Lesson 39 - Intermediate Accounting Course 

39. Absorption Costing vs. Variable Costing

Understanding absorption costing and variable costing is crucial for businesses when calculating product costs, setting prices, and analyzing profitability. These two costing methods allocate costs differently, leading to variations in net income, financial statements, and decision-making.

1️⃣ What Are Absorption Costing and Variable Costing?

✔ Absorption Costing (Full Costing) → Allocates all manufacturing costs (fixed & variable) to the cost of goods sold (COGS).
✔ Variable Costing (Direct Costing) → Allocates only variable manufacturing costs to products; fixed costs are treated as period expenses.

📌 Key Difference:

• Absorption costing includes fixed manufacturing overhead in inventory costs.
  
  

• Variable costing treats fixed manufacturing overhead as an expense in the period incurred.
  
  

2️⃣ Breakdown of Cost Components 

📌 Key Takeaway:

• Under absorption costing, fixed overhead costs are allocated to inventory and only expensed when goods are sold.
  
  

• Under variable costing, fixed overhead costs are expensed immediately, reducing profits in the current period.

3️⃣ Example: How Absorption and Variable Costing Affect Net Income

Scenario:

A company produces 1,000 units in a year but only sells 800 units. Each unit has:

• Direct Materials = $5
  
  

• Direct Labor = $3
  
  

• Variable Overhead = $2
  
  

• Fixed Overhead (Total for Year) = $10,000
  
  

• Selling Price per Unit = $20
  
  

Step 1: Cost Per Unit Calculation

🔹 Absorption Costing:

Total Fixed Overhead is allocated across all units produced:

🔹 Variable Costing:

Fixed Overhead is not included in unit cost:

Step 2: Income Statement Comparison 

📌 Key Takeaways:

• Absorption Costing → Net income is higher when not all units are sold because fixed costs are assigned to unsold inventory.
  
  

• Variable Costing → Net income is lower because all fixed costs are expensed in the period, even if some units remain unsold.

4️⃣ Advantages & Disadvantages of Each Method

✔ Advantages of Absorption Costing:

✅ Required by GAAP & IFRS → Financial reporting compliance.
✅ Higher profits when inventory increases → Fixed costs remain in inventory until sold.
✅ Better representation of total cost per unit → Useful for pricing decisions.

❌ Disadvantages of Absorption Costing:

❌ Can manipulate earnings → Companies can produce more to defer fixed costs.
❌ Not useful for decision-making → Doesn't clearly show cost behavior.

✔ Advantages of Variable Costing:

✅ Better for decision-making → Helps in CVP (Cost-Volume-Profit) analysis.
✅ Shows true profitability → No distortion from inventory changes.
✅ Encourages efficient production → No incentive to overproduce.

❌ Disadvantages of Variable Costing:

❌ Not accepted for external reporting → Only used for internal analysis.
❌ Lower net income when inventory increases → Fixed costs are fully expensed each period.

5️⃣ Key Uses of Absorption vs. Variable Costing 

6️⃣ Final Thoughts

✔ Absorption costing is required for financial reporting and tax purposes, but it can distort profitability when inventory levels change.
✔ Variable costing is more useful for managerial decision-making because it clearly shows cost behavior.
✔ Managers should use both methods depending on the purpose—absorption costing for external reports and variable costing for internal decision-making.