CHAPTER 8 : VARIABLE COSTING VS. ABSORPTION COSTING

Chapter 8 : Variable costing vs Absorption costing

What is the main difference between variable costing and absorption costing?

Variable costing = only variable production costs (DM, DL, variable MOH) are products costs. Fixed MOH is a period cost.

Absorption costing = both variable and fixed production costs. Fixed MOH is allocated to units produced.

Under variable costing, which costs are included in unit product cost?

• Direct materials

• Direct labour

• Variable manufacturing overhead only.

Fixed MOH is treated as a period expense.

Under absorption costing, which costs are included in unit product costs?

• Direct materials

• Direct labour

• Variable manufacturing overhead

• Fixed manufacturing overhead (allocated per unit)

Why do operating incomes differ between absorption costing and variable costing?

Because absorption costing defers a portion of fixed manufacturing overhead in inventory, while variable costing expenses all fixed MOH immediately. If production does not equal sales, income will differ.

How does variable costing operating income change with production and sales?

It only changes with sales volume. Production volume does not affect income.

How does absorption costing operating income change with production and sales?

It changes with both sales and production volume. Producing more units than sold increases inventory and can artificially increase operating income.

Why is variable costing more useful for managers?

• Consistent with CVP analysis

• Highlights impact of fixed costs on profit.

• Easier to estimate product/segment profitability.

• Profit not distorted by inventory changes.

• Income is closer to cash flow.

Why is absorption costing required for external reporting?

Because it follows the matching principles (IAS2): costs must be matched to the revenues they help generate, so fixed MOH must be included in inventory until the product is sold.

How does lean (JIT) production affect differences between absorption and variable costing?

Since production = sales, inventory doesn’t build up. Thus, the difference between the two methods nearly disappears, reducing manipulation opportunities.

When does absorption costing income exceed variable costing income?

When production > sales

Because some fixed MOH is deferred inventory).

CHAPTER 8: VARIABLE VS ABSORPTION

When does the variable costing income equal absorption costing income?

When production = sales

No change in inventory.

Data:

• Units produced annually = 40,000

• Units sold during the year = 35,000 at a selling price of $50 each

• Variable costs per unit:

  • Direct materials, direct labour, variable MOH = $18

  • Variable selling & administrative = $4

• Fixed costs per year:

  • Manufacturing overhead = $200,000

  • Selling & administrative = $120,000

Q1. Compute the unit product cost under:
a) Absorption costing
b) Variable costing

Q2. Prepare an income statement using absorption costing.

Q3. Prepare an income statement using variable costing.

Q4. Reconcile the difference in operating income between the two methods.

Q1. Unit Product Cost

• Absorption costing = Variable cost + (Fixed MOH ÷ Units produced)

=18+200,00040,000=18+5=23=18+40,000200,000​=18+5=23

Unit product cost (absorption) = $23

• Variable costing = Only variable production costs = $18

  Q2. Absorption Costing Income Statement

  • Sales = 35,000 × $50 = $1,750,000

  • COGS = 35,000 × $23 = $805,000

  • Gross Margin = $945,000

  • Selling & Admin = Fixed $120,000 + Variable (35,000 × $4 = $140,000) = $260,000

  • Operating Income = $685,000

    Q3. Variable Costing Income Statement

    • Sales = $1,750,000

    • Variable costs = (35,000 × $18) + (35,000 × $4) = $630,000 + $140,000 = $770,000

    • Contribution Margin = $980,000

    • Fixed costs = $200,000 + $120,000 = $320,000

    • Operating Income = $660,000

      Q4. Reconciliation

      • Difference = $685,000 (absorption) – $660,000 (variable) = $25,000

      • Why? Because 5,000 units (40,000 produced – 35,000 sold) remain in inventory. Each unit carries $5 of fixed MOH.

      5,000×5=25,0005,000×5=25,000

      This $25,000 of fixed MOH was deferred in inventory under absorption costing.