In comparing the two income statements for Bradley, we notice that the cost of goods sold under absorption is $3.90 per unit and $3.30 per unit under variable costing.  The income reported under each statement is off by $600 because of this difference ($8,100 under absorption and $7,500 under variable).  Let’s review how these costs were calculated:

Since fixed overhead cost is given to each unit produced under the absorption costing method, the 1,000 units remaining in inventory carry forward some of May’s fixed costs into the next period.  The variable costing method treats the fixed overhead as relating to May only and not to any specific units.  Ending inventory would be calculated as:

These differences are due to the treatment of fixed manufacturing costs. Under absorption costing, each unit in ending inventory carries $0.60 of fixed overhead cost as part of product cost. At the end of the month, Bradley has 1,000 units in inventory. Therefore, ending inventory under absorption costing includes $600 of fixed manufacturing overhead costs ($0.60 X 1,000 units) and is valued at $600 more than under variable costing.

Under variable costing, companies charge off, or expense, all the fixed manufacturing costs during the period rather than deferring their expense and carrying them forward to the next period as part of inventory cost. Therefore, $6,000 of fixed manufacturing costs appear on the variable costing income statement as an expense, rather than $5,400 ($6,000 fixed overhead costs – $600 fixed manufacturing included in inventory) under absorption costing. Consequently, income before income taxes under variable costing is $600 less than under absorption costing because more costs are expensed during the period.

Finally, remember that the difference between the absorption costing and variable costing methods is solely in the treatment of fixed manufacturing overhead costs and income statement presentation. Both methods treat selling and administrative expenses as period costs. Regarding selling and administrative expenses, the only difference is their placement on the income statement and the segregation of variable and fixed selling and administrative expenses. Variable selling and administrative expenses are not part of product cost under either method.

As a general rule, relate the difference in net income under absorption costing and variable costing to the change in inventories. Assuming a relatively constant level of production, if inventories increase during the year, production exceeded sales and reported income before federal income taxes is less under variable costing than under absorption costing. Conversely, if inventories decreased, then sales exceeded production, and income before income taxes is larger under variable costing than under absorption costing.

Variable costing is not currently acceptable for income measurement or inventory valuation in external financial statements that must comply with generally accepted accounting principles (GAAP) in the United States. However, managers often use variable costing for internal company reports.  Here is a video comparing the two methods:

SUMMARY

1.  Product costs are calculated differently under each method:

2.  Income statement formats are different under each method (both use units sold for variable expenses):

• Absorption uses standard GAAP income statement of Sales – Cost of Goods Sold = Gross Profit – Operating Expenses = Net Operating Income
• Variable uses a contribution margin income statement of Sales – Variable Costs = Contribution Margin – Fixed Expenses = Net Operating Income

3.   Net income on the two reports can be different if units produced do not equal units sold.