BM2021

ABSORPTION AND VARIABLE COSTING

Absorption, Variable, and Throughput Costing

Income is one of the many significant measures managers use to make decisions and evaluate
operational performance. In a manufacturing firm, two (2) alternative accounting treatments of fixed
manufacturing overhead can result in different reported income amounts for the company. The
difference in reported income can alter management’s view of the profitability of a particular decision or
segment of the company (Hilton & Platt, 2017). Normally, accountants and managers make a judgment
when measuring income, and one of the most important factors is choosing the appropriate method in
calculating the product cost.
When managers realized that product costing would affect their evaluation, they started to pay
attention to the determination of product costs. The two (2) product costing methods that differ in the
treatment of the fixed manufacturing overhead are absorption costing and variable costing.
1. Absorption Costing. It is also known as “full costing” or “conventional costing.” In this method, all
manufacturing costs (i.e., direct materials, direct labor, and manufacturing overhead) are
recognized as product costs, regardless of whether they are variable or fixed (Garrison et al., 2018).
This means that all manufacturing costs are assigned to (or absorbed by) the units produced.

Figure 1. Manufacturing costs for absorption costing

Figure 1 illustrates all manufacturing costs needed to produce the product. These are direct
materials, direct labor, variable manufacturing overhead, and fixed manufacturing overhead. As the
goods are produced, these costs are recognized in the balance sheet as part of inventory. As the
goods are sold, all manufacturing costs of the units sold will be part of the cost of goods sold (an
account recognized in the income statement). In using the absorption costing, the fixed overhead
per unit is computed based on the level of production.
Since absorption costing includes all manufacturing costs in costing the product, it cannot be used
to prepare a contribution margin income statement (a measure for evaluating the performance of a
segment or department). In this regard, an alternative costing is used by the management for
internal use only. This is called variable costing.

2. Variable Costing. It is also known as “marginal costing” or “direct costing.” It recognizes that the
cost of the product must include only those production costs that vary directly within the volume of
production. This method only includes variable manufacturing costs in the cost of a unit of product.
It treats fixed manufacturing overhead as period cost.

Figure 2. Manufacturing costs for variable costing

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In Figure 2, all manufacturing costs (except for the fixed manufacturing overhead) are considered
part of the cost of the product. These costs are recognized in the balance sheet as part of the
inventory. As the goods are sold, the cost of the product will be recognized in the income statement
as cost of goods sold. However, the fixed manufacturing overhead will be considered as period cost,
i.e., the cost will be expensed as incurred. This is because this cost will be incurred whether or not
production occurs, and it is improper to allocate these costs to production and defer current costs
of doing business.
Under variable costing, there is a method called throughput costing. It is also known as
“supervariable costing,” which is an extreme form of variable costing in which only direct material
costs are considered product costs included as cost of inventory. All other costs are period costs
that are expensed as incurred.
Table 1 shows the principal differences between variable and absorption costing:
Variable Costing Absorption Costing
1. Cost segregation Costs are segregated into Costs are seldom segregated
variable or fixed. into variable and fixed costs.
2. Cost of inventory Cost of inventory includes only Cost of inventory includes all
the variable costs. the manufacturing costs,
variable and fixed.
3. Treatment of fixed Fixed manufacturing overhead Fixed manufacturing overhead
manufacturing overhead is treated as period cost. is treated as product cost.
4. Income statement Distinguishes between variable Distinguishes between
and fixed costs production and other costs
5. Net Income Net income may differ from each other because of the difference
in the amount of fixed overhead costs recognized as expense
during an accounting period. In the long run, however, both
methods give substantially the same results since sales cannot
continuously exceed production, nor can production continually
exceed sales.
Table 1. Differences between variable costing and absorption costing

Reconciliation of Net Income

The following observations can be developed regarding variable costing and absorption costing in
relation to production and sales (Garrison et al., 2018):
1. Production equals sales. When units produced is equal to units sold, there is no change in
inventory. The same net income will be realized regardless of the method used.
2. Production is greater than sales. When units produced exceed units sold, there is an increase in
inventory. The fixed overhead expensed under absorption costing is less than the fixed overhead
expensed under variable costing. Therefore, the net income reported under absorption costing
will be greater than the net income reported under variable costing.
3. Production is less than sales. When units sold exceeds units produced, there is a decrease in
inventory. The fixed overhead expensed under absorption costing is greater than the fixed cost
expensed under variable costing. Therefore, the net income reported under absorption costing
will be less than the net income reported under variable costing.
When inventory increases or decreases during the year, reported income differs under absorption and
variable costing. This results from the fixed overhead that is inventoried under absorption costing but
expensed immediately under variable costing. The following formula may be used to compute the

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difference in the amount of fixed overhead expensed in a given period under the two (2) costing
methods (Hilton & Platt, 2017):
𝑫𝒊𝒇𝒇𝒆𝒓𝒆𝒏𝒄𝒆 𝒊𝒏 𝒇𝒊𝒙𝒆𝒅 𝒐𝒗𝒆𝒓𝒉𝒆𝒂𝒅 = 𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚 𝒖𝒏𝒊𝒕𝒔 𝒙 𝑭𝒊𝒙𝒆𝒅 𝒐𝒗𝒆𝒓𝒉𝒆𝒂𝒅 𝒑𝒆𝒓 𝒖𝒏𝒊𝒕
The difference in fixed overhead is also the difference between the net income under the two (2) methods.

Pro forma reconciliation

1. Absorption to Variable Costing
Absorption costing Net Income P xxx
Add: Fixed overhead in beginning inventory xxx
Less: Fixed overhead in ending inventory xxx
Variable costing net income P xxx
2. Variable to Absorption Costing
Variable costing Net Income P xxx
Add: Fixed overhead in ending inventory xxx
Less: Fixed overhead in beginning inventory xxx
Absorption costing net income P xxx

EXAMPLE:
ANJY Corporation has the following information in its first year of operations in 201A:
Units produced 40,000
Units sold 36,000
Selling price per unit P60
Variable manufacturing costs P24 per unit produced
Variable selling expenses P6 per unit sold
Fixed manufacturing costs P500,000
Fixed administrative expenses P250,000
Assume that the actual production is the same as the normal operating level for the year. Income
statements under the two (2) methods will be presented as follows:

ANJY Corporation
Income Statement (Absorption Costing)
December 31, 201A

Sales (36,000 x P60) P2,160,000

Less: Cost of Goods Sold (36,000 x P36.50) 1,314,000
Gross Profit 846,000
Less: Selling and Administrative Expenses
Variable Selling (36,000 x P6) P216,000
Fixed administrative 250,000 466,000
Net Income P380,000

The cost of goods sold by P36.50 per unit is computed as the sum of variable and fixed manufacturing
costs per unit [P24 + (P500,000/40,000)]. The cost of ending inventory will be P146,000 (P36.50 x P4,000
units unsold).

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ANJY Corporation
Income Statement (Variable Costing)
December 31, 201A
Sales (36,000 x P60) P2,160,000
Less: Variable Costs
Cost of Goods Sold (36,000 x P24) P864,000
Selling Costs (36,000 x P6) 216,000 1,080,000
Contribution Margin 1,080,000
Less: Fixed Costs
Manufacturing Costs 500,000
Administrative Costs 250,000 750,000
Net Income P330,000

The income statement under variable costing separates variable costs and fixed costs and shows a
contribution margin instead of a gross profit, as shown under absorption costing. The cost of ending
inventory under variable costing is P96,000 (P24 x 4,000 units unsold).
As shown in the two (2) income statements, the difference between the net income of the two (2)
methods is P50,000. This is also the difference between the cost of ending inventory and comprises the
fixed manufacturing overhead in ending inventory of P50,000 (P12.50 x 4,000 units unsold).
To reconcile the net income in the two (2) methods, it shall be computed as follows:
P330,000 Absorption costing net income P380,000
Variable costing net income
Add: Fixed manufacturing costs in Less: Fixed manufacturing costs in
ending inventory (4,000 x P12.50) 50,000 ending inventory (4,000 x P12.50) 50,000
Absorption costing net income P380,000 Variable costing net income P330,000

Assume that the direct material per unit is P12; the following is the income statement using throughput
costing:
ANJY Corporation
Income Statement (Throughput Costing)
December 31, 201A
Sales (36,000 x P60) P2,160,000
Less: Direct Materials (36,000 x P12) 432,000
Throughput Margin 1,728,000
Less:
Variable manufacturing costs (40,000 x
P12) P480,000
Variable Selling Expenses (36,000 XP6) 216,000
Fixed Manufacturing Costs 500,000
Fixed Administrative Expenses 250,000 P1,446,000
Net Income P282,000

In throughput costing, only the cost of materials is included in the cost of inventory. Direct labor and
manufacturing overhead costs are all treated as period costs, treating them as expenses as they are
incurred. This means that it is based on the units produced, not on the units sold. When production
exceeds sales, the net income reported in throughput costing is much lower than variable and
absorption costing.

References:
Garrison, R. H., Noreen, E. W., & Brewer, P. C. (2018). Managerial accounting. McGraw-Hill Education.
Hilton, R. W., & Platt, D. E. (2017). Managerial accounting: Creating value in a dynamic business environment. McGraw-Hill Education.

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