Under absorption costing, all production costs (direct labor, direct materials, and factory overhead whether fixed or variable) are considered products costs. They are considered part of inventory, and are moved to cost of sales only when sold.
Under variable costing, only direct materials, direct labor and variable factory overhead are considered product costs.
Fixed factory overhead costs are charged immediately against revenues as period costs.
All selling and administrative (S&A) expenses, a.k.a. operating expenses, are charged against revenues immediately (period costs) under either absorption or variable costing.
Absorption costing (a.k.a. full costing) is the acceptable method for tax and external reporting. Variable costing (a.k.a. direct costing) is not permitted for external reporting but offers valuable information to management.
| Absorption | Variable | ||
| Direct materials | Product | Product | |
| Direct labor | Product | Product | |
| Variable factory overhead | Product | Product | |
| Fixed factory overhead | Product | Period | |
| Variable S&A expenses | Period | Period | |
| Fixed S&A expenses | Period | Period |
The only difference lies in the treatment of fixed factory overhead.
Absorption costing is the method acceptable for tax and external reporting purposes. It follows the traditional presentation of the income statement.
| Sales | xx |
| Less: Cost of Sales | xx |
| Gross Profit | xx |
| Less: Selling and Administrative Expenses | xx |
| Operating Income | xx |
Variable or direct costing favors the contribution margin income statement format.
| Sales | xx |
| Less: Variable Costs | xx |
| Contribution Margin | xx |
| Less: Fixed Costs | xx |
| Operating Income | xx |
1. When production is equal to sales, meaning there is no difference in the beginning and ending inventories, the operating income under both methods are the same.
2. When production is greater than sales, i.e. ending inventory is greater than the beginning inventory, the operating income under absorption costing is greater.
3. When production is less than sales, i.e. ending inventory is less than the beginning inventory, operating income under variable costing is greater.
4. The difference in operating income is caused by the dissimilar treatment of fixed factory overhead. The difference is equal to the fixed factory overhead per unit multiplied by the difference in inventory.
| Operating income - Absorption costing | xx |
| Add: Fixed FOH in beginning inventory | xx |
| Less: Fixed FOH in ending inventory | xx |
| Operating income - Variable costing | xx |
XYZ Company started the year with 1,000 units in its inventory. During the period, it produced 2,000 units and sold 1,800 units at $50 each. The following costs were incurred.
| Total cost | Cost/unit | ||
| Direct materials | $24,000 | 12 | |
| Direct labor | 20,000 | 10 | |
| Variable factory overhead | 16,000 | 8 | |
| Fixed factory overhead | 12,000 | 6 | |
| Variable S&A expenses | 9,000 | ||
| Fixed S&A expenses | 6,000 |
1. Operating income under absorption costing
| Sales ($50 x 1,800) | $90,000 |
| Less: Cost of Sales ($36 x 1,800) | 64,800 |
| Gross Profit | $25,200 |
| Less: S&A Expenses (9,000 + 6,000) | 15,000 |
| Operating Income | $10,200 |
The cost of sales is computed by multiplying the product cost per unit by the number of units sold. The product cost includes: direct materials, direct labor, variable factory overhead, and fixed factory overhead ($12+10+8+6).
2. Operating income under variable costing
| Sales ($50 x 1,800) | $90,000 |
| Less: Variable Costs* | 63,000 |
| Contribution Margin | $27,000 |
| Less: Fixed Costs** | 18,000 |
| Operating Income | $9,000 |
*The variable costs include: the product costs under variable costing plus variable selling and administrative expenses. [($12+10+8) x 1,800] + $9,000 = $63,000.
**Fixed costs include total fixed factory overhead of $12,000 and total fixed selling & administrative expenses of $6,000.
3. Reconciliation of Difference in Operating Income
| Operating income - Absorption costing | $10,200 |
| Add: FFOH in beg. inventory ($6 x 1,000) | 6,000 |
| Less: FFOH in end. inventory ($6 x 1,200) | 7,200 |
| Operating income - Variable costing | $9,000 |
The difference in operating income can also be computed as: difference in inventory units multiplied by fixed factory overhead per unit (200 units x $6 = $1,200). Since the ending inventory is higher than the beginning inventory, the operating income under absorption costing is higher than that under variable costing by $1,200.
Under absorption costing, all manufacturing costs are considered as product costs.
Under variable costing, only variable costs are treated as product costs. These include direct materials, direct labor and variable factory overhead.
Absorption costing is the acceptable method for tax and external reporting purposes. Variable costing is only used internally to aid management in making decisions.
