Income Statements: Variable Cost vs Absorption Cost

See the Strategic CFO forum on Absorption Cost Accounting that helps managers understand its uses to learn more. Let’s use the example from the absorption and variable costing post to create this income statement. Administrative, selling and manufacturing costs are all separated into three categories by absorption costing. Absorption costing states that every product has a set overhead cost, regardless of whether it is sold or not during a certain period. This means that all costs must be included at the end of an inventory, which is normally done as a balance sheet asset.

  1. Unethical business managers can game the costing system by unfairly or unscrupulously influencing the outcome of the costing system’s reports.
  2. Here, these variable costs are assigned to products and fixed overhead costs for some time.
  3. Under variable costing, the other option for costing, only the variable production costs are considered.
  4. Marginal costing income statements are more useful for analyzing inventory and production costs, while absorption costing is required under some accounting standards.
  5. This cost will be independent of sales during the given period in which the study is established.

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. Generally, absorption costing has to do with situations that affect the manufacturing costs of companies. It includes all product costs, which are both fixed and manufacturing product costs. It is also known as a managerial account used to cover all expenses made on a particular product.

Absorption Costing

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. Variable costing data are quite useful in avoiding incorrect decisions about product discontinuation. Some will usually be more successful than others, and a logical business decision may be to focus on the best-performing units, while discontinuing others. Each is being produced in equal proportion, and the company is fully able to meet customer demand from existing capacity (i.e., producing more will not increase sales). The company is not incurring any variable costs relating to selling, general, and administration efforts.

Aka “full absorption costing” or “full costing.”

The term “absorption costing” means that the company’s products absorb all the company’s costs. All fixed costs, including manufacturing overhead are reported on the income statement at the given amount. Since inventory costs are not expensed until sold, the two income statements will give different operating income. Every other part of the income statement becomes easy to calculate once you have gotten your cost per unit. It is important to note that the variable items are only calculated based on the number sold. This means that cost can only be expensed based on the amount sold while unsold items end up in the inventory.

Depending on a company’s business model and reporting requirements, it may be beneficial to use the variable costing method, or at least calculate it in dashboard reporting. Managers should be aware that both absorption costing and variable costing are options when reviewing their company’s COGS cost accounting process. Using the absorption costing method will increase COGS and thus decrease gross profit per unit produced. This means companies will have a higher breakeven price on production per unit.

Absorption Costing Process

While both methods are used to calculate the cost of a product, they differ in the types of costs that are included and the purposes for which they are used. The differences between absorption costing and variable costing lie in how fixed overhead costs are treated. Because Nepal does not carry inventory, the income is the same under absorption and variable costing.

The basic format is to simply show the sales less the cost of goods sold equal gross profit. And also show the gross profit less the selling and administrative expenses and that equals the operating income. The cost of goods sold (COGS) is calculated when the ending inventory dollar value is subtracted. To compute net operating income for the period, subtract selling expenses. It’s also known as complete costing because it accounts for all direct manufacturing costs, including labor, raw materials, and any fixed or variable overheads. Absorption costing is a tool used in management accounting to capture entire expenses connected to manufacturing a certain product.

Figure 6.11 shows the cost to produce the 10,000 units using absorption and variable costing. Selling, general, and administrative costs (SG&A) are classified as period expenses. Unlike absorption costing, variable costing doesn’t add fixed overhead costs into the price of a product and therefore can give a clearer picture of costs. By assigning these fixed costs to cost of production as absorption costing does, they’re hidden in inventory and don’t appear on the income statement.

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The variable cost could also be referred to as direct costing or marginal costing, and it includes all variable costs like direct labor, direct materials, and variable overhead. Here, these variable costs are assigned to products and fixed overhead costs for some time. Under absorption costing, the fixed manufacturing overhead costs are included in the cost of a product as an indirect cost. These costs are not directly traceable to a specific product but are incurred in the process of manufacturing the product.

This is why under GAAP, financial statements need to follow an absorption costing system. Under variable costing, the fixed overhead is not considered a product cost and would not be assigned to ending inventory. The fixed overhead would have been expensed on the income statement as a period cost. In addition, the use of absorption costing generates a situation in which simply manufacturing more items that go unsold by the end of the period will increase net income. Because fixed costs are spread across all units manufactured, the unit fixed cost will decrease as more items are produced.

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.

GAAP only requires absorption costing for external reporting, not internal reporting. External reports are generated for public consumptions; in the case of publicly traded corporations, shareholders interact with external reports. External reports are designed to reveal financial health and attract capital.

However, most companies may need to transition to absorption costing at some point, which can be important to factor into short-term and long-term decision making. Because absorption costing includes fixed overhead costs in the cost of its products, it is unfavorable compared with variable costing when management is making internal incremental pricing decisions. This is because variable costing will only include the extra costs of producing the next incremental unit of a product. The treatment of fixed overhead costs is different than variable costing, which does not include manufacturing overhead in the cost of each unit produced.

If the manufactured products are not all sold, the income statement would not show the full expenses incurred during the period. Because absorption costing defers costs, the ending inventory figure differs from that calculated using the variable costing method. Absorption costing takes into account all of the costs of production, not just the direct costs as is the case with variable costing. Absorption costing includes a company’s fixed costs of operation, such as salaries, facility rental, and utility bills. Having a more complete picture of cost per unit for a product line can help company management evaluate profitability and determine prices for products.

Further, when inventory levels fluctuate, the periodic income will differ between the two methods. The absorption costing and marginal costing income statements differ significantly in format. Both begin with gross sales and end with net operating income for the period. However, the absorption costing income statement first subtracts the cost of goods sold from sales to calculate gross margin.

These are considerations cost accountants must closely manage when using absorption costing. In the article about income statements under marginal cost, we discussed that marginal costs give a higher net profit figure as compared to absorption costing. Here, we are going to discuss the income statement under absorption costing and see how the net profit differs. Before we look at the income statement, let us have a look at what absorption costing is. According to accounting tools, the primary item on an absorption income statement is gross revenues for the period. To calculate COGS, add the cost of products produced for the time to the dollar worth of initial inventory.