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 asdirect 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