Learning Outcomes
- Compare and contrast operating income using variable costing and full absorption costing
If more units are manufactured than are sold, there will be more units in ending inventory than there were in beginning inventory, so some of the costs “absorbed” by the manufacturing process will be trapped in ending inventory. Let’s assume the company sold 2,900 units but manufactured 3,400, leaving 500 in ending inventory.
Sales will remain the same: 2,900 books sold at $10.00 each = $29,000. We’ll also assume that raw materials inventory and work-in-process inventory beginning inventory was equal to ending inventory in order to eliminate those early layers of the process that absorb costs and therefore affect ending inventory costs.
| Financial Categories | Raw Materials Costs | Work-in-Progress Costs | Finished Goods/Overhead Costs | Financial Totals |
|---|---|---|---|---|
| Sales | $ 29,000.00 | |||
| Subcategory, Cost of Goods Sold | ||||
| Beginning raw materials | $600.00 | |||
| Raw materials purchased | 20,270.00 | |||
| Ending raw materials | (470.00) | |||
| Raw materials transferred to WIP | Single Line | $ 20,400.00 | (VC) | |
| Beginning WIP | – | |||
| Direct Labor | 6,800.00 | (VC) | ||
| Manufacturing overhead | 1,200.00 | (FC) | ||
| Ending WIP | – | |||
| WIP transferred to finished goods | Single Line | $ 28,400.00 | ||
| Beginning finished goods | – | |||
| Goods available for sale | Single Line28,400.00 | |||
| Ending finished goods | (4,175.00) | |||
| Cost of Goods Sold | $ 24,225.00 | |||
| Gross Profit | Single Line4,775.00 | |||
| Subcategory, Selling, general, and administrative costs | ||||
| Sales Salaries | $ 2,000.00 | (FC) | ||
| Commissions | 870.00 | (VC) | ||
| Internet expenses | 200.00 | (FC) | ||
| Total selling, general, and administrative costs | Single Line | 3,070.00 | ||
| Operating income | Single Line1,705.00 | |||
| Provision for income taxes | 21% | 358.05 | ||
| Single Line$ 1,346.95Double line | ||||
| Per unit cost, full absorption | $ 8.35Double line | |||
In this case, we produced 500 units that were not sold, so two things happened:
- The unit cost of the items manufactured went down a bit, because the fixed product costs were allocated over more units.
- 500 units remained in ending inventory, capturing some of the overall costs on the company’s balance sheet. Those costs will be shown as an expense during the period in which those books are sold (presumably in August).
We could perform a CVP analysis based on 3,400 units instead of 2,900, but the bottom line still won’t be the same as the full absorption statement because our CVP analysis assumes production and sales are the same:
| Units | $/Unit | Total | |
|---|---|---|---|
| Sales | 3,400 | $ 10.00 | $ 34,000.00 |
| Variable costs | 3,400 | $ 8.30 | 28,220.00 |
| Contribution Margin | $ 1.70 | Single Line5,780.00 | |
| Fixed costs | 3,400.00 | ||
| Operating income | Single Line$ 2,380.00Double line | ||
| CM ratio | 17.00% |
The point of this analysis is to illustrate that under absorption costing, operating income changes based on increases or decreases in inventory due to producing more or fewer units than were sold in a period, and managers need to be aware of this. Each type of statement has its place:
Financial accounting requires full absorption accounting
Managerial accounting often uses the contribution margin approach
Remember that financial accounting is after-the-fact, reporting historical results for outside users, and managerial accounting is used by internal decision-makers to plan, direct, and control operations, so the two kinds of costing methods are driven by the needs of the users.
A final difference between the two kinds of costing methods is with income statements. This module’s introduction discussed those income statement distinctions, but let’s review those differences one more time:
| Managerial Accounting | Financial Accounting |
| variable costing | full absorption costing |
| Sales | Sales |
| Less: Variable product costs and variable SGA | Less: Cost of Goods sold that include fixed MOH |
| = Contribution margin | = Gross Profit |
| Less: Fixed MOH and Fixed SGA | Less: SGA |
| = Operating Income | = Operating Income |
To bring this all together, here is a comprehensive comparison of the two systems:
You can view the transcript for “Absorption Costing vs. Variable Costing” here (opens in new window).
Now check your understanding of the effect of full absorption costing on the bottom line.
