Question

1. In your own words, explain the difference between absorption costing and variable costing methods. How does each treat fixed manufacturing overhead? Provide an example and calculate the unit product cost using each method.

Answer 1

The main basis for difference in the absorption costing and variaable costing is the their approach and treatment of Fixed Manufacturing Overhead Cost. Absorption Costing is the one which treats all the production related expenses as fixed costs due to which it includes the fixed manufacturing costs as a part of Product Cost and the cost gets allocated over all the units produced whereas in case of Variable Costing it treats all the Production Costs as Product cost except Fixed Manufacturing Costs which is treated as a period cost in the case of Variable Costing due to which it got expensed out in the period in which the costs is incurred rather than deferring it for the future.

Absorption Costing Method is based on Gross Margin Concept which treats all the direct costs of production as part of cost of goods where there is variable cost or fixed cost it is included in unit product cost based on which cost of goods sold is computed whereas the Variable Costing Method is based on concept of Contribution Margin which treats all the variable cost of production being deducted from sales to arrive at Contribution Margin and treating fixed Costs separately either fixed Manufacturing Cost or Other Fixed Costs.

Due to the differenial treatment of fixed manufacturing costs there's always bound to be some differences in the Net Operating Income from both methods which is described as follows

If Production is equal to Sales Level then there is no difference in Operating Income.

If Production Level is more than sales level then Absorption Income will be Higher than that of Variable Costing Income becuse of allocated fixed Manufacturing Overhead Cost.

If Production Level is less than sales Level then Variable Costing Income will be higher than that of Absorption Costing Income becuse in this case fixed Manufacturing Cost deferred in previous period got released in current period.

Treatment of Fixed Manufacturing Overhead

Particulars	Treatment of Fixed Manufacturing Overhead
Absorption Costing	Product Cost
Variable Costing	Period Cost

The above has already been discussed earlier.

Now let's us take an example for better understanding of the same

ABC Ltd

Units Produced = 75,000 Units

Direct Materials Cost per Unit = $ 20

Direct Labour Cost per Unit = $ 10

Variable Manufacturing Overhead per Unit = $ 5

Fixed Manufacturing Overhead = $ 600,000

Calculation of Unit Product Cost as per Variable Costing

Particulars	Amount
Direct Materials Cost per Unit	20
Add: Direct Labour Cost per Unit	10
Add: Variable Manufacturing Overhead per Unit	5
Unit Product Cost	35

Calculation of Unit Product Cost as per Absorption Costing

Particulars	Amount
Direct Materials Cost per Unit	20
Add: Direct Labour Cost per Unit	10
Add: Variable Manufacturing Overhead per Unit	5
Add: Fixed Manufacturing Overhead per Unit	8
Unit Product Cost	43

Notes:-

Particulars	Amount
Fixed Manufacturing Overhead	600,000
÷ Units Produced	75,000
Fixed Manufacturing Overhead per Unit	8