Question

Discuss, using an example from an organization you are familiar with, how a company could use a variable costing system, as well as an absorption costing system. You have the option of using the company you work for as an example. Explain which method is better for the company being discussed?

Answer 1

What is variable costing?

Variable costing is a methodology that assigns variable costs to inventory and all fixed costs are reported as period costs. Hence all fixed costs are incurred as expenses.

What is absorption costing?

All the costs associated with production are attached to inventory as an asset on balance sheet until the goods are sold and post this costs are transferred to COGS (cost of goods sold) on the income statement as an expense.

Major difference between variable costing and absorption costing?

The only difference between the two modes of costing is in the treatment of fixed overheads.

• In variable costing, fixed overhead is reported as period cost
• In absorption costing, fixed overhead is reported as product cost

Consider the example of Prestige, which produces pressure cookers.

Monthly Production	20, 000 units
Sales Price	Rs 50 per unit
Variable porduction cost per unit	Rs 10 per unit
1. Direct material	Rs 5
2. Direct labour	Rs 3
3. Manufacturing overhead	Rs 2
Fixed production cost	Rs 5 per unit, total of (20,000x5)= Rs 1,00,000 per month
Variable selling and administrative cost	Rs 3 per unit
Fixed selling and administrative cost	Rs 10,000 per month

Assuming Prestige has no finished goods inventory at the beginning of the month, we will consider 3 scenarios:

Scenario 1: Number of units produced equals number of units sold

Variable costing	Absorption costing
Sales: 20,000x50= Rs 10,00,000	Sales: 20,000x50= Rs 10,00,000
Variable costing COGS: 20,000x10 (Variable cost)= Rs 2,00,000 Selling and administrative cost: 20,000x3= Rs 60,000 Total variable costs: 2,00,000+60,000= Rs 2,60,000	COGS: RS 2,00,000 (Variable cost)+ Rs1,00,000 (Fixed cost)= Rs 3,00,000
Contribution Margin= Sales- Variable Cost= Rs 7,40,000	Gross Margin: Sales - COGS: Rs 7,00,000
Fixed Costs COGS: Rs 1,00,000 (Fixed production cost) Selling and administrative costs: Rs 10,000 Total fixed costs: Rs 1,10,000	Selling and administrative costs: Rs 10,000 (Fixed selling and administrative cost)+ Rs 60,000 (variable selling and administrative cost)= Rs 70,000
Operating profit: Contribution Margin- Total FIxed costs 7,40,000-1,10,000= Rs 6,30,000	Operating Profit: Gross MArgin - Variable profit: Rs 6,30,000

With absoprtion costing, all fixed overhead costs are totally expensed as all units produced are sold. In variable costing, fixed overheads are treated as period costs and therefore are always expensed in period incurred. Since all the other costs are treated the same regardless of the costing method used, profit is identical when the number of units produced and sold is the same.

Scenario 2: Number of units produced is greater than number of units sold

Consider that Prestige produces 20,000 units but sells only 15,000 units. All the costs are same. In such a scenario, variable and absorption costing can produce results as follows:

Variable costing	Absorption costing
Sales: 15,000x50= Rs 7,50,000	Sales: 15,000x50= Rs 7,50,000
Variable costing COGS: 15,000x10 (Variable cost)= Rs 1,50,000 Selling and administrative cost: 15,000x3= Rs 45,000 Total variable costs: 1,50,000+45,000= Rs 1,95,000	COGS: RS 1,50,000 (10x15,000=Variable cost)+ Rs75,000 (5x15,000=Fixed cost)= Rs 2,25,000 Fixed cost is also calculated as per the number of goods sold ie.15,000
Contribution Margin= Sales- Variable Cost= Rs 5,55,000	Gross Margin: Sales - COGS: Rs 5,25,000
Fixed Costs COGS: Rs 1,00,000 (Fixed production cost) Selling and administrative costs: Rs 10,000 Total fixed costs: Rs 1,10,000	Selling and administrative costs: Rs 10,000 (Fixed selling and administrative cost)+ Rs 45,000 (3x 15,000 variable selling and administrative cost)= Rs 55,000
Operating profit: Contribution Margin- Total FIxed costs 5,55,000-1,10,000= Rs 4,45,000	Operating Profit: Gross MArgin - Variable profit: Rs 4,70,000

Operating profit using absorption costing is higher. Difference in cost is due to Rs 5 per unit fixed production cost assigned to 5,000 units (left unsold) in ending inventory whcih is Rs 5 x 5,000= Rs 25,000 and that is exactly the difference between the two operating profits.

Scenario 3: Number of Units Produced Is less than number of units sold

Consider that Prestige sells 25,000 units (5,000 units left over from previous month) but produced only 20,000 units.

Variable costing	Absorption costing
Sales: 25,000x50= Rs 12,50,000	Sales: 25,000x50= Rs 12,50,000
Variable costing COGS: 25,000x10 (Variable cost)= Rs 2,50,000 Selling and administrative cost: 25,000x3= Rs 75,000 Total variable costs: 2,50,000+75,000= Rs 3,25,000	COGS: RS 2,50,000 (10x25,000=Variable cost)+ Rs1,25,000 (5x25,000=Fixed cost)= Rs 3,75,000 Fixed cost is also calculated as per the number of goods sold ie.25,000
Contribution Margin= Sales- Variable Cost= Rs 9,25,000	Gross Margin: Sales - COGS: Rs 8,75,000
Fixed Costs COGS: Rs 1,00,000 (Fixed production cost) Selling and administrative costs: Rs 10,000 Total fixed costs: Rs 1,10,000	Selling and administrative costs: Rs 10,000 (Fixed selling and administrative cost)+ Rs 75,000 (3x 25,000 variable selling and administrative cost)= Rs 85,000
Operating profit: Contribution Margin- Total FIxed costs 9,25,000-1,10,000= Rs 8,15,000	Operating Profit: Gross MArgin - Variable profit: Rs 7,90,000

Operating profit using variable costing is higher. Difference in cost is due to Rs 5 per unit fixed production cost assigned to 5,000 units (left unsold) in ending inventory whcih is Rs 5 x 5,000= Rs 25,000 and that is exactly the difference between the two operating profits.

For Prestige, variable costing method is better because it allows to determine contribution margin ratios, break even points and perform sensitivity analysis. Absoprtion costing is not useful for internal decision making.

Another advantge of using the variable costing is that it prevents managers from increasing production solely for increasing profits.