The difference between the absorption and variable costing methods centers on the treatment of fixed manufacturing overhead costs. Absorption costing “absorbs” all of the costs used in manufacturing and includes fixed manufacturing overhead as product costs. Absorption costing is in accordance with GAAP, because the product cost includes fixed overhead. Variable costing considers the variable overhead costs and does not consider fixed overhead as part of a product’s cost. It is not in accordance with GAAP, because fixed overhead is treated as a period cost and is not included in the cost of the product.
Absorbing Costs through Overproduction
While companies use absorption costing for their financial statements, many also use variable costing for decision-making. The Big Three auto companies made decisions based on absorption costing, and the result was the manufacturing of more vehicles than the market demanded. Why? With absorption costing, the fixed overhead costs, such as marketing, were allocated to inventory, and the larger the inventory, the lower was the unit cost of that overhead. For example, if a fixed cost of ?1,000 is allocated to 500 units, the cost is ?2 per unit. But if there are 2,000 units, the per-unit cost is ?0.50. While this was not the only reason for manufacturing too many cars, it kept the period costs hidden among the manufacturing costs. Using variable costing would have kept the costs separate and led to different decisions.
Absorption costing considers all fixed overhead as part of a product’s cost and assigns it to the product. This treatment means that as inventories increase and are possibly carried over from the year of production to actual sales of the units in the next year, the company allocates a portion of the fixed manufacturing overhead costs from the current period to future periods.
Carrying over inventories and overhead costs is reflected in the ending inventory balances at the end of the production period, which become the beginning inventory balances at the start of the next period. It is anticipated that the units that were carried over will be sold in the next period. If the units are not sold, the costs will continue to be included in the costs of producing the units until they are sold. Finally, at the point of sale, whenever it happens, these deferred production costs, such as fixed overhead, become part of the costs of goods sold and flow through to the income statement in the period of the sale. This treatment is based on the expense recognition principle, which is one of the cornerstones of accrual accounting and is why the absorption method follows GAAP. The principle states that expenses should be recognized in the period in which revenues are incurred. Including fixed overhead as a cost of the product ensures the fixed overhead is expensed (as part of cost of goods sold) when the sale is reported.
For example, assume a new company has fixed overhead of ?12,000 and manufactures 10,000 units. Direct materials cost is ?3 per unit, direct labor is ?15 per unit, and the variable manufacturing overhead is ?7 per unit. Under absorption costing, the amount of fixed overhead in each unit is ?1.20 (?12,000/10,000 units); variable costing does not include any fixed overhead as part of the cost of the product. (Figure) shows the cost to produce the 10,000 units using absorption and variable costing.
Finished Goods Inventory under Absorption and Variable Costing. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)
Assume each unit is sold for ?33 each, so sales are ?330,000 for the year. If the entire finished goods inventory is sold, the income is the same for both the absorption and variable cost methods. The difference is that the absorption cost method includes fixed overhead as part of the cost of goods sold, while the variable cost method includes it as an administrative cost, as shown in (Figure). When the entire inventory is sold, the total fixed cost is expensed as the cost of goods sold under the absorption method or it is expensed as an administrative cost under the variable method; net income is the same under both methods.
Income Statement When the Entire Inventory Is Sold. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)
Now assume that 8,000 units are sold and 2,000 are still in finished goods inventory at the end of the year. The cost of the fixed overhead expensed on the income statement as cost of goods sold is ?9,600 (?1.20/unit × 8,000 units), and the fixed overhead cost remaining in finished goods inventory is ?2,400 (?1.20/unit × 2,000 units). The amount of the fixed overhead paid by the company is not totally expensed, because the number of units in ending inventory has increased. Eventually, the fixed overhead cost will be expensed when the inventory is sold in the next period. (Figure) shows the cost to produce the 8,000 units of inventory that became cost of goods sold and the 2,000 units that remain in ending inventory.
Cost of Goods Sold and Ending Inventory with the Absorption and Variable Costing Methods. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)
If the 8,000 units are sold for ?33 each, the difference between absorption costing and variable costing is a timing difference. Under absorption costing, the 2,000 units in ending inventory include the ?1.20 per unit share, or ?2,400 of fixed cost. That cost will be expensed when the inventory is sold and accounts for the difference in net income under absorption and variable costing, as shown in (Figure).
Net Income under Absorption and Variable Costing When Ending Inventory Remains. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)
Under variable costing, the fixed overhead is not considered a product cost and would not be assigned to ending inventory. The fixed overhead would have been expensed on the income statement as a period cost.
Because absorption costing defers costs, the ending inventory figure differs from that calculated using the variable costing method. As shown in (Figure), the inventory figure under absorption costing considers both variable and fixed manufacturing costs, whereas under variable costing, it only includes the variable manufacturing costs.
Using the absorption costing method on the income statement does not easily provide data for cost-volume-profit (CVP) computations. In the previous example, the fixed overhead cost per unit is ?1.20 based on an activity of 10,000 units. If the company estimated 12,000 units, the fixed overhead cost per unit would decrease to ?1 per unit. This calculation is possible, but it must be done multiple times each time the volume of activity changes in order to provide accurate data, as CVP analysis makes no distinction between variable costing and absorption costing income statements.
Comparing Variable and Absorption Methods
A company expects to manufacture 7,000 units. Its direct material costs are ?10 per unit, direct labor is ?9 per unit, and variable overhead is ?3 per unit. The fixed overhead is estimated at ?49,000. How much would each unit cost under both the variable method and the absorption method?
Solution
The variable cost per unit is ?22 (the total of direct material, direct labor, and variable overhead). The absorption cost per unit is the variable cost (?22) plus the per-unit cost of ?7 (?49,000/7,000 units) for the fixed overhead, for a total of ?29.