Under variable costing, total product costs were $300,000 and 10% ($30,000) of that amount would be assigned to inventory. As a result, $15,000 more is assigned to inventory under absorption costing. Another way to view the impact of the inventory build-up is to examine the following “cups.” The top set of cups initially contains the costs incurred in the manufacturing process. With absorption costing, those cups must be emptied into either cost of goods sold or ending inventory. A typical illustration of decision making based on variable costing data looks simple enough.
Absorption costing is typically used in situations where a company wants to understand the full cost of producing a product or providing a service. This includes cases where a company is required to report its financial results to external stakeholders, such as shareholders or regulatory agencies. But with absorption costing, this measure includes all of the costs that go into the manufacturing of a product. The key to absorption costing is understanding how costs are absorbed and spread over a period of time. With this information, you can work towards streamlining your operations—and your expenses.
The difference between the methods is attributable to the fixed overhead. Therefore, the methods can be reconciled with each other, as shown in Figure 6.17. The difference in the methods is that management will prefer one method over the other for internal decision-making purposes. The other main difference is that only the absorption method is in accordance with GAAP. Calculate gross profit by subtracting the cost of goods sold from sales.
The fixed cost per unit is $7.50, determined by dividing the $150,000 total fixed factory overhead cost by the number of units produced, 20,000. The $7.50 per unit is then multiplied by 15,000, the number of units sold to get $112,500. Both costing methods can be used by management to make manufacturing decisions.
All fixed costs, including manufacturing overhead are reported on the income statement at the given amount. 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. Most people, especially those in accounting, would have questions to ask about absorption costing and income statements.
Absorption costing is often used interchangeably with the term full costing, and they are usually identified to have similar meanings. Another advantage of absorption costing social media is its compliance with GAAP, a metric that the IRS requires. And because absorption costing includes all sales costs, you get a more accurate representation of profit.
The point of this analysis is to illustrate that under absorption costing, operating income changes based on increases or decreases in inventory due to producing more or fewer units than were sold in a period. Such changes are unrelated to a company’s operating performance, and managers need to be aware of this type of distortion under absorption costing. On a variable costing income statement, changes in inventory have no effect on operating income, making this method more reliable and desirable for analyzing profitability for an accounting period. Because absorption costing defers costs, the ending inventory figure differs from that calculated using the variable costing method.
Companies, however, can get information from variable costing and absorption costing systems as long as the companies can calculate the amount of every manufacturing fixed overhead per unit. It is necessary to note that there would always be an imbalance in the balance sheet of absorption cost; the inventory is always higher than the expenses on an income statement. This is because an absorption cost includes manufacturing products, employees’ wages, raw materials, and every other production cost. Under absorption costing, however, operating income changes when the company’s inventory balance changes. The results from the three absorption income statements presented earlier are shown again, as follows. The three variable costing income statements at the different levels of production were exactly the same, each yielding operating income of $100,000, as shown in the following comparative statements.
Direct materials cost is $3 per unit, direct labor is $15 per unit, and the variable manufacturing overhead is $7 per unit. Under absorption costing, the amount of fixed overhead in each unit is $1.20 ($12,000/10,000 units); variable costing does not include any fixed overhead as part of the cost of the product. Figure 6.11 shows the cost to produce the 10,000 units using absorption and variable costing. Under absorption costing, all manufacturing costs, both direct and indirect, are included in the cost of a product. Absorption costing is typically used for external reporting purposes, such as calculating the cost of goods sold for financial statements. Full absorption costing (often simply called absorption costing) is required by generally accepted accounting principles (GAAP) for external reporting.
Absorption vs. variable costing will only be a factor for companies that expense costs of goods sold (COGS) on their income statement. Although any company can use both methods for different reasons, public companies are required to use absorption costing due to their GAAP accounting obligations. The variable cost per unit is $22 (the total of direct material, direct labor, and variable overhead). The absorption cost per unit is the variable cost ($22) plus the per-unit cost of $7 ($49,000/7,000 units) for the fixed overhead, for a total of $29.
We will use the UNITS SOLD on the income statement (and not units produced) to determine sales, cost of goods sold and any other variable period costs. In any case, the variable direct costs and fixed direct costs are subtracted from revenue to arrive at the gross profit. Additionally, it is not helpful for analysis designed to improve operational and financial efficiency or for comparing product lines. 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).
It fails to recognize certain inventory costs in the same period in which revenue is generated by the expenses, like fixed overhead. Absorption costing is also often used for internal decision-making purposes, such as determining the selling price of a product or deciding whether to continue producing a particular product. In these cases, the company may use absorption costing to understand the full cost of producing the product and to determine whether the product is generating sufficient profits to justify its continued production. The traditional income statement, also known as the absorption costing income statement, is created using absorption costing. Costs are divided into product and period costs in this income statement.
Determining the appropriate costing system and the type of information to be provided to management goes beyond providing just accounting information. The costing system should provide the organization’s management with factual and true financial information regarding the organization’s operations and the performance of the organization. Unethical business managers can game the costing system by unfairly or unscrupulously influencing the outcome of the costing system’s reports. 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. In both of the above examples, we are assuming that the company produced and sold 2,900 books using a Just-in-Time inventory management system, and therefore, operating income for both statements is $1,530.00.