15.1 Variable Costing versus Absorption Costing

Variable Costing versus Absorption Costing

Variable and absorption costing is listed among the planning-and-control techniques of Management Services (syllabus topic 1.2.4). Board problems ask for operating income under both methods, the reconciliation between them, and the reasons management prefers variable costing internally even though PFRS requires absorption costing externally.

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1. Product Costs versus Period Costs

The only difference is fixed factory overhead. Absorption costing spreads it over units produced (at a rate based on normal capacity), so part of it sits in ending inventory; variable costing expenses all of it when incurred.

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2. Income Statement Formats

• Absorption costing (functional format): Sales - Cost of goods sold (including fixed overhead at the standard or normal rate, adjusted for any volume variance) = Gross profit - Selling and administrative expenses = Operating income.
• Variable costing (contribution format): Sales - All variable costs (production and selling) = Contribution margin - All fixed costs (factory, selling, administrative) = Operating income.

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3. Worked Example: Two Years

Iligan Products sells its product at PHP 100. Variable production cost is PHP 50 per unit (materials PHP 30, labor PHP 15, variable overhead PHP 5); variable selling cost is PHP 5 per unit. Fixed factory overhead is PHP 300,000 a year at a normal capacity of 30,000 units (PHP 10 per unit), and fixed selling and administrative cost is PHP 200,000 a year. There is no beginning inventory in Year 1.

Variable costing

Absorption costing (unit product cost PHP 60)

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4. Reconciling the Two Incomes

$\text{Absorption income} - \text{Variable income} = (\text{Ending inventory units} - \text{Beginning inventory units}) \times \text{Fixed overhead rate per unit}$

• Year 1: (5,000 - 0) x 10 = PHP 50,000; absorption income is higher (675,000 vs. 625,000) because PHP 50,000 of fixed overhead is deferred in ending inventory.
• Year 2: (0 - 5,000) x 10 = -PHP 50,000; absorption income is lower (800,000 vs. 850,000) because last year's deferred fixed overhead is released through cost of goods sold.
• Over both years combined, total income is equal (PHP 1,475,000) because production equals sales over the two periods.

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5. Why Management Uses Variable Costing Internally

• Profit follows sales, not production, so managers cannot raise reported income simply by overproducing and deferring fixed overhead in inventory, a known weakness of absorption costing.
• The contribution format supports CVP analysis, relevant costing, segment evaluation, and flexible budgeting.
• Fixed costs appear in full on the income statement, which highlights their total impact.

Variable costing is not acceptable for external reporting: PAS 2 requires fixed production overhead to be allocated to inventory based on normal capacity, and the BIR follows absorption-based inventory costing. Companies that use variable costing internally convert to absorption costing for their published statements and tax returns.

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6. Inventory Valuation and Throughput Costing

Ending inventory values differ by the fixed overhead attached to it. In the Year 1 example, the 5,000 units in ending inventory are carried at PHP 250,000 under variable costing (5,000 x PHP 50) and PHP 300,000 under absorption costing (5,000 x PHP 60). The PHP 50,000 difference is exactly the income difference computed in Section 4.

Throughput (super-variable) costing goes a step further. It inventories only direct materials and treats direct labor and all overhead as period costs. It is used with the theory of constraints: throughput contribution = Sales - Direct materials, and managers are discouraged from building inventory at all. Board questions sometimes ask which method gives the lowest inventory value, which is throughput costing, followed by variable costing and then absorption costing.

Common pitfalls:

• Do not include variable selling costs in the unit product cost under either method.
• Under absorption costing with a normal-capacity rate, remember the volume (denominator) variance when actual production differs from normal capacity.
• Use the fixed overhead rate per unit (not total fixed overhead divided by units sold) when reconciling the two incomes.