Variable Costing Versus Absorption costing

Variable Versus Full Absorption Costing

  • ·         Generally Accepted Accounting Principles (GAAP) requires that all manufacturing costs be treated as part of the cost of the product and counted as inventory until the product is sold.  This approach is known as full absorption costing because the product must “fully absorb” all costs incurred to produce it.  Variable costing is based on the distinction between variable costs and fixed costs.  Variable costing is used only for internal decision making and dies not meet GAAP external reporting requirements.

 

Full absorption costing is based on the distinction between manufacturing and non-manufacturing costs.  Gross margin is the difference between sale revenue and the cost of goods sold.  For external reporting (GAAP), cost of goods sold reflects the full manufacturing cost of the units sold.  The full manufacturing cost of units manufactured but not sold is counted as inventory on the balance sheet.  Non-manufacturing costs are expensed immediately and subtracted after gross margin to arrive at net operating income.  Variable costing captures the distinction between variable and fixed costs and ignores whether the costs are related to manufacturing or non-manufacturing activities.  The difference between sales revenue and variable costs is called contribution margin. Fixed costs are deducted after the contribution margin to arrive net profit.

 

In terms of bottom line profitability, the two methods will provide the same results as long as production and sales are equal.  The two methods can give different results, however, for any company that builds or depletes inventory.

 

  • o       Reconciling Variable and Full Absorption Costing – These are three general rules of thumb regarding reconciling income under full absorption costing and variable costing:
    • §        If production > sales in the period, there will be an increase in inventory and absorption costing profit will be > than variable costing profit.
    • §        If production = sales in the period, there will be no change in inventory and absorption costing profit is = to variable costing profit.
    • §        If production is < sales, then inventory will decrease and absorption costing profit < than variable costing profit.

 

A key note is that in the end, all costs will reconcile and be equal.  These changes denote how a firm will report profit in a period under both costing methods.  One costing method is not superior to the other, but they do have different purposes for management.