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MAS-LECTURE NOTES ARMIN GLENN ARANETA, CPA

PRODUCT COSTING

Absorption Costing (also called full costing, conventional costing) – is a 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 a product cost.

Variable Costing (also called direct costing) – is a 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.

Distinction between period costs and product costs:

Period costs Product costs

1. Refers to an item charged against current 1. Refers to an item included in product costing
revenue on the basis of time period regardless which is apportioned between the sold and
of the difference between production and sales unsold units.
volume.

2. Does not form part of the cost of inventory. 2. The portion of the cost, which has been
allocated to the unsold units, becomes part of
the inventory.

3. Diminishes income for the current period by 3. Diminishes current income by that portion
its full amount. 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 ABSORPTION COSTING

ABSORPTION COSTING VARIABLE COSTING

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

2. Cost of Inventory Cost of inventory includes all Cost of inventory includes

the manufacturing costs. only the variable
manufacturing costs.

3. Treatment of factory Fixed factory overhead is Fixed factory overhead is

overhead treated as product cost. treated as period cost.

4. Income statement Distinguishes between Distinguishes between

production and other costs. variable and fixed costs.

5. 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 nor
production can continually exceed sales.
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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 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 a decrease in inventory. Fixed overhead expensed
under absorption costing is greater than fixed overhead expensed under variable costing.
Therefore, absorption income is less than variable costing.

THROUGHPUT COSTING (Supervariable Costing)

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

TM = Revenue – Direct material COGS

Practice Problems:

Problem 1: All I ask Company manufactures a professional grade microwave and began
operations in 2015. For 2015, the company had no price, spending, or efficiency variances, and
writes off production-volume variance to cost of good sold. Actual data for 2015 are given as
follows:

Units produced 18, 000

Units sold 17, 500
Selling price P 300
Variable costs:
Materials P 30
Manufacturing labor P 25
Manufacturing overhead P 60
Marketing P 45
Fixed costs:
Manufacturing P 900, 000
Selling and administrative 750, 000

Requirements:
1. The inventoriable unit cost for internal reporting purposes under variable costing.
2. The inventoriable unit cost for internal reporting purposes under absorption costing.
3. Operating income for 2015 under variable costing.
4. Operating income for 2015 under absorption costing.
5. Compute the throughput margin (TM) and income under throughput costing.
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Problem 2: Ambon Corporation developed the following standard unit cost at 100% of its
normal production capacity, which is 20, 000 units per year:
Prime costs P 4.00
Factory overhead (40% variable) 5.00
Unit product cost P 9.00

The product is sold for P15 per unit. Variable commercial expenses are P2 per unit sold, and
fixed commercial expenses total P50, 000 for the period. During the year, 21, 000 units were
produced and 19, 000 units were sold. There is no work in process beginning or ending
inventories, and finished goods inventory is maintained at standard cost, which has not changed
from the preceding year. In the current year, there is a net unfavorable variable cost variance in
the amount of P4, 000. All standard cost variances are written off to COGS at the end of the
period.

Requirements:
1. Prepare an income statement on the absorption costing basis.
2. Prepare an income statement on the variable costing basis.
3. Compute and reconcile the difference in operating income for the current year under
absorption and variable costing.

Problem 3: The following information is available for Send my Love 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

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

Requirements:
1. Ending inventory, assuming the use of direct costing.
2. Ending inventory, assuming the use of absorption costing.
3. Total variable costs charged to expense for the year, assuming the use of direct costing.
4. Total variable costs charged to expense for the year, assuming the use of absorption costing.

Problem 4: Just play pretend Company was organized just a year ago. The result of the
company’s first year of operations are shown below (absorption costing basis):
Just play pretend Company
Statement of financial performance

Sales (2, 000 units) P 135, 000

Less: Cost of goods sold/variable cost:
Beginning inventory P 0
Cost of goods manufactured 105, 000
Goods available for sale P 105, 000
Ending inventory 21, 000 84, 000
Gross margin P 51, 000
Less: Selling and administrative expenses 42, 000
Net income P 9, 000

The company’s selling and administrative expenses consist of P 32, 000 per year in fixed
expenses and P5 per unit sold in variable expenses. The company’s unit product cost is computed
as follows:
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Variable manufacturing cost P32

Fixed manufacturing overhead(based on normal capacity of 2, 500 units) 10
Unit product cost P 42

Requirements:
1. Re-do the company’s statement of financial performance in the contribution margin 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.

Problem 5: The following information pertains to Jealous Company:

Maximum productive capacity 24, 000 units per year
Normal capacity 20, 000 units
Standard variable manufacturing cost per unit P10
Fixed factory overhead P 40, 000
Variable selling expenses per unit P4
Fixed selling expenses P 30, 000
Unit sales price P20
2015 operating results:
Sales 19, 000 units
Production 19, 200 units
Net unfavorable variance for standard variable manufacturing cost P 10, 000

Requirements:
1. Income under both costing methods.
2. Break-even point.
3. Margin of safety.
4. Required sales to earn after-tax-profit of P 140, 000.
5. Required sales in pesos to earn profit of 10% of sales.

Problem 6: During its first year of operations, Almost is never enough 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 P 10, 000. This fixed overhead variance was closed to COGS. 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) P 454, 750
Less: COGS ( 170, 500 )
Gross margin P 284, 250
Less: Selling and admin(all fixed) ( 120, 000 )
Net income P 164, 250

Requirements:
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
figure.

Problem 7: Secret love Song Company began operations on January 1 to produce a single
product. It used a standard absorption costing system with a planned production volume of 10,
000 units. During its first year of operations, no variance were incurred and there were no fixed
selling or administrative expenses. Inventory on December 31 was 20, 000 units, and net income
for the year was P 240, 000. If Secret love Song had used variable costing, its net income would
have been P 220, 000.

Requirements: Compute the break-even point in units.

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Problem 8: Saludo ako Sa’yo 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 Saludo ako Sa’yo Company. All variances are disposed
of at year-end by an adjustment to COGS. Both variable and fixed costs are expected to continue
at the same rates for the balance of the year (i.e., fixed costs at P 200, 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 costs is the same in the current
year as in the previous year.

Requirements:
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.

Problem 9: The following annual flexible budget has been prepared for use in decision
relating to Product X.

100, 000 units 150, 000 units 200, 000 units

Sales volume P 800, 000 P 1, 200, 000 P 1, 600, 000

Manufacturing costs:

Variable P 300, 000 P 450, 000 P 600, 000

Fixed P 200, 000 P 200, 000 P 200, 000

P500, 000 P 650, 000 P 800, 000

Selling and other

expenses:

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

Fixed P 160, 000 P 160, 000 P 160, 000

P 360, 000 P 460, 000 P 560, 000

Income(Loss) (P 60, 000) P 90, 000 P 240, 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 the year and all costs incurred
coincide with the budget.

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

First quarter 10%
Second quarter 20%
Third quarter 30%
Fourth quarter 40%
100%

Requirements:
1. Reported net income (loss) for the first six months under absorption costing.
2. Reported net income (loss) for the first six months under direct costing.

“The secret of getting ahead is getting started.”

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