Variable and absorption costing

How much does a Classic chair cost? Lesson 2 gave two answers: $102 of variable manufacturing cost, or $132 if fixed manufacturing overhead is included at the normal volume. The choice is not academic. It determines the value of inventory on the balance sheet and, whenever production and sales differ, the operating income reported for the period. Absorption costing (also called full costing) treats all manufacturing costs, variable and fixed, as product costs. Variable costing (also called direct or marginal costing) treats only variable manufacturing costs as product costs and expenses fixed manufacturing overhead in the period incurred. This lesson compares the two, reconciles their incomes, explains why external reporting requires absorption costing, and shows how absorption costing can tempt managers to build inventory to raise reported profit.

The one difference: fixed manufacturing overhead

The two methods agree about every cost except one. Direct materials, direct labour and variable overhead are product costs under both. Selling and administrative costs, whether variable or fixed, are period costs under both. The only disagreement is fixed manufacturing overhead. Absorption costing attaches it to units and holds it in inventory until the units are sold. Variable costing treats it as a cost of having the capacity to produce in the period, like rent on a building, and expenses all of it immediately.

# Classic chair: unit product cost under each method (illustrative)
dm, dl, voh = 60, 30, 12
fixed_moh, normal_volume = 216_000, 7_200

variable_unit = dm + dl + voh
fixed_per_unit = fixed_moh / normal_volume
absorption_unit = variable_unit + fixed_per_unit
print(f"Variable costing unit cost:   ${variable_unit}")
print(f"Fixed overhead per unit:      ${fixed_per_unit:.0f}  (at {normal_volume:,} chairs)")
print(f"Absorption costing unit cost: ${absorption_unit:.0f}")

Variable costing unit cost:   $102
Fixed overhead per unit:      $30  (at 7,200 chairs)
Absorption costing unit cost: $132

Income statements when production exceeds sales

In its first year of operating the chair line at its present scale, Cedar Ridge makes 7,200 chairs (its normal volume) but sells 7,000, so 200 chairs go into finished goods inventory. There is no beginning inventory. The selling price is $180, variable selling cost is $6 per chair, fixed manufacturing overhead is $216,000 and fixed selling and administrative cost is $144,000. The two methods give different incomes.

Absorption costing reports $6,000 more income. The reason is visible in the inventory: the 200 unsold chairs carry $30 each of fixed overhead, $6,000 in total, on the balance sheet under absorption costing. Under variable costing that $6,000 was expensed this year. Ending inventory is $26,400 (200 × $132) under absorption costing and $20,400 (200 × $102) under variable costing.

Reconciling the two incomes

The difference between the two incomes always equals the change in the fixed overhead held in inventory. When inventory rises, absorption income is higher, because some of this period's fixed overhead is deferred to future periods. When inventory falls, absorption income is lower, because fixed overhead from earlier periods is released into cost of goods sold. When production equals sales, the two incomes are equal (assuming the fixed overhead rate per unit does not change).

# Three years of chair results under both methods (illustrative)
price, v_mfg, v_sell = 180, 102, 6
fixed_moh, fixed_sa, normal = 216_000, 144_000, 7_200
rate = fixed_moh / normal                     # $30 per chair
years = [(7_200, 7_000), (6_800, 7_000), (7_000, 7_000)]   # (produced, sold)

inv = 0
for y, (made, sold) in enumerate(years, 1):
    sales = sold * price
    var_income = sales - sold * (v_mfg + v_sell) - fixed_moh - fixed_sa
    volume_variance = (normal - made) * rate  # unabsorbed fixed overhead, to COGS
    cogs = sold * (v_mfg + rate) + volume_variance
    abs_income = sales - cogs - sold * v_sell - fixed_sa
    beg, inv = inv, inv + made - sold
    print(f"Year {y}: made {made:,}, sold {sold:,}, ending inventory {inv:>3}  "
          f"variable ${var_income:,.0f}  absorption ${abs_income:,.0f}  "
          f"difference ${abs_income - var_income:+,.0f} = {inv - beg:+} x ${rate:.0f}")

Year 1: made 7,200, sold 7,000, ending inventory 200  variable $144,000  absorption $150,000  difference $+6,000 = +200 x $30
Year 2: made 6,800, sold 7,000, ending inventory   0  variable $144,000  absorption $138,000  difference $-6,000 = -200 x $30
Year 3: made 7,000, sold 7,000, ending inventory   0  variable $144,000  absorption $144,000  difference $+0 = +0 x $30

Over the three years total production equals total sales (21,000 chairs), so total income is the same under both methods: $432,000. Absorption costing simply moves $6,000 of income from year 2 to year 1 by deferring fixed overhead in inventory. In year 2, Cedar Ridge makes only 6,800 chairs, below its normal volume of 7,200. The 400 chairs of unused capacity leave $12,000 of fixed overhead unabsorbed, which is charged to cost of goods sold as an unfavourable production volume variance (lesson 11 explains volume variances). That treatment follows the financial reporting rule, discussed below, that inventory should not absorb the cost of idle capacity.

Why the difference matters: incentives

Under variable costing, operating income moves with sales: if sales are flat, income is flat. Under absorption costing, income also responds to production. A manager whose bonus depends on absorption income can raise this year's profit simply by producing more than can be sold, deferring fixed overhead into inventory. The inventory then ties up cash, takes up warehouse space, risks obsolescence and damage, and eventually drags down income in a later year when it is sold or written down. This is one reason lean thinking (BUS-230 lesson 11) regards excess inventory as waste.

Companies limit the problem in several ways: evaluating managers on variable costing or contribution margin reports, setting targets for inventory levels or inventory turnover, charging a capital cost for inventory held (lesson 12 introduces residual income), and using multi-year rather than single-year bonus measures. Ethically, deliberately building unneeded inventory to manipulate reported results conflicts with the integrity standards discussed in lesson 1.

External reporting and tax

For external reporting, both IFRS (IAS 2 Inventories) and ASPE (Section 3031) require absorption costing: the cost of inventory includes a systematic allocation of fixed production overhead. The allocation is based on the normal capacity of the production facilities. In a period of abnormally low production, the fixed overhead per unit is not increased, and unallocated overhead is expensed as incurred, exactly as the year 2 calculation does. In periods of abnormally high production, the fixed overhead per unit is reduced so that inventory is not measured above cost. Variable costing is therefore an internal tool. For income tax, the Canada Revenue Agency generally expects inventory to be valued using a method that is consistent with the business's accounting and that reflects full cost.

Arguments for each method

Supporters of variable costing argue that fixed manufacturing overhead is a cost of capacity, not of units: the factory lease is the same whether Cedar Ridge makes 6,800 or 7,200 chairs, so charging it to units is an arbitrary allocation that obscures cost behaviour. Variable costing reports fit CVP analysis directly, make income follow sales, remove the incentive to overproduce, and are easier for non-accountants to understand.

Supporters of absorption costing argue that production is impossible without capacity, so fixed overhead is as much a cost of making a chair as the hardwood. They point out that over the long run prices must cover all costs, and that pricing from variable costs alone can lead to selling below full cost. Absorption costing also matches costs with revenues when inventory is built ahead of seasonal sales, and it is required externally, so using it internally avoids keeping two sets of numbers. In practice many companies keep their ledger on an absorption basis and produce contribution margin reports for internal use, which modern accounting systems make easy.

A third approach, throughput costing (also called super-variable costing), treats only direct materials as product costs and expenses all conversion costs. Its supporters argue that in the short run labour and overhead are largely fixed, and that throughput costing removes almost all incentive to build inventory. It is associated with the theory of constraints and is mainly an internal tool.

# Inventory value of 200 unsold chairs under three methods (illustrative)
unsold = 200
unit_costs = {"Absorption": 60 + 30 + 12 + 30,
              "Variable": 60 + 30 + 12,
              "Throughput": 60}
for method, cost in unit_costs.items():
    print(f"{method:<11} ${cost:>4} per chair   inventory ${unsold * cost:>7,}")

Absorption  $ 132 per chair   inventory $ 26,400
Variable    $ 102 per chair   inventory $ 20,400
Throughput  $  60 per chair   inventory $ 12,000

Segment reporting with variable costing

Variable costing extends naturally to segment reports, which show each product line's or division's contribution margin, then subtract the fixed costs traceable to that segment to give its segment margin, before common fixed costs that no single segment causes. Lesson 9 uses segment margins to decide whether to drop a product line, and lesson 12 uses them to evaluate managers. The key rule is not to allocate common fixed costs to segments when judging whether a segment is worth keeping, because those costs would remain even if the segment were dropped.