Explain the difference between variable and absorption costing.

How unit product cost is computed under

two methods?
Variable and absorption are two different costing methods. Almost all successful companies in the world
use both the methods. Variable costing and absorption costing cannot be substituted for one another
because both the systems have their own benefits and limitations.
These costing approaches are known by various names. For example, variable costing is also known as
direct costing or marginal costing and absorption costing is also known as full costing or traditional
costing.
The information provided by variable costing method is mostly used by internal management for decision
making purposes. Absorption costing provides information that is used by internal management as well as
by external parties like creditors, government agencies and auditors etc.

Computation of unit product cost under two methods:

Under absorption costing system, the product cost consists of all variable as well as all
fixed manufacturing costs i.e., direct materials, direct labor and factory overhead (FOH). But when
variable costing system is used, the fixed cost (both manufacturing and non-manufacturing) is treated as
a period or capacity cost and is, therefore, not included in the product cost.
Following exhibition summarizes the difference between variable costing and absorption costing:
Variable versus absorption costing

For further clarification of the concept, consider the following examples:

Example 1
A company manufactures and sells 5000 units of product X per year . Suppose one unit of product X
requires the following costs:
Direct materials: $5 per unit
Direct labor: $4 per unit
Variable manufacturing overhead: $1 per unit
Fixed manufacturing overhead: $20,000 per year
The unit product cost of the company is computed as follows:
Absorption Costing
$5
$4
$1
$4*
$14

Variable Costing
$5
$4
$1

$10

* $20,000 / 5,000
Notice that the fixed manufacturing overhead cost has not been included in the unit cost under variable
costing system but it has been included in the unit cost under absorption costing system. This is the
primary difference between variable and absorption costing.

Example 2
Sunshine company produces and sells only washing machines. The company uses variable costing for
internal reporting and absorption costing for external reporting. The data for the year 2010 is given
below:
Direct materials
Direct labor
variable manufacturing overhead
Fixed manufacturing overhead
Fixed marketing and administrative expenses
Variable marketing and administrative expenses

$150/unit
$45/unit
$25/unit
$160,000 per year
$110,000 per year
$15/unit sold

Company produced and sold 8,000 machines during the year 2010.
Required: Compute unite product cost under variable costing and absorption costing.

Solution
Materials
Labor
Variable overhead
Fixed overhead

Absorption Costing
$150
$45
$25
$20*
240
-

Variable Costing
$150
$45
$25

220
-

*$160,000 / 8,000 Units = $20

Note: Marketing and administrative expenses are period costs and are not relevant in the computation of
unit product cost.
Why variable costing and absorption costing produce different net operating income? How to reconcile
net operating income figures produced by these two costing approaches?
Variable costing and absorption costing usually produce different net operating income figures. The
reason is that the fixed manufacturing overhead cost is not treated the same way under two costing
methods. To understand how the difference in treatment of fixed manufacturing overhead cost changes
the net operating income figures of two costing systems, we need to prepare two income statements, one
under variable costing and one under absorption costing. For this purpose, consider the following
example:

Example
A company prepares variable costing income statement for the use of internal management and
absorption costing income statement for the use of external parties like creditors, banks, tax authorities
etc. The company manufactures a product that is sold for $80. The variable and fixed cost data is given
below:
Direct materials

$30.00

Direct labor

$19.00

Factory over head:

Variable cost

$6.00

Fixed cost ($45,000 / 9000 units)

$5.00

Marketing, general and administrative:

Variable cost (per unit sold)
Fixed cost (per month)

$4.00
$28,000

During June 9,000 units were produced and 7,500 units were sold. The opening inventory was 2,000
units.
Required:
1. Prepare two income statements, one using variable costing method and one using absorption costing
method.
2. Explain the difference in net operating income (if any) under two approaches.

Solution
(1)
Income Statement Absorption Costing
Sales (7,500 units $80)

$600,000

Cost of goods sold:

Beginning inventory (2000 units $60)

$120,000

Units manufactured this month (9,000 $60)

$540,00
-

Available for sale

$660,000

Ending inventory (3,500* $60)

$210,000
-

Cost of goods sold

$450,000
-

Gross profit

$150,000

Marketing, general and administration expenses:

Variable (7,500 units $4)

$30,000

Fixed

$28,000

$58,000

Net operating income

$92,000
-

*Computation of units in ending inventory:

Beginning inventory

2,000 units

Produced during the month

9,000 units

Units available for sale

11,000 units

Sold during the month

7,500 units

Ending inventory

3,500 units
-

Income Statement Variable Costing

Sales (7,500 $80)

$600,000

Variable cost of goods sold:

Beginning inventory (2000 units $55)

$110,000

Units manufactured this month (9,000 units $55)

$495,00
-

Available for sale

$605,000

Ending inventory (3,500 units $55)

$192,500
-

Variable cost of goods sold

$412,500
-

Gross contribution margin

$187,500

Variable marketing, general and administration expenses:

$30,000
-

Contribution margin
Less fixed costs:

$157,500

Net operating income

$45,000

Marketing, general and administration expenses

$28,000

$73,000

Net operating income

$84,500
-

(2) Reconciliation of net operating income:

Net operating income under variable costing

$84,500

Fixed manufacturing overhead cost deferred (1500 units $5)

$7,500

Net operating income under absorption costing

$92,000

Explanation of the difference in net operating income:

Notice that the net operating income under absorption costing is $7,500 ($92,000 $84,500) higher than
the net operating income under variable costing. This difference is because of fixed manufacturing
overhead that becomes the part of ending inventory under absorption costing system. The ending
inventory absorbs a portion of fixed manufacturing overhead and reduces the burden of the current
period. In this way a portion of fixed cost that relates to the current period is transferred to the next period.
Under variable costing, the fixed manufacturing overhead cost is not included in the product cost but
charged to the income statement of the relevant period in its entirety. Therefore no portion of fixed cost is
absorbed by the ending inventory.
In our example, the net operating income is higher under absorption costing than variable costing
because closing inventory is higher than the opening inventory.

Important points to remember:

1. The net operating income under absorption costing systems is always higher than variable costing
system when inventory increases.
2. The net operating income under variable costing systems is always higher than absorption costing
system when inventory decreases.
3. When inventory increases, the fixed manufacturing overhead cost is deferred to inventory.
4. When inventory decreases, the fixed manufacturing overhead cost is released from inventory.
Explain the impact of just in time (JIT) manufacturing and inventory control system on the variable and
absorption costing income statements of the companies.
A company using both variable and absorption costing usually finds a difference in net operating income
figures produced by the income statements prepared under these two costing methods. This difference
may be confusing especially for those who do not fully understand these two costing approaches.
Thedifference in the net operating income under variable and absorption costing can largely be reduced
by using a system called just in time (JIT) manufacturing and inventory control system. This system

encourages companies to eliminate all types of inventory (materials, work-in-process and finished goods).
When inventories are reduced, the difference in the net operating income figure is automatically reduced.
Adoption of just in time (JIT) does not change the computation of unit product cost but eliminates the
inventories. When inventories are eliminated, the difference in net operating income is automatically
eliminated because they are the root cause of the difference.

Example:
The following data relates to two manufacturing companies company A and company B. Company A
uses traditional manufacturing system and company B uses a strict just in time (JIT) manufacturing
system. Company B does not manufacture a unit unless an order is received for it.
Sales price per unit
Manufacturing expenses:
Direct materials
Labor
Factory overhead:
Variable
Fixed (A: 7,500/m B: $9,375/m )
Total manufacturing expenses
Opening inventory
Production
Available for sale
Closing inventory
Sales
Marketing and admin expenses:
Variable (per unit sold)
Fixed

Company A
$40

Company B
$60

$15
$5

$15
$10

$2
$3
$25
500 Units
2,500 Units

3,000 Units
300 Units

2,700 Units

$10
$5
$40
0
1875 Units

1875 Units
0

1,875 Units

$5
$5000

$8
$4,000

Now we will prepare income statements of both the companies under variable costing and absorption
costing methods and observe the impact of just in time (JIT) manufacturing system on the company Bs
net operating income figure.
Absorption costing:
Sales revenue
Less cost of goods sold (COGS):
Opening inventory
Cost of goods manufactured
Cost of goods available for sale
Closing inventory
Cost of goods sold (COGS)
Gross margin (sales COGS)
Less marketing and administration exp:

Company A
108,000
-

Company B
112,500
-

12,500
62,500
75,000
7,500
67,500
40,500
-

0
75,000
75,000
0
75,000
37,500
-

Variable
Fixed
Total marketing and administration exp.
Net operating income

13,500
5,000
18,500
22,000
-

15,000
4,000
19,000
18,500
-

Variable costing:
Sales revenue
Less variable cost of goods sold (VCOGS):
Opening inventory
Cost of goods manufactured
Cost of goods available for sale
Closing inventory
Variable cost of goods sold (VCOGS)
Gross contribution margin (Sales VCOGS)
Less variable marketing and admin. exp
Contribution margin
Less fixed expenses:
Manufacturing
Marketing and administration
Total fixed expenses
Net operating income

Company A
108,000
-

Company B
112,500
-

11000
55,000
66,000
6,600
59,400
48,600
13,500
35,100
-

0
65,625
65,625
0
65,625
46,875
15,000
31,875
-

7,500
5,000
12,500
22,600
-

9,375
4,000
13,375
18,500
-

Company As net operating income is different under two costing methods because it does not follow just
in time (JIT) system (maintains inventory).
Company Bs net operating income is same under both the costing methods because it follows just in
time (JIT) system (does not maintain inventory).
The change in inventory during the period is responsible for the difference in net operating income.
Company B does not maintain any inventory hence no change in inventory. When inventory does not
change the operating income remains same under variable costing and absorption costing.
In our example company Bs opening and closing inventory is zero, but in practice it may not always be
possible. Companies using just in time method may have some opening and closing inventories. The
concept of just in time is to maintain minimum inventory. When inventories are minimized, confusion of
operating income difference between variable and absorption costing is automatically minimized.

Important points to remember:

1. The change in inventory is the reason of difference in the net operating income figure under variable
costing and absorption costing.
2. The difference in the net operating income figure can be minimized or eliminated by adopting just in time
manufacturing system.

What are advantages and disadvantages of variable costing system?

Companies need absorption costing to prepare statements to satisfy external parties and variable costing
for better management. Both the costing methods have benefits and limitations. Following are the main
advantages and disadvantages of variable costing system:

Advantages
1. Variable costing provides a better understanding of the effect of fixed costs on the net profits because
total fixed cost for the period is shown on the income statement.
2. Various methods of controlling costs such as standard costing system and flexible budgets have close
relation with the variable costing system. Understanding variable costing system makes the use of those
methods easy.
3. Companies using variable costing system prepare income statement in contribution margin format that
provides necessary information for cost volume profit (CVP) analysis. This data cannot be directly
obtained from a traditional income statement prepared under absorption costing system.
4. The net operating income figure produced by variable costing is usually close to the flow of cash. It is
useful for businesses with a problem of cash flows.
5. Under absorption costing system, income of different periods changes with the change of inventory
levels. Sometime income and sales move in opposite directions. But it does not happen under variable
costing.

Disadvantages
1. Financial statements prepared under variable costing method do not conform to generally accepted
accounting principles (GAAP). The auditors may refuse to accept them.
2. Tax laws of various countries require the use of absorption costing.
3. Variable costing does not assign fixed cost to units of products. So the production costs cannot be truly
matched with revenues.
4. Absorption costing is usually the base for evaluating top executives efficiency.