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19.4 Explain and Use Variable Costing and Absorption Costing

Two Costing Methods​

There are two main methods for costing products: variable costing (also called direct costing) and absorption costing (also called full costing).

Variable Costing​

Variable costing includes only variable manufacturing costs in product costs. Fixed manufacturing costs are treated as period costs and expensed in the period incurred.

Product Costs (Variable Costing):

  • Direct materials
  • Direct labor (if variable)
  • Variable manufacturing overhead

Period Costs (Variable Costing):

  • Fixed manufacturing overhead
  • Selling expenses
  • Administrative expenses

Income Statement Format (Variable Costing):

Sales Revenue                    €XX,XXX
Less: Variable Cost of Goods Sold (XX,XXX)
Less: Variable Selling & Admin    (XX,XXX)
────────────────────────────────────────
Contribution Margin               XX,XXX
Less: Fixed Manufacturing Overhead (XX,XXX)
Less: Fixed Selling & Admin       (XX,XXX)
────────────────────────────────────────
Net Income                       €XX,XXX

Absorption Costing​

Absorption costing includes all manufacturing costs (both variable and fixed) in product costs. Fixed manufacturing overhead is allocated to products.

Product Costs (Absorption Costing):

  • Direct materials
  • Direct labor
  • Variable manufacturing overhead
  • Fixed manufacturing overhead (allocated)

Period Costs (Absorption Costing):

  • Selling expenses
  • Administrative expenses

Income Statement Format (Absorption Costing):

Sales Revenue                    €XX,XXX
Less: Cost of Goods Sold         (XX,XXX)
────────────────────────────────────────
Gross Profit                      XX,XXX
Less: Selling Expenses            (XX,XXX)
Less: Administrative Expenses     (XX,XXX)
────────────────────────────────────────
Net Income                       €XX,XXX

Key Differences​

AspectVariable CostingAbsorption Costing
Fixed Mfg. OverheadPeriod costProduct cost
Inventory ValuationLower (no fixed overhead)Higher (includes fixed overhead)
Income StatementContribution formatTraditional format
Net IncomeMay differ from absorptionRequired for external reporting
UseInternal decision-makingExternal reporting, tax

Example: Comparison​

Data:

  • Units produced: 1,000
  • Units sold: 800
  • Selling price: €20 per unit
  • Variable manufacturing cost: €8 per unit
  • Fixed manufacturing overhead: €6,000 total
  • Variable selling: €2 per unit
  • Fixed selling: €2,000

Variable Costing:

  • Product cost per unit: €8 (variable only)
  • Fixed overhead: €6,000 (period cost)
  • Income: (800 × €20) - (800 × €8) - (800 × €2) - €6,000 - €2,000 = €2,000

Absorption Costing:

  • Fixed overhead per unit: €6,000 ÷ 1,000 = €6
  • Product cost per unit: €8 + €6 = €14
  • Income: (800 × €20) - (800 × €14) - (800 × €2) - €2,000 = €2,800

Difference: €800 (200 units in inventory × €4 fixed overhead per unit)

When Net Income Differs​

Net income differs between the two methods when:

  • Production ≠ Sales (inventory changes)
  • Fixed overhead is allocated differently

If Production > Sales:

  • Absorption costing shows higher income (fixed overhead in inventory)
  • Variable costing shows lower income (all fixed overhead expensed)

If Production < Sales:

  • Absorption costing shows lower income (fixed overhead from previous period released)
  • Variable costing shows higher income

If Production = Sales:

  • Both methods show same income (no inventory change)

Uses of Each Method​

Variable Costing:

  • Internal decision-making
  • CVP analysis
  • Performance evaluation
  • Pricing decisions
  • Product profitability analysis

Absorption Costing:

  • External financial reporting (required by GAAP/IFRS)
  • Tax reporting (in many jurisdictions)
  • Inventory valuation
  • Full cost analysis

Luxembourg Compliance Note​

In Luxembourg:

  • Financial reporting typically requires absorption costing (full costing)
  • Tax reporting may require absorption costing
  • Internal management can use variable costing for decisions
  • PCN accounts support both methods
  • Consider Luxembourg tax implications

Think It Through​

Why might a company use variable costing for internal decisions but absorption costing for external reporting? What are the advantages and disadvantages of each method?