1 Strategic Cost Management: Unit 4

UNIT 4: Variable and Absorption Costing

Managers need to be able to evaluate the activities over

which they have responsibility. The separation of fixed and
variable costs in variable costing is critical for making accurate
evaluations. Without a distinction between fixed and variable
costs, the evaluation of profit-making activities and the
resulting decision may both be erroneous.

Learning Outcomes

At the end of this chapter, you should be able to:

Prepare income statements under variable and absorption costing
Explain the difference in net operating income, inventory value and treatment of
operating costs between variable costing and absorption costing
Reconcile net income computed in net operating income, inventory values and
treatment of operating costs between variable costing and absorption costing
Prepare segmented income statements

Hi! Remember that by knowing the

backbone of the formulas, you can answer
almost any type of question no matter
how they twist it. Please master the
difference between variable and
absorption costing. Variable costing is
useful in preparing segmented income
statements. Through this, the manager
can evaluate each segment’s contribution
to overall firm performance. Don’t
hesitate to message your instructor if
anything confuses you.
2 Strategic Cost Management: Unit 4

Many companies consist of separate business units called profit center. It is important for these
companies to determine both the overall performance of the business and the performance of the
individual profit centers. The overall income statement is useful for looking at overall company
performance. However, this income statement is of little use for determining the viability of the
individual business units or segments. Instead, it is important to develop a segmented income
statement for each profit center. Two methods of computing income have been developed: one
based on variable costing and the other based on full or absorption costing. These are costing
method because they refer to the way in which product costs are determined. Recall the product
costs are inventoried; they include direct materials, direct labor, and overhead. Period costs, such as
selling and administrative expense, are expensed in the period incurred. The difference between
variable and absorption costing hinges on the treatment of one particular cost: fixed factory
overhead.
A. Absorption Costing
 Assigns all manufacturing costs to the product
 Fixed overhead is viewed as a product cost, not a period cost
 Fixed overhead is assigned to the product through the use of a predetermined fixed
overhead rate and is not expensed until the product is sold (inventoriable cost)
Inventory Valuation:
Absorption Costing Product Cost = DM + DL + VOH + FOH
B. Variable Costing
 Assigns only variable manufacturing costs to the product
 Fixed overhead is treated as a period expense and is excluded from the product cost.
The FOH of a period is seen as expiring that period and is charged in total against
the revenues of the period.
*The rationale of this is that fixed overhead is a cost of capacity, or staying in
business. Once the period is over, any benefits provided by capacity have expired
and should not be inventoried.
Inventory Valuation:
Variable Costing Product Cost = DM + DL + VOH
Note:
GAAP require absorption costing for external reporting. The FASB, the IRS, and other
regulatory bodies do not accept variable costing as a product-costing method for external
reporting.
For internal application, variable costing is an important managerial too because it can
supply vital cost information for decision making and control, information not supplied by
absorption costing.
3 Strategic Cost Management: Unit 4

Absorption Costing Variable Costing

Product Costs Direct Materials Direct Materials
Direct Labor Direct Labor
Variable Overhead Variable Overhead
Fixed Overhead
Period Costs Selling Expenses Fixed Overhead
Administrative Expenses Selling Expenses
Administrative Expenses

Illustrations:
Information for 1-4:
During the most recent year, Fairchild Company had the following data associated with the product
it makes:

Units in Beginning Inventory -

Unit produced 10,000
Units sold (P300 per unit) 8,000
Variable costs per unit:
Direct materials P50
Direct labor P100
Variable overhead P50
Fixed costs:
Fixed overhead per unit P25
produced P100,000
Fixed selling and administrative

Requirements for 1 and 2

a. How many units are in ending inventory?
b. Calculate the per-unit product cost.
c. What is the value of ending inventory?

1. Compute Inventory Cost under Absorption Costing

Remember: Unit cost under absorption costing includes all product costs, both fixed and
variable. It is a long run measure of product costing.
Solution:
a. Units Ending Inventory = Units Beginning Inventory + Units Produced – Units Sold
= 0 + 10,000 – 8,000
= 2,000 units
4 Strategic Cost Management: Unit 4

b. Absorption costing units cost:

Direct Materials P50

Direct Labor 100
Variable Overhead 50
Fixed Overhead 25
Unit product cost P225

c. Value of Ending Inventory = Units Ending Inventory x Absorption Unit Product Cost
= 2,000 units x P225
= P450,000
Note: The inventory cost computed under absorption costing is the traditional product cost
used for external financial statements and for GAAP. Each unit includes all variable
manufacturing costs as well as a portion of fixed factory overhead.
2. Computing Inventory Cost under Variable Costing

Remember: Unit cost under variable costing includes only variable product cost. Fixed
product cost is a period cost that is not attached to inventory.

Solution:

a. Units Ending Inventory = Units Beginning Inventory + Units Produced – Units Sold
= 0 + 10,000 – 8,000
= 2,000 units
b. Absorption costing units cost:

Direct Materials P50

Direct Labor 100
Variable Overhead 50
Unit product cost P225

c. Value of Ending Inventory = Units Ending Inventory x Absorption Unit Product Cost
= 2,000 units x P200
= P400,000

Note: We can see that the only difference between the two approaches is the treatment of
fixed factory overhead. Thus, the unit product cost under absorption costing is always
greater than the unit product cost under variable costing.

Requirements for 3 and 4

a. Calculate the Cost of Goods Sold
b. Prepare an Income Statement
5 Strategic Cost Management: Unit 4

3. Preparing an Absorption-Costing Income Statement

Remember: Absorption-costing income statements are used for external reporting. All
product costs are included in Cost of Goods Sold.

a. Cost of Goods Sold = Absorption Unit Product Cost x Units Sold

= P225 x 8,000
= P1,800,000
b. Income Statement
Fairchild Company
Absorption-Costing Income Statement
Sales (P300 x 8,000) P2,400,000
Less: Cost of goods sold 1,800,000
Gross margin P600,000
Less: Selling and administrative expenses 100,000
Operating income P500,000

Note: As we can see, the cost of goods sold includes some but not all fixed factory overhead.
Total fixed factory overhead is P250,000 (P25 x 10,000 units produced). However, only
P200,000 (P25 x 8,000 units sold) of fixed overhead was expensed in cost of goods sold.
Where did the other P50,000 of fixed overhead go? It is included in the cost of ending
inventory.
4. Preparing a Variable-Costing Income Statement

Remember: Variable-costing income statements are useful for internal decision making. All
fixed costs are considered period costs. When the tie period is over, fixed costs’ usefulness
has expired.

Solution:
a. Cost of Goods Sold = Variable Unit Product Cost x Units Sold
= P200 x 8,000
= P1,600,000
b. Income Statement
Fairchild Company
Variable-Costing Income Statement
Sales (P300 x 8,000) P2,400,000
Less variable expenses:
Variable cost of goods sold 1,600,000
Contribution margin P800,000
Less fixed expenses:
Fixed overhead
Fixed selling and administrative 350,000
Operating income P450,000
6 Strategic Cost Management: Unit 4

Note: Compare the income statements under both method. Operating income under
absorption costing is P500,000, whereas operating income under variable costing is
only P450,000. Remember that P50,000 of current period product cost in fixed factory
overhead is included in the costs for variable costing. Notice that selling and
administrative expenses are never included in product cost. They are always expensed
on the income statement and never appear on the balance sheet.

Production, Sales, and Income Relationships

The relationship between variable-costing income and absorption-costing income changes
as the relationship between production and sales changes. If more is sold than was produced,
variable-costing income is greater than absorption-costing income. This situation is just the
opposite of the Fairchild (illustration) example. Selling more than was produced means that
beginning inventory and units produced are being sold. Under absorption costing, units coming out
of inventory have attached to them fixed overhead from a prior period. In addition, units produced
and sold have all of the current period’s fixed overhead attached. Thus, the amount of fixed
overhead expenses by absorption costing is greater than the current period’s fixed overhead by the
amount of fixed overhead flowing out of inventory. Accordingly, variable-costing income is greater
than absorption-costing income by the amount of fixed overhead flowing out of beginning
inventory.
If production and sales are equal, of course, no difference exists between the two reported
incomes. Since the units produced are all sold, absorption costing, like variable costing, will
recognize the total fixed overhead of the period as an expense. No fixed overhead flows into or out
of inventory.
Important Summary!

If Then
Absorption income > Variable
income
1. Production > Sales
Absorption income < Variable
2. Production < Sales
income
3. Production = Sales
Absorption income = Variable
income

The difference between absorption and variable costing centers on the recognition of
expense associated with fixed factory overhead. Under absorption costing, fixed factory overhead
must be assigned to units produced. This presents two problems that we have not explicitly
considered.

 First, how do we convert factory overhead applied on the basis of direct labor hours or
machine hours into factory overhead applied to units produced?
 Second, what is done when actual factory overhead does not equal applied factory
overhead?
7 Strategic Cost Management: Unit 4

The solution to these problems is reserved for a more advanced accounting course.

Evaluating Profit-Center Managers

The evaluation of managers is often tied to the profitability of the units that they control.
How income changes from one period to the next and how actual income compares with planned
income are frequently used as signals of managerial ability. To be meaningful signals, however,
income should reflect managerial effort. For example, if a manger has worked hard and increased
sales while holding costs in check, income should increase over the prior period, signalling success.
In general terms, if income performance is expected to reflect managerial performance, then
managers have the right to expect the following:

 As sales revenue increases from one period to the next, all other things being equal, income
should increase.
 As sale revenue decreases from one period to the next, all other things being equal, income
should decrease.
 As sales revenue remains unchanged from one period to the next, all other things being
equal, income should remain unchanged.
Variable costing ensures that the above relationships hold; however, absorption costing may
not.
Segmented Income Statements using Variable Costing
Variable costing is useful in preparing segmented income statements because it gives useful
information n variable and fixed expenses. A segment is a subunit of a company of sufficient
importance to warrant the production of performance reports. Segments can be divisions,
departments, product lines, customer classes, and so on. In segmented income statements, fixed
expenses are broken down into two categories: direct fixed expenses and common fixed expenses.
This additional subdivision highlights controllable versus noncontrollable costs and enhances the
manager’s ability to evaluate each segment’s contribution to overall firm performance.
 DIRECT FIXED EXPENSES

Direct fixed expenses are fixed expenses that are directly traceable to a
segment. These are sometimes referred to as “avoidable fixed expenses” or
“traceable fixed expenses” because they vanish if the segment is eliminated, then
those fixed expenses would disappear.
For example, Patty’s Bakehouse, bakes and sells cakes and pastries. The
ovens and cooking equipment are fixed costs for the Bakehouse. If the Bakehouse
were eliminated, those costs would disappear.

 COMMON FIXED EXPENSES

Common fixed expenses are jointly caused by two or more segments. These
expenses persist even if one of the segments to which they are common is
eliminated.
8 Strategic Cost Management: Unit 4

For example, depreciation on the corporate headquarters building, the

salary of the CEO, and the cost of printing and distributing the annual report to
shareholders are common fixed expenses for Walt Disney Company. If Walt Disney
Company were to sell a theme park or open a new one, those common expenses
would not be affected.
Illustration:
Preparing a Segmented Income Statement
Remember: Segmented income statements allow managers to see the profitability of individual
segments of the company. Segments can be products, regions, customer type, and so on.
Information:
Audiomatronics Inc. produces MP3 players and DVD players in a single factory. The following
information was provided for the coming year.

MP3 Players DVD Players

Sales P400,000 P290,000
Variable cost of goods sold 200,000 150,000
Direct fixed overhead 30,000 20,000

A 5% sales commission is paid for each of the product lines. Direct fixed selling and
administrative expense was estimated to be P10,000 for the MP3 line and P15,000 for the DVD line.
Common fixed overhead for the factory was estimated to be P100,000; common selling and
administrative expense was estimated to be P20,000.
Required:
Prepare a segmented income statement for Audiomatronics Inc. for the coming year, using
variable costing.
Solution:
Audiomatronics Inc.
Segmented Income Statement
For the Coming Year
MP3 Players DVD Players Total

Sales P400,000 P290,000 P690,000

Variable cost of goods sold (200,000) (150,000) (350,000)
Variable selling expense* (20,000) (14,500) (34,500)
Contribution margin P180,000 P125,500 P305,500
Less direct fixed expenses:
Direct fixed overhead (30,000) (20,000) (50,000)
Direct selling and administrative (10,000) (15,000) (25,000)
Segment margin P140,000 P90,500 P230,500
Less common fixed expenses:
Common fixed overhead (100,000)
Common selling and administrative (20,000)
 9 Strategic Cost Management: Unit 4

Operating income P110,500

*Variable Selling Expense for MP3 Players = 0.05 x Sales = 0.05 x P400,000 = P20,000
Variable Selling Expense for DVD Players = 0.05 x Sales = 0.05 x P290,000 = P14,500
Note:
Notice how it shows that both products have large positive contribution margins (P180,000
for MP3 players and P125,500 for DVD players). Both products are providing revenue above
variable costs that can be used to help cover the firm’s fixed costs. However, some of the firm’s fixed
costs are caused by the segments themselves. Thus the real measure of the profit contribution of
each segment is what is left over after these direct fixed costs are covered.
The profit contribution each segment makes toward covering a firm’s common fixed cost is
called the segment margin. A segment should at least be able to cover both its own variable costs
and direct fixed costs. A negative segment margin drags down the firm’s total profit, making it time
to consider dropping the product. Ignoring any effect a segment may have on the sales of other
segments, the segment margin measures the change in a firm’s profits that would occur if the
segment were eliminated.
Illustration:
Comparison of Segmented With and Without Allocated Common Fixed Expense
Folsom Company information for last year:

Alpha Beta Gamma

Units produced and sold 10,000 30,000 26,000
Price P30 P25 P14
Variable cost per unit P20 P18 P12
Direct fixed expense P35,000 P38,000 P40,000

B. Segmented Income Statement

A. Segmented Income Statement with
without Allocation of Common Fixed
Allocation of Common Fixed Expense
Expense:
Alpha Beta Gamma Total Alpha Beta Gamma Total
Sales P300,000 P750,000 P364,000 P1,414,000 P300,000 P750,000 P364,000 P1,414,000
Less: Variable Cost 200,000 540,000 312,000 1,052,000 200,000 540,000 312,000 1,052,000
Contribution Margin P100,000 P210,000 P52,000 P362,000 P100,000 P210,000 P52,000 P362,000
Less: Direct fixed cost 35,000 38,000 40,000 113,000 35,000 38,000 40,000 113,000
Segment margin P65,000 P172,000 P12,000 P249,000 P65,000 P172,000 P12,000 P249,000
Less: Allocated common cost 21,220 53,040 25,740 100,000 100,000
Operating Income P43,780 P118,960 P(13,740) P149,000 P149,000