CHAPTER FOUR: Absorption Costing and Variable Costing

There are two alternative ways of product (inventory) costing in manufacturing companies:
1. Absorption Costing- under this inventory valuation procedure all manufacturing costs
are assigned to inventory cost (all manufacturing costs: Direct material used, direct labor
cost, variable manufacturing overhead, and Fixed manufacturing overhead-are
inventorible costs). This is also known as full costing or traditional costing approach. It
is used in general purpose financial statements prepared for external users in accordance
with generally accepted accounting principles.

2. Variable (Direct) Costing

This is an inventory valuation procedure that assigns only variable manufacturing (Direct
material used, Direct manufacturing labor cost, and variable manufacturing overhead) to units
produced. All other costs including fixed manufacturing overhead are treated as period costs.
Look at the following Exhibit.

Absorption Variable/direct
costing costing
DM used
Product cost
DL cost
Product cost
Variable FOH

Fixed FOH

Variable Selling & Admin. Exp. Period cost

Period cost
Fixed Selling & Admin. Exp.
Exhibit 2:5 Absorption Costing and Variable Costing

Note- the difference between absorption costing and direct costing as you can see from Exhibit
2:5 the treatment of fixed manufacturing overhead which is considered as Product cost under
absorption costing and period cost under variable costing approach.

Income Effect of Alternative Product Costing (Absorption versus Variable Costing

Approaches)
Under absorption costing, all production costs are absorbed into products and the unsold stock is
measured at total cost of production, whereas, invariable costing only variable costs of
production are allocated to products and the unsold stock (inventory) is measured at variable cost
of production. Fixed production costs are treated as a cost of the period in which they are
incurred.
The income effect of the two costing approach, & the general income statement under the two
approaches:

Absorption Variable
Revenues xx Revenues xx
Less: CGS (xx) Less: Variable costs (CGS&VC) (xx)
Gross Margin xx Contribution Margin xx
Less: S&A Exp (V&F) (xx) Less: Fixed Costs (xx)
Operating Income xx Operating Income xx

The income statements prepared based on the two costing methods differs in their treatment of
fixed manufacturing costs and the classification and presentation of costs on the income
statement. On the traditional (absorption) costing method income statement, costs are classified
on the basis of functions: Manufacturing, Selling, Administrative, etc. Whereas on a variable
(direct) costing method income statement costs are classified on the basis of behaviour pattern:
Fixed and Variable.

ILLUSTRATION 1
In 2011, ABC Company began producing a product that has the following selling price, variable
costs, and contribution margin.
Unit Selling Price Br 25
Unit variable costs:
Direct Material 4
Direct Labor 7
Manufacturing overhead 2
Selling and Administrative 2
Total unit variable cost 15
Unit contribution margin Br 10
Annual fixed costs of ABC Company include:
Fixed Manufacturing overhead Br 120, 000
Selling and Administrative 80, 000
Now, if the company produced and sold 30,000 units of products during the year, what is
operating income under the two approaches?
At a production volume of 30,000 unit’s costs per unit under the two approaches is computed as
follow:
Cost per unit
Cost items Absorption approach Variable approach
Direct Material 4 4
Direct Labor 7 7
Variable manufacturing overhead 2 2
Fixes manufacturing overhead 4 0
Total cost per unit 17 13
Absorption Costing Approaches Income Statement:
ABC Company
Income Statement
 For Year ended, Dec. 31, 2011
Sales (30,000units x 25) Br 750,000
Less: Cost of goods sold (30,000 x 17) 510,000
Gross Margin Br 240,000
Less: Selling and Administrative Expenses:
Variable (30,000 x 2) Br 60,000
Fixed 80,000 140,000
Operating income Br 100, 000

Direct Costing Approach Income Statement:

ABC Company
Income Statement
For Year ended Dec. 31, 2011
Sales (30,000 x 25) Br 750,000
Less: variable costs:
Cost of goods sold (30,000 x 13) Br 390,000
Variable Selling and administrative (30,000 x2) 60,000 450,000
Contribution margin 300,000
Less: Fixed costs:
Fixed manufacturing costs Br 120, 000
Fixed selling and Administrative costs 80, 000 200,000
Operating income Br 100, 000

ILLUSTRATION 2
Consider illustration 1 above except that out of the 30,000 units of products produced only
20,000 units were sold during the period. Look at the income statements under the two
approaches.
Absorption Costing Approach
ABC Company
Income statement
For the year ended, Dec. 31, 2011
Sales (20,000 x 25) Br 500,000
Less: Cost of goods sold (20,000 x 17) 340,000
Gross margin 160,000
Less: Selling and Administrative Expenses:
Variable selling and Admin. (20,000 x 2) Br 40,000
Fixed selling and Admin. 80,000 120,000
Operating income Br 40, 000

Direct Costing Approach

ABC Company
Income Statement
For the Year ended, Dec. 31, 2011
 Sales (20,000 x 25) Br 500,000
Less: Variable Expenses:
Cost of goods sold (20,000 x 13) Br 260,000
Selling and Administrative (20,000 x 2) 40,000 300,000
Contribution margin 200, 000
Less: Fixed Costs:
Fixed manufacturing overhead Br 120, 000
Fixed selling and Administrative 80, 000 200,000
Operating income Br 0

Practice Exercise -1
Consider illustration 2 above and the company produced 30,000 units during 2012 and sold
40,000 units, the other information’s remaining the same; prepare (determine) income statement
under the two approaches.

Now, you see the income effect of the two costing methods, when there is change in inventory
level. The difference in operating income under both illustration 2 and exercise above is
explained by the amount of fixed manufacturing overhead assignment in “inventory” by
absorption costing, where as immediately expensing the amount in the period incurred.