What you will learn to do: Distinguish between variable costing and full absorption costing

Operating income on the income statement is one of the most important results that a manufacturing company reports on its financial statements. External parties such as investors, creditors, and governmental agencies look to this amount to evaluate a company’s performance and how it affects them. Managers and others within a company use operating income as a measure for evaluating and improving operational performance.

There are two basic ways accountants present sales and expense data:

Variable costing – which is the method you’ve been studying in this module, and

Full absorption costing – which is the method financial accountants use

Full absorption costing (often simply called absorption costing) is required by generally accepted accounting principles (GAAP) for external reporting. All manufacturing costs, whether fixed or variable, must be treated as product costs and included in an inventory amount on the balance sheet (absorbed by inventory) until the product is sold. When the product is sold, its cost is then expensed as cost of goods sold on the income statement.

Here is a CVP analysis based on 2,900 units produced and sold:

Here is the same information using absorption costing:

Expenses are separated into two accounts: Cost of Goods Sold, which are product costs of the manufactured goods themselves, and Selling, General, and Administrative Expenses, which are general operating costs.

Each of these two expense accounts includes both variable and fixed costs. Cost of Goods Sold is made up of the three costs of manufacturing: direct materials and direct labor, which are variable, and factory overhead, which may be both variable and fixed. Likewise, Selling and Administrative (SGA) Expenses may include both variable and fixed costs.

Under both methods, direct costs (materials and labor) and variable factory overhead costs are applied to the cost of the product. The difference between the two costing methods is how the fixed factory overhead costs are treated. Under variable costing, fixed factory overhead costs are expensed in the period in which they are incurred, regardless of whether the product is sold yet. Under absorption costing, fixed factory overhead costs are expensed only when the product is sold.

In both of the above examples, we are assuming that the company produced and sold 2,900 books using a Just-in-Time inventory management system, and therefore operating income for both statements is $1,530.00.

However, as you will see in the following sections, because we allocate costs to units produced but not yet sold, under a full absorption costing system, operating income will not be equal to the CVP operating income unless we modify that model significantly. Remember, in managerial accounting, we don’t have to follow Generally Accepted Accounting Principles; instead, we create reports that help management plan, control, and direct both short and long-term operations, so if we wanted to come up with a more complicated CVP model, we could.

To recap, the variable costing income statement is different from the absorption costing income statement in several ways:

When you are done with this section, you will be able to:

• Distinguish between variable costing and full absorption costing
• Compare and contrast operating income using variable costing and full absorption costing

Learning Activities

The learning activities for this section include the following:

• Reading: Full Absorption Costing
• Self Check: Full Absorption Costing
• Reading: Variable v. Absorption Costing
• Self Check: Variable v. Absorption Costing