Absorption Costing & Variable Costing Explained

External parties such as investors, creditors, and governmental agencies look to this amount to evaluate a company’s performance and how it affects them. Managers and others within a company use operating income as a measure for evaluating and improving operational performance. Recognize that a reduction in inventory during a period will cause the opposite effect from that shown. Specifically, a portion of the contents of the beginning inventory cup would be transferred to expense commensurate with the decrease in inventory. Since the inventory cup contains less under variable costing, expect expenses to be lower and income to be higher.

• While companies use absorption costing for their financial statements, many also use variable costing for decision-making.
• Using the absorption costing method on the income statement does not easily provide data for cost-volume-profit (CVP) computations.
• We have been preparing income statements for manufacturers using this basic structure.
• As a result, the company may conclude that they are better off building cars at a “loss” to avoid an even “larger loss” that would result if production ceased.
• Absorption costing “absorbs” all of the costs used in manufacturing and includes fixed manufacturing overhead as product costs.
• Under absorption costing, normal manufacturing costs are considered product costs and included in inventory.

This is why, companies are not allowed to use the variable costing method for the preparation of external reports. Despite the good benefits that companies can derive from using the absorption costing method, it has some disadvantages. The major dark sides of this costing method include the fact that it results in the increase of net income. Because this method accounts for fixed costs, the https://turbo-tax.org/where-does-your-tax-money-go/ higher the goods produced at a time, the lesser the fixed costs that will be attributable to the production of the goods, which in turn causes the net income to increase. Hence, the fixed costs accounted for in this method is less favorable compared to variable costing. Another disadvantage of absorption costing is that cost volume profit (CVP) is difficult to analyze when it is being used.

Variable Costing In Action

Variable costing poorly upholds the matching principle, as related expenses are not recognized in the same period as related revenue. In our example above, under variable costing, we would expense all fixed manufacturing overhead in the period occurred. According

to the accounting standards for external financial reporting, the cost of

inventory should include all costs to prepare the inventory for its intended

use. This includes a reasonable portion of production overhead incurred in

connection with manufacturing the inventory.

The variable cost of adding one more passenger to an unfilled seat is quite negligible, and almost any amount of revenue that can be generated has a positive contribution to profit! An automobile manufacturer may have a contract with union labor requiring employees to be paid even when the production line is silent. As a result, the company may conclude that they are better off building cars at a “loss” to avoid an even “larger loss” that would result if production ceased. Professional sports clubs will occasionally offer deep discount tickets for unpopular games.

Variable Costing vs. Absorption Costing

The key point here is that variable costing information is useful, but it should not be the sole basis for decision making. The main reason behind prohibiting variable costing in preparation of financial statements for external use is because it fails to accord with the matching principle of accounting standards. Under variable costing, expenses are not reported in the same period with respect to the revenue generated from those expenses. On the other hand, the absorption costing approach requires reporting of expenses in the same period as the revenue generated from those expenses, which adheres to the matching principle. If the entire finished goods inventory is sold, the income is the same for both the absorption and variable cost methods. The difference is that the absorption cost method includes fixed overhead as part of the cost of goods sold, while the variable cost method includes it as an administrative cost, as shown in Figure 6.12.

(5) Fixed production costs are shown below the contribution margin on the income statement with fixed operating costs. Under both methods, direct costs (materials and labor) and variable factory overhead costs are applied to the cost of the product. The difference between the two costing methods is how the fixed factory overhead costs are treated. Under variable costing, fixed factory overhead costs are expensed in the period in which they are incurred, regardless of whether the product is sold yet.

Financial reporting

Under absorption costing, fixed factory overhead is allocated to the finished goods inventory account and is expensed to cost of goods sold when the product is sold. For internal accounting purposes, both can also be used to value work in progress and finished inventory. The overall difference between absorption costing and variable costing concerns how each accounts for fixed manufacturing overhead costs. Using the absorption costing method on the income statement does not easily provide data for cost-volume-profit (CVP) computations.

This information must be interlaced with knowledge of markets, customer behavior, and the like. The resulting conclusions can set in motion plans of action that bear directly on the overall fate of the organization. The variable costing method helps the management in understanding the relationship between profit, cost, and volume.

Advantages and Disadvantages of the Absorption Costing Method

For external financial reporting purposes, you must use absorption costing to comply with Generally Accepted Accounting Principles (GAAP). Keep in mind, companies using the cash method may not need to recognize some of their expenses as immediately with variable costing since they are not tied to revenue recognition. Note that product costs are costs that go into the product while period costs are costs that are expensed in the period incurred. In summary, while private companies have more flexibility, it is generally advisable for them to follow GAAP and use absorption costing for financial reporting. This ensures consistency, comparability, and credibility in the eyes of external stakeholders. Knowing the rules and regulations is essential because it will help you decide which accounting method to use.

Still, it may need to know the total price of the company’s fixed costs to know if the selling price is too low. To recap, the variable costing income statement is different from the absorption costing income statement in several ways. (3) Variable selling and administrative expenses are grouped with variable production costs as part of the calculation of contribution margin. (4) Contribution margin is listed after deducting all variable costs from sales.

A company may see an increase in gross profit after paying off a mortgage or finishing the depreciation schedule on a piece of manufacturing equipment. These are considerations cost accountants must closely manage when using absorption costing. An ethical and evenhanded approach to providing clear and informative financial information regarding costing is the goal of the ethical accountant. Ethical business managers understand the benefits of using the appropriate costing systems and methods. The accountant’s entire business organization needs to understand that the costing system is created to provide efficiency in assisting in making business decisions.

This treatment is based on the expense recognition principle, which is one of the cornerstones of accrual accounting and is why the absorption method follows GAAP. The principle states that expenses should be recognized in the period in which revenues are incurred. Including fixed overhead as a cost of the product ensures the fixed overhead is expensed (as part of cost of goods sold) when the sale is reported. It is not necessary that all units produced within a given period will be sold in the same period as well.