Variable and Absorption Costing

Absorption costing (or full costing) is the acceptable method for tax and external reporting. Variable costing (or direct costing) is not permitted but offers valuable use internally.

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 under each method.

Treatment of Costs - Absorption vs. Variable

 
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 Income Statement

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 Costing Income Statement

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

Difference in Operating Income

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.

Reconciliation of Absorption and Variable Costing Operating Income

Operating income - Absorption costing
xx
Add: Fixed FOH in beginning inventory
xx
Less: Fixed FOH in ending inventory
xx
Operating income - Variable costing
xx

Example

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.

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