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
|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|
|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:
Here is how the Income Statement looks:
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:
|Ending inventory||1000 units|
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:
|Beginning inventory||1000 units|
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.).