Absorption and Variable Costing.ppt

ABSORPTION /
FULL COSTING…?
• Absorption Costing is an approach to product costing in
which all manufacturing costs, variable and fixed, are
charged to the cost of goods manufactured and
inventories.
• It is a method of costing in which product costs include
direct materials, direct labour, fixed and variable
overheads.
• It is required for external financial statements and for
income tax reporting.

SCHEME OF
ABSORPTION COSTING
STOCK OF
FINISHED GOODS
PROFIT AND LOSS
ACCOUNT
MATERIAL DIRECT
LABOUR COST
OVERHEADS
WORK-IN-PROGRESS
MANUFACTURING COSTS NON-MANUFACTURING COSTS
COST

SCHEME OF
ABSORPTION COSTING
• Recall that Cost of Goods Sold includes following manufacturing costs: Direct Material, Direct
Labour and Manufacturing overheads. Manufacturing overheads include FIXED OVERHEADS as
well as VARIABLE OVERHEADS.
• All these costs becomes part of the PRODUCT COST in Absorption Costing. These costs are
expensed as COGS when products are sold or else they form part of the inventory and appear in
the assets side of the balance sheet.
• Further, non-manufacturing costs such as selling, general and administrative costs are considered
as period costs and expensed when they are incurred.
In Absorption Costing,
manufacturing costs are
treated as PRODUCT costs
and non-manufacturing
costs are treated as
PERIOD costs.

VARIABLE/DIRECT/
MARGINAL COSTING?
• Variable Costing is an approach to product
costing in which only variable costs are
accumulated as product costs and are charged
to goods manufactured and inventories while
fixed costs are charged as period cost.
• Variable costing treats direct materials, direct
labor, and variable manufacturing overheads as
product costs and treats fixed manufacturing
overhead along with selling, general, and
administrative costs as period costs.

SCHEME OF
VARIABLE COSTING
STOCK OF FINISHED GOODS PROFIT AND LOSS
ACCOUNT
WORK-IN-PROGRESS
DIRECT MATERIAL
COST
DIRECT
LABOUR COST
VARIABLE
OVERHEAD
FIXED
OVERHEAD
OVERHEADS
MANUFACTURING COSTS NON-MANUFACTURING COSTS
COST

SCHEME OF
VARIABLE COSTING
• Since a change in sales is associated only with a change in variable costs, Variable costing focusses
on variable costs to calculate Contribution Margin.
• Variable costing is more consistent with the focus of cost-volume-profit analysis on differentiating
fixed from variable costs, and it provides useful information for internal decision making that is
often not apparent when using absorption costing.
• All fixed costs including fixed manufacturing overheads, fixed selling, general and administrative
costs and other fixed expenses are deducted from the Contribution margin to arrive at Net
Operating Profit.
In Variable Costing, all
variable costs are treated
as PRODUCT costs and all
fixed costs are treated as
PERIOD costs.

CONTRIBUTION MARGIN
….that part of sales revenue which is
left after meeting all variable
expenses
…. that part of sales revenue which
contributes to the coverage of fixed
costs and the realisation of net
operating income.
Contribution Margin = Sales - Variable Cost

ABSORPTION COSTING VS
VARIABLE COSTING
• The only major difference between absorption and
variable costing is the treatment of fixed overhead.
• Under absorption costing, fixed overhead is treated as a
product cost, added to the cost of the product and
expensed only when the product is sold.
• Under variable costing, fixed overhead is treated as a
period cost and is expensed when incurred

VARIABLE COSTING
• Absorption Costing is about categorization of costs as
Product Costs and Period Costs
• Variable Costing is about categorization of costs as Fixed
Costs and Variable Costs.

VARIABLE COSTING
• The only difference between absorption and variable
costing is the treatment of fixed overhead.
• Under absorption costing, fixed overhead is treated as a
product cost, added to the cost of the product and
expensed only when the product is sold.
• Under variable costing, fixed overhead is treated as a
period cost and is expensed when incurred

PRODUCTION, SALES AND INCOME
RELATIONSHIP
IF THEN
1. PRODUCTION > SALES
ABSORPTION NET INCOME >
VARIABLE NET INCOME
2. PRODUCTION < SALES
ABSORPTION NET INCOME <
VARIABLE NET INCOME
3. PRODUCTION = SALES
ABSORPTION NET INCOME =
VARIABLE NET INCOME

A DEBATE ……
SHOULD WE GO FOR
ABSORPTION COSTING
OR SHOULD WE GO FOR
VARIABLE COSTING …?

Problems with Absorption Costing
The use of absorption costing for internal
decision making can result in less than-
optimal decisions.
For Example: By increasing production,
unethical managers can increase
income, reduce cost of goods sold, meet
their own bonus goals, and saddle the
company with the costs of unsold
inventory and storing/insurance costs.
© 2014 Cengage Learning India Pvt Ltd. All rights reserved.

Choosing the Best Method for
Performance Evaluation
For external reporting and income tax
filing, managers have no choice but to
use absorption costing, as it is
required by GAAP.
However, using variable costing for
internal decision making removes the
impact of changing production levels
on income and is best for performance
evaluation of managers.

Five Advantages of
Variable Costing
1
Changes in
production and
inventory levels do
not impact the
calculation of
profits.
5
4
2
3

1
2
Variable costing focuses
attention on relevant product
costs rather than on fixed
product costs, which are often
unavoidable.
5
4
3
Five Advantages of Variable
Costing

3
5
1
2
4
Under variable costing,
cost behavior is
emphasized and fixed
costs are
separated from variable
costs on the income
statement.
Costing

Costing
4
5
1
3
2
Variable costing
is consistent with
the use of
variance analysis.

Costing
5
Variable costing
income is more
closely aligned with
a company’s cash
flows.
1
4
2
3

Absorption and Variable Costing.ppt

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