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Overview of Absorption
and Variable Costing
Exhibit 8-1

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 Quick Check 

Which method will produce the highest

values for work in process and finished
goods inventories?
a. Absorption costing.
b. Variable costing.
c. They produce the same values for these
inventories.
d. It depends. . .

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 Quick Check 

Which method will produce the highest

values for work in process and finished
goods inventories?
Answer:
a. Absorption costing.

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 Unit Cost Computations Part 1
Harvey Company produces a single product with the
following information available:

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 Effect of Changes in Production
on Operating Income
• Units sold in year 1 are: 20,000 units

• Units sold in year 2 are: 30,000 units

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Effect of Changes in Production
Harvey Company Year One

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Unit Cost Computations for Year
One
Unit product cost is determined as follows:

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Absorption Costing: Year One
Unit product
cost.

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Variable Costing: Year One

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Effect of Changes in Production:
Harvey Company Year Two

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Unit Cost Computations for Year
Two
Unit product cost is determined as follows:

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Absorption Costing: Year Two

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Variable Costing: Year Two
Variable
manufacturing
costs only.

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 Comparing the Two Methods

Conclusion:
• Net operating income is not affected by changes in
production using variable costing.
• Net operating income is affected by changes in
production using absorption costing even though the
number of units sold is the same each year.

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Explaining Changes in Operating
Income

• Variable costing income is only affected by changes

in unit sales. It is not affected by the number of units
produced. As a general rule, when sales go up, net
operating income goes up, and vice versa.
• Absorption costing income is influenced by changes
in unit sales and units of production. Net operating
income can be increased simply by producing more
units even if those units are not sold.

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 Unit Cost Computations Part 1
Harvey Company produces a single product with the
following information available:

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 Unit Cost Computations Part 2
Unit product cost is determined as follows:

Under absorption costing, selling and administrative expenses

are always treated as period expenses and deducted from
revenue as incurred.
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Variable Costing vs Absorption
Costing

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 Income Comparison of
Absorption and Variable Costing
• Let’s assume the following additional information for
Harvey Company:
• 20,000 units were sold during the year at a price of
$30 each.
• There were no units in beginning inventory.

Now, let’s compute net operating income using both

absorption and variable costing.

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 Absorption Costing
Unit product
cost.

Fixed manufacturing overhead deferred in inventory is

5,000 units × $6 = $30,000.
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Variable Costing

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Comparing the Two Methods

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Reconcile Variable Costing and
Absorption Costing
We can reconcile the difference between
absorption and variable income as follows:

Fixed mfg. Overhead $150,000

= = $6.00 per unit
Units produced 25,000 units

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Extended Comparison of Income Data:
Harvey Company Year Two

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 Unit Cost Computations

Since there was no change in the variable costs

per unit, total fixed costs, or the number of
units produced, the unit costs remain unchanged.

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Absorption Costing

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Variable Costing
Variable
manufacturing
costs only.

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Comparing the Two Methods 1
We can reconcile the difference between
absorption and variable income as follows:

Fixed mfg. Overhead $150,000

= = $6.00 per unit
Units produced 25,000 units

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Comparing the Two Methods 2

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COMPARATIVE INCOME EFFECTS OF ABSORPTION AND VARIABLE COSTING
Relationship between
Relationship between Absorption and Variable
Production and Sales Costing Operating
for the Period Effect on Inventories Incomes
Production = Sales No change in inventories Absorption costing operating
income = Variable costing
operating income
Production > Sales Inventories increase Absorption costing operating
income > Variable costing
operating income*
Production < Sales Inventories decrease Absorption costing operating
income < Variable costing
operating income†
*Operating income is higher under absorption costing, since fixed manufacturing overhead
cost is deferred in inventory under absorption costing as inventories increase.
†Operating income is lower under absorption costing, since fixed manufacturing overhead
cost is released from inventory under absorption costing as inventories decrease.

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Choosing A Costing Method: Impact
on the Manager
• Opponents of absorption costing argue that
shifting fixed manufacturing overhead costs
between periods can lead to faulty decisions.
• These opponents argue that variable costing income
statements are easier to understand because net
operating income is only affected by changes in unit
sales. This produces net operating income figures that
are more consistent with managers’ expectations.

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 CVP Analysis and Absorption
Costing and Decision Making
• Absorption costing treats fixed manufacturing
overhead as a variable cost by assigning a per unit
amount of the fixed overhead to each unit of
production.
• Treating fixed manufacturing overhead as a
variable cost can:
• Lead to faulty pricing decisions and keep-or drop
decisions.
• Produce positive net operating income even when the
number of units sold is less than the breakeven point.

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 External Reporting and Income
Taxes
• Absorption costing is required for external reports in the
United States and is the predominant method used in
Canada. For income tax purposes in Canada, the Canada
Revenue Agency permits both variable and absorption
costing for determining taxable income.
• Since top executives are usually evaluated based on
external reports to shareholders, they may feel that day to
day decisions should be based on absorption cost income.

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 Advantages of Variable Costing
and the Contribution Approach
• Consistent with CVP analysis.
• Profit is not affected by changes in inventories.
• Management finds it more useful.
• Impact of fixed costs on profits emphasized.
• Easier to estimate profitability of products and
segments.
• Consistent with standard costs and flexible budgeting.
• Net operating income is closer to net cash flow.

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Variable versus Absorption Costing

• Absorption Costing  Fixed manufacturing

costs must be assigned to products to
properly match revenues and costs.
• Variable Costing  Fixed manufacturing
costs are capacity costs and will be incurred
even if nothing is produced.

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 Impact of Lean Production

• In a lean production (JIT) inventory system,

productions tends to be equal to sales.
• So, the difference between variable and
absorption income tends to disappear.

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