Wize University Managerial Accounting Textbook > Alternative Costing Methods
Absorption and Variable Costing
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Absorption and Variable Costing
The difference between absorption costing and variable costing is how fixed manufacturing overhead is treated.
- Under absorption costing, fixed MOH is treated as a product cost, it goes into inventory when it is incurred and is included in the calculation of Cost of Goods Sold.
- Under variable costing, fixed MOH is treated as a period cost and is expensed on the income statement when it is incurred and is not included in the calculation of Cost of Goods Sold.
Example
ABC Inc. produces skateboards and incurs the following manufacturing costs in producing 20,000 units:
- Direct Materials $10/unit
- Direct Labour $12/unit
- Variable Manufacturing Overhead $5/unit
- Fixed Manufacturing Overhead $200,000
Product Cost per unit:
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Income Statements
The income statements are different under the two costing method to account for the differences in the treatment of fixed manufacturing overhead.
- The absorption costing income statement follows a more traditional format of computing gross profit first and then subtracting operating expenses.
- Variable costing uses the Contribution Margin format and separates cost based on their behaviour (fixed and variable).
Example
ABC Inc. produces skateboards and incurs the following manufacturing costs in producing 20,000 units:
- Direct Materials $10/unit
- Direct Labour $12/unit
- Variable Manufacturing Overhead $5/unit
- Fixed Manufacturing Overhead $200,000
There is no beginning inventory and 12,000 units were sold for $45 each. The company incurs a variable selling expense of $2 per unit and fixed selling and administrative expenses of $50,000.
Reconciling Between Absorption and Variable Costing
Understanding the difference between absorption costing and variable costing allows us to quickly determine the effects of switching from method to the other, we call this reconciling.
Simply, by either adding or subtracting the difference in costs we can use the income from one costing method to find the income from the other.
Change in Inventory Units x Difference in Unit Cost = Difference in Net Income
- When Units Produced > Units Sold
- Inventory increases
- Absorption Costing Net Income > Variable Costing Net Income
- Absorption Costing Inventory > Variable Costing Inventory
- When Units Produced < Units Sold
- Inventory decreases
- Absorption Costing Net Income < Variable Costing Net Income
- Absorption Costing Inventory < Variable Costing Inventory
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Example: Absorption Costing
The following information pertains to ABC Corporation for a period:
Assume a total of 10,000 units were produced and 6,000 units were sold and that there was no beginning inventory.
- What is the cost per unit of inventory under absorption costing.
- Compute the cost of ending inventory under absorption costing.
- Prepare an income statement using absorption costing, ignore income taxes.
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Example: Variable Costing
The following information pertains to ABC Corporation for a period:
Assume a total of 10,000 units were produced and 6,000 units were sold and that there was no beginning inventory.
- What is the cost per unit of inventory under variable costing.
- Compute the cost of ending inventory under variable costing.
- Prepare an income statement using variable costing, ignore income taxes.
Mark Yourself Question
- Grab a piece of paper and try this problem yourself.
- When you're done, check the "I have answered this question" box below.
- View the solution and report whether you got it right or wrong.
Practice: Variable Costing
Washburn Washers North York factory manufactures an all in one washer and dryer unit. During the month of April, the cost accountant recorded the following regarding the operations of the plant.
Prepare the income statement using variable costing and reconcile the net income with absorption costing.
Mark Yourself Question
- Grab a piece of paper and try this problem yourself.
- When you're done, check the "I have answered this question" box below.
- View the solution and report whether you got it right or wrong.
Practice: Absorption Costing
Washburn Washers North York factory manufactures an all in one washer and dryer unit. During the month of April, the cost accountant recorded the following regarding the operations of the plant.
Prepare the income statement using absorption costing and reconcile the net income with variable costing.