When inventories are increasing will absorption income be higher or lower than variable income?

Absorption costing is a costing method in which all costs attributed to the production of a product are estimated. This costing method entails a full estimation of total expenses incurred in manufacturing a product.

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Absorption Costing vs. Variable Costing
Impact of Absorption Costing and Variable Costing on Profit
Advantages of Using Variable Costing
Advantages of Absorption Costing
Disadvantages of Absorption Costing
(2). Explanation of the difference in net operating income:
Important points to remember:

Direct costs such as costs of procuring raw materials, labor wages and indirect costs such as costs of acquiring a facility, utility costs and others are calculated in absorption costing. The absorption costing method accumulates all costs of a finished product including overhead costs and direct costs.

Under U.S. GAAP, all non-manufacturing costs (selling and administrative costs) are treated as period costs because they are expensed on the income statement in the period in which they are incurred.

Although absorption costing is used for external reporting, managers often prefer to use an alternative costing approach for internal reporting purposes called variable costing.

Variable costing requires that all variable production costs be included in inventory, and all fixed production costs (fixed manufacturing overhead) be reported as period costs.

Thus all fixed production costs are expensed as incurred.

The only difference between absorption costing and variable costing is in the treatment of fixed manufacturing overhead.

Using absorption costing, fixed manufacturing overhead is reported as a product cost.

Using variable costing, fixed manufacturing overhead is reported as a period cost.

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Absorption Costing vs. Variable Costing

Absorption costing and variable costing are two distinct methods of assigning costs to the production of goods and services.

The difference between absorption costing and variable costing is in the treatment of fixed manufacturing overhead costs.

Absorption costing treats fixed manufacturing overhead as a product cost (included in inventory on the balance sheet until sold), while variable costing treats fixed manufacturing overhead as a period cost (expensed on the income statement as incurred).

When comparing absorption costing with variable costing, the following three rules apply:

(1) When units produced equals units sold, profit is the same for both costing approaches.

(2) When units produced is greater than units sold, absorption costing yields the highest profit.

(3) When units produced is less than units sold, variable costing yields the highest profit.

Impact of Absorption Costing and Variable Costing on Profit

If a company uses just-in-time inventory, and therefore has no beginning or ending inventory, profit will be exactly the same regardless of the costing approach used.

However, most companies have units of product in inventory at the end of the reporting period.

Since absorption costing includes fixed manufacturing overhead as a product cost, all products that remain in ending inventory (i.e., are unsold at the end of the period) include a portion of fixed manufacturing overhead costs as an asset on the balance sheet.

Since variable costing treats fixed manufacturing overhead costs as period costs, all fixed manufacturing overhead costs are expensed on the income statement when incurred.

Thus if the quantity of units produced exceeds the quantity of units sold, absorption costing will result in higher profit.

Advantages of Using Variable Costing

Variable costing provides managers with the information necessary to prepare a contribution margin income statement, which leads to more effective cost-volume-profit (CVP) analysis.

By separating variable and fixed costs, managers are able to determine contribution margin ratios, break-even points, and target profit points, and to perform sensitivity analysis.

Conversely, absorption costing meets the requirements of U.S. GAAP, but is not as useful for internal decision-making purposes.

Another advantage of using variable costing internally is that it prevents managers from increasing production solely for the purpose of inflating profit.

However, in the short run, the manager will increase profit by increasing production.

This strategy does not work with variable costing because all fixed manufacturing overhead costs are expensed as incurred, regardless of the level of sales.

Advantages of Absorption Costing

The use of the absorption costing method comes with a lot of benefits. The major benefits of this costing method include;

Absorption costing method reflects fixed costs that are attributable to the production of goods and services. It identifies the necessity of fixed costs when estimating costs involved in production.
It is a more accurate costing method when compared to other traditional costing methods and even its counterpart; variable costing.
Absorption costing also account for the expenses of unsold products, this is important for external reporting as required by GAAP.
This method achieves a better and higher net income estimation. This is because it helps to achieve less fluctuation in net profits.

Disadvantages of Absorption Costing

Despite the good benefits that companies can derive from using the absorption costing method, it has some disadvantages. The major dark sides of this costing method include the fact that it results in the increase of net income. Because this method accounts for fixed costs, the higher the goods produced at a time, the lesser the fixed costs that will be attributable to the production of the goods, which in turn causes the net income to increase. Hence, the fixed costs accounted for in this method is less favorable compared to variable costing. Another disadvantage of absorption costing is that cost volume profit (CVP) is difficult to analyze when it is being used.

Related Topics

Variable costing and absorption costing usually produce different net operating income numbers. The reason is that the fixed manufacturing overhead cost is not treated the same way under two costing methods.

To understand how the difference in treatment of fixed manufacturing overhead cost changes the net operating income numbers of two costing systems, we need to prepare two income statements – one under variable costing and one under absorption costing. For this purpose, consider the following example:

Example

A company prepares variable costing income statement for the use of internal management and absorption costing income statement for the use of external parties like creditors, banks, tax authorities etc. The company manufactures a product that is sold at a price of $80 per unit. The variable and fixed cost data is given below:

Direct materials: $30.00
Direct labor: $19.00

Factory over head:Variable cost: $6.00

Fixed cost ($45,000/9000 units): $5.00

Marketing, general and administrative:Variable cost (per unit sold): $4.00

Fixed cost (per month): $28,000

During the month of June, 9,000 units were produced and 7,500 units were sold. The opening inventory was 2,000 units.

Required:

Prepare two income statements, one using variable costing method and one using absorption costing method.
Explain the reason of difference in net operating income (if any) under two approaches.

Solution

(1) Income statements

(a). Absorption Costing:

*Computation of units in ending inventory:

(b). Variable Costing:

Reconciliation of net operating income:

(2). Explanation of the difference in net operating income:

Notice that the net operating income under absorption costing is $7,500 ($92,000 – $84,500) higher than the net operating income under variable costing. This difference of net operating income is because of fixed manufacturing overhead that becomes the part of ending inventory under absorption costing but not under variable costing system.

The ending inventory absorbs a portion of fixed manufacturing overhead and reduces the cost burden of the current period. Consequently, a portion of fixed cost that relates to the current period is transferred to the next period. This is typically known as the deferring of fixed cost in the inventory. In our example, the portion of fixed overhead deferred in inventory is $7,500 (= 1,500 units x $5).

Under variable costing, the fixed manufacturing overhead cost is not included in the product cost but charged to the income statement of the relevant period in its entirety. Therefore, no portion of fixed cost can be absorbed by the ending inventory.

In our example, the net operating income is higher under absorption costing than under variable costing because closing inventory units are greater than the opening inventory inventory units.

Important points to remember:

Students always need to remember the following key points while solving their questions related to variable and absorption costing income statements:

The net operating income under absorption costing systems is always higher than variable costing system when inventory increases during the period.
The net operating income under variable costing systems is always higher than absorption costing system when inventory decreases during the period.
When inventory increases, the fixed manufacturing overhead cost is deferred to inventory which reduces the current period’s total cost burden.
When inventory decreases, the fixed manufacturing overhead cost is released from inventory which causes an increase in the current period’s total cost burden.