MODULE 3: VARIABLE COSTING &

ABSORPTION COSTING The Absorption Costing

There are two profit determination models that are Absorption costing operates within the framework of
popularly used the variable costing and the absorption the International Financial Reporting Standards. It is also
costing. known as " full costing" or "traditional costing". It
classifies costs and expenses according to the functional
The Variable Costing nature of business operations such as cost of goods sold,
marketing, selling, and administrative expenses. The
Variable Costing is premised on the philosophy that pro-forma absorption costing is shown below:
costs are either fixed or variable. Variable costs relates
to units sold. The difference between sales and variable Absorption Costing
cost is called the contribution margin. It is used to Pro-Forma Condensed Statement of Profit or Loss
absorb fixed costs and generate profit. For a Given Period

A condensed variable costing statement of profit or loss Sales

is shown below: Less: Cost of Goods Sold
Gross Profit
Variable Costing Less: Marketing. Selling and Administrative Expense
Pro-Forma Statement of Profit or Loss Earnings before interest and tax
For a Given Period Less: Interest Expense
Profit before Tax
Sales Px Less: Provision for Income Tax
Less: Variable Cost and Expenses x Profit
Contribution Margin x
Less: Fixed Cost and Expenses x The Difference between Absorption and Variable
Profit Px Costing Methods

The difference between absorption and variable costing

The variable costing (also called marginal costing or methods lies on how the fixed overhead is treated.
direct costing) income statement is not in accordance Under the absorption costing, fixed overhead is treated
with the established financial reporting standards. as a product cost while under the variable costing, fixed
Rather, it follows the economic model of determining overhead is treated as period cost. The matrix below
profit and gives business managers much more accurate shows how costs and expenses are classified under
perspective on how profit and operating wealth are absorption and variable costing systems.
accumulated and controlled.
Cost and Expenses Absorption Costing Absorption
Variable costing follows the economic model in Costing
determining profit, Direct Materials Product Cost Product Cost
Direct Labor Product Cost Product Cost
The Variable Costing Profit or Loss Statement -
Variable Overhead Product Cost Product Cost
Expanded Form FIXED OVERHEAD PRODUCT COST PERIOD COST
Variable Expenses Period Cost Period Cost
Variable cost may be segregated into variable cost of Fixed Expenses Period Cost Period Cost
goods sold and variable selling and administration
expenses. Fixed costs may be segregated into direct and
indirect fixed costs and expenses. And direct fixed costs Product costs, also called inventoriable costs or
and expenses may be controllable or non-controllable. deferrable costs, are those that are associated with units
produced. These costs follow the flow of the units
Variable Costing produced. They are deferred to inventory if the units are
Pro-Forma Statement of Profit or Loss still unsold and are charged to expense (e.g. cost of
For a Given Period goods sold) once sold.

Sales Period costs are charged outright as expenses are

Less: Variable Cost of Goods Sold incurred in the period. They are not affected on whether
Manufacturing Margin the units are already sold or not. They do no relate to the
Less: Variable Selling and Administrative expenses. flow of units but, rather in the period of incurrence.
Contribution Margin
Less: Controllable direct fixed cost and expenses Under the absorption costing method, the fixed overhead
Controllable margin is a product cost and therefore is deducted from sales
Less: Non-controllable direct fixed costs and expenses. based on the number of units sold (i.e. units sold x
Segment(direct) margin standard unit fixed overhead). In variable costing, the
Less: Indirect Fixed cost and Expenses fixed overhead is a period cost and therefore, treats the
Profit entire budgeted fixed overhead as expense during the
period.
The margins are sorted to serve the specific needs in
management activities.
Sample Problem: Profit (Loss) Calculation, Assuming Normal Capacity Equals Actual Production

Mela Corporation has the following standard costs and production data in 2020:

Unit sales price P200

Unit variable cost of production 120
Unit fixed over overhead 20
Unit variable expenses 10
Unit fixed expenses 5
Beginning inventory 4,000 units
Normal Capacity 20,000 units

The company fixed its expenses based on normal capacity.

Required: Determine the operating profit or loss using the absorption costing and variable costing system in each of the
following cases:

Case Production Sales

A 20,000 22.000
B 20,000 19,000
C 20,000 20,000

Discussions: Case A Sales (22, 000 units) > Production (20,000 units)

1. Formulas

Sales Quantity Sold x Unit Sales Price

Variable Cost of Good Sold Quantity Sold x Unit Variable Production Cost
Variable Cost of Goods Quantity Produced x Unit Variable Production
Manufactured Cost
Variable expenses Quantity Sold x Unit variable Expenses
Standard Fixed Overhead Rate Budgeted Fixed Cost/Normal Capacity
Standard Fixed Expenses Rate Budgeted Fixed Expenses/ Normal Capacity

2. The Case Environment

Notice that the cases have the same level of production at 20,000 units which is equal to the normal capacity, Normal
capacity is the expected capacity over the long-term. This is an important observation. It means we do not have volume
variance in this sample problem.

Next, in case "A" sales are greater than production, in case B, sales are less than production, and in case C, sales is equal
to production.

3. Profit (loss) determination

Now, let us compute the profit and loss by getting the differences in sales, costs, and expenses under each costing
systems. Costs and expenses include all of the available cost of goods sold. fixed overhead, variable expenses, and fixed
expenses. The profit under each method is computed as follows:
The fixed overhead under the absorption costing method is based on the number of units sold (i.e. 22,000 units) because it
is a product cost and therefore is expensed based on the number of unit sold.

The fixed overhead under variable costing method is a period cost. As such all the budgeted fixed overhead is deducted
from sales without regard to the number of units sold. The budgeted fixed overhead and budgeted fixed expenses are
computed as follows:

= 20,000 units x P20

= P400,000

= 20,000 units x P5

= P100,000
To emphasize, budgeted fixed overhead and fixed expenses are based on normal capacity. In case actual fixed overhead is
given, the same shall be included in the variable costing income statement, instead that of the budgeted fixed overhead.
However, under the absorption costing system, the fixed overhead based on standard cost and the difference between the
actual and standard fixed overhead is reported as fixed overhead variance to be reflected in the profit or loss statement.

The fixed expenses is allocated over normal capacity for more strategic reason is used purposely for this particular type of
problem. For short-term analysis, the standard fixed expense rate us related to units sold.

3. The difference in profit

In Case A. the difference in profit is P40,000 (i.e.P1,040,000-P1,000,000). The difference in profit between absorption
and variable costing methods may be accounted for using four (4) methods, as follows:

Method 1. Direct Reconciliation, Get the difference in the amount of fixed overhead charged under the two methods, as
shown below:

Note that sales, variable cost of goods sold, variable expenses and fixed expenses are the same under each method. Only
the fixed overhead differs in amount between the absorption and variable costing methods. The difference in the fixed
overhead amount explains the difference in profit between the two profit modeling systems.

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Unit variable costs include the costs of direct materials, direct labor, and variable overhead. The fixed overhead is a period
cost, and not a product cost, under the variable costing method.

6. The Cost of Goods Sold

Cost of goods sold is units sold times the unit product cost. It could also be determined using the financial accounting as
follows:

Case B-Sales (19,000 units) < Production units (20,000 units)

The profit is computed as follows:

Variable costing profit follows the trend in sales. When sales are greater than production. variable costing profit is greater
than absorption costing profit; and when sales are lower than production, variable costing profit is less than absorption
costing profit. When sales equal. production, the profit (loss) between variable costing and absorption costing is equal.

When sales exceed production, the cost of fixed overhead recorded in the absorption costing is greater than that of
variable costing. This is because the amount of fixed overhead charged against income is determined based on the number
of actual units sold. Therefore, in as much as sales in units are greater than production, the fixed overhead is recorded
under absorption costing is also greater, resulting to higher cost of goods sold and lower profit than that of the variable
When sales are lower than production, the fixed overhead charged in the absorption costing is lower and its profit is
higher than variable costing. The fixed overhead charged in the variable costing is constant regardless of the level of sales
while the fixed overhead charged in the absorption costing changes in relation to its units sold.

In variable costing, as sales increase, profit also increases, as sales decline, profit also declines.

This observation follows a manager's normal train of thought with regard to the relationship of shares and profit. This
differs from the reports using absorption costing where there are instances that sales are increasing but profit is declining
and vice-versa.

If variable costing follows sales, then absorption costing follows production. If production is greater than sales, absorption
costing income is greater than that of variable costing. If production is less than sales, absorption costing profit is less than
that of variable costing.

The fixed expenses are also based on normal capacity.

Required: Determine the operating income under absorption costing and variable costing under each of the following
independent cases:
Volume variance represents the ability of the business to meet the normal capacity. Volume variance is related to fixed
overhead, it is constant per total amount but changes per unit. In short, fixed overhead is not controlled on its total amount
but is controlled in relation to volume (production). Over the years, a business would have already developed it average
capacity (i.e. normal capacity) that settles at the middle of the ups and downs of its production levels. If normal capacity is
greater than the actual capacity, there is a under-absorbed capacity and it is an unfavorable variance. If normal capacity is
less than the actual capacity, there is an over- absorbed capacity, a favorable variance.

2. A cost variance is the difference between the actual costs and standard costs. If actual costs are greater than standard
costs, the cost variance is unfavorable. If actual costs are less than standard costs, the cost variance is favorable.

Under the standard costing system, the costs are recorded at standard. Financial reports, however, are prepared at actual
data. As such, unfavorable variances are added to standard cost of goods sold, while favorable variance are deducted from
standard cost of goods sold to get the actual cost of goods sold. That is why unfavorable cost variance is also called debit
variance. why favorable cost variance is called credit variance.

Volume variance is included only in the absorption costing income statement. Since volume variance relates to fixed
overhead which is a product cost under the absorption method, hence the volume variance is considered. Under the
variable costing, however, the fixed overhead is a period cost, an expense and is not subject to cost variable analysis.

The computation of profit (loss), with volume variance, is shown below:

The favorable volume variance is added because the profit is computed directly. The normal treatment, though, for a
favorable cost variance is to deduct it from the standard cost of goods sold. Note that the volume variance is treated only
under the absorption costing method.

The difference of profit of P20,000 is accounted as follows:

Production 21,000 units

2. The profit (loss) is computed as follows:

The unfavorable volume variance is deducted from profit. The normal treatment of an unfavorable variance is as addition
to the standard cost of goods sold. Using a direct method of computing profit, an increase in cost of goods sold is a
deduction from profit.

The difference in operating profit of P60,000 is accounted for as follows:

MODULE 4: PROFIT PLANNING & COST-VOLUME PROFIT ANALYSIS

Profit Planning
• Profit planning is the process of anticipating profit under varying conditions and analyzing the effects of
variables affecting it. It directly relates to the normal operating activities and is short-term in nature.
Variable Costing and Profit Planning
• The Variable Costing system is preferred as a managerial tool in profit planning. Variable costing is
straight forward, stresses the importance of quantity and price to sales and profit and follows the foundation of
economic principles. In this model, costs are classified as fixed or variable. Total fixed costs are related to
normal capacity and are independent from the changes in the level of sales volume. Variable costs change directly
in relation to the change in volume of sales. Variable costing system (also known as marginal costing system
or contribution margin approach) determines profit as follows:

Contribution Margin
Sales and variable costs directly relate with sales volume. The difference in sales and variable costs is originally called
profit/volume, but is now popularly referred to as contribution margin. This amount is used to absorb fixed costs. The
difference between contribution margin and fixed costs is profit. The format to determine profit using the variable costing
system is as follows:

For the purpose of profit analysis and control, managers give emphasis to the contribution margin. To avoid
operating loss, contribution margin should be at least equal to fixed costs. Any amount of contribution margin in excess
of fixed costs is profit. A peso increase in contribution margin is a peso increase in operating profit.
Assumptions in Profit Planning and CVP Analysis
• Management has to control costs. The process of understanding the relationships of costs; sales price and sales
volume as they impact profit is known as Cost-Volume Profit analysis, e.g. CVP analysis. The process of
understanding and controlling the impact of changes in costs, sales price, volume and sales mix to profit
in order to identify the level of optimal operating performance in achieving the overall goal of an enterprise
is profit planning.
• The variables of profit are the unit sales price, unit variable costs, total fixed costs, sales volume (or volume) and
the sales mix. Sales mix is happens when a business sells two or more products. The assumptions to these
variables as they relate to units sold, are as follows:
Profit Planning Assumptions

Basic Assumptions
• The sales price is considered constant for planning purposes. It is influenced by competition variability in
supply and demand, laws, technology, distribution, channels, emerging practices, production input prices,
taxes, subsidies, seasonality, and other determinants. However, once set by the marketing and planning
department, the sales price is considered constant hence, considered outside the controllable domain of
 the expense management. The most the management accountant can do is to influence the setting of the sales
price.
• The variable cost rate is considered constant for planning purposes. It is affected by a change in the prices of
suppliers, labor, rentals, telecommunications, fuel, warehousing, distribution, taxes and licenses, agency costs,
and such other determinants. The total fixed costs and expenses are also considered constant for planning
purposes.
The Basic CVP Analysis is based on following assumptions:

Cost-volume profit analysis also assumes that labor productivity, production technology, and market
conditions will not change. Or if they change, their impact shall be covered in the sensitivity analysis.
Also, it is assumed that there is no inflation, or if it can be forecasted, it is already included in the CVP analysis
data. CVP sensitivity assumptions The assumption that sales price, unit variable costs, and total fixed costs are
constant are used to establish the “standard costs”. These costs serve as the “ballpark figures” or initial
points of understanding the results of business operations. The assumptions used in the basic CVP analysis
are stiff, unreal, and are not reflective of practical business conditions. In the real world, changes abound and
their impacts are sometimes profound. Sales price change. Unit variable costs and total fixed costs also
change. Sales mix changes as well. The process of considering the impact and the results of the profit
of the changes in its variables is called CVP sensitivity analysis.