Absorption costing

and
Variable costing
Absorption costing:
(i) It is costing system which treats all manufacturing
costs including both the fixed and variable costs as
product costs.
(ii) Also known as full costing.
(iii) All manufacturing cost are fully absorbed into
finished goods.
(iv) Fixed cost are absorbed on actual basis or on
predetermined rate basis (based on normal capacity)
(v) Under/over absorption of fixed overheads are
adjusted before computing profit.
(v) Stocks are valued at total cost.
(vi) Non-manufacturing costs are treated
as period cost i.e. charged to profit and
loss account.
Income statement under Absorption costing
Particulars Rs.
(A) Sales xxxx
Production cost:
direct material xx
direct labour xx
variable manufacturing overhead xx
Fixed manufacturing overhead xx
Cost of goods produced: xxxx
Add: Opening stock of finished goods(valued at cost of previous xx
period’s production)
Cost of goods available for sale xxxx
Less: Closing stock of finished goods xx

Cost of goods sold xxxx

Add/less: under/over absorption of fixed manufacturing o/h xx
Add: non-manufacturing cost xx
(B) Total cost xxxx
Profit (sales – total cost) or (A – B) xxx
Variable costing: CIMA – “The system in
which variable costs are charged to cost units
and fixed costs of the period are written off in
full against the aggregate contribution.”

(i) The variable manufacturing costs as product

costs.
(ii) The fixed costs are regarded as period cost.
(iii) The work in progress and finished stocks
are valued at variable cost only.
(iv) Contribution is difference between sales
and variable cost of sales.
 Income statement under Variable costing
Particulars Rs.
(A) Sales xxxx
Production cost:
direct material xx
direct labour xx
variable manufacturing overhead xx

Cost of goods produced: xxxx

Add: Opening stock of finished goods(valued at variable cost of previous period’s xx
production)
Cost of goods available for sale xxxx
Less: Closing stock of finished goods xx

Cost of goods sold xxxx

Add: non-manufacturing variable cost xx

(B) Total variable cost xxxx
Contribution(sales – variable cost) or (A – B) xxx
(C) Less: Fixed manufacturing & non-manufacturing cost xx
Profit ( B – C) xxx
(Q) ABC company has a production capacity of 12,500
units and normal capacity utilization is 80%. Opening
stock of finished goods on 01-01-2014 was 1000 units.
During the year ending 31-12-2014, it produced 11,000
units while it sold only 10,000 units. Standard variable
cost per unit is Rs 6.5 and standard fixed factory cost
per unit Rs 1.50.Total fixed selling and administration
overhead amounted to Rs. 10,000.The company sells its
product at Rs 10/unit.
Prepare income statement under absorption and
variable costing.
 Income statement under absorption costing
Rs
(A)Sales (10,000 x Rs 10) 1,00,000
Variable cost (11,000 x Rs 6.50) 71,500
Fixed manufacturing cost(11,000 x Rs 1.50) 16,500
Cost of goods produced 88,000
Add: opening stock (1000 x Rs 8) 8,000

Cost of goods available for sale 96,000

Less: Closing stock (2000 x Rs 8) (16,000)

Cost of goods sold 80,000

Less:Over absorption of overhead(1,000 x Rs 1.5) (1,500)
Add: non-manufacturing fixed cost 10,000
(B)Total cost 88,500

Profit (A – B) 11,500
 Income statement under Variable costing
Rs
(A)Sales (10,000 x Rs 10) 1,00,000
Variable cost (11,000 x Rs 6.50) 71,500

Variable Cost of goods produced 71,500

Add: opening stock (1000 x Rs 6.5) 6,500

Cost of goods available for sale 78,000

Less: Closing stock (2000 x Rs 6.5) (13,000)

(B)Variable Cost of goods sold 65,000

Contribution(A – B) 35,000

less: Manufacturing fixed cost (15,000)

non-manufacturing fixed cost (10,000)
(C) Profit 10,000
Difference in profit under Absorption and Variable
costing:
Profit under two systems may be different because of
difference of stock valuation
(a) Production equal to sale:
(i) When there is no opening stock & closing stock, profit/loss
under both system are equal
(ii) When opening stock equals closing stock then profit/loss
under both system are equal provided the fixed cost element in
opening and closing stock is the same amount.

(b) production more than sales: ( closing stock more than

opening stock): profit under Absorption costing will be more
than Variable costing because part of fixed cost included in
the closing stock are carry forward to next accounting period.
(c) Production less than sales(opening stock
more than closing stock):
- Profit shown by Variable costing will be more
than Absorption costing profit.

- This is because under absorption costing cost

of goods sold is higher because of a part of
fixed cost from preceding period is added in
current year’s cost of goods sold in the form of
opening stock
.
Difference between Absorption costing and
Variable costing:
Basis Absorption costing Variable costing

i. Treatment of Fixed manufacturing expenses Fixed manufacturing expenses

fixed overhead are treated as product cost. are treated as period cost.

ii. Difference in Values stock at total Stock are valued at Variable

valuation of stock production cost. i.e. fixed plus cost only, hence value of
variable cost, hence value of closing stock will be low
closing will be high.
iii. Contribution Absorption costing calculate Variable costing calculate
Net profit. Contribution.
iv. Reporting purpose Absorption costing is mostly Variable costing is mainly use
for external reporting and for internal reporting.
taxable income computation.
Advantage of Absorption costing:
i. Consideration of Fixed cost: Fixed costs are used in
production of goods and services. So treated as product cost.
ii. Efficient pricing policy: The pricing policy based on
Absorption costing ensures that all costs are covered.
iii. Conformity with Accrual and Matching concept: Which
requires matching costs with revenue for a particular accounting
period.
iv. External Reporting and Income taxes: absorption costing has
been recognized for the purpose of preparing external reports
and stock valuation. FASB, ASB recommended this system.
v. No need to separate costs as Fixed and Variable cost.
vi. Relevance of under/ over costing: It disclosed inefficient or
efficient utilization of production resources.
Disadvantages of Absorption Costing System:

(i) Absorption costing is not useful for decision making: It consider fixed manufacturing
overhead as product cost which increase the cost of output. Managerial problems, such as
optimum capacity utilization, selection of product-mix, whether to buy or manufacture,
evaluation of performance, choice of alternatives can be solved only with the help of
variable costing analysis.

(ii) Absorption costing is not helpful in control of cost: It is not useful in fixing the
responsibility for incurrence of costs. It is not practical to hold a manager accountable
for costs over which he/she has not control.
(iii) Fixed Costs are Period Costs: Many accountants argue that fixed costs, whether
related to manufacturing or to non-manufacturing, are period costs which produce no
future benefits and therefore, should not be included in the cost of the product and
inventory.
(iv) Costs Hide in Inventory : Since the company allocates fixed overhead to the finished
unit level in absorption costing, until the company sells a unit, the cost does not show up as
an expense, or Cost of Goods Sold.
Q. A company has produced 1,500 units against a budgeted quantity of
2,000 units. Actual sales were 1,300 units. The company’s policy is to value
stocks at standard absorption cost. Following details are given-

Direct material Rs 100 per unit

Direct labour Rs 100 per unit(at normal efficiency)
Variable overhead Rs 50 per unit
Fixed OH at budgeted capacity Rs 1,00,000
Variable selling OH Rs 26,000
Budgeted fixed selling OH Rs 30,000
Actual fixed selling overhead Rs 25,000
Selling price Rs 400 per unit
There was no opening stock

Present the profitability statement under absorption costing system

Fixed OH at budgeted capacity = Rs 1,00,000
Budgeted quantity = 2,000 units.
Fixed OH per unit = Rs 100,000/2000 = Rs 50 per unit
Actual production = 1,500 units
Actual absorbed fixed OH = 1500 x 50 = Rs 75,000
Under Absorption = Rs 1,00,000 – 75,000
= Rs 25,000
 Income statement under Absorption costing
Rupees
(A)Sales (1,300 x 400) 5,20,000

Production cost:
Direct material Rs. 100 x 1,500 = Rs 1,50,000
Direct labour Rs 100 x 1,500 = Rs 1,50,000
Variable OH Rs 50 x 1,500 = Rs. 75,000
Fixed OH Rs 50 x 1,500 = Rs 75,000
Cost of goods produced 4,50,000
Add: Opening stock Nil
Less: Closing stock (Rs 300 x 200) (60,000)
Cost of goods sold 3,90,000
Add: Under absorption Fixed OH(Rs.50 x 500) 25,000
Add: Non Manufacturing variable OH 26,000
Non manufacturing fixed OH 25,000
(B)Total cost 4,66,000
Profit (A – B) 54,000
Q. For several months, top management of company has been puzzled by fluctuation in the
income reported by the accountant. The result reported are as follows:

(Rs)February March April

Sales 18,00,000 18,00,000 9,00,000
Less: Manufacturing cost
of sales 16,60,000 13,60,000 4,30,000
Selling & Admn. Expense 4,40,000 4,40,000 4,40,000
Total expense 21,00,000 18,00,000 8,70,000
Net Income/loss (3,00,000) 0 30,000

There has been no change in sales price during the 3 month period. During the months of
February and March, the plant sold 3,00,00,000 units. In April it sold 1,50,00,000 units.

The production for the 3 months was as follows:

 February March April
Opening Inventory 3,01,00,000 1,00,000 1,00,000
Production 0 3,00,00,000 6,00,00,000
3,01,00,000 3,01,00,000 6,01,00,000
Units sold 3,00,00,000 3,00,00,000 1,50,00,000
Ending inventory 1,00,000 1,00,000 4,51,00,000

The standard cost for the units sold discloses the following information:
Cost per 1,000 units (Rs)
Direct material and labour 30
Variable OH 2
Fixed OH 10
42
The fixed manufacturing costs budgeted for each of the months were Rs.4,00,000. There
were no spending or efficiency variances during three months. All selling & administrative
expenses were fixed nature.
Prepare comparative income statement for the 3 months using Absorption and Variable
costing system.
The fixed manufacturing costs budgeted for each month = Rs.4,00,000.

Fixed OH per 1000 units = Rs 10

February March April

Production 0 3,00,00,000 6,00,00,000

Actual Fixed OH incurred 0 30,000 x 10 60,000 x 10
= Rs 3,00,000 = Rs 6,00,000

Over/under Absorbed 4,00,000 100,000 (2,00,000)

 Income statement under Absorption costing

February March April(Rs)

Sales 18,00,000 18,00,000 9,00,000

Cost of goods produced:

Variable cost Nil 9,60,000 19,20,000
fixed cost Nil 3,00,000 6,00,000
Cost of goods produced 0 12,60,000 25,20,000

Add: Opening stock(30,100 x 42) 12,64,200 42,00 42,00

Cost of goods available for sale 12,64,200 12,64,200 25,24,200
Less: Closing stock (4,200) (4,200) (18,94,200)
Cost of goods sold 12,60,000 12,60,000 6,30,000

Add/less: Over/ under absorption of fixed cost 4,00,000 1,00,000 (2,00,000)

Add: Non-manufacturing cost 4,40,000 4,40,000 4,40,000
Total cost 21,00,000 18,00,000 8,70,000

Profit (3,00,000) Nil 30,000

 Income statement under Variable costing

February March April(Rs)

Sales 18,00,000 18,00,000 9,00,000

Cost of goods produced:

Variable cost Nil 9,60,000 19,20,000
Cost of goods produced 0 9,60,000 19,20,000

Add: Opening stock(30,100 x 32) 9,63,200 32,00 32,00

Cost of goods available for sale 9,63,200 9,63,200 19,23,200
Less: Closing stock (3,200) (3,200) (14,43,200)
Cost of goods sold 9,60,000 9,60,000 4,80,000

Contribution 8,40,000 8,40,000 4,20,000

Less: Non-manufacturing cost 4,40,000 4,40,000 4,40,000

Less: Fixed cost 4,00,000 4,00,000 4,00,000

Profit Nil Nil (4,20,000)

Advantage of variable costing:

i. Planning and control: Variable costing emphasis on cost behaviours which provides
necessary information to understand how different costs will change in reaction to
changes in activity level.

ii. Managerial decision making: Information regarding variable cost and contribution
facilitates making policy decisions like fixing selling price below cost, make or buy,
introduction of new product line, utilization of spare plant capacity etc.

iii. Cost control: The management can concentrate more on the control of variable cost
which are generally controllable and pay less attention to fixed cost.

iv. No under and over absorption of overheads

v. Realistic valuation of stock: No fictitious profit can arise due to fixed cost being
absorbed in unsold stock. This is because variable costing prevents the carry forward
in stock valuation of some portion of current year’s fixed cost.
Limitation of Variable costing:

i. Improper basis of pricing: Pricing policies can be fully based on marginal

costing system(few exceptions)

ii. Product costs not without fixed cost: Complete product cost does not
depend only variable production cost.

iii. Ignore time factor: By ignoring fixed costs, time factor is also ignored.

iv. Difficulty in application: It is difficult to apply variable costing system

in industries where large stocks of work in progress are locked up

v. Separation of costs into fixed and variable component

Q. The Gurgaon plant of Maruti Udyog ltd. Assembles Zen motor vehicle. The
standard unit manufacturing cost per unit in 2016 as follows:
Direct material = Rs 60,000
Direct manufacturing labor = Rs 18,000
Variable manufacturing OH = Rs 20,000
The Gurgaon plant is highly automated. The maximum production capacity per
month is 4000 vehicles. Fixed manufacturing OH in 2016 is allocated on the
basis of normal capacity utilization of the plant. In 2016, the budgeted
normal capacity is 3,000 vehicles per month. The budgeted monthly Fixed
manufacturing OH is Rs 7,50,000. On January1 , 2016 there is zero beginning
inventory of Zen vehicles. The actual unit production and sales figure for the
first three months are:
January February March
Production 3,200 2,400 3,800
Sales 2,000 2,900 3,200

Selling price per vehicle is Rs 2,00,000

Prepare income statement for the three months under absorption and
Variable costing system. Prepare reconciliation statement to reconcile the
difference in net income in the two costing system.
1. Direct material = Rs 60,000
Direct manufacturing labor = Rs 18,000
Variable manufacturing OH = Rs 20,000
Total variable cost per vehicle= Rs 98,000

2. Budgeted Fixed manufacturing OH = Rs 7,50,000

Budgeted normal capacity = 3,000 vehicles
fixed manufacturing OH absorption rate = 7,50,000/3000
= 250 per vehicle

January February March(Rs)

Variable production cost 32,00 x 98,000 2400 x 98,000 3,800 x 98,000
= 31,36,00,000 = 23,52,00,000 = 37,24,00,000

Under/over absorption of fixed 200 x 250 600 x 250 800 x 250

manufacturing OH =(50,000) = 1,50,000 =(2,00,000)

Opening stock Nil 1200 x 98,250 700 x 98,250

= 11,79,00,000 = 6,87,75,000
 Income statement under Absorption costing

January February March(Rs)

Sales 400,00,000 580,00,000 640,00,000

Cost of goods produced:

Variable cost 31,36,00,000 23,52,00,000 37,24,00,000
fixed cost 8,00,000 6,00,000 9,50,000
Cost of goods produced 31,44,00,000 23,58,00,000 37,33,50,000

Add: Opening stock Nil 11,79,00,000 6,87,75,000

Cost of goods available for sale 31,44,00,000 35,37,00,000 44,21,25,000

Less: Closing stock 11,79,00,000 6,87,75,000 12,77,25,000

Cost of goods sold 19,65,00,000 28,49,25,000 31,44,00,000

Add/less:Over/under absorption of fixed OH (50,000) 1,50,000 (2,00,000)

Add: Non-manufacturing cost Nil Nil Nil

Total cost 19,64,50,000 28,50,75,000 31,42,00,000

Profit 20,35,50,000 29,49,25,000 32,58,00,000

 Income statement under Variable costing

January February March(Rs)

Sales 400,00,000 580,00,000 640,00,000

Cost of goods produced:

Variable cost 31,36,00,000 23,52,00,000 37,24,00,000

Cost of goods produced 31,36,00,000 23,52,00,000 37,24,00,000

Add: Opening stock Nil 11,76,00,000 6,86,00,000

Cost of goods available for sale 31,44,00,000 35,28,00,000 44,10,00,000

Less: Closing stock 11,76,00,000 6,86,00,000 12,74,00,000

Variable Cost of goods sold 19,60,00,000 28,42,00,000 31,36,00,000

Contribution 20,40,00,000 29,58,00,000 32,64,00,000

Less: Fixed manufacturing OH (7,50,000) (7,50,000) (7,50,000)
Less: Non-manufacturing OH Nil Nil Nil

Net profit 20,32,50,000 29,50,50,000 32,56,50,000

 Reconciliation of difference in net income
January February March

Absorption costing income 20,35,50,000 29,49,25,000 32,58,00,000

Variable costing income 20,32,50,000 29,50,50,000 32,56,50,000
Difference in net income +3,00,000 (-)1,25,000 +1,50,000

Carry forward amount --- (3,00,000) (1,75,000)

Stock values: Absorption costing

Closing stock 11,79,00,000 6,87,75,000 12,77,25,000

Variable costing:

Closing stock 11,76,00,000 6,86,00,000 12,74,00,000

difference in closing stock 3,00,000 1,75,000 3,25,000

Net difference income 3,00,000 (1,25,000) 1,50,000