Variable Costing and

Absorption Costing
Chapter Twelve
Management Accounting by
Khan and Jain (3rd Ed.)

Different views of product

cost
Financial accounting is concerned with the
aggregate cost of inventory while
management accounting is concerned
with the cost of an individual unit of
inventory.
In financial accounting, product cost
includes only manufacturing costs. In
management accounting, product cost
includes all manufacturing and non
manufacturing costs.
2-2

Manufacturing and Non

Manufacturing Costs
Manufacturing Costs

Direct Material, Direct

Labor and
Manufacturing
Overheads like Factory
Supervisors salary,
Factory Rent,
Depreciation of Plant
and Machinery etc.

Non-manufacturing Costs

Other than
Manufacturing
Overheads like Office
Overhead,
Administrative
Overhead, Marketing
Overhead, Selling and
Distribution Overhead,
R&D expenses,
Designing Expense, etc.

Product Cost and Period Cost

(Financial Accounting
Perspective)
Product Cost
Period Cost

These are costs which

are included to
ascertain value for
Inventory.
Financial accountants
include only
Manufacturing Costs
(DM, DL and
Manufacturing
Overheads) to value
Inventory.

These are costs which are

not included to ascertain
value for Inventory.
They are expensed in the
period they are incurred.
These are other costs like
R&D costs, Designing,
Marketing, Selling, Office,
Administrative overheads
are not included to value
Inventory.

Product Costs and Period Costs

(Financial Accounting
perspective)

IGAAP considers all manufacturing expenses

as Product Costs.
It considers all non-manufacturing expenses
as Period Costs.
This is because expenditures like advertising,
R&D, product improvement are seen as too
subjective and difficult to estimate, so they
are not reported as product costs.
All Costs are based on Historical Data (Both
manufacturing and non-manufacturing costs).

Product Costs and Period Costs

(Management Accountants
perspective)

All Costs whether Manufacturing or Nonmanufacturing are treated as Product

Costs to calculate the Total Cost (Cost of
Sales) of the Product.
This is because Management
Accounting reports help in ascertaining
the selling price of the product and in
decision-making which is prospective in
nature.

Variable and Absorption Costing Introduction

Variable costing is a technique in which only variable

costs are taken into account for product costing,
inventory valuation and other management decisions.
Absorption costing or full costing method absorbs all
manufacturing costs necessary to produce the product
and have it in a saleable form.
The two techniques are, however, not mutually
exclusive and are complementary in nature.
Income statements for external reporting and tax
purposes are on a full cost basis.
Variable costing is more useful for internal reporting
purposes.

Variable and Absorption Costing: A

Comparison

Variable
Manufacturing Overhead
costs are period costs.
Manufacturing Overhead
costs are expensed each
year (same year).

Overheads, other than

manufacturing, are
treated as period costs,
the same as in
absorption costing.

Absorption
Manufacturing Overhead
costs are product costs.
Manufacturing Overhead
costs are carried to next
year as part of cost of
inventory.
Overheads other than
manufacturing are
treated as period costs.

Variable and Absorption

Costing: A Comparison

The profits under two methods would

be different.
Example 12.3 (Page 12.7)
Manufacturing Overhead cost is part of
Inventory Cost in Absorption costing.
Manufacturing Overhead cost is not a
part of Inventory Cost in Variable
costing.

Variable and Absorption

Costing: Reconciliation

Difference: Standard Fixed Overhead Rate

(SFOR) Change in inventories that has
taken place during the period.
Variable costing focuses on Sales
while Absorption costing focuses on
Production.
In absorption costing there could be profits
without sales because of over production.
In reality, profits depend upon both sales
and production.

Advantages of Variable
Costing
Unlike absorption costing, problem of allocating

and absorbing manufacturing overheads to

different products is not there.
Over-absorption or under-absorption of
manufacturing overheads is not to be dealt with.
(Capacity Variance).
Management finds it easier to understand as they
are more intuitive. Profit increases when sales
increases.
Impact of fixed cost is emphasized as they are
deducted 100%.

Advantages of Variable
Costing

Helps in control function: Variable costs

are controllable at every level of
management whereas fixed costs are only
controllable at the top level of management.
Helps in Profit Planning: Variable costing
helps to arrive at the correct profits for
decision making.
It provides contribution margin per unit
which is the basis of cost volume profit
relationship.

Limitations of Variable
Costing
Segregation of semi-variable costs into fixed and

variable costs is a difficult task.

It carries a potential danger of encouraging a shortsighted approach to profit planning at the cost of
long-term view.
It may give an impression that there are short-term
profits based on variable costs. But profits are there
only when all long-term fixed costs are recovered.
In case of highly capital intensive industry with low
component of variable costs, it becomes difficult to
apply.

Assignment

Practical Problems: P.12.1 to P.12.5

in Chapter 12, in
Management Accounting by
Khan
and Jain ; 3rd Edition

Appendix:
Over absorption and
Under-absorption of
Overheads

Over and Under-absorption of

overheads

Overheads are usually charged to different cost units

on the basis of a pre determined overhead rate
At the end of the accounting period the total
overheads charged will be roughly equal to actual
overheads incurred during that period
In case the overheads recovered on the basis of a pre
determined rate are more than the actual overheads,
there is said to be over absorption of overheads.
In the reverse case it is termed as under absorption of
overheads.

Reasons for over & under-absorption

Wrong estimation of overhead expenses

Wrong estimation of output or hours to be

worked

Under or over utilization of production

capacity

Over or Under-Absorption
Calculation

SFOR =
Budgeted Fixed O/H
Budgeted Direct labor hours

where SFOR : Standard Fixed Overhead Rate

Absorbed Overhead:
Actual Direct Labor Hours * SFOR
Over/ Under Absorption:
Absorbed Overhead Actual Overhead
(-) Under-absorbed

(+) Over-absorbed

Problem 1:
The budgeted activity and cost data for six
months period (Jan 10 June 10) is as follows:
Direct Labor hours
68,000 Hrs.
Direct Wages
Rs. 42,500
Overhead: Fixed
Rs. 37,400
Variable
Rs. 64,600
Actual results are as follows:
Direct labor hours incurred
65,000 Hrs.
Direct Wages
Rs. 45,500
Overheads : Fixed
Rs. 38,700
Variable
Rs. 65,800

The existing method of absorbing

overhead is direct labor hour rate
analyzed into fixed and variable
overhead.
You are required to calculate:

The budgeted direct labor hour rates

of
overheads absorption for fixed
and
variable overheads

The absorbed overhead

The over and under absorbed

overhead

Solution to Problem 1:
Over head absorption rate = Budgeted Overheads
Labor Hour
Rate for fixed overheads = Rs.37,400 = Rs. 0.55 per
DL hour
68,000 Hrs.
Rate for variable overhead = (Rs. 64,600/ 68,000 Hrs.)
= Rs. 0.95 per DL hour

Absorbed overheads =
Actual direct labor hours x Pre determined
overhead rate
Absorbed fixed O.H:65,000 Hrs. X Rs.0.55/Hr =
Rs. 35,750
Absorbed variable O.H:65,000 Hrs. X Rs. 0.95/Hr.
= Rs. 61,750
Total absorbed overheads = Rs. 97,500
Actual overheads = Rs. 1,04,500
Under absorption of 97,500 1,04,500 = Rs.
-7,000

Problem 2:
Following are the details given by a factory
Normal working hours in a week
40 hrs
No. of machines
15 Nos.
No. of weekly loss of hours on maintenance - 4 hrs
per
machines
Estimated annual overheads
Rs. 1,55,520
Estimated Direct wages rate
Rs. 3 per hour
No. of weeks worked per year
48 Weeks
Actual results in respect of a 4 week period are:
Overhead incurred
Rs. 15,000
Wages Incurred
Rs. 7,000
Machine hours (productive)
2,200 Hrs.

Calculate the overhead rate per machine hour and the

amount of over and under absorption of overheads

Solution to Problem 2
No. of machines
Effective Hours per week
No. of weeks per year

15 Nos.
36 Hours
48 Weeks

Effective Machine hrs. per year 15 x 36 x 48 = 25,

920 Hrs.
Estimated Annual Overheads
Rs. 1,55,520
Overhead rate per machine hr (Rs. 1,55,520 / 25,920
Hrs.) = Rs. 6 per machine hour
Overheads Absorbed: 2,200 M/c Hrs. x Rs. 6 per M/c
Hr = Rs. 13,200
Overheads incurred:
Rs. 15,000
Under absorbed overheads Rs. 13,200 Rs. 15,000