Absorption Costing Versus Variable Costing

My video lectures about variable costing and absorption costing as alternative methods of determining unit product costs can be found in my managerial accounting course and CPA exam lessons.   Or Browse other courses from menu above.

Absorption costing and Variable Costing

Managerial Accounting Course

Variable costing are only manufacturing costs that vary with output are treated as product costs.

Variable and absorption costing are alternative methods of determining unit product costs. Under variable costing, only those manufacturing costs that vary with output are treated as product costs. This includes direct materials, variable overhead, and ordinarily direct labor. Fixed manufacturing overhead is treated as a period cost and it is expensed on the income statement as incurred. 

By contrast, absorption costing treats fixed manufacturing overhead as a product cost, along with direct materials, direct labor, and variable overhead. Under both costing methods, selling and administrative expenses are treated as period costs and they are expensed on the income statement as incurred.

Because absorption costing treats fixed manufacturing overhead as a product cost, a portion of fixed manufacturing overhead is assigned to each unit as it is produced. If units of product are unsold at the end of a period, then the fixed manufacturing overhead cost attached to those units is carried with them into the inventory account and deferred to a future period. When these units are later sold, the fixed manufacturing overhead cost attached to them is released from the inventory account and charged against income as part of cost of goods sold. Thus, under absorption costing, it is possible to defer a portion of the fixed manufacturing overhead cost from one period to a future period through the inventory account.

Unfortunately, this shifting of fixed manufacturing overhead cost between periods can cause erratic fluctuations in net operating income and can result in confusion and unwise decisions. To guard against mistakes when they interpret income statement data, managers should be alert to changes in inventory levels or unit product costs during the period.

Segmented income statements provide information for evaluating the profitability and performance of divisions, product lines, sales territories, and other segments of a company. Under the contribution approach, variable costs and fixed costs are clearly distinguished from each other and only those costs that are traceable to a segment are assigned to the segment. A cost is considered traceable to a segment only if the cost is caused by the segment and could be avoided by eliminating the segment. Fixed common costs are not allocated to segments. The segment margin consists of revenues, less variable expenses, less traceable fixed expenses of the segment.

The dollar sales required for a segment to break even is computed by dividing the segment’s traceable fixed expenses by its contribution margin ratio. A company’s common fixed expenses should not be allocated to segments when performing break-even calculations because they will not change in response to segment-level decisions.

Absorption Costing Income Statement:

Absorption costing includes all of the direct costs associated with manufacturing a product, while variable costing can exclude some direct fixed costs. … Variable costing includes all of the variable direct costs in COGS but excludes direct, fixed overhead costs.


Absorption Costing GAAP:

Generally accepted accounting principles require use of absorption costing

Also known as full costing — a costing method where inventory absorbs direct costs and variable and fixed factory overhead

“>absorption costing (also known as “full costing”) for external reporting. Under absorption costing, normal manufacturing costs are considered product costs and included in inventory.

As sales occur, the cost of inventory is transferred to cost of goods sold, meaning that the gross profit is reduced by all costs of manufacturing, whether those costs relate to direct materials, direct labor, variable manufacturing overhead, or fixed manufacturing overhead. Selling, general, and administrative costs (SG&A) are classified as period expenses.

The rationale for absorption costing is that it causes a product to be measured and reported at its complete cost. Because costs like fixed manufacturing overhead are difficult to identify with a particular unit of output does not mean that they were not a cost of that output. As a result, such costs are allocated to products. However valid the claims are in support of absorption costing, the method does suffer from some deficiencies as it relates to enabling sound management decisions. absorption costing

Also known as full costing — a costing method where inventory absorbs direct costs and variable and fixed factory overhead

“>Absorption costing information may not always provide the best signals about how to price a product, reach conclusions about discontinuing a product, and so forth.