Under absorption costing, the profit for a period is affected by changes in inventory

Absorption costing is a cost accounting method (required by US GAAP) in which a manufacturer must assign fixed manufacturing overhead costs to the goods it produces. Therefore, the goods that are in inventory as well as the goods that have been sold will have "absorbed" the fixed manufacturing overhead costs (as well as the costs of variable manufacturing overhead, direct labor, and direct materials).

Fixed manufacturing overhead costs are usually incurred in large amounts (depreciation, salaries of manufacturing supervisors, etc.) that are then assigned (allocated or applied) in small increments to all of the products manufactured. If more units are manufactured, the fixed manufacturing overhead cost per unit becomes smaller. When the units are sold, the gross profit per unit will be larger and the net income will be larger.

Example of Absorption Costing Causing an Increase in Net Income

Assume a company has no beginning inventory and it plans to manufacture 100,000 units. Also assume that its annual fixed manufacturing overhead costs are $600,000. If 100,000 units are manufactured, the fixed manufacturing overhead cost per unit will be $6 ($600,000 divided by 100,000 units). If the 100,000 units are sold for $20 each, the income statement will report sales revenues of $2,000,000 and its cost of goods sold will include $600,000 of fixed manufacturing overhead.

Now let's assume that the fixed manufacturing overhead costs remain at $600,000 but the company decides to manufacture 120,000 units (even though sales are expected to be only 100,000 units). In this situation, the fixed manufacturing overhead cost per unit will be applied at a rate of $5 per unit ($600,000/120,000 units manufactured). Since the sales remain at $2,000,000 (100,000 units X $20) but the cost of goods sold will include only $500,000 of fixed manufacturing overhead costs (100,000 units sold X $5), the gross profit will be $100,000 larger. The reason for the additional $100,000 in gross profit is that each of the additional 20,000 units in inventory have absorbed (been assigned) $5 of fixed manufacturing overhead costs.

Under absorption costing, the profit for a period is affected by changes in inventory

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Absorption costing and variable costing are methods used to value companies' work in progress and inventory, for accounting purposes. Absorption costing includes all the costs associated with the manufacturing of a product. Variable costing includes the variable costs directly incurred in production and none of the fixed costs. For reporting purposes, absorption costing is required under the Financial Accounting Standards Board’s Generally Accepted Accounting Principles (GAAP).

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.

  • Absorption costing includes all of the direct costs associated with manufacturing a product.
  • Variable costing can exclude some direct fixed costs.
  • Absorption costing entails allocating fixed overhead costs to all units produced for an accounting period.
  • Variable costing includes all of the variable direct costs in COGS but excludes direct, fixed overhead costs.
  • Variable costing can provide a clearer picture of per-unit cost and inventory value because it excludes the fixed overhead cost.

Before looking at absorption versus variable costing, it's important to understand the difference between direct and indirect costs on the income statement. Direct costs are usually associated with COGS, which affects a company’s gross profit and gross profit margin. Indirect costs are associated with the operating expenses of a company. These costs heavily influence operating profit and the operating profit margin.

Some of the direct costs associated with manufacturing a product include wages for workers physically manufacturing a product, the raw materials used in producing a product, and direct overhead costs involved in manufacturing a product.

Indirect expenses are not directly associated with manufacturing. These can include:

  • Research and development
  • Some depreciation
  • Amortization of intangibles
  • Selling expenses
  • Marketing expenses
  • Administrative expenses
  • Other expenses

Absorption costing is also known as full costing. Public companies are required to use the absorption costing method in cost accounting management for their COGS. Many private companies also use this method because it is GAAP-compliant whereas variable costing isn't.

Absorption costing involves allocating all of the direct costs associated with manufacturing a product to COGS. This includes any variable costs directly associated with manufacturing, such as:

  • Cost of raw materials
  • Hourly cost of labor
  • Salaries of manufacturing workers
  • Variable costs of electricity used to run a plant in manufacturing mode

This also includes any direct fixed costs, such as:

  • The mortgage payment on a building used for manufacturing
  • Insurance on a manufacturing property
  • Depreciation on a manufacturing machine

Depending on a company’s level of transparency, an income statement using absorption costing may break out variable direct costs and fixed direct costs into two line items or combine them together to report a comprehensive COGS. In any case, the variable direct costs and fixed direct costs are subtracted from revenue to arrive at the gross profit.

Using the absorption costing method will increase COGS and thus decrease gross profit per unit produced. This means companies will have a higher breakeven price on production per unit. It also means that customers will pay a slightly higher retail price. Furthermore, it means that companies will likely show a lower gross profit margin.

The impact of absorption costing will depend on the business. For example, a company has to pay its manufacturing property mortgage payments every month regardless of whether it produces 1,000 products or no products at all. A company may see an increase in gross profit after paying off a mortgage or finishing the depreciation schedule on a piece of manufacturing equipment. These are considerations cost accountants must closely manage when using absorption costing.

The absorption costing method is typically the standard for most companies with COGS. It is required for compliance with GAAP. Auditors and financial stakeholders will require it for external reporting. Depending on the type of business structure, small businesses may also be required to use absorption costing for their tax reporting. 

A main advantage of absorption costing is that it is GAAP-compliant. That means that's the only method needed if it's what a company prefers to use. If a company prefers the variable costing method for management decision-making purposes, it may also be required to use the absorption costing method for reporting purposes.

Some companies may choose to use the variable costing method. With variable costing, all of the variable direct costs are included in COGS. The fixed direct costs are allocated to operating expenses rather than COGS. The types of fixed direct costs are the same whether a company uses absorption or variable costing:

  • A mortgage payment on a building used for manufacturing
  • Insurance on a manufacturing property
  • Depreciation on a manufacturing machine

Variable costing will result in a lower breakeven price per unit using COGS. This can make it somewhat more difficult to determine the ideal pricing for a product. Variable costing results in gross profit that will be slightly higher. In turn, that results in a slightly higher gross profit margin compared to absorption costing.

Keep in mind, companies using the cash method may not need to recognize some of their expenses as immediately with variable costing since they are not tied to revenue recognition. This can be an advantage.

The reason variable costing isn't allowed for external reporting is because it doesn't follow the GAAP matching principle. It fails to recognize certain inventory costs in the same period in which revenue is generated by the expenses, like fixed overhead.

Both costing methods can be used by management to make manufacturing decisions. For internal accounting purposes, both can also be used to value work in progress and finished inventory. The overall difference between absorption costing and variable costing concerns how each accounts for fixed manufacturing overhead costs.

Here's a summary of their differences.

  Absorption Costing  Variable Costing
Method Applies all direct costs, fixed overhead, and variable manufacturing overhead to the cost of a product Only variable costs are applied to the cost of a product; fixed overhead costs are expensed in the period in which they occur
Use Calculates a per-unit cost of fixed overhead Determines a lump-sum for fixed overhead costs
Inventory Inventory value includes direct material, direct labor, and all overhead Inventory value does not include fixed overhead
Accounting Can cloud picture of company profitability for an accounting period because all fixed costs are not deducted from revenues (unless all inventory is sold) Doesn't match expenses to revenue (with regard to inventory) in the same accounting period; may result in a more realistic inventory value and actual profit since unsold stock doesn't absorb fixed overhead costs
Reporting Acceptable costing method under GAAP Not an acceptable costing method under GAAP

Let's say that ABC company manufactures and sells 20,000 units of its product yearly. A single product includes these costs:

  • Direct materials: $3 per unit
  • Direct labor: $5 per unit
  • Variable manufacturing overhead: $2 per unit
  • Fixed manufacturing overhead: $35,000 per year, which computes to a $1.75 per unit cost ($35,000/20,000 annual units)

Under the absorption costing method, the per unit cost of product would be:

$3 + $5 + $2 + $1.75 = $11.75

Under the variable costing method, the per unit cost of product would be:

$3 + $5 + $2 = $10

It can be, especially for management decision-making concerning break-even analysis to derive the number of product units needed to be sold to reach profitability.

Unlike absorption costing, variable costing doesn't add fixed overhead costs into the price of a product and therefore can give a clearer picture of costs. By assigning these fixed costs to cost of production as absorption costing does, they're hidden in inventory and don't appear on the income statement.

While it's a valuable management tool, it isn't GAAP-compliant and can't be used for external reporting by public companies. Therefore, if a company uses variable costing, it may also have to use absorption costing (which is GAAP-compliant).

Most companies will use the absorption costing method if they have COGS. What's more, for external reporting purposes, it may be required because it's the only method that complies with GAAP. Companies may decide that absorption costing alone is more efficient to use.

Depending on a company’s business model and reporting requirements, it may be beneficial to use the variable costing method, or at least calculate it in dashboard reporting. Managers should be aware that both absorption costing and variable costing are options when reviewing their company’s COGS cost accounting process.

If a company has high direct, fixed overhead costs it can make a big impact on the per unit price. Companies that use variable costing may be able to allocate high monthly direct, fixed costs to operating expenses. This could result in a more reasonable per unit price in some cases. However, most companies may need to transition to absorption costing at some point, which can be important to factor into short-term and long-term decision making.