Variable and Absorption

Costing
How They are Different
Variable and absorption costing are two
methods of costing that are different in
only two ways:
1. The treatment of fixed manufacturing
overhead (such as factory rent), and
2. The presentation on the statement of
profit or loss of different costs.
1. Treatment of Fixed Factory
Costs
Under variable costing, fixed factory
overheads are treated as a period cost
and are expensed as they are incurred.

Under absorption costing, fixed factory

overheads are allocated to the units
that were produced during the period.
Absorption Predetermined Rate

Budgeted Monetary Amount of Fixed

Manufacturing Overhead
Budgeted Activity Level of Allocation Base
Variable
Fixed
Factory
Overhead
Variable
Fixed
Factory
Overhead
Income
Statement
Variable Absorption
Fixed Fixed
Factory Factory
Overhead Overhead
Income
Statement
Variable Absorption
Fixed Fixed
Factory Factory
Overhead Overhead
Income Balance
Statement Sheet
Variable Absorption
Fixed Fixed
Factory Factory
Overhead Overhead
Income Balance
Statement Sheet

Income
Statement
Variable Absorption
Fixed Fixed
Factory Factory
Overhead Overhead
Income Balance
Statement Sheet
Year
End Income
Statement
Example: Fixed overhead is applied to units produced on the
basis of direct labor hours. The standard number of direct labor
hours allowed per unit produced is 0.5 hours. The company
budgets 1,500,000 in fixed overhead costs for the year and
budgets to produce 750,000 units.
Since 0.5 hours of direct labor are allowed per unit produced, the
standard number of direct labor hours allowed for the budgeted
number of units is 750,000 × 0.5, or 375,000 DLH. The fixed
overhead application rate is therefore 1,500,000 ÷ 375,000, or
4.00 per DLH.
The company actually produces 800,000 units, incurring 1,490,000
in actual fixed factory overhead. The amount of fixed overhead
applied to the units produced is 4.00 × (800,000 × 0.5), which
equals 1,600,000. Fixed factory overhead is over-applied by
110,000 (1,600,000 applied − 1,490,000 actual incurred cost).
Note that the fixed factory overhead incurred did not increase
because a greater number of units was produced than had
been planned. In fact, fixed overhead incurred was actually lower
than the budgeted amount. That can occur because fixed factory
overhead does not change in total because of changes in the
activity level, as long as the activity level remains within the
relevant range.
In contrast, variable factory overhead, which is applied to
production in the same way as fixed factory overhead, does
change in total because of changes in the activity level.
Effect of Changing Inventory Levels
When inventory increases (production >
sales), absorption provides a higher
net income.

When inventory decreases during the

period (production < sales), absorption
provides a lower net income.
2. Presentation
Classification of costs is different under the
two methods.
• Absorption breaks down costs as
manufacturing and nonmanufacturing.
• Variable breaks the costs down as
variable and fixed.
Absorption Costing Presentation
Sales revenue
− COGS (incl. variable and fixed mfg. costs)
= Gross margin
− Variable non-manufacturing costs (expensed)
− Fixed non-manufacturing costs (expensed)
= Income from operations
Variable Costing Presentation
Sales revenue
− Variable manufacturing costs
= Manufacturing contribution margin
− Variable non-manufacturing costs (expensed)
= Contribution margin
− All fixed manufacturing costs (expensed)
- All fixed non-manufacturing costs (expensed)
= Income from operations
Variable / Absorption Comparison
Though absorption costing is required by US GAAP,
variable costing is generally considered to be better for
decision making by management because:
• Fixed costs are usually not relevant in decision making.
• Operating income is influenced by the level of sales only
and not by changes in inventory levels.
• Variance analysis under absorption costing is difficult.
• The impact on income of fixed costs is visible under
variable costing.
• It is easier to calculate contribution for a division or
product when variable costing is used.