PRODUCT COSTING

ABSORPTION COSTING (also called full costing, conventional costing)

Costing method that includes all manufacturing costs (direct materials, direct labor, and both variable
and fixed manufacturing overhead) in the cost of a unit of product. It treats fixed manufacturing
overhead as product cost.

VARIABLE COSTING (also called direct costing)

Costing method that includes only variable manufacturing costs (direct materials, direct labor, and
variable manufacturing overhead) in the cost of a unit of product. It treats fixed manufacturing overhead
as a period cost.

DISTINCTIONS BETWEEN PERIOD COSTS AND PRODUCT COSTS:

PERIOD COST PRODUCT COST

Refers to an item charged against current Refers to an item included in product costing
revenue on the basis of time period which is apportioned between the sold and
regardless of the difference between unsold units.
production and sales volume.

Does not form part of the cost of inventory. The portion of the cost, which has been
allocated to the unsold units, becomes part of
the inventory.

Diminishes income for the current period by
its full amount.
Diminishes current income by the portion
thereof identified with the sold units only
with the remainder being deferred to the
next accounting period as part of the cost of
ending inventory.

PRINCIPAL DIFFERENCES BETWEEN VARIABLE AND CONVENTIONAL ABSORPTION COSTING:

ABSORPTION COSTING VARIABLE COSTING

Cost Segregation Seldom segregates costs into Costs are segregated into
variable and fixed costs variable and fixed

Cost of inventory Cost of inventory includes all Cost of inventory includes only
the manufacturing costs: the variable manufacturing
materials, labor, variable factory costs: materials, labor and
overhead, and fixed factory
 ABSORPTION COSTING VARIABLE COSTING

overhead variable factory overhead

Treatment of fixed factory Fixed factory overhead is Fixed factory overhead is

overhead treated as product cost. treated as period cost.

Income statement Distinguished between Distinguishes between variable

production and other costs. and fixed costs.

Net income Net income between the two methods may differ from each other
because of the difference in the amount of fixed overhead costs
recognized as expense during an accounting period. This is due to
variations between sales and production. In the long run, however,
both methods give substantially the same results since sales cannot
continuously exceed production, noe production can continually
exceed sales.

DIFFERENCE IN NET INCOME UNDER ABSORPTION AND VARIABLE COSTING:

Variable and absorption costing methods of accounting for fixed manufacturing overhead result in
different levels of net income in most cases. The differences are timing differences, i.e., when to
recognize the fixed manufacturing overhead as an expense. In variable costing, it is expensed during the
period when the fixed overhead is incurred, while in absorption costing, it is expensed in the period
when the units to which such fixed overhead has been related are sold.

Production Equals Sales:

When production is equal to sales, there is no change in inventory. Fixed overhead expensed under
absorption costing equals fixed overhead expensed under variable costing. Therefore, absorption costing
income equals variable costing income.

Production is Greater Than Sales:

When production is greater than sales, there is an increase in inventory. Fixed overhead expensed under
absorption costing is less than fixed overhead expensed under variable costing. Therefore, absorption
income is greater than variable costing.

Production is less than Sales:

When production is less than sales, there is decrease in inventory. Fixed expensed under absorption is
greater than fixed overhead expensed under variable costing. Therefore, absorption income is greater
variable costing income.

ARGUMENTS FOR THE USE OF VARIABLE COSTING

Variable costing reports are simpler and more understandable.

Date needed for break-even and cost-volume-profit analysis are readily available.
The problems involved in allocating fixed costs are eliminated.

Variable costing is more compatible with the standard cost accounting system.

Variable costing reports provide useful information for pricing decisions and other decision-making
problems encountered by management.

ARGUMENTS AGAINST VARIABLE COSTING

Segregation of costs into fixed and variable might be difficult, particularly in the case of mixed costs.

The matching principle is violated by using variable costing which excludes fixed overhead from product
costs and charges the same to period costs regardless of production and sales.

With variable costing, inventory costs and other related accounts, such as working capital, current ratio,
and acid-test ratio are understated because of the exclusion of fixed overhead in the computation of
product cost.

THROUGHTPUT COSTING (or SUPER VARIABLE COSTING)

An extreme form of variable costing in which only direct material costs are included as inventorable
costs. All other costs are costs of the period in which they are incurred.

Throughout margin = Revenue – Direct material cost of the goods sold

EXERCISES:

Jervick Company began business in 2015. Production for the year was 50,000 units of hairpin, and sales
were 48,000 units. Selling price is P1.10 per unit. Costs incurred during the year were as follows:

Materials P15,000

Direct labor 7,500

Variable overhead 12,500

Fixed overhead 5,000

Variable selling expenses 5,760

Fixed selling and administrative expenses 10,000

Total actual costs P55,760

Compute the product cost per unit under absorption and variable costing.

What was variable Cost of Goods Sold for 2015 under variable costing?

What was the Cost of Goods Sold for 2015 under absorption costing?

What was the value of ending inventory under variable costing? Under absorption costing?
What was income for 2015 under variable costing? Under absorption costing?

How much fixed overhead was changed to expense in 2015 under variable costing? Under absorption
costing?

Refer to Item 1. Compute the throughput margin and income under throughput costing.

Leonor Corporation developed the following standards unit cost at 100% of its normal production
capacity, which is 20,000 units per year:

Materials P5

Labor 20

Factory overhead (80% variable) 40

Unit product cost P65

The product is sold for P100 per unit. Variable selling and administrative expenses are P6 per unit sold,
and fixed non-manufacturing expenses total P92,000 for the period. During the year, 22,000 units were
produced and 23,000 units were sold. There is not work if proves beginning or ending inventories, and
finished goods inventory is maintained at standard costs, which has not changed from the preceding
year. In the current year, there is a favourable prime cost variance of P8,000 and an unfavourable
variable overhead variance of P12,000. All standard cost variances are written off to cost of goods sold at
the end of the period.

REQUIRED: 1 Prepare an income statement on the absorption costing basis.

2. Prepare an income statement on the variable costing bases.

3. Compute and reconcile the difference in operating income for the current
year under absorption costing a variable costing.

Kotsekotsehan Motors assembles and sells miniature toy motor vehicles and uses standard costing.
Actual data relating to April and May 2015 are as follows:

Unit data: April May

Beginning inventory 0 150

Production 500 400

Sales 350 520

Variable costs:

Manufacturing cost per unit P10,000 P10,000

produced
Unit data: April May

Operating (marketing) cost 3,000 3,000

per unit sold

Fixed costs:

Manufacturing costs P2,000,000 P10,000

Operating (marketing) costs 600,000 600,000

The selling price per toy vehicle is P24,000. The budgeted level of production used to calculate
the budgeted fixed manufacturing cost per unit is 500 units. There are no price, efficiency, or
spending variances. Any production-volume variance is written off to cost of goods sold in the
month in which it occurs.

REQUIRED:

Prepare April and May 2015 income statements for Kotsekotsehan Motors under (a)
variable costing and (b) absorption costing.

Prepare a numerical reconciliation and explanation of the difference between operating

income for each month under variable costing and absorption costing.

The variable manufacturing costs per unit of Kotsekotsehan Motors are as follows:

April May

Direct materials P6,700 P6,700

Direct labor 1,500 1,500

Factory overhead 1,800 1,800

Prepare income statements for Kotsekotsehan Motors in April and May of 2015 under
throughput costing.

The following information is available for Yamyam Company’s new product line:

Sale price per unit P 15

Variable manufacturing cost per unit of production 8

Total annual fixed manufacturing cost 25,000

Variable administrative cost per unit 3

Total annual fixed and administrative expenses 15,000

Sale price per unit P 15

There was no inventory at the beginning of the year. Normal capacity is 12,500 units. During the year,
12,500 units were produced and 10,000 units were sold.

REQUIRED:

Ending inventory, assuming the use of direct costing.

Ending inventory, assuming the use of absorption costing.

Total variable cost charged to expense for the year, assuming the use of direct costing.

Total fixed cost charged to expense for the year, assuming the use of absorption costing.

Lorrea Company was organized just a year ago. The results of the company’s first year of operations are
shown below (absorption costing basis):

LORREA COMPANY

Income Statement

Sales (2,000 units) P135,000

Less: Cost of goods sold/variable cost:

Beginning inventory P -0-

Cost of goods manufactured 105,000

Goods available for sale P105,000

Ending inventory 21,000 84,000

Gross margin 51,000

Less: Selling and administrative expenses 42,000

Net income P 9,000

The company’s selling and administrative expenses consist of P32,000 per year in fixed expenses
and P5 per unit sold in variable expenses. The company’s unit product cost is computed as
follows:

Variable manufacturing cost P32

Fixed manufacturing overhead (based on normal capacity of 2,500 units) 10

Variable manufacturing cost P32

Unit product cost P42

REQUIRED: 1. Redo the company’s income statement in the contribution format using variable
costing.

2. Reconcile any difference between the net income figure on your variable costing
income statement and the net income figure on the absorption costing income
statement above.

M. Raagas Company produces and sells a single product. The following costs relate to its production and
sales:

Variable cost per unit:

Materials P9

Labor 10

Manufacturing overhead 5

Selling and administrative expenses 3

Fixed costs per year:

Manufacturing overhead P150,000

Selling and administrative expenses 400,000

During the last year, 25,000 units were produced and 22,000 units were sold. The finished Goods
Inventory account at the end of the year shows a balance of P72,000 for the 3,000 unsold units.

REQUIRED: 1. Is the company using absorption costing or variable costing to cost units in the
Finished Goods Inventory account?

2. Assume that the company wished to prepare financial statements for the year to
issue to its stockholders.

Is the P72,000 figure for Finished Goods Inventory the correct amount to use
on these statements for external reporting purposes?

At what peso amount should the 3,000 units be carried in the inventory for
external reporting purposes?

During its first year of operations, Sugar Ray Company produced 55,000 jars of hand cream based on a
formula containing 10 percent glycolic acid. Unit sales were 53,500 jars. Fixed overhead was applied at
P0.50 per unit produced. Fixed overhead was underapplied by P10,000. This fixed overhead variance was
closed to Cost of Goods Sold. There was no variable overhead variance. The results of the year’s
operations are as follows (on an absorption-costing basis):

Sales (53,500 units @ P8.50) P454,750

Less: Cost of goods sold (170,500)

Gross margin P284,250

Less: Selling and administrative (all fixed) (120,000)

Net income P164,250

REQUIRED: 1. Give the cost of the firm’s ending inventory under absorption costing. What is the
cost of the ending inventory under variable costing?

2. Compute the income under variable costing. Reconcile the difference between
the two income figures.

Els Company had net income for the first 10 months of the current year of P200,000. They used a
standard costing system, and there were no variances through October 31. One hundred thousand units
were manufactured during the period, and 100,000 units were sold. Fixed manufacturing overhead was
P2M over the 10 month period. There are no selling and administrative expenses for Els Company. All
variances are disposed of at year-end by an adjustment to cost of goods sold. Both variable and fixed
costs are expected to continue at the same rates for the balance of the year (i.e., fixed costs at P200,000
per month and variable costs at the same variable cost per unit). There were 10,000 units in inventory on
October 31. Eighteen thousand units are to be produced and 22,000 units are to be sold in total over the
last two months of the current year. Assume the standard unit variable cost is the same in the current
year as in the previous year.

REQUIRED: 1. If operations proceed as described, will net income be higher under variable or
absorption costing for the current year in total?

2. If operations proceed as described, what will net income for the year in total be
under: a) variable costing; and b) absorption costing? Ignore income taxes.

“Now this doesn’t make any sense at all,” said Florence Gale, financial vice president for Warner Bros.
Company. “Our sales have been steadily rising over the last several months, but profits have been going
in the opposite direction. In September we finally hit P2,000,000 in sales, but the bottom line for that
month drops off to a P100,000 loss. Why aren’t profit more closely correlated with sales?”

The statements to which Ms Gale was referring are shown below:

 July August September

Sales (@P25) P1,750,000 P1,875,000 P2,000,000

Less cost of goods sold:

Beginning inventory 80,000 320,000 400,000

Cost applied to production:

Variable manufacturing cost 765,000 720,000 540,000

Fixed manufacturing overhead 595,000 560,000 420,000

Cost of goods manufactured 1,360,000 1,280,000 960,000

Goods available for sale 1,440,000 1,600,000 1,360,000

Less ending inventory 320,000 400,000 80,000

Cost of goods sold 1,120,000 1,200,000 1,280,000

Underapplied or (overapplied) fixed

Overhead cost (35,000) -0- . 140,000

Adjusted cost of goods sold 1,085,000 1,200,000 1,420,000

Gross margin 665,000 675,000 580,000

Less selling and administrative expenses 620,000 650,000 680,000

Net income (loss) P 45,000 P 25,000 P (100,000)

Harry Harp, a new graduate from Jose Rizal Memorial State University who has just been hired by
Warner, has stated to Ms. Gale that the contribution approach, with variable costing, is a much better
way to report profit data to management. Sales and production data for the last quarter follow:

July August September

Production in units 85,000 80,000 60,000

Sales in units 70,000 75,000 80,000

Additional information about the company’s operations is given below:

Five thousand units were in inventory on July 1.

Fixed manufacturing overhead costs total P1,680,000 per quarter and are incurred
evenly throughout the quarter. This fixed manufacturing overhead cost is applied to
 units of product on the basis of a budgeted production volume of 80,000 units per
month.

Variable selling and administrative expenses are P6 per unit sold. The remainder of the
selling and administrative expenses on the statements above are fixed.

The company uses a FIFO inventory flow assumption. Work in process inventories are
insignificant and can be ignored.

“I know production is somewhat out of step with sales,” said Karla Cortes, the company’s controller. “But
we had to build inventory early in the quarter in anticipation of a strike in September. Since the union
settled without a strike, we then had to cut back production in September in order to work off the excess
inventories. The income statements you have are completely accurate.”

REQUIRED:

Without preparing income statements, compute the income for each month using variable costing.

Compute the monthly breakeven point under variable costing

Explain to Ms. Gale why profits have moved erratically over the three-month period shown in the
absorption closing statements above and why profits have not been more closely related to changes in
sales volume.

Reconcile that the company had decided to introduce JIT inventory methods at the beginning of
September. (Sales and production during July and August were as shown above)

How many units would have been produced during September under JIT?

Starting with next quarter (October-December) would you expect any difference between the income
reported under absorption costing and under variable costing? Explain why there would or would not be
any difference.

The following annual flexible budget has been prepared for use in making decisions relating to Product X.

100,000 Units 150,000 Units 200,000 Units

Sales volume P800,000 P1,200,000 P1,600,000

Manufacturing costs:

Variable P300,000 P450,000 P600,000

Fixed 200,000 200,000 200,000

P500,000 P650,000 P800,000

 100,000 Units 150,000 Units 200,000 Units

Selling and other expenses:

Variable P 200,000 P 300,000 P 400,000

Fixed 160,000 160,000 160,000

P360,000 P460,000 P560,000

Income (or loss) (P60,000) P90,000 P240,000

The 200,000 unit budget has been adopted and will be used for allocating fixed manufacturing costs
to units of Product X. at the end of the first six months the following information is available:

Units

Production completed 120,000

Sales 60,000

All fixed costs are budgeted and incurred uniformly throughout year and all costs incurred coincide
with budget.

Over- and underapplied fixed manufacturing costs are deferred until year-end. Annual sales have
the following seasonal pattern:

Portion of Annual Sales

First quarter 10%

Second quarter 20%

Third quarter 30%

Fourth quarter 40%

100%

REQUIRED:

The amount of fixed factory costs applied to product during the first six months under absorption costing
would be

Overapplied by P20,000

Equal to the fixed costs incurred

Underapplied by P40,000

Underapplied by P80,000
Reported net income (or loss) for the first six months under absorption costing

Reported net income (or loss) for the first six months under direct costing.

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