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Absorption vs. Variable Costing
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In a manufacturing firm, costs are divided into two major categories: manufacturing costs and non-manufacturing costs. The latter are often referred to as selling and administrative expenses, and we will use the terms non-manufacturing costs and selling and administrative expenses interchangeably.  Manufacturing costs can be further subdivided into the following categories: direct labor, direct material, variable overhead, and fixed overhead. Direct labor is the cost of labor used in making the finished product. It can typically be associated directly with specific steps in the manufacturing process, hence the term direct labor. Similarly, direct materials are the costs of the physical material that makes up the finished product. For example, we can figure out how much lumber and fabric it takes to make a piece of furniture, so we can directly associate the cost of that material with the finished item. Variable and fixed overhead are examples of indirect costs, and we will use the terms indirect costs and overhead interchangeably. Variable overhead includes things like some portion of heat, light and power, small tools, lubricants, and disposable things like rags and sandpaper. Fixed overhead includes factory rent, supervision, insurance premiums, property taxes and depreciation. Utilities might include a fixed component if there were some minimum charge, irrespective of the quantity used [i.e., there is a charge to be hooked up to the power grid whether you actually use any or not] . Recall that variable costs are those that vary in total in proportion to production or sales. Fixed costs are constant in total, irrespective of the volume of production or sales [within some range of volume, which we call the relevant range]. A plot of variable and fixed costs would look like this:

Generally Accepted Accounting Principles require that manufacturing firms use what is known as absorption costing. This is what you learned about in your financial accounting course, although they probably didn't use a special name for it; you just did it "the way the book said to." Under absorption costing, fixed manufacturing overhead is charged to inventory and written off pro-rata as part of cost of goods sold. In somewhat simplistic terms, this means that if we sell, say 75% of the production during the year, we'll expense 75% of the fixed manufacturing overhead. If we sell only 40% of what we make, we'll expense 40% of the overhead. The remaining amount [25% in the first instance, 60% in the second] will remain in finished goods inventory.

Note that absorption costing results in what is essentially a functional classification of costs in the income statement. The costs of manufacturing are grouped together and the costs of sales and administration are grouped together:

Absorption Costing Income Statement

Functional categories

 What about behavior of the costs? What happens if we don't sell everything we make?
  Revenue      
minus cost of goods sold Direct material These are the costs associated with manufacturing the stuff we sell Note that we have both fixed and variable costs here The value of whatever we do not sell will show up in inventories on the balance sheet.
Direct labor
Variable overhead
Fixed overhead
equals  Gross profit      
minus Variable selling and administrative expenses These are the costs of administration and sales Note that we also have both fixed and variable costs here These costs NEVER show up in inventory. They are always expensed in the period in which they occur, and are thus sometimes called period costs.
Fixed selling and administrative expenses
equals  Net income      

There is an alternative income statement format which is used extensively in managerial accounting. Because it categorizes costs by behavior [all the variable costs together in one group and all the fixed costs together in another] this method is especially useful in decision making.  Variable costing [a.k.a. the contribution margin approach] is also the basis for the breakeven and cost-volume profit-analysis material in chapter 2 in the text. Breakeven analysis assumes that all fixed costs are expensed as incurred. Variable costing gives us an income statement that looks like this:

Variable Costing Income Statement

Functional categories

 What about behavior of the costs? What happens if we don't sell everything we make?
  Revenue      
minus variable costs Direct material Note that we have both manufacturing and non-manufacturing costs here Now we have just variable costs in this grouping The value of the variable manufacturing cost of whatever we do not sell will show up in inventories on the balance sheet.
Direct labor
Variable overhead
Variable selling expenses Variable S & A expenses are NEVER inventoried; 100% expensed in the period incurred
equals  Contribution margin      
minus fixed costs Fixed manufacturing overhead Again, we have both manufacturing and non-manufacturing costs here All fixed costs are together here These costs NEVER show up in inventory. They are always expensed in the period in which they occur, and are thus sometimes called period costs.
Fixed selling and administrative expenses
equals  Net income      

To illustrate the differences in these two ways of financial reporting, we'll used a very simple illustration called Crista's Critters. Crista makes teddy bears and other stuffed animals. She buys the fabric and stuffing, cuts the pieces and assembles them. She gives a sales commission to her sister Suzie for every animal Suzie sells. Here is the basic data:

Basic information for Crista's Critters
Direct material cost/unit  $          5.00
Direct labor cost/unit  $          3.00
Variable overhead/unit  $          4.00
Total variable manufacturing cost/unit  $        12.00
Variable selling expenses/unit sold [commissions]  $          2.00
Total variable cost/unit  $        14.00
Annual fixed manufacturing overhead  $        5,000
Annual fixed selling expenses  $        3,000
Annual production [units]          10,000
Annual sales [units]            8,000
Selling price/unit  $        15.00

Based on the information above, we can calculate the net incomes under the two different methods. Note that as long as production and sales are equal, net income under the two systems will be the same. Work through the numbers in the illustrations below to be sure you understand how they are derived.

Absorption costing income statement for Crista's Critters   Variable costing income statement for Crista's Critters
Revenue    $     150,000   Revenue    $   150,000
Less cost of goods sold       Less variable cost of goods sold    
Direct material    $      50,000   Direct material  $  50,000  
Direct labor    $      30,000   Direct labor  $  30,000  
Variable overhead [thread, miscellaneous stuff that's too much of nuisance to measure]    $      40,000   Variable overhead [thread, miscellaneous stuff that's too much of nuisance to measure]  $  40,000  
Fixed manufacturing overhead       Total variable manufacturing costs    $   120,000
Total fixed overhead  $        5,000     Variable selling expenses    $     20,000
Total units produced          10,000     Total variable costs    $   140,000
Fixed overhead per unit  $          0.50     Contribution margin    $     10,000
Total units sold          10,000     Fixed manufacturing overhead  $    5,000  
Fixed overhead charged to cost of goods sold [$/unit * units sold]    $        5,000   Fixed selling expenses  $    3,000  
Total cost of goods sold    $     125,000   Total fixed costs    $      8,000
Gross margin    $      25,000   Net income    $      2,000
Variable selling expenses    $      20,000        
Fixed selling expenses    $        3,000        
Total selling expenses    $      23,000        
Net income    $        2,000        

Now let's assume that production is 10,000 units as originally stated, but Suzie decides she has better ways to spend her time than sell stuffed animals for her sister. She sells only 8,000, leaving 2,000 in inventory. Here is what the income statements look like now:

Absorption costing income statement for Crista's Critters   Variable costing income statement for Crista's Critters
Revenue    $     120,000   Revenue    $   120,000
Less cost of goods sold       Less variable cost of goods sold    
Direct material    $      40,000   Direct material  $  40,000  
Direct labor    $      24,000   Direct labor  $  24,000  
Variable overhead [thread, miscellaneous stuff that's too much of nuisance to measure]    $      32,000   Variable overhead [thread, miscellaneous stuff that's too much of nuisance to measure]  $  32,000  
Fixed manufacturing overhead       Total variable manufacturing costs    $     96,000
Total fixed overhead  $        5,000     Variable selling expenses    $     16,000
Total units produced          10,000     Total variable costs    $   112,000
Fixed overhead per unit  $          0.50     Contribution margin    $      8,000
Total units sold            8,000     Fixed manufacturing overhead  $    5,000  
Fixed overhead charged to cost of goods sold [$/unit * units sold]    $        4,000   Fixed selling expenses  $    3,000  
Total cost of goods sold    $     100,000   Total fixed costs    $      8,000
Gross margin    $      20,000   Net income    $           -  
Variable selling expenses    $      16,000        
Fixed selling expenses    $        3,000        
Total selling expenses    $      19,000        
Net income    $        1,000        

We produced 10,000 units but sold only 8,000, so there is a balance sheet impact here:

Production [units]          10,000          
Sales {units]            8,000          
Difference [when production > sales, we are building inventory for the next fiscal period; when production < sales, we are drawing down inventory left from the prior period]            2,000          
Value of units left in inventory       Value of units left in inventory    
Direct material  $  10,000.00     Direct material    $10,000.00
Direct labor  $    6,000.00     Direct labor    $  6,000.00
Variable overhead  $    8,000.00     Variable overhead    $  8,000.00
Fixed overhead  $    1,000.00     Total value of inventory under variable costing    $24,000.00
Total value of inventory under absorption costing  $  25,000.00          

Notice the following relationships:

Absorption costing   Variable costing
Net income  $      1,000   Net income  $           -  
Value of inventory  $25,000.00   Value of inventory  $24,000.00

Under absorption costing, we have held back $1,000 worth of fixed overhead [2,000 units @ $0.50 each] in inventory. This $1,000 will be written off as part of cost of goods sold in the next fiscal period [or whenever Suzie decides she needs to earn a little money]. Under variable costing, the entire annual cost of fixed overhead has been expensed as a lump sum [what we call a period cost--the cost of operating for a fiscal period. The "extra" $1,000 has been written off on the income statement [but, note that it is NOT part of cost of goods sold here], so net income is $1,000 lower and the value of inventory is $1,000 lower. Net income is zero under variable costing in this scenario because 8,000 units happens to be the breakeven point. Suggestion: Do the calculation to prove to yourself that the breakeven point is, in fact, 8,000 units.

Now suppose that the situation is reversed. Crista is the one who slacks off, and makes only 8,000 units. Suppose further that Suzie is gung ho to earn more money and sells all 8,000 units that Crista makes and she also sells the 2,000 units that were in inventory from the year before [when Crista had her act together and produced 10,000 units as planned]. Assuming that the costs and prices in the prior year were the same as in the current year, determine the net income under each approach. Click here for the answer. Determine the value of ending inventory under each approach. [Hint: the latter is REALLY easy. Why?] Click here for the answer.

Copyright © 2010 Gerald M. Myers
Last modified: 1/31/2011; 17:24