Accountingverse.com
>

Variable Costing and Absorption Costing

Introduction

Learn about absorption costing (or full costing) and variable costing, how they work, their differences and how to reconcile them when needed.

In a Nutshell

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.

Absorption Costing

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.

Variable Costing

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 but offers valuable information to management.

Treatment of Costs Summary - 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.

Who we are
ACCTG VRSE
Accountingverse is your prime source of expertly curated information for all things accounting. more..
Featured pages
CPA CMA etc.
Accounting Certifications
Boost your career potential
101
Accounting Basics
Lessons & tutorials
Copyright © 2021 – Accountingverse.com
Your Online Resource For All Things Accounting