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Unit III Variable and Absorption Costing for Managerial Accounting Mcom Delhi University


Unit III Variable and Absorption Costing for Managerial Accounting Mcom Delhi University

Unit III Variable and Absorption Costing for Managerial Accounting Mcom Delhi University:- we will provide complete details of Unit III Variable and Absorption Costing for Managerial Accounting Mcom Delhi University.

Unit III Variable and Absorption Costing for Managerial Accounting Mcom Delhi University

Explain the difference between variable and absorption costing. How unit product cost is computed under two methods?

Variable and absorption are two different costing methods. Almost all successful companies in the world use both the methods. Variable costing and absorption costing cannot be substituted for one another because both the systems have their own benefits and limitations.

These costing approaches are known by various names. For example, variable costing is also known as direct costing or marginal costing and absorption costing is also known as full costing or traditional costing.

The information provided by variable costing method is mostly used by internal management for decision making purposes. Absorption costing provides information that is used by internal management as well as by external parties like creditors, government agencies and auditors etc.

Computation of unit product cost under two methods:

Under absorption costing system, the product cost consists of all variable as well as all fixed manufacturing costs i.e., direct materials, direct labor and factory overhead (FOH). But when variable costing system is used, the fixed cost (both manufacturing and non-manufacturing) is treated as a period or capacity cost and is, therefore, not included in the product cost.

Following exhibition summarizes the difference between variable costing and absorption costing:

Variable versus absorption costing

For further clarification of the concept, consider the following examples:

Example 1

A company manufactures and sells 5000 units of product X per year . Suppose one unit of product X requires the following costs:

Direct materials: $5 per unit
Direct labor: $4 per unit
Variable manufacturing overhead: $1 per unit
Fixed manufacturing overhead: $20,000 per year

The unit product cost of the company is computed as follows:

Absorption Costing: $5 + $4 + $1 + $4* = $14

Variable Costing: $5 + $4 + $1 = $10

* $20,000 / 5,000

Notice that the fixed manufacturing overhead cost has not been included in the unit cost under variable costing system but it has been included in the unit cost under absorption costing system. This is the primary difference between variable and absorption costing.

Example 2

Sunshine company produces and sells only washing machines. The company uses variable costing for internal reporting and absorption costing for external reporting. The data  for the year 2016 is given below:

Direct materials: $150/unit
Direct labor: $45/unit
Variable manufacturing overhead: $25/unit
Fixed manufacturing overhead: $160,000 per year
Fixed marketing and administrative expenses: $110,000 per year
Variable marketing and administrative expenses: $15/unit sold

Company produced and sold 8,000 machines during the year 2016.

Required: Compute the unite product cost under variable costing and absorption costing.

Solution:

*$160,000 / 8,000 Units = $20

Note: Marketing and administrative expenses are period costs and are not relevant in the computation of unit product cost.

Unit III Variable and Absorption Costing for Managerial Accounting Mcom Delhi University

Variable and absorption costing generate different levels of cost and net income in cost accounting, so it’s important to understand the differences so you can select a costing method to use internally for decision-making.

Say your business manufactures handsaws. Here is a summary of production, sales, and costs in Year 1.

Year 1 Production — Sales and Costs
Production (units)3,000
Sales (units)2,500
Sales (at $25 per unit)$62,500
Fixed manufacturing costs$21,000
All other product costs$33,000

Because you didn’t sell all of your production, you created ending inventory:

Ending inventory = units produced – units sold

Ending inventory = 3,000 – 2,500

Ending inventory = 500

Your fixed manufacturing costs are $7 per unit produced ($21,000 ÷ 3,000 units). Absorption costing requires you to assign $3,500 of fixed manufacturing costs to ending inventory ($7 x 500 units). The next table outlines the profit in Year 1, comparing variable and absorption costing.

Year 1 Profit — Variable Versus Absorption Costing
Variable CostingAbsorption Costing
Sales (at $25 per unit)$62,500$62,500
Fixed manufacturing costs$21,000$17,500
All other costs$27,500$27,500
Total costs$48,500$45,000
Profit$14,000$17,500

Absorption costing deferred $3,500 of fixed manufacturing costs. The fixed manufacturing costs are only $17,500. You see that absorption costing has a $3,500 higher profit ($17,500 versus $14,000).

In Year 2, assume that your sales and sales price are the same. You also sell all your production, plus the 500 units that were in ending inventory. Your sales (2,500 units) are 500 units more than your production (2,000 units). Because you produced less in Year 2, the all-other-cost number declines to $22,500. Less production means less cost. Check out this next table.

Year 2 Production — Sales and Costs
Production (units)2,000
Sales (units)2,500
Sales (at $25 per unit)$62,500
Fixed manufacturing costs$21,000
All other costs$22,500

Variable and absorption costing are the same if you sell all of your production. You don’t produce any ending inventory, so you don’t defer any fixed manufacturing costs into inventory items. Here is the profit in Year 2.

Year 2 Profit — Variable Versus Absorption Costing
Variable CostingAbsorption Costing
Sales (at $25 per unit)$62,500$62,500
Fixed manufacturing costs$21,000$24,500
All other costs$27,500$27,500
Total costs$48,500$52,000
Profit$14,000$10,500

Five hundred units from Year 1 ending inventory are sold in Year 2. In the third table, production of 2,000 is 500 units less than sales of 2,500. You had 500 units available for sale at the beginning of Year 2.

Fixed manufacturing costs for Year 2 are the same for both methods ($21,000). However, absorption costing added the $3,500 fixed manufacturing cost that was deferred in Year 1. The fixed manufacturing cost is $24,500 ($21,000 + $3,500).

The variable costing profit in Year 2 is $3,500 higher than the absorption costing profit ($14,000 versus $10,500). In Year 1, variable costing profit was $3,500 lower than the absorption costing. When Year 1 ending inventory is sold in Year 2, absorption picks up the fixed manufacturing cost that was deferred.

Over two years, all the production is sold. The total profit over two years is the same for both costing methods.

You’re probably wondering about which method to use. Your profit eventually is the same under either method. In the long run, there is no advantage to using one method over another.

You should select a method and stick with it. By doing so, you’re applying the principle of consistency. For a financial statement reader to compare your results year by year, you need to use the same method. It’s the old idea of an apples-to-apples comparison.

Unit III Variable and Absorption Costing for Managerial Accounting Mcom Delhi University

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