21 Variable and Absorption Costing
- Calculate income and the value of ending inventory using absorption costing
- Calculate income and the value of ending inventory using variable costing
- Explain the difference between income under absorption and variable costing
The Theory
Under generally accepted accounting principles (GAAP), firms must include all manufacturing costs—both fixed or variable—in the costs of their products. A system which attaches fixed manufacturing costs to goods is called absorption costing. While absorption costing is required for external reporting, it poses challenges both from theoretical and practical perspectives.
Fixed manufacturing costs such as rent, depreciation, insurance, and labor costs for salaried employees are attached to goods because they are necessary to support production. Because they are related to manufacturing the product, they are included in inventory [1] until goods are sold, when they are expensed as Cost of Goods Sold.
However, from a theoretical perspective, fixed manufacturing costs are costs of providing manufacturing capacity, not the cost of manufacturing each individual unit. These costs will be incurred from period to period regardless of how many units are produced, because they are the costs of the infrastructure within which production occurs. For this reason, some argue that fixed manufacturing costs should be treated as period costs rather than product costs.
From a practical perspective, attaching fixed manufacturing costs to goods can incentivize overproduction, as the fixed costs will be attached to all the units that are produced, even the ones that are in inventory at the end of the period. The fixed costs attached to goods in inventory, therefore, end up as assets on the balance sheet (as part of the value of that inventory) rather than as expenses on the income statement (as cost of goods sold). Lower expenses mean higher overall income, so managers may be tempted to use this tactic to meet income targets even if extra inventory is not needed.
This tactic can lead to higher inventory carrying costs, including the cost of storing and insuring the inventory, the opportunity cost of the funds tied up in inventory, and a higher risk of inventory obsolescence, spoilage, and shrinkage. In addition, overproduction in one period typically leads to underproduction in later periods to reduce excess inventory, which can lead to disruptions in workflow and supply chains.
Another drawback of absorption costing is that when product costs include fixed costs, they can be misleading for short-term decision making purposes, as fixed costs are not relevant in the short run. They can also obscure the nature of a firm’s cost structure, making cost-volume-profit analysis more difficult for both internal managers and external financial statement users.
To address these issues, some firms use variable costing for internal purposes. Under variable costing, only variable manufacturing costs are attached to products, while fixed manufacturing costs are treated as period costs—they are expensed in the period incurred. Using variable costing gives managers a clearer view of the firm’s cost structure, highlights the firm’s contribution margin, facilitates the use of cost-volume-profit analysis, and supports more effective performance evaluation.
Income statements prepared using absorption costing follow a gross margin format: cost of goods sold is subtracted from revenues to yield gross margin, and operating expenses are then subtracted to arrive at operating income. In contrast, variable costing uses a contribution margin format: variable costs (both manufacturing and non-manufacturing) are subtracted from revenues to yield contribution margin, and then fixed costs are subtracted to determine operating income. These differences are displayed below; note that the amount of variable cost of goods sold, variable operating expenses, and fixed operating expenses will be the same across both income statements, while the amount of fixed cost of goods sold may differ.
Absorption Costing
Sales revenue
Less: Cost of goods sold
(variable and fixed)
Gross margin
Less: Variable operating expenses
Less: Fixed operating expenses
Operating income
Variable Costing
Sales revenue
Less: Cost of goods sold
(variable)
Less: Variable operating expenses
Contribution margin
Less: Fixed manufacturing overhead
Less: Fixed operating expenses
Operating income
A gross margin format income statement showing how to calculate income using absorption costing, and a contribution margin format income statement showing how to calculate income using variable costing.
The difference in operating income between the two methods depends on changes in inventory levels—and more specifically, on the amount of fixed manufacturing overhead deferred in or released from inventory. If the amount of fixed manufacturing overhead cost in inventory increases, income will be higher by that amount under absorption costing than variable costing. On the other hand, if the amount of fixed manufacturing overhead cost in inventory decreases, income will be lower by that amount under absorption costing than variable costing.
The Method
Although both absorption and variable costing include the same total costs over time, they assign those costs to periods differently. Understanding how and why income can differ under the two systems—and being able to reconcile the difference—is essential for interpreting financial results and identifying incentives that may affect managerial behavior.
- First, calculate income and the value of ending inventory using absorption costing and report it in gross margin format.
- Next, calculate income and the value of ending inventory using variable costing and report it in contribution margin format.
- Next, reconcile the difference between income under absorption costing and income under variable costing by comparing it to the change in fixed manufacturing overhead in absorption costing inventory.
- Finally, interpret the results. Was income higher under absorption costing or variable costing, and why?
Illustrative Example
Glenhaven Manufacturing produces custom kitchen cabinetry for residential construction projects. To comply with financial reporting requirements, the company uses absorption costing. However, management has recently adopted variable costing for internal decision-making. The change was made to better support cost-volume-profit (CVP) analysis. Information from the quarter ended March 31 follows:
| Category | Amount |
|---|---|
| Direct materials used | 750,000 |
| Direct labor | 300,000 |
| Variable manufacturing overhead | 270,000 |
| Fixed manufacturing overhead | 360,000 |
| Variable portion of beginning inventory | 120,000 |
| Fixed portion of beginning inventory | 60,000 |
| Units in beginning inventory | 500 units |
| Units produced during the quarter | 6,000 units |
| Units sold during the quarter | 5,400 units |
| Sales revenue | 2,400,000 |
| Variable operating costs | 240,000 |
| Fixed operating costs | 150,000 |
The controller has asked you to prepare income statements using both methods and reconcile the difference between them.
First, calculate income and the value of inventory using absorption costing and report it in gross margin format.
- Cost of goods manufactured = direct materials $750,000 + direct labor $300,000 + variable manufacturing overhead $270,000 + fixed manufacturing overhead $360,000 = $1,680,000
- The cost per unit is $1,680,000 ÷ 6,000 units produced = $280 per unit
- The fixed cost per unit is $360,000 ÷ 6,000 units produced = $60 per unit
- Units in ending inventory = units in beginning inventory 500 + units produced 6,000 – units sold 5,400 = 1,100
- Value of ending inventory: 1,100 units × $280 per unit = $308,000
- The fixed portion of this cost is 1,100 units × $60 per unit = $66,000
- Cost of goods sold = beginning inventory value $120,000 + $60,000 + cost of goods manufactured $1,680,000 – ending inventory value $308,000 = $1,552,000
- Gross margin format income statement:
| Revenue | 2,400,000 |
|---|---|
| Cost of goods sold | 1,552,000 |
| Gross margin | 848,000 |
| Variable operating costs | 240,000 |
| Fixed operating costs | 150,000 |
| Operating income | 458,000 |
Next, calculate income and the value of inventory using variable costing and report it in contribution margin format.
- Cost of goods manufactured = direct materials $750,000 + direct labor $300,000 + variable manufacturing overhead $270,000 = $1,320,000
- The cost per unit is $1,320,000 ÷ 6,000 units produced = $220 per unit
- Value of ending inventory: 1,100 units × $220 per unit = $242,000
- Cost of goods sold = beginning inventory value $120,000 + cost of goods manufactured $1,320,000 – ending inventory value $242,000 = $1,198,000
- Contribution margin format income statement:
| Revenue | 2,400,000 |
|---|---|
| Variable cost of goods sold | 1,198,000 |
| Variable operating costs | 240,000 |
| Contribution margin | 962,000 |
| Fixed manufacturing overhead | 360,000 |
| Fixed operating costs | 150,000 |
| Operating income | 452,000 |
Next, reconcile the difference between income under absorption costing and income under variable costing by comparing it to the change in fixed manufacturing overhead in inventory.
- Absorption costing income $458,000 – variable costing income $452,000 = $6,000
- Fixed manufacturing overhead in ending inventory $66,000 – fixed manufacturing overhead in beginning inventory $60,000 = $6,000
Finally, interpret the results. Was income higher under absorption costing or variable costing, and why?
- Income was higher under absorption costing than under variable costing. This is because production exceeded sales, causing inventory to increase. Under absorption costing, the fixed manufacturing costs associated with the unsold units are included on the balance sheet as part of the value of ending inventory, while under variable costing, those same costs are expensed on the income statement as part of cost of goods sold.
Mesa Custom Bikes builds high-performance bicycles for competitive and recreational riders. The company uses absorption costing for external reporting, but its CFO prefers variable costing for internal analysis. Recently, the CFO noticed that inventory levels have dropped and would like to understand how this affects reported income under each method.
Data for the quarter ended June 30:
- Units in beginning inventory: 800 units
- Variable cost per unit in beginning inventory: $230
- Total fixed cost in beginning inventory: $72,000
- Units produced during the quarter: 3,200 units
- Units sold during the quarter: 3,500 units
- Direct production costs: $620,000
- Variable manufacturing overhead: $160,000
- Fixed manufacturing overhead: $288,000
- Variable operating costs: $190,000
- Fixed operating costs: $120,000
- Sales revenue: $1,995,000
-
- First, calculate income and the value of ending inventory using absorption costing and report income in gross margin format.
- Next, calculate income and the value of ending inventory using variable costing and report income in contribution margin format.
- Next, reconcile the difference between income under absorption costing and income under variable costing by comparing it to the change in fixed manufacturing overhead in absorption costing inventory.
- Finally, interpret the results. Was income higher under absorption costing or variable costing, and why?
Lecture Example
EmberGlass Studios is a small artisan company that produces custom-blown architectural glass for commercial installations. For internal decision-making, the company uses variable costing to evaluate performance and inform pricing decisions. During the most recent quarter, the company produced more glass panels than it sold, adding to its inventory of finished goods.
At the beginning of the quarter, EmberGlass had 200 units of finished goods inventory, with a variable cost per unit of $180 and total fixed manufacturing cost of $14,000. During the quarter, the company produced 1,600 units and ended the period with 300 units in inventory. Current period production costs were as follows: variable production costs totaled $312,000, including $264,000 in direct costs. Fixed manufacturing overhead cost was $112,000. Variable operating costs for the quarter were $66,000, and fixed operating costs were $80,000. The company reported sales revenue of $825,000.
- Prepare income statements using both absorption costing and variable costing, calculate the value of ending inventory under each method, and reconcile the difference in operating income between the two approaches.
- The presence of work-in-process inventories complicates the procedures in this topic, so we will assume zero work-in-process inventories throughout this chapter. ↵
A costing system that attaches fixed manufacturing costs to goods
Producing more units than needed to meet current demand and inventory requirements
The total costs a business incurs to store and maintain inventory, typically including storage costs, insurance and taxes, depreciation, obsolescence, shrinkage, and the opportunity cost of capital tied up in unsold inventory
A decline in the value of inventory because it is no longer in demand, it is outdated, or it is no longer usable
The cost to produce units that are ruined during production that cannot be sold as good units
Loss of inventory due to causes such as theft, damage, or administrative errors
Producing fewer units than needed to meet current demand
A costing system that only attaches variable manufacturing costs to goods, while fixed manufacturing costs are expensed in the period incurred
A format of income statement in which gross margin (sales minus cost of goods sold) is emphasized to users
A format of income statement in which contribution margin (sales minus variable costs) is emphasized to users
