 What is variable costing and absorption costing? Those are two costing method that helps you determine your product cost. However, there are two different method. One is used internally, which is variable costing, and we'll see why and how and when used externally, which is absorption costing. Absorption costing basically is the gap method. So what's the difference between the two? It boils down to one thing, how we treat fixed overhead costs under both methods. Let's take a look at how so. If you remember under product costing, we include direct material, direct labor, manufacturing overhead, MOH, whether it's variable, whether it's fixed, all these one, two, three, four. So one, two, three, four are included in product cost. So we include those in product cost. And this method is called absorption costing. Absorption costing means it absorbs all the costs, whether the manufacturing overhead is fixed or variable. And this is the gap method. And this is what gap wants us to do when we compute cost of goods sold. So manufacturing overhead include both variable and fixed. It includes this one and this one. Now also we have period costs and under period costs, remember we can break down the period costs into variable selling and administrative and fixed selling and administrative expenses. Just kind of quick example for example, variable selling is the sales commission that we pay for our employees that conduct sales and fixed selling and administrative could be HR, HR people or salaries that we pay for sales people or salaries that we pay for the marketing people. So those are examples of variable selling and administrative and fixed selling and administrative, but those are period costs under absorption costing. Under variable costing, under variable costing, what's included in the product cost? What's included in the product cost is only direct material, direct labor and variable overhead. It does not include, the product cost does not include fixed manufacturing overhead. The product cost does not include fixed manufacturing overhead. So that's the key, remember fixed manufacturing overhead is not included when we compute the product cost. So that's basically in a nutshell the main difference. Now having said so, let's see if we can answer this question. Which method will produce the highest value for work in process and finished goods inventory? Simply put, which of the two methods will give you a higher inventory amount? Let's take a look at this. I would have to say product cost under absorption method will give me a higher inventory. Why? Because I'm including more per unit. I'm including more per unit. I'm including more per unit. So anything that's not sold, anything that's not sold, it's going to sit in my ending inventory that therefore it's going to give me a higher, a higher inventory. Why? Because fixed manufacturing head under variable, I am expensive. I'm treating it as a period cost. Therefore, it's not going to be part of my inventory. It's going to, so my inventory will always be lower. Okay, this is why absorption costing will give you a higher inventory value. Okay, and the best way to illustrate this is to actually work an example to see how this works. So let's take a look at this example. We have Harvey company produce a single product with the following information. Unit produced 25,000. Now it's very important when you are looking at variable costing and absorption costing, how many units were produced versus how many units are sold. So please follow the example carefully as we work through this. For this year, let's call it year one, we produced 25,000 unit, our variable cost per unit altogether, material, labor and overhead, is $10, our selling and administrative expense that's variable is $3, fixed cost per unit, manufacturing overhead is 150,000, right here, 150,000, and selling and administrative expenses that's fixed is 100,000. Now remember the main difference between the two is how we treat this number here, fixed manufacturing overhead, how we treat fixed manufacturing overhead, it's going to be the difference. So let's take a look first at how we compute the unit cost, the product unit cost. Let's look at absorption costing first. Under absorption costing, we have $10 for the variable cost, material, labor and overhead, this is going to give us $10. Now fixed manufacturing overhead, we have 150,000 divided by 25,000 unit what we produced, so our fixed manufacturing overhead is $6 per unit, therefore we can say that our unit cost under absorption costing is $16. Now under variable costing, our cost per unit would only include the $10, would only include the $10 and you're saying so what are we going to do with the fixed manufacturing overhead? The fixed manufacturing overhead, the 150,000 we are going to treat it as a period cost, what does that mean? It means this 150, it's going to be expensed on the income statement, all together it's going to go on the income statement. So let's assume that for that year we sold 20,000 unit, remember we produced 25, we sold 20, this means we still have 5,000 unit in ending inventory, just kind of want to make sure you understand the big picture and each unit was sold for $30 and let's assume there are no beginning inventory, we're starting this company, now let's compute net operating income using both absorption and variable costing. So let's take a look at absorption costing first, sales is 20,000 times $30 is 600,000, cost of goods sold is 20,000 unit, we sold 20,000 unit times $16, remember the cost per unit is $16, I want to break this down for you one more time, $10 was variable cost and $6 was part of the fixed manufacturing cost which gives us 320,000, sales minus cost of goods sold we call this gross margin, so the terminology is important here, for absorption costing sales minus cost of goods sold is called the gross margin less, less than we subtract variable costing which is 20,000 unit times $3 of selling and administrative and fixed overhead cost is 100,000, we expense 100,000 of fixed manufacturing overhead, I'm sorry fixed selling and administrative expenses which are those are period costs, so 280 minus 160 will give us net income of 120,000, so this is net income under absorption costing, now here's what you need to understand, we still have 5,000 unit and ending inventory, that 5,000 unit include an additional $6 per fixed manufacturing overhead that's going to be sitting in our inventory, so our inventory would include that 5,000 unit times $6 additional that was not that was not that was not expensed which is going to be expensed under the variable costing which I'll show you in a moment, so let's take a look at the variable costing, variable costing sales is the same, variable cost of goods sold is 20,000 unit times $10 only the variable manufacturing cost and we could also deduct we will also deduct the variable selling and administrative which is $3 per unit, so what we say is sales and here's an important formula sales minus variable cost which is variable cost include everything will give us something called contribution margin and this is important so what is contribution margin if I ask you what is contribution margin you would say sales minus variable cost and variable cost is period cost period as well as product cost so this is important so notice the terminology is a little bit different then we are going to subtract fixed manufacturing overhead and notice what happened we're going to subtract every single dollar of fixed manufacturing overhead the whole 150 is expensed the whole 150 then we subtract also obviously the fixed selling and administrative expenses all in all operating income is 90,000 so the difference between absorption costing and variable costing is $30 again where did that $30 came from under absorption costing there is we did not expense this $6 of fixed manufacturing overhead we did not expense $6 times 5,000 unit we did not expense $30,000 what happened to that $30,000 that $30,000 live in our inventory so because it was not sold it is in our inventory simply put to look at this picture again here's what actually happened cost of goods sold under absorption costing was 320,000 okay notice the fixed manufacturing expense the fixed manufacturing expense 120 of it was cost of goods sold and 30,000 of it was an ending inventory under absorption costing so notice what's highlighted in yellow 120 was cost and 30 was inventory if we look under variable costing what happened to that 150 this whole 150 was expensed and that's the difference that's the difference the difference is this 30,000 let me just the difference is this $30,000 that stayed with us on the balance sheet that's what made the difference the difference is that 30,000 that made the difference another way to look at it if we compute our variable costing net operating income which is 90,000 variable costing then we can add to it we can add to it any fixed manufacturing overhead cost that's the third which is the 30,000 y 30,000 5000 unit times $6 was the third we did not expense it under absorption costing 90,000 plus 30 will give us the absorption costing let's take a look at year two the same company now here's what happened in year two they produced 25,000 unit but that year they sold they sold 30,000 unit hold on a second this does not make any sense well yes it does make sense why because from the prior year if you remember from the prior year I had 5,000 unit from the prior year I had 5,000 unit and this is why I was able to sell 30,000 unit unit sales is $30 and the data is the same direct material is $10 selling an administrative it's $3 also variable a fixed cost per year is 150 for the manufacturing overhead and selling an administrative is 100,000 let's take a look at unit cost for each method it's 16 under absorption 10 under variable which is the same thing that we did earlier so nothing have changed let's look now at variable costing under variable costing we're going to have sales of 900,000 variable cost of goods sold 30,000 times 10 which is 300,000 the variable selling 30,000 times 3 is 90,000 sales minus variable cost will give us remember it's called the contribution margin then from the contribution margin we are going to deduct the whole $150,000 fixed manufacturing overhead we are going to also deduct obviously the fixed selling and administrative which is period cost so 5,10 contribution margin minus the fixed expenses will give us 260,000 and simply put let me just show it to you one more time this is so simply put sales minus variable cost gives me contribution margin minus fixed cost give me net operating income this is the variable income statement this is a very important formula now so net operating income is 260 let's look at absorption costing under absorption costing 900,000 of sales which is the same cost of goods sold we sold 30,000 unit times 16 gross margin notice the terminology once again is different 420 then we deduct variable cost of 30,000 times 3 fixed cost the whole 100,000 this one is expensed under both so net operating income is only 230 so what happened is this the difference between variable costing net operating income under variable costing was 260 and net operating income under absorption costing is 230 what happened is this under variable costing under variable cost and I'm sorry let's let's look at absorption costing under absorption costing you remember the 30,000 that we the third last year 30,000 dollar was the third last year now it's expensed in here so in here in cost of goods sold this year we released 30,000 dollar of cost of goods sold we released 30,000 dollar of cost of goods sold that was deferred from the prior year therefore our cost of goods sold is 30,000 dollar more than absorption costing so why didn't variable costing deducted this 30,000 variable costing already deducted this 30,000 last year therefore to reconcile the difference if we take variable variable costing minus anything that's released from inventory from the prior year which is we released 5000 will give us absorption costing so notice variable costing has more profit this year why does it have more profit this year because why did we have more profit this year I'll tell you why because we sold more than production what does that mean because we sold more than we produced it means we are going to expense inventory from prior year that includes fixed manufacturing overhead that was already expensed that's why variable costing will give us a higher net income in year one what happened in year one year one we produced greater than what we sold so we produced more than what we sold what does that mean it means some of the fixed manufacturing overhead that we produced was not sold therefore it was not expensed under absorption costing but it was expense under variable costing that's why in year one absorption costing has more income in year two variable costing has more income because we sold more than what we produce okay we sold what does that mean we sold more than we produce it means we are selling units from prior years and under variable costing those units will cost us less because we already expense that fixed manufacturing overhead cost therefore if that's the case we take variable costing minus the what we released will give us the absorption costing net income okay let's take a look at this at this basically a summary of the rules between the two if the unit produced equal to the unit sold for any given year that means there is no change in inventory guess what absorption costing and variable costing gives us the same answer why if you really think about it if you really think about it we expensed everything if everything that we produce sold so it doesn't matter how fixed manufacturing overhead is used because we expense it under variable costing we expense it under absorption costing therefore net income will be the same for both method if the unit produced more than the unit sold if we produce more unit and we did not sell them what's going to happen our inventory will go up our inventory will go up as a result if our inventory goes up it means we are not expensing certain manufacturing overhead cost therefore some of the cost is hitting an inventory therefore absorption method the absorption costing method will have a higher income than the variable method why because we hid that fixed manufacturing overhead cost and inventory in years where unit produced is less than unit sold unit produced is less than unit sold it means overall our inventory will go down because what happened is we sold units from prior year solding units from prior year it means your inventory will go down under this method absorption costing would give you a lower income than variable costing why because variable costing already expensed certain items in prior year and that certain items is fixed manufacturing overhead now we're selling those units but we're not expensing the fixed manufacturing overhead absorption costing is expensing them now in this year therefore absorption costing will have more expenses higher cost of goods sold therefore lower net income so this is basically a good summary of the difference between the two on net income simply put if you want to just summarize it variable costing it's a good for the cvp analysis which we're going to look look for later once again let me summarize it we'll take sales minus variable cost gives us contribution margin minus fixed cost will gives us net operating income this is an important formula it measures profitability better so variable costing it doesn't look at fixed manufacturing overhead because it assumes fixed manufacturing overhead is fixed therefore it's kind of in a sense it's not relevant for pricing decision therefore it's better for decision making variable costing is used for internal decision making okay variable costing is only affected by changes in unit sales not by unit produce and this is very important why because if you look at the examples that we worked in year one because we did not sell all the units okay absorption costing gives us a low higher income just because we did not sell all the units it's not because we were more profitable it's because some of our cost was hitting an absorption costing was hitting an inventory and this is really misleading because what managers would do if they're using absorption costing for for for pricing purposes they will produce more units as we produce more units they're fixed overhead cost per unit will go down as a result they think they are making more profit which in reality they're not all what happens is they produce more unit their fixed cost per unit goes down so absorption costing which is the gap method gives you the impression that fixed manufacturing overhead is a variable with respect to the unit produce so the more unit you produce in theory your fixed overhead cost is lower but if you don't sell those units then they're no good but that's not the case that's not the case fixed manufacturing overhead is fixed in total now per unit it's it's lower the result may be inappropriate pricing decision and product discontinuation or continuation you think it's your making profit but really you're not you're just basically you're it's giving you the wrong incentive to produce more unit to reduce your fixed manufacturing overhead cost so hopefully this is a good summary of variable costing versus absorption costing the best way the best way to illustrate this is to work a few examples which I will few questions to reinforce the variable costing versus absorption costing if you have any questions any comments by all means email me if you're studying for your cma or cpa study hard it's worth it