Cost Accounting — Variable Costing and Absorption Costing: Why Profits Differ

Financial statements for external reporting use absorption costing: fixed manufacturing overhead is included in product cost and deferred in inventory. Internal management often uses variable costing, which treats fixed manufacturing overhead as an expense of the period incurred, so that profit moves with sales volume rather than production volume. The two methods differ in only one respect, but that one respect can change profit a great deal.

1. How the two methods differ

Comparison of cost treatment
Cost	Absorption costing	Variable costing
Direct materials, direct labor, variable manufacturing overhead	Product cost	Product cost
Fixed manufacturing overhead	Product cost (included in inventory)	Period cost
Variable and fixed selling and administrative costs	Period cost	Period cost
Income statement format	Gross margin	Contribution margin

2. Comparing two years

Company BE’s selling price is ₩100,000 per unit, variable manufacturing cost ₩30,000 per unit and variable selling cost ₩10,000 per unit. Annual fixed manufacturing overhead is ₩20 million and fixed selling and administrative costs ₩5 million; normal capacity is 1,000 units. In 20X1 it made 1,000 units and sold 800; in 20X2 it made 800 and sold 1,000. There is no opening inventory, and fixed manufacturing overhead per unit under absorption costing is ₩20,000 based on normal capacity.

Operating profit by year (unit: ₩10,000)
Item	20X1 absorption	20X1 variable	20X2 absorption	20X2 variable
Sales	8,000	8,000	10,000	10,000
Cost of sales (absorption: 5 per unit)	(4,000)		(5,000)
Unapplied fixed overhead (below capacity)			(400)
Variable costs (4 per unit)		(3,200)		(4,000)
Fixed manufacturing overhead		(2,000)		(2,000)
Variable selling costs	(800)		(1,000)
Fixed selling and administrative costs	(500)	(500)	(500)	(500)
Operating profit	2,700	2,300	3,100	3,500

Under absorption costing in 20X2, output was 200 units below normal capacity, so ₩4 million of fixed manufacturing overhead was not applied and was expensed in the period (the volume variance of chapter 11).

3. Why profits differ

Profit difference between the two methods

\text{Absorption profit} - \text{Variable profit} = (\text{Closing units} - \text{Opening units}) \times \text{Fixed overhead per unit}

In 20X1 inventory rose by 200 units, so absorption profit is higher by (200 − 0) × 2 = 400 (₩4 million). In 20X2 inventory fell by 200 units, so it is lower by (0 − 200) × 2 = −400.

When inventory rises, part of fixed manufacturing overhead is buried in inventory and carried to the next period, so absorption profit is higher. When inventory falls, fixed costs deferred in earlier periods are released, so absorption profit is lower. Over the two years combined, production and sales are equal (1,800 units) and total profit is the same ₩58 million.

Variable-costing profit follows sales volume alone. When sales rise from 800 to 1,000 units, contribution margin (₩60,000 per unit) rises by ₩12 million and profit rises by ₩12 million. Under absorption costing it rose by only ₩4 million.

4. Throughput costing

Throughput costing goes a step further and treats only direct materials as product cost, expensing even direct labor and variable manufacturing overhead as period costs, on the judgement that in the short run labor costs are effectively fixed too. It almost removes the incentive to build inventory to boost profit. Sales minus direct materials is called throughput contribution.

Check your understanding

Company BF’s fixed manufacturing overhead per unit (based on normal capacity) is ₩15,000. Opening inventory is 300 units, closing inventory 700 units, and variable-costing operating profit is ₩40 million. Assuming no volume variance, what is absorption-costing operating profit? If inventory falls from 700 to 100 units the following year, what is the difference between the two methods’ profits?

Inventory rose by 400 units, so absorption profit is higher by $400 \times 1.5 = 600$ (₩6 million). Absorption-costing operating profit is ₩46 million. The following year inventory falls by 600 units, so absorption profit is lower than variable-costing profit by $600 \times 1.5 = 900$ (₩9 million).

References

Charles Horngren, Srikant Datar and Madhav Rajan, Cost Accounting: A Managerial Emphasis, ch. 9
Eliyahu Goldratt and Jeff Cox, The Goal
Ray Garrison, Eric Noreen and Peter Brewer, Managerial Accounting, ch. 6