VARIABLE COSTING:

MODULE 2
 Variable costing (Direct Costing)
• is a method of recording and reporting costs
which regards only the variable manufacturing
costs as the variable manufacturing costs as
product costs. Fixed manufacturing costs are
written off as period costs.
 Absorption Costing
• Absorption costing (also known as full,
traditional, conventional, and normal costing)
is a method of product costing in which all
manufacturing costs, fixed and variable, are
treated as product or inventoriable costs. This
method is generally accepted for external
reporting purposes.
 Comparison between Variable Costing and
Absorption Costing
As to treatment of the various operating costs
VARIABLE COSTING
Product Costs
Direct materials
Direct labor
Variable manufacturing overhead
Period Costs
Fixed manufacturing overhead
Variable selling and administrative expenses
Fixed selling and administrative expenses
 Comparison between Variable Costing and
Absorption Costing
As to treatment of the various operating costs
ABSORPTION COSTING
Product Costs
Direct materials
Direct labor
Variable manufacturing overhead
Fixed manufacturing overhead
Period Costs
Variable selling and administrative expenses
Fixed selling and administrative expenses
 Comparison between Variable Costing and
Absorption Costing
As to net operating income
Net income is not affected by changes in production under variable costing. Net
income, however is affected by the changes in production when absorption
costing is in use. Net income goes up under the absorption approach in
response to the increase in production for a particular year and goes down
when production goes down. The reason for this effect can be traced to the
shifting of fixed manufacturing cost between periods under the absorption
costing method as explained below.
 Comparison between Variable Costing and
Absorption Costing
As to amount of inventory
Inventory value under absorption costing would be higher in amount than that under variable costing.
The inventory amount would carry a portion of fixed overhead incurred during the period under
absorption costing.
Reconciliation of Net Income under Variable Costing with Net Income under Absorption
Costing
The reconciliation of the net income figures under the two product costing methods may be done as
follows:

Net income, Absorption costing Pxx

Add: Fixed overhead in ending inventory xx
Total Pxx
Less: Fixed overhead in ending inventory xx
Net income, Variable costing Pxx
 PRODUCT COST COMPONENTS

ABSORPTION COSTING VARIABLE COSTING

Direct Materials Direct Materials
+ Direct Labor + Direct Labor
+ Variable FOH + Variable FOH
+ Fixed FOH Product Cost
Product Cost
 DISTINCTIONS BETWEEN PERIOD COSTS AND
PRODUCT COSTS

PERIOD COSTS PRODUCT COSTS

1. Cost that is charged against current 1. Cost that is included in the computation of
revenue during a time period regardless of a product cost that is apportioned between
the difference between production and the sold and unsold units.
sales volume.
2. Does not form part of the cost of inventory. 2. An inventoriable cost. The portion of the
cost that has been allocated to the unsold
unite becomes part of the cost of inventory.
3. Reduces income for the current period by 3. Reduces current income by the portion
its full amount. allowed to the sold units.
PRINCIPAL DIFFERENCES BETWEEN ABSORPTION
AND VARIABLE COSTING METHODS
AB S O R P T I O N CO S T ING V AR I A B L E C O S T I N G
1. Cost Segregation S e l d o m s e g r e g a t e s c o s t s into Costs are segregated into
variable a n d f ixed costs. variable a n d f ixed.
2. C o s t of In v e n tor y C o s t of in vento r y inc lu des all C o s t of invent or y inc ludes
t he ma nuf ac tu r i n g costs: only the variable
materia ls, labor, variable manufacturing costs:
f actory o v e rh ea d, a n d f ixed materia l, l a bor a n d variable
f actory o v e r h e a d . f actory o v e r h e a d .
3. Treatment of Fixed Fixed factory overhead is Fixed factory overhead is
Factory O ve rh e ad t r e a ted a s p r o d u ct cost. t r e a ted a s p e r i o d cost.
4. In co me Statement Distinguishes between Distinguishes between
p r o d u c ti on a n d o t h e r c o s t s variable a n d f ixed c o s t s
S a le s xx Sales xx
-Cost of Goods Sold xx - V a r ia b le C o s t s xx
Gross Profit xx C M xx
- S &A Costs xx - FxC xx
Profit xx Profit xx
5. Net In co me N e t i n c o me b e t w e e n t he t w o m e t h o d s m a y differ f ro m e a c h
o the r b e c a u s e of the d iff erence in th e a m o u n t of f ixed
o v e r h e a d c o s ts re c og n i z ed a s e x p e n s e d ur i ng a n a c co un t i ng
in period. Th i s is d u e to variations b e t w e e n s a le s a n d
p ro du ct io n in th e l ong run, ho w e v e r, b ot h m e t h o d s g i ve
substantial ly t he s a m e result s i nc e s a le s c a n no t con t inu ou s ly
e x c e e d p rod uc t ion no r p ro du ct io n c a n continually e x c e e d
sales.
 DISTINCTIONS BETWEEN PERIOD COSTS AND
PRODUCT COSTS

PERIOD COSTS PRODUCT COSTS

1. Cost that is charged against current 1. Cost that is included in the computation of
revenue during a time period regardless of a product cost that is apportioned between
the difference between production and the sold and unsold units.
sales volume.
2. Does not form part of the cost of inventory. 2. An inventoriable cost. The portion of the
cost that has been allocated to the unsold
unite becomes part of the cost of inventory.
3. Reduces income for the current period by 3. Reduces current income by the portion
its full amount. allowed to the sold units.
 DIFFERENCE IN NET INCOME UNDER ABSORPTION
AND VARIABLE COSTING

Variable and absorption costing methods of accounting for fixed

manufacturing overhead result in different levels of net income
in most cases. The differences are timing difference, i.e., when to
recognize the fixed manufacturing overhead as an expense. In
variable costing, it is expensed during the period when the fixed
overhead is incurred, while in absorption costing, it is expensed
in the period when the units to which such fixed overhead has
been related are sold.
 PRODUCTION EQUALS SALES:
When production is equal to sales, there is no
change in inventory. Fixed overhead expensed
under absorption costing equals fixed overhead
expensed under variable costing. Therefore,
absorption costing income equals variable
costing income.
 PRODUCTION IS GREATER THAN SALES:

When production is greater than sales, there is

an increase in inventory. Fixed overhead
expensed under absorption costing is less than
fixed overhead expensed under variable costing.
Therefore, absorption income is less than
variable costing income.
 ACCOUNTING FOR DIFFERENCE INCOME

Change in inventory (Production less Sales) xx

x Fixed FOH cost per unit xx
Difference in income xx
END OF MODULE