These costs are also treated as period expenses and are not allocated to the product. Variable costing, also known as direct costing or marginal costing, only includes variable manufacturing costs in the product cost. If a company prefers the variable costing method for management decision-making purposes, it may also be required to use the absorption costing method for reporting purposes. Absorption vs. variable costing will only be a factor for companies that expense costs of goods sold (COGS) on their income statement. Although any company can use both methods for different reasons, public companies are required to use absorption costing due to their GAAP accounting obligations.
The difference in the methods is that management will prefer one method over the other for internal decision-making purposes. The other main difference is that only the absorption method is in accordance with GAAP. Production is estimated to hold steady at 5,000 units per year, while sales estimates are projected to be 5,000 units in year 1; 4,000 units in year 2; and 6,000 in year 3. Textbook content produced by OpenStax is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike License .
Absorption Costing vs. Variable Costing: What’s the Difference?
The reason variable costing isn’t allowed for external reporting is because it doesn’t follow the GAAP matching principle. It fails to recognize certain inventory costs in the same period in which revenue is generated by the expenses, like fixed overhead. Depending on a company’s level of transparency, an income statement using absorption costing may break out variable direct costs and fixed direct costs into two line items or combine them together to report a comprehensive COGS.
Public companies are required to use the absorption costing method in cost accounting management for their COGS. Many private companies also use this method because it is GAAP-compliant whereas variable costing isn’t. Variable costing is quite commonly used by management to assist with a variety of decisions.
Absorption costing considers all fixed overhead as part of a product’s cost and assigns it to the product. Thus all fixed manufacturing overhead costs are expensed in the period incurred regardless of the level of sales. Under the absorption costing method, all costs of production, whether fixed or variable, are considered product costs.
The only difference between absorption costing and variable costing is in the treatment of fixed manufacturing overhead. Using absorption costing, fixed manufacturing overhead is reported as a product cost. Figure 6.8 “Absorption Costing Versus Variable Costing” summarizes the similarities and differences between absorption costing and variable costing.
As you review Figure 6.9 “Number of Units Produced Equals Number of Units Sold”, notice that when the number of units produced equals the number sold, profit totaling $90,000 is identical for both costing methods. With absorption costing, fixed manufacturing overhead costs are fully expensed because all units produced are sold (there is no ending inventory). With variable costing, fixed manufacturing overhead costs are treated as period costs and therefore are always expensed in the period incurred. Because all other costs are treated the same regardless of the costing method used, profit is identical when the number of units produced and sold is the same. Variable costs such as direct materials, direct labor and variable manufacturing overhead are added as product costs, while all the total fixed costs are expensed in the year of production as period costs. This is in conflict with the GAAP requirement that all costs of manufacturing a particular product be expensed at once.
Absorption Costing vs. Variable Costing: An Overview
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.
Keep in mind, companies using the cash method may not need to recognize some of their expenses as immediately with variable costing since they are not tied to revenue recognition. Absorption costing is not as well understood as variable costing because of its financial statement limitations. See the Strategic CFO forum on Absorption Cost Accounting that helps managers understand its uses to learn more.
7 Using Variable Costing to Make Decisions
This includes a reasonable portion of fixed manufacturing costs incurred to produce the inventory. The variable costing approach ignores such fixed manufacturing costs, thereby understating the overall cost of the product. There are no uses for variable costing in financial reporting, since the accounting frameworks (such as GAAP and IFRS) require that overhead also be allocated to inventory. The frameworks do not favor the use of variable costing, because it does a poor job of matching revenues with all related expenses.
One avenue through which shareholders can monitor the progress of the management is through financial statements. Since the variable costing approach doesn’t present accurate income figures, it is not allowed in the preparation of financial statements for external users. This is one of the premises on which the GAAP disallows the use of variable costing in the preparation of financial statements.
- These costs are also treated as period expenses and are not allocated to the product.
- Though this does mean that the reported gross margin is higher, it does not mean that net profits are higher – the overhead is charged to expense lower in the income statement instead.
- 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 6.12.
- This strategy does not work with variable costing because all fixed manufacturing overhead costs are expensed as incurred, regardless of the level of sales.
It also aligns the income with sales volume, avoiding income inflation due to overproduction. To implement absorption costing, you must first identify the fixed manufacturing overhead costs related to the production process, such as depreciation, rent, utilities, and supervision. Then, select an activity measure or cost driver that reflects how these costs are consumed by the products. After that, calculate the predetermined overhead rate by dividing the total fixed manufacturing overhead costs by the total activity measure for the period.
Next, apply the predetermined overhead rate to each product by multiplying it by the actual activity measure for each product. Finally, add the applied overhead costs to the direct materials and direct labor costs to get the full product cost per unit. Using the absorption costing method on the income statement does not easily provide data for cost-volume-profit (CVP) computations.
Product Costing
If a company has high direct, fixed overhead costs it can make a big impact on the per unit price. Companies that use variable costing may be able to allocate high monthly direct, fixed costs to operating expenses. However, most companies may need to transition to absorption costing at some point, which can be important to factor into short-term and long-term decision making. 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.
Traditional
costing includes all overhead costs (fixed and variable) into the cost of
inventory, while variable costing treats all fixed overhead costs as period
costs. Therefore, variable costing does not comply with the external reporting
requirements. In order to understand how to prepare income statements using both methods, consider a scenario in which a company has no ending inventory in the first year but does have ending inventory in the second year. Outdoor Nation, a manufacturer of residential, tabletop propane heaters, wants to determine whether absorption costing or variable costing is better for internal decision-making. The total of direct material, direct labor, and variable overhead is $5 per unit with an additional $1 in variable sales cost paid when the units are sold.
For example, one might conduct a breakeven analysis to determine the sales level at which a business earns a zero profit. Another possibility is to use it to establish the lowest possible price at which a product can be sold. Yet another use is to formulate internal financial statements into a contribution margin format (which must be adjusted before they can be issued to outside parties). Managers as agents of shareholders have a duty to protect and generally increase the value of the shareholders’ wealth.
