Profit Reporting under Variable Costing and Absorption Costing
Overview of variable of absorption costing
Variable costing
Absorption Costing
Absorption costing is a method used by companies to determine the full production cost of a unit.
and indirect costs
includes direct costs
wages
machinery
rent
electricity
materials
Fixed production costs are treated as period costs and written off against profit in variable costing
Variable costing is a simpler method than absorption costing
In variable costing, the cost per unit is calculated as ⭐direct material + direct labour + variable overheads per unit
NB!! ⭐ Revenue from each unit sold pays for fixed costs
⭐Profit= Total Contribution (sales revenue minus variable costs) - fixed costs
How is it different
NB!! included in the cost of each unit is
⭐Fixed overhead costs are allocated to units based on a predetermined overhead rate
Includes all manufacturing costs, including fixed overhead costs, in the cost per unit of production.
Direct material
Direct Labor
variable overhead
⭐fixed overhead costs
How is it different
Fixed overhead costs are not allocated to units, so changes in production volume do not affect the cost per unit.
Unit Cost Calculation
Absorption Cost
Here is an example of how to calculate the unit cost under absorption costing
1.) Assume that a company produces 10,000 units of a product in a month, and incurs the following costs
Variable manufacturing overhead: $10,000
⭐Fixed manufacturing overhead: $20,000
Direct labor cost: $30,000
Total manufacturing costs: $110,000
Direct materials cost: $50,000
2.) To calculate the unit cost under absorption costing, follow these steps:
i. Calculate the Total Manufacturing Cost per Unit:
ii. Add any other costs that are not included in the manufacturing cost per unit, such as selling and administrative expenses, to get the total cost per unit.
Variable manufacturing overhead per unit = $10,000 / 10,000 =
Fixed manufacturing overhead per unit = $20,000 / 10,000 =
Direct labor cost per unit = $30,000 / 10,000 =
Total manufacturing cost per unit = $5 + $3 + $1 + $2 =
Direct materials cost per unit = $50,000 / 10,000 =
$5 per unit
$3 per unit
$1 per unit
$2 per unit
$11 per unit
For example, if the company has $5,000 in selling and administrative expenses in the month, the total cost per unit would be:
Total cost per unit = $11 + ($5,000 / 10,000) =
$11.50 per unit
Variable Cost
Also Known as ⭐Overhead absorption rate
⭐Overhead absorption rate is a predetermined rate used to allocate ⭐Fixed Manufacturing overhead costs to products or services produced
1.) To calculate the overhead absorption rate
1.) the company first estimates the total amount of fixed manufacturing overhead costs for the period; such as
2.) The total fixed manufacturing overhead cost is then divided by an estimated level of activity for the period, such as:
depreciation
insurance
rent
utilities
the number of machine hours to be used
the number of units to be produced
Example
let's assume a company estimates that its total fixed manufacturing overhead costs for the month are $50,000 and it expects to produce 10,000 units of a product in that month.
The overhead absorption rate would be calculated as follows:
NB!! Overhead absorption rate = Total fixed manufacturing overhead costs / Estimated level of activity
$50,000 / 10,000 units
= $5 per unit
Variable costing is a method of costing that includes only variable costs in the calculation of the cost of a product
vary with changes in production or sales volume, such as
direct labour
variable overhead
direct materials
NB!! Fixed costs, on the other hand, are not included in the unit cost calculation.
The formula for calculating the unit cost using variable costing is:
Unit Cost = Direct Materials + Direct Labour + Variable Overhead
Broken Down Components
Direct Labour
Variable Overhead
Direct Materials
⚠Direct Materials per Unit = Total Direct Materials Cost / Total Units Produced
⚠Direct Labor per Unit = Total Direct Labor Cost / Total Units Produced
⚠Variable Overhead per Unit = Total Variable Overhead Cost / Total Units Produced
⚠Total Unit Cost = Direct Materials per Unit + Direct Labor per Unit + Variable Overhead per Unit
Profit Comparison of Absorption and Variable Costing
Effect of Changes in Production on Profit
Production doesn't always equal sales
However, when production equals sales
there's no change in inventories, and all current fixed manufacturing overhead will flow through to the statement of profit or loss.
If production exceeds sales
Some of the current fixed manufacturing overhead costs will be deferred in inventories.
and the operating profit reported under absorption costing will be greater than under variable costing.
This is because under absorption costing, fixed manufacturing overhead costs are allocated to units produced and included in the cost of goods sold
while under variable costing, fixed manufacturing overhead costs are expensed as period costs and are not included in the cost of goods sold
As a result, the cost of goods sold under absorption costing will be higher than under variable costing, which leads to a higher operating profit under absorption costing.
If sales exceed production
some of the fixed manufacturing overhead costs that had been deferred in inventories in previous periods will be released to the statement of profit or loss as a charge against profit
And the operating profit reported under absorption costing will be less than under variable costing
Over an extended period of time
the cumulative operating profit figures reported under absorption costing and variable costing will be about the same.
Variable costing operating profit is not affected by changes in production volume
while absorption costing operating profit is affected by changes in production volume
Summary
If production is greater than sales
If sales are greater than production
inventories will increase, and absorption profit will be greater than variable profit.
inventories will decrease, and absorption profit will be less than variable profit.
Advantages And Disadvantages
Absorption Costing
Variable Costing
Advantages
Disadvantages
Helps calculate profitability of products
Helps in budgeting
Helps determine actual cost of production
May lead to overproduction
Ignores variable costs
Can result in inaccurate cost allocation
Advantages
Disadvantages
Helps in decision making
Improved cost control
Accurate measurement of costs:
Easy to understand
Better inventory valuation
Overlooks fixed costs
Difficult to allocate overheads
Does not comply with GAAP
May not reflect long-term costs
Not suitable for long-term planning