Absorption vs Variable Costing
There are some internal methods of reporting income that are better for analysis than what U.S. GAAP is required for external reporting. One of these methods is the variable method.
The traditional U.S. GAAP method says we take sales minus the cost of goods sold, which equals the gross profit. Then we subtract our general and administrative expenses, and that equals operating income.
Under the traditional method, we record the cost of goods sold when we sell the units, not when we manufacture them. This means that the costs are absorbed into the inventory accounts, which is why the traditional method is called the absorption method. Then we have our general and administrative expenses, which are our period costs. We expense these as they are incurred.
Then how does the variable method of the income statement differ from the traditional method? The costs are categorized differently on the income statement for the variable method.
The variable method income statement appears as follows:
Sales - Variable Costs = Contribution Margin - Fixed Costs = Operating Income
Right after sales, instead of the cost of goods sold, we have variable costs. These can be any kind of costs that are dependent on our amount of activity. Then after we subtract the variable costs, we have the contribution margin. That’s why the variable method can also be called the contribution method.
And then we subtract out our fixed costs, which brings us to our operating income. We see that everything has to be either a variable cost or a fixed cost. The traditional method is not as clean-cut as the variable method is. For example, when we record the product cost to inventory, they include both fixed and variable elements because we’re recording both variable overhead and fixed overhead.
And then below the gross profit for the traditional method in the general and administrative expenses section, those are both variable and fixed general and administrative costs. As we see, the variable method separates everything into either variable costs or fixed costs, and the traditional method does not.
A key difference between the two methods is that fixed overhead is recorded as a product cost in the traditional method and as a fixed cost in the variable method. This means that fixed overhead is only expensed when the product is sold under absorption costing. Whereas the fixed overhead is expensed immediately under the variable method, regardless of when the goods are sold.
Study Tip 😀
The fixed overhead marks the difference between the traditional method and the variable method.
Imagine that you manufactured 100 units and you only sold 90 units. With the variable method, we’re going to record the fixed overhead expenses for all 100 units, and for the traditional method, we’re only going to expense the fixed overhead for those 90 units.
Therefore, we would have a greater amount of expenses for the variable method leading to a lower operating income compared to the traditional method.
Then consider the opposite situation. Imagine that we produced 100 units, but we sold 110 units. This is because we have units that we manufactured in the prior period.
In this case, we’re going to expense the fixed overhead for 110 units for the traditional method, but we’re only going to expense fixed overhead for 100 units for the variable method leading to a lower operating income for the traditional method.
If you manufactured 100 units and sold 100 units, then your expenses would be the same under both the variable method and the traditional method leading to the same operating income as well.
