COURSE FINANCIAL MANAGEMENT

DEVELOPER This module is prepared by Mr. Val Lawrence V. Flores. He is a Certified Public
AND THEIR Accountant. He teaches basic accounting, financial accounting courses and
BACKGROUND advanced financial accounting courses. Mr. Flores is currently a Member of
Philippine Institute of Certified Public Accountants (PICPA).
COURSE This course is a dynamic discipline constantly responding to the needs of
DESCRIPTION managers in a highly competitive and global business world. Managers need cost
accounting measurements to determine product costs for internal management
and external financial reporting.
COURSE 1. Cost concepts and cost behavior
OUTLINE 2. Activity based and variable costing
3. Job order costing
4. Accounting for materials (with JIT and backflush costing)
5. Accounting for labor
6. Accounting for factory overhead
7. Standard costing and variance analysis
8. Process costing
9. Joint product and by-product costing
CHAPTER NO. 2
TITLE Activity based and variable costing
I. RATIONALE

Activity-based costing (ABC) is a tool of Activity Based Management. It is a method of assigning

costs that calculates a more accurate product cost than traditional methods. It does so by
categorizing all indirect costs by activity, tracing the indirect costs to those activities, and assigning
those costs to products or services using a cost driver related to the cause of the cost. Activity-
based costing is an important tool of activity-based management because it improves the accuracy
in allocating activity-driven costs to cost objects.
Income from operations is one of the most important items reported by a company. Depending on
the decision-making needs of management, income from operations can be determined using
absorption or variable costing.

INSTRUCTION TO THE USERS

This module covers cost concepts and cost behavior, the first topic of Advanced Financial
Accounting and Reporting 1 course. In its developmental activities section, it provides substantial
discussions of the topics. It discusses the concepts, nature, scope and principles of the topics.
Ample examples, illustrations and word problems with suggested solutions are provided for the
application of concepts and practical exercises. To evaluate what the students have learned, this
module provides work exercises at the closure activities section. To ensure that learning objectives
are attained at the end of the semester, the learner / students are evaluated based on attendance,
portfolio journal, formative assessment and summative assessment. See evaluation section for the
details. For further readings, see assignment / agreement section.

II. LEARNING OBJECTIVES

1. Define activity-based costing and activity-based management and distinguish them from
traditional analysis of costs.
2. Identify the circumstances in which activity-based costing gives more credible results
than traditional product costing.
3. Identify different levels of costs and drivers in activity-based costing and give examples
of each.
4. Calculate product costs using activity-based costing and reconcile them with a traditional
system’s product cost.

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 5. Know the difference and salient features of variable costing.
6. Understand the difference between variable costing and absorption or conventional
costing methods.
7. Prepare income statements using variable and absorption costing.
8. Reconcile absorption costing income with variable costing income.
III. CONTENT
A. PREPARATORY ACTIVITIES

This module covers the cost concepts and cost behavior. With this, learners / students must:
1. Since this chapter is a new chapter and has nothing to do with past accounting
subjects already taken, read in advance the topic on the suggested books given in the
syllabus of the subject.
B. DEVELOPMENTAL ACTIVITIES

Please refer to the discussion below

Determining the cost of a product is termed product costing. Product costs consist of direct materials,
direct labor, and factory overhead. The direct materials and direct labor are direct costs that can be
traced to the product. However, factory overhead includes indirect costs that must be allocated to the
product. The methods of allocating factory overhead costs are as follows:

1. Single plant-wide factory overhead rate method

2. Activity-based costing method

Managers are concerned about allocating factory overhead because the allocation affects the accuracy
of product costs. In turn, product costs are used for decisions such as determining product mix,
establishing product price, and determining whether or not to discontinue a product line.

A company may use a predetermined factory overhead rate to allocate factory overhead costs to
products. Under the single plant-wide factory overhead rate method, factory overhead costs are
allocated to products using only one rate.

Illustration 1

Assume the following data for Ruiz Company, which manufactures product RED and BLUE in a
single factory.
Total budgeted factory overhead costs for the year . . . . . . . . . P 1,600,000
Total budgeted direct labor hours (as computed below) . . . . . 20,000 hours

RED BLUE Total

Planned production for the year . . . 1,000 units 1,000 units
Direct labor hours per unit . . . . . . x10 hours x10 hours
Budgeted direct labor hours . . . . . 10,000 hours 10,000 hours 20,000 hours

Under the single plant-wide factory overhead rate method, the P 1,600,000 budgeted factory overhead
is applied to all products by using one rate. This rate is computed as follows:

Total Budgeted Factory Overhead

Single plant-wide factory overhead rate =
Total Budgeted Plant-wide Allocation Base

The budgeted allocation base is a measure of operating activity in the factory. Common allocation
bases would include direct labor hours, direct labor dollars, and machine hours. Ruiz Company
allocates factory overhead using budgeted direct labor hours as the plant-wide allocation base. Thus,
Ruiz’s single plantwide factory overhead rate is P80 per direct labor hour, computed as follows:

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 P1,600,000
Single plant-wide factory overhead rate =
20,000 Direct Labor Hours

= P80 per direct labor hour

Ruiz uses the plant-wide rate of P80 per direct labor hour to allocate factory overhead to RED and
BLUE as shown below.

Single Plantwide Factory Direct Labor Hours Factory Overhead

Overhead Rate per Unit Cost per Unit
RED P80 per direct labor hour x 10 direct labor hours = P800
BLUE P80 per direct labor hour x 10 direct labor hours = P800

As shown above, the factory overhead allocated to each product is P800. This is because each product
uses the same number of direct labor hours.

The primary advantage of using the single plant-wide overhead rate method is that it is simple and
inexpensive to use. However, the single plant-wide rate assumes that the factory overhead costs are
consumed in the same way by all products. For example, in the preceding illustration Ruiz Company
assumes that factory overhead costs are consumed as each direct labor hour is incurred. The preceding
assumption may be valid for companies that manufacture one or a few products. If, however, a
company manufactures products that consume factory overhead costs in different ways, a single plant-
wide rate may not accurately allocate factory overhead costs to the products.

Illustration 2

The total factory overhead for Morris Company is budgeted for the year at P650,000. Morris
manufactures two office furniture products: a credenza and desk. The credenza and desk each require
four direct labor hours (d/h) to manufacture. Each product is budgeted for 5,000 units of production
for the year. Determine (a) the total number of budgeted direct labor hours for the year, (b) the single
plant-wide factory overhead rate, and (c) the factory overhead allocated per unit for each product
using the single plant-wide factory overhead rate.

a. Credenza: 5,000 units x 4 direct labor hours = 20,000 direct labor hours
Desk: 5,000 units x 4 direct labor hours = 20,000
40,000 direct labor hours

b. Single plant-wide factory overhead rate: P650,000/40,000 dlh P16.25 per dlh

c. Credenza: P16.25 per direct labor hour x 4 dlh per unit = P65 per unit
Desk: P16.25 per direct labor hour x 4 dlh per unit = P65 per unit

The activity-based costing (ABC) method focuses on the cost of activities and then allocates these
costs to products using a variety of activity bases. Under activity-based costing, factory overhead
costs are initially accounted for in activity cost pools. These cost pools are related to a given activity,
such as machine usage, inspections, moving, production setups, and engineering activities.

Activity-based costing identifies the causal relationship between the incurrence of cost and activities,
determines the underlying drive of activities, establishes cost pools related to individual drivers,
develops costing rates, and applies cost to product on the basis of resources consumed (drivers).

Definition of terms:

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  Activity – is an event, task or unit of work with a specified purpose. Examples of activities
are designing products, and setting up machines
o Unit-level activities – these activities are performed for each unit of product that is
produced. Some examples are hours of work, inspecting each item, operating a
machine (drilling, cutting, trimming, pressing) and performing a specific assembly
task, sewing, painting, sanding, etc.
o Batch-level activities – these activities occur each time a batch is produced. Some
examples are machine setup, purchasing, materials handling, and batch inspection.
o Product-sustaining activities – these activities are incurred in order to support the
production of a different product from what is currently produced. Examples include
product design, and engineering changes.
o Facility-sustaining activities – these activities are incurred to support production in
general and are generally fixed costs such as, security, maintenance, plant
management, depreciation of the factory and property taxes.
 Cost Object – is anything for which costs are accumulated for managerial purposes.
 Cost Driver – is anything (it can be an activity, an event, or a volume of something) that
causes costs to be incurred each time the driver occurs. Examples of cost drivers are set-ups,
moving, number of parts, casting, packaging or handling.

Types of Cost Allocation

Traditional ABC
Description 1. Also called as Volume Based 1. Involves a two-stage costing
or Throughput Based Costing processes

2. Group all overhead costs into 2. First stage: Accumulation of

one cost pool and apply costs for each activity level
overhead to units based on a (creation of cost pool)
single denominator activity (no.
of units produced, direct labor 3. Second stage: Assigning cost
hours, machine hours, % of of each activity to the cost
direct labor, etc.) object by using cost drivers.
(Calculation of Pool Rates)
3. Technically, only has one
goal, to allocate cost and 4. Improves the unit costing
determine the unit cost of the especially when there are low
cost object. and high volume of production
or different consumption ratios.
4. Loses its significance if the
denominator activity does not 5. Uses multiple cost drivers
represent the actual incurrence that reflect the causes of costs in
of overhead costs. an organization.
Cost Pools One One for each activity (first stage
allocation)
Costs Total Overhead Cost Total overhead is divided
among various cost pool.
Activities One plant-wide measure of One per cost pool which
production volume measures the level of the pool’s
activity
Predetermined Rate One plant-wide predetermined One rate for each activity cost
overhead rate pool

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Illustration 3

To illustrate the activity-based costing method, the prior illustration for Ruiz Company is used.
Assume that the following activities have been identified for producing product RED and BLUE:

1. Fabrication, which consists of cutting metal to shape the product. This activity is machine-
intensive.

2. Assembly, which consists of manually assembling machined pieces into a final product.
This activity is labor-intensive.

3. Setup, which consists of changing tooling in machines in preparation for making a new product.
Each production run requires a setup.

4. Quality-control inspections, which consist of inspecting the product for conformance to

specifications. Inspection requires product tear down and reassembly.

5. Engineering changes, which consist of processing changes in design or process specifications for a
product. The document that initiates changing a product or process is called an engineering change
order (ECO).

Fabrication and assembly are now identified as activities rather than departments. As a result, the
setup, quality-control inspections, and engineering change functions that were previously allocated to
the fabrication and assembly departments are now classified as separate activities.

The budgeted factory overhead for each activity cost pool is as follows:

Activity Cost Pool Budgeted Factory Overhead Costs

Fabrication . . . . . . . . . . . . . . . . . . . . . . . . . . . . . P 530,000
Assembly . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70,000
Setup . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 480,000
Quality-control inspections . . . . . . . . . . . . . . . . . 312,000
Engineering changes . . . . . . . . . . . . . . . . . . . . . 208,000
Total budgeted factory overhead costs . . . . . . P1,600,000

Activity Rates and Allocation

The activity cost pools are assigned to products using factory overhead rates for each activity. These
rates are called activity rates because they are related to activities. Activity rates are determined as
follows:

Activity Budgeted Activity Cost

=
Rate Activity Base

The term activity base, rather than allocation base, is used because the base is related to an activity
cost pool.

To illustrate, it is assumed that RED is a new product for Ruiz Company, and engineers are still
making minor design changes. BLUE has been produced by Ruiz Company for many years.
Additional data about the two products include:

RED BLUE
Estimated units of total production 1,000 units 1,000 units

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Estimated engineering change orders 12 change orders 4 change orders
Estimated setups 100 setups 20 setups
Units per production run 10 units (1,000/100 setups) 50 units (1,000/20 setups)
Quality-control inspections 100 inspections 4 inspections

The number of direct labor hours used by each product is 10,000 hours as shown below.

Direct Labor Number of Units Total Direct

Hours per Unit of Production Labor Hours
RED:

Fabrication Department . . . . . 8 hours 1,000 units 8,000 hours

Assembly Department . . . . . . 2 hours 1,000 units 2,000 hours
Total . . . . . . . . . . . . . . . . . . 10,000 hours

BLUE:

Fabrication Department . . . . . 2 hours 1,000 units 2,000 hours

Assembly Department . . . . . . 8 hours 1,000 units 8,000 hours
Total . . . . . . . . . . . . . . . . . . 10,000 hours

The activity bases for each product are summarized below:

Activity Base
Quality-Control Engineering
Products Fabrication Assembly Setup Inspections Changes
RED 8,000 dlh 2,000 dlh 100 setups 100 inspections 12 ECOs
BLUE 2,000 8,000 20 4 4_____
Total activity base 10,000 dlh 10,000 dlh 120 setups 104 inspections 16 ECOs

The activity rates for each activity are determined as follows:

Activity Budgeted Activity Cost

=
Rate Activity Base

The activity rates for Ruiz Company are shown below:

Budgeted
Activity
Activity Cost Pool ÷ Activity Base = Activity Rate

Fabrication P530,000 ÷ 10,000 dlh = P53 per dlh

Assembly P 70,000 ÷ 10,000 dlh = P7 per dlh
Setup P480,000 ÷ 120 setups = P4,000 per setup
Quality-control inspections P312,000 ÷ 104 inspections = P3,000 per insp.
Engineering changes P208,000 ÷ 16 EC = P13,000 per ECO

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 RED BLUE
Activity Activity Activity Activity Activity Activity
x = x =
Activity Base Rate Cost Base Rate Cost

Fabrication 8,000 dlh P53/dlh P 424,000 2,000 dlh P53/dlh P 106,000

Assembly 2,000 dlh P7/dlh 14,000 8,000 dlh P7/dlh 56,000
Set up 100 setups P4,000/setup 400,000 20 setups P4,000/setup 80,000
Quality Control Inspections 100 inspections P3,000/inspection 300,000 4 inspections P3,000/inspection 12,000
Engineering Changes 12 ECOs P13,000 ECO 156,000 4 ECOs P13,000 ECO 52,000

Total Factory Overhead Cost P 1,294,000 P 306,000

Budgeted Units of Production ÷ 1,000 ÷ 1,000

Factory Overhead Cost Per unit P 1,294 P 306

The factory overhead costs per unit for Ruiz Company using the two allocation methods are shown
below.

Factory Overhead Cost per Unit—

Two Cost Allocation Methods
Single Plant-wide Activity-Based
Rate Costing
RED P800 P1,294
BLUE 800 306

Dangers of Product Cost Distortion

If Ruiz Company used the P800 factory overhead cost allocation (single plant-wide rate) instead of
activity-based costing for pricing product RED and product BLUE, the following would likely result:
1. The Product RED would be underpriced because its factory overhead cost is understated by P494
(P1,294 - P800).
2. The Product BLUE would be overpriced because its factory overhead cost is overstated by P494
(P800 - P306).

As a result, Ruiz would likely lose sales of product BLUE because they are overpriced. In contrast,
sale of product RED would increase because they are underpriced. Due to these pricing errors, Ruiz
might incorrectly decide to expand production of product RED and discontinue making product
BLUE. If Ruiz uses the activity-based costing method, its product costs would be more accurate.
Thus, Ruiz would have a better starting point for making proper pricing decisions. Although the
product cost distortions are not as great, similar results would occur if Ruiz had used the multiple
production department rate method.

Illustration 4
The total factory overhead for Morris Company is budgeted for the year at P600,000, divided into
four activity pools: fabrication, P300,000; assembly, P120,000; setup, P100,000; and material
handling, P80,000. Morris manufactures two office furniture products: a credenza and desk. The
activity-base usage quantities for each product by each activity are as follows:
Fabrication Assembly Setup Material Handling
Credenza 5,000 dlh 15,000 dlh 30 setups 50 moves
Desk 15,000 5,000 220 350
20,000 dlh 20,000 dlh 250 setups 400 moves

Each product is budgeted for 5,000 units of production for the year. Determine (a) the activity rates
for each activity and (b) the activity-based factory overhead per unit for each product.

a. Fabrication: P300,000/20,000 direct labor hours = P15 per dlh

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 Assembly: P120,000/20,000 direct labor hours = P6 per dlh
Setup: P100,000/250 setups = P400 per setup
Material handling: P80,000/400 moves = P200 per move

b.
Credenza Desk
Activity Activity Activity Activity Activity Activity
x = x =
Activity Base Rate Cost Base Rate Cost

Fabrication 5,000 dlh P15/dlh P 75,000 15,000 dlh P15/dlh P 225,000

Assembly 15,000 dlh P6/dlh 90,000 5,000 dlh P6/dlh 30,000
Set up 30 setups P400/setup 12,000 220 setups P400/setup 88,000
Materials Handling 50 moves P200/move 10,000 350 moves P200/move 70,000

Total Factory Overhead Cost P 187,000 P 413,000

Budgeted Units of Production ÷ 5,000 ÷ 5,000

Factory Overhead Cost Per unit P37.40 P82.60

Illustration 4

Hammer Company plans to use activity-based costing to determine its product costs. It presently uses
a single plant-wide factory overhead rate for allocating factory overhead to products, based on direct
labor hours. The total factory overhead cost is as follows:

Department Factory Overhead

Production Support . . . . . . . . . . . . . . . . . . P1,225,000
Production (factory overhead only) . . . . . . . 175,000
Total cost . . . . . . . . . . . . . . . . . . . . . . . . . P1,400,000

The company determined that it performed four major activities in the Production Support
Department. These activities, along with their budgeted costs, are as follows:

Production Support Activities Budgeted Cost

Setup . . . . . . . . . . . . . . . . . . . . . . . . . . P 428,750
Production control . . . . . . . . . . . . . . . . 245,000
Quality control . . . . . . . . . . . . . . . . . . . 183,750
Materials management . . . . . . . . . . . . . 367,500
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . P1,225,000

Hammer Company estimated the following activity-base usage and units produced for each of its
three products:

Products Number of Direct Setups Production Inspections Material

units Labor Orders Requisitions
Hours
TV 10,000 25,000 80 80 35 320
Computer 2,000 10,000 40 40 40 400
Cellphone 50,000 140,000 5 5 0 30
Total 62,000 175,000 125 125 75 750

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Instructions:
1. Determine the factory overhead cost per unit for the TV, computer, and cell phone under the single
plant-wide factory overhead rate method. Use direct labor hours as the activity base.
2. Determine the factory overhead cost per unit for the TV, computer, and cell phone under activity-
based costing. Round off to whole centavos.
3. Which method provides more accurate product costing? Why?
Solution:

P 1,400,000
=
1. Single plant-wide factory overhead rate 175,000 direct labor hours

= P8 per direct labor hour

2. Under activity-based costing, an activity rate must be determined for each activity pool:

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3. Activity-based costing is more accurate, compared to the single plant-wide factory overhead rate
method. Activity-based costing properly shows that the cell phone is actually less expensive to make,
while the other two products are more expensive to make. The reason is that the single plant-wide
factory overhead rate method fails to account for activity costs correctly. The setup, production
control, quality control, and materials management activities are all performed on products in rates
that are different from their volumes. For example, the computer requires many of these activities
relative to its actual unit volume. The computer requires 40 setups over a volume of 2,000 units
(average production run size 50 units), while the cell phone has only 5 setups over 50,000 units
(average production run size 10,000 units). Thus, the computer requires greater support costs relative
to the cell phone. The cell phone requires minimum activity support because it is scheduled in large
batches and requires no inspections (has high quality) and few requisitions. The other two products
exhibit the opposite characteristics.

ABSORPTION AND VARIABLE COSTING

General Objective:

 To determine when an expense will be recognized (when an asset will be re-classified

as an expense)
 Expense (expiration of benefits) is incurred when an asset is used up or sold for the
purpose of generating income.
Types of cost as to purpose

 Product costs
 The costs of goods manufactured or the cost of goods purchased for resale.
 These costs are inventoried until the goods are sold.

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  When the product costs are expensed, it will form part of the cost of goods
sold.
 Can be found in three types of inventories, raw materials, work-in-process,
and finished goods.
 Period costs
 All other non-products costs in an organization.
 Such costs are not inventoried but are expenses as time passes.
 Examples
 Selling expenses (Delivery expense, advertising expense, sales
commission)
 General and administrative (Accounting, Professional fee, Research
and development)
 When period costs are expensed, it will form part of the operating expenses.
Point of incurrence:

Point of Production Point of Sales

Cost Incurred Cost Incurred

1. Direct Materials 1. Variable Selling and
2. Direct Labor Administrative
3. Variable Overhead 2. Fixed Selling and
4. Fixed Overhead Administrative

Types of Product Costing Method

 Variable Costing
 Definition
 Product cost is comprised solely of variable manufacturing costs
 Fixed manufactured overhead is viewed as a cost of being ready to
produce, not an actual production cost since it will remain constant
no matter how many units are produced. Hence, expensed
immediately.
 Also called as Direct or Marginal Costing
 Direct Materials, Direct Labor, and Variable Overhead
 Advantages
 It can be used in constructing the contributing format approach
income statement to highlight the cost behavior structure of the
entity.
 Fit nicely with Cost-Volume-Profit Analysis
 Net income unaffected by changes in production levels
 Net income closely tied to changes in sales level – not production
levels which makes it easier to predict the level of operating income.
 Fixed costs are not accounted for as an inventoriable cost –
simplifying the record keeping – no need for allocation.
 Companies can also break down each department or product line
under variable costing, which provides a more thorough analysis of a
company’s business operation
 Disadvantages
 Does not conform to generally accepted accounting principles

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 Costs are required to be separated into fixed and variable - cost
segregation techniques can be subjective.
 Expensing fixed production costs as a period expense lowers net
income for each accounting period
 Too much emphasis may be given to variable costs at the expense of
disregarding fixed costs – fixed costs should still be recovered from
operations.
 Absorption Costing
 Definition:
 All costs related to the manufacture of goods are product costs.
 Direct materials, Direct labor, Variable and Fixed Overhead
 Advantages
 Results in the preparation of a traditional income statement
 Is considered GAAP and is generally acceptable for tax reporting
 Considers all cost when setting the price (cost plus pricing method)
 Disadvantages:
 Does not consider excess capacity since fixed costs are already
allocated to the different units
 Distort the results of decisions made to discontinue a business
segment – fixed cost will remain whether the company will eliminate
the segment or not.
Summary of Product Costs:

Variable Costing Absorption Costing

Direct Materials Product Product
Direct Labor
Variable Overhead
Fixed Overhead* Period
Variable Selling and Administrative Period
Fixed Selling and Administrative
*Causes the difference in variable and absorption costing.

Computing Net Income:

 Variable Costing and the Contribution Format Income Statement
Sales (the same with that of absorption costing) xx
Less: Variable Costs:
Variable cost of sale
Beginning inventory (Units x Var. Production Costs) xx
Costs of goods manufactured (Units Produced x xx
Var. Production Costs/unit) _____________
Total Goods Available for Sale xx
Less: Ending Inventory (Units x Var. Prod. (xx)
Costs/Unit) _____________ xx
Variable Selling and Administrative (Units Sold x VS&A/unit) xx (xx)
Contribution Margin xx
Less: Fixed Costs
Fixed Overhead xx
Fixed Selling and Administrative xx ___ (xx)
Operating Income xx

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  Absorption Costing and the Functional Income Statement
Sales (the same with that of variable costing) xx
Less: Cost of Sales
Beginning Inventory (Units x Production Costs/unit) xx
Cost of Goods Manufactured (Units Produced x Prod. xx
Costs/unit) _____________
Total Goods Available for Sale xx
Less: Ending Inventory (Units x Prod. Costs/unit) (xx) (xx)
Gross Profit xx
Less: Operating Expenses
Variable Selling and Administrative (Units Sold x
VS&A/unit) xx
Fixed Selling and Administrative xx (xx)
Operating Income xx

Effects of Product Costs in Net Income

 Since absorption costing will always have a higher inventory value (due to the fixed
overhead) – the effect net income of changes in production and sales level will be
highlighted using the absorption costing.
 When Production is greater than Sales – will result to a higher ending inventory
which will decrease total costs of sales that will result in an increase in operating
income. Hence, absorption costing net income will be HIGHER than variable costing
net income.
 When Production is less than Sales – will result to a lower ending inventory which
will increase total cost of sales that will result in a decrease in operating income.
Hence absorption costing net income will be LOWER than variable costing net
income.
 Summary:

If Production > Sales Ending Inventory Cost of Sales Absorption Net Income
If Production < Sales Ending Inventory Cost of Sales Absorption Net Income
If Production = Sales = Ending Inventory (no change)

Reconciling Absorption and Variable Costing Net Income:

 Beginning Inventory = Fixed cost that will be released that will make Cost of Sales;
Net Income (AC-NI < VC-NI)
 Ending Inventory = Fixed cost that will be deferred that will make Cost of Sales; Net
Income (AC-NI > VC-NI)
 Reconciling Item : Fixed Cost Component in the Inventories
 Summary:

Absorption Costing Net Income xx Variable Costing Net Income xx

Add: Fixed Cost Expensed last xx Add: Fixed Cost Deferred (EI) xx
period (BI)
Less: Fixed Cost Expensed this xx Less: Fixed Cost Released (BI) xx
period (EI)
Variable Costing Net Income xx Absorption Costing Net Income xx

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Comprehensive Illustration:

To illustrate the procedures involved in product costing and income determination under the two
methods, let us use the following example:

Annabelle Manufacturing Corp. produces and sells earphones. Its production, sales and cost data for a
three-year period are shown below:

Year 1 Year 2 Year 3

Manufacturing Costs:
Materials (per unit) P3.00 P3.00 P3.00
Labor (per unit) 2.00 2.00 2.00
Variable Overhead (per unit) 1.00 1.00 1.00
Fixed Overhead (total) P2,000.00 P2,000.0 P2,000.00
0
Selling and administrative
costs:
Variable (per unit) P1.50 P1.50 P1.50
Fixed (total) P800.00 P800.00 P800.00
Production (in units) 1,000 1,000 1,000
Sales (in units) 1,000 800 1,100
Selling Price (per unit) P15.00 P15.00 P15.00

Required: Assuming that Annabelle Manufacturing Corporation started commercial operations in year
1, prepare income statements for each year using (1) absorption costing and (2) variable costing.

Solution

Year 1 – Production = Sales

Since the company started operating in year 1, there is no inventory of finished goods as of
the beginning of this year. Moreover, considering that all the units produced in year 1 were sold in the
same period (production = sales), there is no ending inventory in year 1.
To simplify the preparation of income statements, let us first compute the product cost per
unit for absorption and direct costing methods:

Product Cost Per Unit – Absorption Costing:

Direct Materials P3.00
Direct Labor 2.00
Variable Overhead 1.00
Fixed Overhead (P2,000/1,000units) 2.00 P8.00

Product Cost Per Unit – Variable Costing:

Direct Materials P3.00
Direct Labor 2.00
Variable Overhead 1.00 P6.00

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The income statements for year 1 under the two costing methods are shown below:

The two income statements that we presented for year 1 show that the income figures
computed using the two methods are the same (P4,700). This is so because all the revenue and cost
items included in the computation of income under the two methods are exactly the same. To
emphasize this point, let us make a comparison of the figures:

Note the emphasis given to the fixed overhead figures in the tabulation. Actually, if we want
to compare income figures under absorption and variable costing, we do not gave to consider sales,
materials, labor, variable overhead and operating expenses, for these items are definitely equal under
the two methods. As mentioned earlier, the basic difference between absorption and variable
costing is on the treatment of fixed factory overhead, which is treated as product cost under
absorption and as period cost under variable costing.

In our example, the cost of fixed overhead incurred in manufacturing operations during the
period (year 1) is P2,000. As a rule, this total amount is charged to expense as a period cost under
variable costing. For absorption costing, this total fixed overhead cost of P2,000 should be allocated
to sold and unsold units. However, since production is equal to sales in year 1, no amount of fixed
overhead cost incurred during the year is allocated to unsold units. Neither is there any amount of
fixed overhead incurred in the previous period that is charged to cost of goods sold during this year
because there is no inventory of finished goods at the beginning of year 1. Hence, the period cost
(fixed overhead) of P2,000 recognized as expense under variable costing is equal to the product cost
(fixed overhead) of P2,000 charged to cost of goods sold under absorption costing.

Generalization:

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Based on the above discussions, we can have the following generalizations:

Year 2 – Production is greater than Sales

Since we did not have any inventory at the end of year 1, neither shall we have any inventory
at the beginning of year 2. However, during this year, the company produced 1,000 units and sold
only 800 units. Hence, we have an inventory of 200 units at the end of year 2.
The income statement under absorption and variable costing are presented below:

The total variable selling and administrative expenses decreased from P1,500 in year 1 to
P1,200 in year 2 because generally, the variable cost items is dependent on the units sold. However,
the total fixed selling and administrative cost remained the same despite the decrease in units sold
because fixed costs do not vary with volume.

For year 2, our income figure computed under absorption costing (P3,600) is greater than the
amount determined using variable costing (P3,200). As mentioned earlier, in knowing the reason
behind this difference in income, we should just concentrate on the fixed overhead cost, since the
revenue and all the cost items (except fixed overhead cost) under the two methods are exactly the
same.

Let us now take a closer look at fixed overhead. Under absorption costing, the total fixed
overhead incurred for production during year 2 amounts to P2,000 (1,000 units produced x P2.00/
unit). However, not all of this total amount is charged to expense (through cost of goods sold) during
the year because not all the units produced were sold during the same period. Instead, the total fixed
overhead cost of P2,000 is allocated to cost of goods sold (800 x P2.00 = P1,600) and ending
inventory (200 x P2.00 = P400). Hence, only P1,600 is charged to expense during the year via cost of

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goods sold. The amount of P400 assigned to ending inventory is treated at the end of the year as an
asset. Its recognition as expense is deferred until these units are sold in the next period.

Under variable costing, on the other hand, the amount of fixed overhead incurred during the
year (P2,000) is totally charged to expense during the period even if not all the units produced were
sold. Let us reiterate that under this method, fixed overhead is treated as a period cost and not a
product cost, hence, the total amount incurred is expensed during the period of incurrence, regardless
of production and sales.

To illustrate let us consider the figure below.

Recall that our income under absorption is P3,600, while under variable costing, it is only
P3,200. The difference of P400 (P3,600 – P 3,200) is due to the fixed overhead cost assigned to the
ending inventory under absorption costing, which is charged as an expense for the period under
variable costing.

The ending inventory costs may be analyzed as shown below.

Generalizations:

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 We can now have the following generalizations based on the foregoing discussions:

Year 3 – Production is less than Sales:

During year 3, the company sold 1,100 units, which is 100 units more than the production
volume of 1,000. These additional 100 units came from the beginning inventory of 200 units. Let us
illustrate how income will be computed under the two methods in this case be presenting the income
statements shown below.

The cost of goods sold section of our income statements show in detail the cost of production
and inventories. Since the costs per unit of product used in the calculation of cost of goods sold are
uniform (P8 for absorption and P6 for variable costing), the cost of goods sold can be computed using
a simpler and shorter formula:

Applying this formula to our illustrative case, the cost of goods sold figures can be computed
as follows:

For year 3, income reported under absorption costing is only P5,250, which is less than the
amount of P5,450 reported under variable costing. Let us account for the difference in income under
the two methods by considering the diagram below.

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 The total fixed overhead recognized as expense during year 3 under absorption costing
amounts to P2,200 though the company incurred only P2,000 for the year’s production. The additional
P200 came from the fixed overhead included in the beginning inventory of P400 (200 units x P2), one
half of which was sold during the period, hence charged to expense through the cost of goods sold.
The balance of 100 units in which fixed overhead amounts to P200, will be the ending inventory for
year 3. The same will again be recognized first as asset until the sale of such goods.
Under variable costing, fixed overhead recognized as expense amount to only P2,000,
representing the current year’s fixed manufacturing cost. No additional fixed overhead cost was
contributed by additional units coming from inventory, since this item does not have fixed overhead
cost element. Under this method, recall that the cost of inventory includes only variable
manufacturing cost elements. No amount of fixed overhead was deferred as asset last year despite the
fact that not all the units produced were sold. Instead, all the fixed overhead costs incurred were
charged to expense during the same period.
The difference in income of P200 (P5,250 – P5,450) between the two methods is therefore
attributable to the fixed overhead in the beginning inventory (100 x P2 = P200) that is recognized as
additional expense during the period when the units were sold.

Generalizations:

Based on the foregoing, we can now have the following generalizations:

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Accounting for income difference

As noted earlier in the preceding discussions, the difference in income between absorption
and variable costing is due to the fixed overhead cost charged to inventories. When production is
greater than sales, the fixed overhead cost allocated to the increase in inventory (unsold units) under
absorption costing diminishes the amount assignable to cost of goods sold, which results to a higher
income figure. When production is less than sales, the fixed overhead previously assigned to
inventories sold (coming from beginning inventory) during the current period increases the amount
assigned to cost of goods sold. With a higher cost of goods sold figure (expense), absorption costing
shows lower income than the amount computed under variable costing.

Therefore, in accounting for the difference in income, we just have to consider the fixed
overhead cost included in the increase or decrease in inventory and the same can be done using the
following formulas:

Let us apply the above formulas to our illustrative case, using the figures for year 2 and year 3:

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Reconciliation of Absorption and Variable Costing Income Figures

Income under absorption can be reconciled with income under variable costing with the use
of the following formula:

Notes:
1. Beginning inventory increases cost of goods sold and decrease income. The presence of
fixed overhead in the cost of beginning inventory under absorption costing cause its income
to be less than income under variable costing. To reconcile, we increase absorption costing
income by adding back fixed overhead in the beginning inventory to income under absorption
costing method.
2. Ending inventory decreases cost of goods sold and increase income. The inclusion of fixed
overhead in ending inventory cost under absorption costing causes its income to be higher
than that of variable costing. To reconcile, the fixed overhead in the ending inventory is
deducted from income under absorption costing to reduce it to the income level computed
under variable costing.

To illustrate, let us reconcile the income figures under the two methods for year 2 and 3:

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IV. SYNTHESIS / GENERALIZATION
1. Product costs may be distorted when a single plant-wide factory overhead rate is used. Activity-
based costing reduces the possibility of product cost distortions.
2. Variable and Absorption costing are methods of costing inventories. The basic difference
between these two methods is on the treatment of fixed factory overhead. Under absorption
costing, fixed overhead is treated as product cost, while under direct costing, fixed overhead is
treated as period cost.
V. EVALUATION

The student / learner’s performance in this module is evaluated as follows:

20% Attendance, Poll Questioning and Oral Exercises

20% Portfolio Journal for work exercises
20 % Formative Examination
40% Summative Examination (This topic is included in the Online / Offline Written Midterm
Examination)

VI. ASSIGNMENT / AGREEMENT

The next topic is Job Order Costing. Learner / student is advised to read in advance the topic in the
book of Pedro P. Guerrero, Cost Accounting Principles and Procedural Application/Norma D. De
Leon, Ellery D. De Leon, Guillermo M. De Leon Jr., Cost Accounting and Control/Carter, Cost
Accounting 14th edition. Thomson Asian Edition/Warren, Reeve, Duchac, Managerial Accounting
10e/Cost Accounting- Kinney, Raiborn and Carter (Compilation Version) 2013.
REFERENCES
Carter, Cost Accounting 14th edition. Thomson Asian Edition
Cost Accounting- Kinney, Raiborn and Carter (Compilation Version) 2013
Rodelio S. Roque, Management Advisory Services
Pedro P. Guerrero, Cost Accounting Principles and Procedural Application
Norma D. De Leon, Ellery D. De Leon, Guillermo M. De Leon Jr., Cost Accounting and Control
Roque, R.S. Management Advisory Services. 16th Edition

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