Absorption Costing and Variable Costing: the Differences

In the previous article, we looked at how the Income Statements look different under Absorption Costing and Variable Costing. However, the two approaches do not only differ in their presentations of financial information. The fundamental difference between the two lies in whether or not they treat fixed manufacturing overheads as part of inventory cost.

 

Absorption Costing vs Variable Costing

Absorption Costing

Variable Costing

Fixed manufacturing overhead cost is “absorbed” into inventory and is part of cost of inventory Fixed manufacturing overhead cost is deducted as an expense of the period and is not part of cost of inventory
Cost of ending inventory (inventory unsold at year end) contains fixed manufacturing overhead costs Cost of ending inventory does not contain fixed manufacturing overhead costs

 

The difference in treatment of fixed manufacturing overhead costs can result in a different operating income reported. Here is an example:

Direct material $9 Per unit of finished goods
Direct labor $6 Per unit of finished goods
Variable manufacturing overhead cost $5 Per unit of finished goods
Fixed manufacturing overhead cost $80,000 In total

 

Suppose the company produced 8,000 units of goods, which is the same as actual production (if the planned and actual production volumes are different, it will result in a production-volume variance. We will skip that for now).

Based on the information above, the company’s per-unit inventoriable costs are as follows:

Variable Costing Absorption Costing
$ $
Variable manufacturing cost per unit produced
Direct materials 9 9
Direct labor 6 6
Variable manufacturing overhead 5 5
Total variable manufacturing cost 20 20
Fixed manufacturing cost per unit produced 0 (Not included as inventoriable cost) $80,000/8,000 = $10
Total inventoriable cost per unit produced 20 30

 

Here is the data for 2012:

Production 8000 units
Sales 8000 units
Beginning inventory 0
Ending inventory 0

 

Here is how the Income Statement looks:

 

Income Statement under variable costing and absorption costing where production volume is equal to sales

Income Statement under variable costing and absorption costing where production volume is equal to sales

 

Note that there is no difference in operating income between the two. This is because there is no beginning nor ending inventory.

 

Absorption Costing vs Variable Costing where Sales Volume does NOT Equal Production Volume

Case 1: Production Volume > Sales Volume

Suppose the cost of producing the finished goods remains the same and this is the data for 2013:

Production 8000 units
Sales 7000 units
Beginning inventory 0
Ending inventory 1000 units

 

Income Statement under variable costing and absorption costing where production volume is larger than sales

Income Statement under variable costing and absorption costing where production volume is larger than sales

 

Note that in 2013, the operating income under absorption costing is higher than that of variable costing. This is because $10,000 in fixed manufacturing overhead ($10 per unit times 1000 units) is absorbed in ending inventory. The whole amount of $30,000 will be treated as a current asset. However, that $10,000 will be expensed under variable costing.

 

Case 2: Production Volume < Sales Volume

Suppose the cost of producing the finished goods remains the same and this is the data for 2014:

Production 8000 units
Sales 9000 units
Beginning inventory 1000 units
Ending inventory 0

 

Income Statement under variable costing and absorption costing where production volume is smaller than sales

Income Statement under variable costing and absorption costing where production volume is smaller than sales

 

Note that in 2013, the operating income under absorption costing is lower than that of variable costing. This is because $10,000 in fixed manufacturing overhead ($10 per unit times 1000 units) is absorbed in beginning inventory. This amount is included in cost of goods sold and expensed accordingly.

As you can see, absorption costing and variable costing can give us different operating incomes if production volume does not equal sales volume. Some variations occur when the costs of manufacturing differ across years, or when budgeted production volume does not equal actual production volume. These are issues we will look at in future articles.

 

Reference: Horngren, C., Datar, S., Rajan, M. (2015). Inventory Costing and Capacity Analysis. In Cost Accounting: A Managerial Emphasis (Fifteenth ed.).

 

Back to “Management Accounting”