 2-2. (Basic Computation). FRANZ MICHAEL Company manufacturers a

professional grade vacuum cleaner and began its operation in 2021. For 2022, the company
had no price, spending, or efficiency variances and writes off production-volume variance to
cost of goods sold. Actual data for 2022 are given as follows: Units produced – 20,000; Units
sold – 17,000; Unit Selling Price – P300; Materials – P30; Manufacturing labor – P25;
Variable Manufacturing Overhead – P50; Variable Marketing and Admin Expense – P45;
Fixed Manufacturing Cost – P900,000; Fixed Selling and Administration Expense –
P750,000.

Requirements:
a. Compute the inventoriable unit cost for internal and external reporting purposes
b. Compute the operating income for 2022 under variable and absorption costing.
c. Provide a reconciliation in income under the two costing methods.

Exercise 2-3 (Basic Computation) CHERINA MARIE CO. Began its operations on
January 1, and produces a single product that sells for P15 per unit. CHERINA MARIE
uses an actual cost system. During the year, 100,000 units were produced and 85,000 units
were sold. There was no work in process inventory at December 31. Manufacturing and
selling, administrative expenses for the year were as follows:
Fixed Cost Variable Costs
Raw Materials P0 P3.00 per unit produced
Direct Labor P0 P1.875 per unit produced
Factory Overhead P180,000 P1.125 per unit produced
Selling and Admin P105,000 P1.50 per unit sold

Requirements:
a. Compute the cost of finished goods inventory at December 31 under variable costing
and under absorption costing
b. Compute the net income under variable costing and under absorption costing

Chapter 2 – Absorption Costing vs Direct Costing 53

Exercise 2-4 (Multiple Years). Information for the year 2020- 2022 are as follows:
2020 2021 2022
Beginning Inventory 0 ? ?
Production 1,500 1,500 1,500
Sales 1,200 1,600 1,500
Ending inventory ? ? ?

Costs incurred are as follows: Direct materials – P9/unit; Direct labor – P3.00/unit;
Variable manufacturing overhead – P2/unit; Fixed manufacturing overhead – P9,000;
Variable Marketing Expense – P3/unit; Fixed marketing Expense – P12,000; Unit Selling
Price – P45
Requirements:
a. Compute the unit product cost under absorption costing, variable costing and
throughput costing.
b. Compute the net income under Absorption Costing, Variable Costing and
Throughput Costing for 2020-2022
c. Prepare a reconciliation for the three methods.

Chapter 2 – Absorption Costing vs Direct Costing 54

Exercise 2-5. (Reconciliation) JIAN NALLOS Corp. manufactures a variety of products.
The ff. data pertain to the company’s operations over the last 2 years;
Variable Costing Net Operating Income, last year ……………… P 82,700
Variable Costing Net Operating Income, this year ………………… 87,800
Increase in ending inventory last year ……………………………… 900
Decrease in ending inventory this year …………………………….. 3,100
Fixed manufacturing overhead cost per unit 2

Requirement:
Determine the absorption costing net operating income last year and this year.
Supply the necessary computation and amount to be added or deducted:

Last Year This Year

Variable Costing Net Operating Income ……………………… P 82,700 P87,800
Add FFO deferred in inventory under AC:

Less FFO released from inventory under AC:

_________ _________
Absorption Costing Net Operating Income …………………… P P
========= =========

Exercise 2-6 (With Variances). The president of PATRICK KARL, Inc. has been
reviewing the income statements of the two most recent months. He is puzzled because
sales rose and profits fell in March, and she asks you, the controller, to explain.
August September
Sales (P30 per case) P 810,000 P 990,000
Standard cost of sales 405,000 495,000
Standard gross profit P 405,000 P495,000
Volume variance 60,000 (75,000)
Selling and administrative expenses (225,000) (225,000)
Income P240,000 P195,000
======== ========
The standard fixed cost per case is P10, based on normal capacity of 20,000 cases per
month.

Requirements:
a. Determine the production volume for each month.
b. Prepare the March income statement using variable costing.

Chapter 2 – Absorption Costing vs Direct Costing 55

Exercise 2-7. (With Variances) JANELLE THERESE Products presents the following data
from absorption costing income statements for the last two years:
20A 20B
Sales .................................................................................... P2,000,000 P2,500,000
Cost of goods sold (at standard) ............................................ 800,000 950,000
Over- or underapplied overhead ............................................ 25,000 (25,000)
Marketing and general expense ............................................. 500,000 550,000
Operating income ................................................................. 675,000 1,050,000

Required: Prepare the direct costing income statements for each year, assuming that there
were no changes in capacity between years and that the unit variable costs are
constant. (Hint: Use the high- and low-points method to determine the fixed and
variable portions of each cost element.)

Exercise 2-8. Cadbury Co. uses a standard cost system in accounting for its only product
which it sells @ P22 per unit. The standard unit cost is:
Direct materials..................................................................................... P 4
Direct labor.......................................................................................... 6
Variable factory overhead.................................................................... 2
Fixed factory overhead (based on normal capacity of 60,000 units)......... 3
P 15
====
All variances are closed to Cost of Goods Sold. On October 1, there were 10,000
units on hand. During October, 50,000 units were produced and 45,000 were sold. Costs
incurred during October were:
Direct materials P 198,000
Direct labor 305,000
Variable factory overhead 103,000
Fixed factory overhead 186,000
Variable marketing and administrative 50,000
Fixed marketing and administrative 74,000

Required: (1) Explain whether the company uses direct or absorption costing.
(2) Prepare an income statement for October, using direct costing.
(3) Compute the operating income for October if absorption costing is used.

Chapter 2 – Absorption Costing vs Direct Costing 56

Exercise 2-9. K Corp. developed the following standard unit costs @ 100% of its normal
production capacity, which is 50,000 units per year:
Direct materials…....................P 3
Direct labor............................... 3
Variable factory overhead........ 2
Fixed factory overhead…......... 3
P 11
====
The selling price of each unit of product is P20. Variable commercial expenses are P1 per
unit sold and fixed commercial expenses total P 150,000 for the period. During the year,
49,000 units were produced and 52,000 units were sold. There are no work in process
beginning or ending inventories, and finished goods inventory is maintained at standard
cost, which has not changed from the preceding year. For the current year, there is a net
favorable variable cost variance of P1,000.

Required: (1) Prepare an income statement on the absorption costing basis.

(2) Prepare an income statement on the direct costing basis.
(3) Reconcile the differential profit for the current year under AC and DC.

Problem 2-1. MARIE NICOLE Company produces a single product provided the following
data concerning its most recent month of operations: Unit Selling Price – P157.50; Units
Produced – 3,875; Units Sold – 3,750; Direct Materials per unit – P27.50; Direct Labor per
unit – P53.75; Variable Manufacturing Overhead – P3.75; Variable Selling and admin
expense – P12.50; Fixed Manufacturing Overhead – P112,375; Fixed Selling and
Administrative Expense – P52,500

Requirements: Fill in the missing amounts

Absorption Costing Variable Costing Throughput Costing

Product Cost per Unit
Total Period Cost
Gross Profit/
Contribution Margin/
Throughput Margin
Net Income

Chapter 2 – Absorption Costing vs Direct Costing 57

Problem 2-2. RAVEN DAVE Company was organized just a year ago. The results of the
company’s first year of operations are shown below under absorption costing:

Income Statement

Sales (2,000 units) P135,000

Less: Cost of Goods Sold
Beginning Inventory P0
Cost of Goods manufactured 105,000
Goods Avaliable for Sale P105,000
Ending Inventory 21,000 84,000
Gross Margin P51,000
Less: Selling and Admin 42,000
Expense
Net Income P9,000
The company’s selling and administrative expense consist of P32,000 per year in
fixed expenses and P5 per unit sold in variable expenses. The company’s unit product cost is
computed as follows: Variable manufacturing cost – P32; Fixed Manufacturing cost (Based
on normal capacity of 2,500 units) – P10. Compute the net income under variable costing.

Problem 2-3. LIZA MARIE Corporation, developed the following standard unit cost at
100% of its normal production capacity, which is 20,000 units per year: Prime cost – P4.00;
Factory overhead (60% fixed) – P5.00.
The product cost is sold for P16 per unit. Variable commercial expenses are P2 per
unit sold, and fixed commercial expenses total P50,000 for the period. During the year,
19,000 units were produced and 21,000 units were sold. There is no work in process
beginning or ending inventories, and finished goods inventory is maintained at standard
cost, which has not changed from the preceding year. In the current year, there is a net
favorable variable cost variance in the amount of P5,000. All standard cost variances are written
off to cost of goods sold at the end of the period. Compute the net income under Absorption
costing and Variable Costing.

Chapter 2 – Absorption Costing vs Direct Costing 58

Problem 2-4. The following information pertains to LANCE CHRISTOPHER Company:
Maximum Productive Capacity 24,000 units per year
Normal Capacity 20,000 units
Standard Variable manufacturing cost per unit P10
Fixed factory overhead P40,000
Variable Selling expenses per unit P4
Fixed selling expenses P30,000
Unit sales price P20

Additional information for the current year are as follows: Sales – 19,000 units;
Production – 19,200 units; Net unfavorable variance for standard variable manufacturing
cost – P10,000.

Requirements:
1. Compute the net income under Absorption Costing and Variable Costing
2. Compute the breakeven point in units
3. Compute the margin of safety in units
4. Required sales (pesos) to earn after tax profit of P140,000 (tax is 30%)
5. Required sales (pesos) to earn profit of 10% of sales

Chapter 2 – Absorption Costing vs Direct Costing 59

Problem 2-5. ISAIAH GRAN Motors assembles and sells miniature toy motor vehicles and
uses standard costing. Actual data relating to April and May 2020 are as follows:

April May
Beginning Inventory in units 0 150
Production in units 500 400
Sales in units 350 520

Variable Costs:
Manufacturing cost per unit P10,000 P10,000
Selling and Admin per unit 3,000 3,000
Fixed Costs:
Manufacturing Cost P2,000,000 P2,000,000
Selling and Admin Cost 600,000 600,000

The selling price per toy vehicle is P24,000. The budgeted level of production used to
calculate the budgeted fixed manufacturing cost per unit is 500 units. There are no price,
efficiency, or spending variance. Any production – volume variance is written off to cost of
goods sold in the month in which it occurs.

Requirements:
1. Prepare the April and May income statement under Absorption and Variable
Costing.
2. Reconcile the costing methods
3. The variable manufacturing costs of ISAIAH GRAN Motors are as follows:
April May
Direct Materials P6,700 P6,700
Direct Labor 1,500 1,500
Factory overhead 1,800 1,800
Prepare the financial statement for ISAIAH GRAN in April and May under
throughput costing.

Chapter 2 – Absorption Costing vs Direct Costing 60

Case 2-1 “Now this doesn’t make any sense at all,” said Florence Gale, financial vice
president for Warner Bros. Company. “Our sales have been steadily rising over the last
several months, but profits have been going in the opposite direction. In September we
finally hit P2,000,000 in sales, but the bottom line for that month drops off to a P100,000
loss. Why aren’t profits more closely correlated with sales?”

The statements to which Ms Gale was referring are shown below:

July August September
Sales (P25) P1,750,000 P1,875,000 P2,000,000
Less: Cost of Goods Sold
Beginning Inventory 80,000 320,000 400,000
Cost applied to production:
Variable MFTG cost 765,000 720,000 540,000
Fixed MFTG cost 595,000 560,000 420,000
Cost of Goods Manufactured 1,360,000 1,280,000 960,000

Goods Available for Sale 1,440,000 1,600,000 1,360,000

Less: Ending Inventory 320,000 400,000 80,000
Cost of Goods Sold 1,120,000 1,200,000 1,280,000
Under/OverApplied Fixed OH (35,000) (0) 140,000
Adjusted CGS 1,085,000 1,200,000 1,420,000
Gross Margin P665,000 P675,000 P580,000
Less: Selling and Admin Expense 620,000 650,000 680,000
Net income(loss) P45,000 P25,000 P(100,000)

Klein, a new graduate from a USCE who has just been hired by Warner, has stated to Ms.
Gale that the contribution margin approach, with variable costing, is a much better way to
report profit data to management. Sales and production data for the last quarter follow:
July August September
Production in units 85,000 80,000 60,000
Sales in units 70,000 75,000 80,000

Additional Information about the company’s operations is given below:

a. 5,000 units were in inventory on July 1
b. Fixed manufacturing overhead costs total P1,680,000 per quarter and are incurred
evenly throughout the quarter. This fixed manufacturing overhead cost is applied to
units of product on a basis of a budgeted production volume of 80,000 units per
month
c. Variable selling and admin expenses are P6 per unit sold. The remainder of the
selling and admin expenses on the statements above are fixed.
d. The company uses FIFO inventory flow assumption. Work in process inventories are
insignificant and can be ignored.

Chapter 2 – Absorption Costing vs Direct Costing 61

“I know production is somewhat out of step with sales,” said Karla E, the company’s
controller. “But we had to build inventory early in the quarter in anticipation of a strike in
September. Since the union settled without a strike, we than had to cut back production in
September in order to work off the excess inventories. The income statements you have are
completely accurate.

Requirements:
1. Compute the net income for each month using variable costing
2. Compute the monthly breakeven point under variable costing
3. Explain to Ms. Gale why profits have moved erratically over the three month period
shown in the absorption costing statements above and why profits have not been
more closely rated to changes in sales volume.

Chapter 2 – Absorption Costing vs Direct Costing 62