LECTURE 7 – ABSORPTION AND VARIABLE STANDARD COSTING
The Difference Between AC and VC – Fixed Overhead
It is essential that you carefully compare the two descriptions below, and understand that the only difference between
the two is the treatment of fixed overhead:
Absorption Costing Systems Variable Costing Systems
All manufacturing costs (whether fixed or variable, i.e. DM, Only variable manufacturing costs (DM, DL, V OH) are
DL, V OH, F OH) are treated as inventoriable costs. treated as inventoriable costs, i.e. go into WIP, FG and
Inventoriable costs are stored in inventory accounts until COGS.
the goods to which they relate are sold, at which time they
are expensed to COGS. DM, DL, V OH and F OH applied
are all entered into WIP, then FG, and then COGS.
All non-manufacturing costs (and only non-manufacturing Fixed manufacturing costs (Fixed OH) are treated in the
costs) have been treated as period costs. Period costs are same way as non-manufacturing costs, i.e. as period costs.
expensed to the Profit and Loss account in the period in Fixed OH is not applied through WIP, FG and COGS, but
which they are incurred. They do not go into WIP, FG and actual fixed OH incurred is expensed directly (immediately
COGS. incurred) into Profit and Loss.
The practical effect on the accounts of the description
above is that where a firm uses variable costing:
The inventoriable cost will not include fixed OH.
Fixed OH applied will no longer exist. Only
variable OH will be applied to WIP.
Fixed OH will not go into WIP, FG and COGS
Fixed OH variances will no longer be entered into
Actual fixed OH is treated as a period cost.
Comparison – amount of fixed OH expensed to the period under AC and VC
Assume the following data for a firm which budgeted for and actually produced 1,000 units in a period:
o Standard F OH per unit of $2
o Sold 3 units
o Actual F OH incurred was $1,500.
For a firm which used standard AC, the amount of fixed overhead being expensed to the period via COGS is:
$2 x 3 = $6
If the same firm used standard VC, the amount of fixed overhead expensed to the period (straight to P&L) is:
Requirements of AASB102
Absorption costing is required under AASB102: “costs of conversion … include (an) allocation of fixed and
For external financial reporting purposes, firms must use absorption costing to cost inventory.
What is the point of Variable Costing then?
There are two reasons why it is necessary for you to understand both costing methods.
a) Many firms are not required to comply with the accounting standards. Such firms may choose either AC or VC.
b) Evidence suggests that even where firms are required to comply with the accounting standards for external
reporting purposes, some firms still prepare variable costing reports for internal purposes. The reason they do
this is because for them the benefits of variable costing outweigh the additional costs of either preparing two
sets of records (one AC, one VC), or of converting from VC records to AC for financial reporting purposes. Advantages of Each System
There are a number of generally acknowledged advantages of each of the costing systems.
o It is not possible to conclude that one system is inherently "better than" the other.
They are two accepted costing methods. Some firms for various reasons will prefer AC, others
will prefer VC.
Arguments in support of ABSORPTION COSTING include: Arguments in support of VARIABLE COSTING include:
Inventories should carry a fixed cost component because It highlights the contribution margin and is compatible
both variable and fixed costs are necessary to produce the with techniques used for management decision-making,
goods. particularly short-term, e.g. CVP analysis. Classifying costs
according to cost behaviour (this occurs in VC) is more
The fixed overhead component of inventory
represents a future economic benefit in the same useful for management decision-making than is a
way as the variable component – sale of inventory functionalclassification.
Absorption costing better reflects the cost of inventories. It avoids the problem of manipulation of production in order
Variable costing may significantly understate the cost of to increaseprofit. Thisisaparticularly importantissue
inventories. (It could be argued, however, that both
methods are deficient because neither method includes all
costs, i.e. costs other than the production costs in the
AC satisfies the matching principle. It expenses only the It avoids fixed overheads being capitalised in unsaleable
costsrelatedto unitssold. stocks
AC avoids fictitious losses being reported. For example, in The inclusion of fixed overhead in inventories does not
firms with seasonal production activities, under VC if you satisfy thecriteriaforanitem to bedefinedasanasset.
“produce this period and sell next period” you can show a
large loss in the period when you are producing because you
expense all fixed overhead but have no revenue to match it
VC is notsuitablefora firmwantingto recover fullcost. Fixed overhead is more closely related to a firm’s capacity
to producethanto the productionofspecificunits.
In an advanced technological environment, with fixed
overhead becoming a larger component of production cost,
variable costing is likely to become a less attractive option,
because a now-significant part of cost (fixed OH) would be
omittedfrom the unitinventoriablecost.
AC isrequired underAASB102.
Use of the Contribution Margin Format
This format classifies expenses as follows:
o Firstly according to cost behaviour, i.e. fixed or variable, and then
o Within that classification, according to function.
Manipulating Profit Under AC – Build Up of Inventories
Where firms use absorption costing, one way to increase profits is to produce more inventory than required.
o This will lead to a favourable fixed overhead volume variance, and if the variance is transferred to COGS
it will reduce expense and increase profit.
o The larger the number of units in excess of demand, the larger the impact on profit. Scenario 1:
Budgeted fixed overhead $20,000
Actual fixed overhead incurred $19,800
Fixed overhead rate $2 per unit
Units produced 9,500 units
Units sold 9,500 units
Assume variances are transferred to COGS
WORK EXAMPLE HERE
Assume the same data as for scenario 1 except that the manager of the division produced 20,000 units and sold 9,500
units. The fixed overhead variances for scenario 2 are:
WORK EXAMPLE HERE
Because we are given no information about the reasons for the manager’s action in scenario 2 no definitive
conclusions can be made.
o For example, it is possible that for some reason the firm was expecting high demand in the following
period and the manager was instructed by a superior in the firm to produce for inventory.
o However, it is also possible that the manager’s actions were to benefit the manager and not the firm.
This can occur as follows:
(1) If the manager is being rewarded based on bottom-line profit, then profit, and as a result the
manager’s performance reward, is increased merely by building up inventories.
(2) It is very likely that build-up of inventory incurs costs and few benefits. If this is so, then the
manager’s actions are not “goal-congruent”, i.e. they are not in the interests of the firm as a
WORK EXAMPLE ON PAGE 5, 6, 7 HERE
Reconciling Profit Differences AC/VC
Profit under VC is driven by changes in sales only. If sales period 2 is higher than period 1, profit is higher period
Under AC this is not always the case, because profit is a function of both the level of sales and the level of
o This is because of the way that fixed overhead (deferred in inventory under AC) affects profit in the
There will be a difference in profit under the two costing systems whenever production is not equal to sales.
This is because under AC fixed overhead related to unsold inventory is "attached" to inventory and is not
expensed but is deferred (by remaining in inventory accounts) until the subsequent period in which the goods
are sold. The difference is compounded because both opening and closing inventories impact on profit.
Opening inventory increases the amount of expense (COGS) for the period and therefore reduces profit; closing
inventory reduces the amount of expense (COGS) and therefore increases profit.
The general rule to move from one system’s profit to the other is:
+ F OH in opening inventory (this adds back into AC profit the amount of Fixed OH by which expense
was increased under AC because of opening inventory)
- F OH in closing inventory (this subtracts from AC profit the amount of Fixed OH by which expense
was decreased under AC because of closing inventory)
(Alternatively, VC profit + F OH in closing – F OH in opening = AC profit)
This rule is applicable regardless of whether the fixed OH per unit in opening and closing inventories has
changed, or remains the same. The short-cut rule following may only be used when fixed OH per unit in opening
inventory is equal to fixed OH per unit in closing inventory.
WORK EXAMPLE HERE Short-Cut Rule
Where fixed OH per unit is unchanged from the previous period it is possible to calculate the amount of the
difference, and the direction of the difference (i.e. which method leads to the higher profit) using the following
This can be calculated as follows:
Change in inventory (from beginning to end) x F OH per unit
= $693,250 - $692,050 = $1,200.
Because inventory changes from 5,000 units to 7,000 units, the change is 2,000 units, and the amount of the
2,000 x $0.60 = $1,200, which is the correct amount.
The direction of the difference can be determined as follows (but remember, ONLY if the F OH per unit in
closing inventory is the same amount as in opening inventory):
o If inventory has increased (production exceeds sales), AC profit will be greater than VC profit.
o If inventory has decreased (sales exceeds production), VC profit will be greater than AC.
o Whereproductionequalssales, VC profitwillequalACprofit.
In summary, because the standard costs are unchanged from the previous period, and because inventory has increased,
AC profit is greater than VC profit by an amount of $1,200.
The Variance Report
The variance report covered in the standard costing lectures (which included costs only) can be extended to
include revenues, and prepared in the format of the contribution margin Income Statement.
Recall that the variance report of costs related to the number of units produced, because the calculation of cost
variances always relates to the units produced. Income Statements, however, show the firm’s income
generated from the number of units sold.
The extended variance report covered here is a popular report in practice, but its major limitation is that it is
useful only for firms where units produced = units sold.
Analysis of Profit
Theprinciplesofpreparingthe reportareidenticalto theearlierreportcoveringcosts
Budget figures (now for costs and revenues) at static activity (far right column) are flexed to actual activity (middle
column) in exactly the same way that costs were flexed to actual activity level. These budget figures are then
comparedwithactualcostsand revenues(far leftcolumn).
The only difference with the inclusion of sales revenue is that the direction of variances (F or U) for revenue and
profititemswill be intheopposite directionto thoseforcostitems. Ifsalesandresultingprofitis:
o higherthanbudget,thevariance is favourable
o lowerthanbudget,thevariance is unfavourable
WORK EXAMPLE HERE
As previously, the difference between the actual column and the static budget column is called the static budget
variance($5,000 -$5,120 =$120 U). Cost and sales variances (flexible budget variances $840 U) + Volumevariances
($720 F)=the Staticbudgetvariance($120U).
Forthepurposesofthisunityouarerequiredto insert asmuch(oraslittle)detailasyouaregiveninaproblem. For
example,intheproblem aboveyouaregiven detailsofthevariablecosts,thereforeyoulistthem. Ifyouwere notgiventhe
details,youwould justwriteinthetotalvariablecosts. If given detailsofoverhead items(not giveninexampleabove)you
wouldlistthem also. LECTURE EXAMPLE
Standard costs per unit (unchanged from previous accounting period):
DM $2.50 (10 sq.m x 25c)
DL $6 (20 mns DL x $18)
Variable OH $1 (40 mns machine time x $1.50)
Fixed OH $0.60 (40 mns machine time x 90c)
Total budgeted fixed overhead $36,000
Actual data for a period follows:
Assume no WIP inventories.
Opening inventory of finished goods 5,000 units (cardboard boxes)
Production 50,000 units
Sales 48,000 units @ $25
Actual fixed overhead $37,400
Actual variable overhead $59,500
Assume for the purposes of the example that selling and administrative costs are zero.
Total variable variances $14,550 unfavourable
Fixed spending $1,400 unfavourable; fixed volume $6,000 unfavourable
Assume that variances are disposed of to COGS at the end of the period.
LECTURE 7, Lecture Example 2