Management Accounting
Variable and Absorption Costing
Distinction between product costs and period costs
✓ Product Costs
o The costs of goods manufactured or the cost of goods purchased for resale.
o These costs are inventoried until the goods are sold.
o When product costs are expensed, it will form part of the cost of goods sold.
o Can be found in three types of inventories, raw materials, work-in process, and finished goods.
✓ Period Costs
o All other non-product costs in an organization
o Such costs are not inventoried but are expensed as time passes.
o Examples
• Selling expenses (Delivery Expense, Advertising Expense, Sales Commission)
• General and Administrative (Accounting, Professional Fee, research and development)
o When period costs are expensed, it will form part of the operating expenses.
Inventory costs between variable costing and absorption costing
Nature and treatment of fixed factory overhead costs – See #2 and #3 in Annex A
Reconciliation of operating income under variable costing and absorption costing




Beginning Inventory = Fixed cost that will be released that will make ↑Cost of Sales; ↓Net Income (AC – NI <
VC – NI)
Ending Inventory = Fixed cost that will be deferred that will make ↓Cost of Sales; ↑Net Income (AC – NI > VC –
NI)
Reconciling Item: Fixed Cost Component in the Inventories
Summary:
Absorption Costing Net Income
xx
Variable Costing Net Income
xx
Add: Fixed Cost Expensed last period (BI)
xx
Add: Fixed Cost Deferred (EI)
xx
Less: Fixed Cost Expensed this period (EI)
xx
Less: Fixed Cost Released (BI)
xx
Variable Costing Net Income
xx
Absorption Costing Net Income
xx
Shortcut in reconciliation:
Δ Profit = Δ Inventory x unit FFOH
Where:
Δ Profit = AC Profit – VC Profit
Δ Inventory = Production – Sales = Ending Inventory – Beginning Inventory
Unit FFOH = Total FFOH ÷ Production
See Annex B for rules on net income and explanation to the reconciliation
1|Page
Management Accounting
Additional Concepts and Discussions:



Throughput Costing
o Assigns only the unit-level spending for direct costs as the cost of products or services
o A unit-level cost is incurred every time that a unit of product is manufactured
Variable Costing
o Definition
• Product cost is comprised solely of variable manufacturing costs
• Fixed manufacturing overhead is viewed as a cost of being ready to produce, not an actual production cost
since it will remain constant no matter how many units are produced. Hence, expensed immediately.
• Also Called as Direct or Marginal Costing
• Direct Materials, Direct Labor, and Variable Overhead
o Advantage
• It can be used in constructing the contribution format approach income statement to highlight the cost
behavior structure of the entity.
• Fit nicely with Cost-Volume-Profit Analysis
• Net income unaffected by changes in production levels
• Net income closely tied to changes in sales level – not production levels which makes it easier to predict
the level of operating income.
• Fixed costs are not accounted for as an inventoriable cost – simplifying the record keeping – no need for
allocation.
• Companies can also break down each department or product line under variable costing, which provides a
more thorough analysis of a company's business operation
o Disadvantage
• Does not conform to generally accepted accounting principles
• Costs are required to be separated into fixed and variable – cost segregation
• techniques can be subjective.
• Expensing fixed production costs as a period expense lowers net income for each accounting period
• Too much emphasis may be given to variable costs at the expense of disregarding fixed costs – fixed costs
should still be recovered from operations.
Absorption Costing
o Definition: All costs related to the manufacture of a good are product costs. (Direct materials, Direct Labor,
Variable and Fixed Overhead)
o Advantages
• Results in the preparation of a traditional income statement.
• Is considered GAAP and is generally acceptable for tax reporting.
• Considers all cost when setting the price (cost plus pricing method)
o Disadvantage
 Does not consider excess capacity since fixed costs are already allocated to the different units
 Distort the results of decisions made to discontinue a business segment – fixed cost will remain whether
the company will eliminate the segment or not.
2|Page
Management Accounting
Annex A: Summary of differences:
1. Other Names
2. Treatment of FFOH
3. Reason behind Treatment
4. Period Costs
5. Product Costs
6. Cost of Inventory
7. Matching Principle
8. Income Statement
9. Main Function
10. Common Applications
ABSORPTION COSTING
Full Costing, GAAP Costing
Product Cost: Inventory, then Expense
FFOH is necessary to produce units
Selling & Administrative Expenses
DM, DL, VFOH & FFOH
Higher than Variable Costing’s
Compliant
Functional Presentation (“CGS” Format)
External Financial Reporting
Financial Statements, Reporting to BIR
& SEC
VARIABLE COSTING
Direct Costing, Marginal Costing
Period Cost: Full Amount as Expense
FFOH is incurred with or without
production
FFOH, Selling & Administrative Expenses
DM, DL & VFOH
Lower than Absorption Costing’s
Non-Compliant
Behavioral Classification (“CM” Format)
Management Decision Aid (Internal Use)
CVP Analysis, Relevant Costing, Pricing
Decision
Annex B: Rules on Net Income
1
Situation
Production = Sales
Implication
AC Profit = VC Profit
2
Production > Sales
AC Profit > VC Profit
3
Production < Sales
AC Profit < VC Profit
Compiled by:
Kent Adrian P. Mariano, CPA, CMA
Sources:
Roque, Rodelio S.
Agamata, Franklin T.
Abitago, Karim G.
CPAR
RESA
CRC-ACE
3|Page
Explanation
Since Ending Inventory = Beginning Inventory, then
FFOH expensed under AC is equal to FFOH expensed
under VC
Since Ending Inventory > Beginning Inventory, then
FFOH expensed under AC is lower than FFOH expensed
under VC
Since Ending Inventory < Beginning Inventory, then
FFOH expensed under AC is higher than FFOH
expensed under VC