Absorption vs. Variable Costing
Product cost includes Direct Materials, direct labor and overhead. Period costs are selling, general and administrative costs.
Contribution Margin is Sales – Variable Costs.
Absorption Costing (or full costing):
- Typically used for financial reporting (GAAP)
- ALL manufacturing costs are included in the cost (direct materials, direct labor, fixed and variable overhead)
- Can be misleading as some costs are not affected by products
- Fixed manufacturing overhead costs are applied to units PRODUCED and not just unit sold
- Fixed manufacturing overhead per unit calculated as Fixed manufacturing costs divided by units PRODUCED.
- Cost of goods sold = units sold x absorption cost per unit (including direct materials, direct labor, fixed and variable overhead)
- ONLY includes product variable costs meaning costs that increase with volume (DM, DL & Variable OH)
- Does not include FIXED costs as volume levels do not change these costs (fixed costs treated as period costs not product costs)
- Can provide more accurate information for decision makers as costs are better tied to production levels
- Can be applied to ALL costs and not just product costs.
Comparing Absorption and Variable Cost per unit:
|Fixed Overhead||Include||DO NOT include|
|Total Product Costs||Sum||sum|
|÷ Total Units||÷ Total Units||÷ Total Units|
|Product Cost per Unit||= Cost per unit||= Cost per unit|
Note: Same formula can be applied for each product cost (Cost ÷ Units produced) to get direct material cost per unit, direct labor per unit, etc.
Income Statement Formats:
- Absorption Costing – this is your standard income statement showing Sales – Cost of Goods sold = Gross Margin (or Gross Profit) – Operating Expenses = Net Income and cost of goods sold is based on the number of units SOLD x absorption cost per unit.
- Variable Costing – this is a Contribution Margin Income Statement showing Sales – VARIABLE expenses = Contribution Margin – Fixed Expenses = Net Income and variable expenses are based on number of units sold x variable cost per unit.
- Net income on the two reports can be different if units produced do not equal units sold.
Click Absorption Variable Key Takeaway for a printable copy.