- Explain the difference in Variable and Absorption Costing - Demonstrate computing unit product costs - Explain the difference in income statements for Variable and Absorption costing - Demonstrate how to reconcile Variable and Absorption Costing net operating incomes and explain why there is a difference in the amounts - Discuss the advantages of using the variable costing and the contribution approach [SLIDE 1] There are two methods used for valuing inventories and cost of goods sold. They are: Variable Costing: method of inventory costing in which all variable manufacturing costs (direct and indirect) are included as inventoriable costs. All fixed manufacturing costs are excluded and treated as costs of the period in which they are incurred. Absorption Costing: method of inventory costing in which all variable and fixed manufacturing costs are included as inventoriable costs. Variable costing considers only those production costs that vary with output as product costs. Variable costing uses the contribution approach income statement and aids CVP analysis since its emphasis is on separating variable and fixed costs. Variable costing considers a unit of product cost to consist of direct materials, direct labor and variable overhead. It considers fixed manufacturing overhead and both variable and fixed selling and administrative costs as period costs and expenses them from revenue as they are incurred. Absorption costing considers all costs of production as product costs and makes no distinction between variable and fixed costs. Absorption costing does not work well with CVP analysis. Absorption costing considers unit of product cost to consist of direct materials, direct labor, and both variable and fixed overhead. It considers variable and fixed selling and administrative costs as period costs and expenses them from revenue as they are incurred. As you can see there are differences between the two methods. Variable costing is used for internal use and absorption costing is used for external reporting. [SLIDE 2] The easiest way to understand the difference between variable costing and absorption costing is with an example. Timber Ltd produces recycled timber for various uses. We will focus on its building timber product line. Data for Timber Ltd for 2014 To establish the cost of its building timber, Timber uses a costing system to:

trace direct costs to product
allocate indirect manufacturing costs (overhead) using predetermined rates.

Timber Ltd's management wants to prepare an income statement for 2014 to evaluate the performance of the timber line. The operating information for 2014 is:

	Meters of timber produced
Production	50,000
Beginning inventory of finished goods	0
Actual production	50,000
Sales	50,000
Ending inventory of finished goods	0

Actual price and cost data for 2014 are:

Actual fixed manufacturing overhead	$60,000.00
Variable product cost per meter ^a	7.00
Absorption product cost per meter	8.20
Actual fixed selling and administration (S&A) expenses	50,000.00
Actual variable S&A expenses per meter	1.00
Selling price per meter	15.00

^a The variable product cost per unit is made up of direct materials (50%), direct manufacturing labor (25%) and variable manufacturing overhead. To simplify this example, I have not shown this detail above. For simplicity, we will assume the following:

Timber Ltd incurs manufacturing and selling and administration (S&A) costs only. The cost driver for all variable manufacturing costs is meters produced; the cost driver for variable S&A costs is meters sold. The budgeted (standard) price and cost data for 2014 are the same as the actual price and cost data.
Work-in-process inventory is zero.
Timber Ltd budgeted production of 50,000 meters for 2014. This was used to calculate the budgeted fixed manufacturing cost per meter of $1.20 ($60,000/50,000 meters).
Timber Ltd budgeted sales of 50,000 meters for 2014, which is the same as the actual sales for 2014.
The actual production for 2014 is 50,000 meters. As a result, there is no difference between actual and budgeted manufacturing costs in 2014.

For Timber Ltd, inventoriable costs per meter produced in 2014 under the two methods are:

Per meter produced	Variable costing	Absorption costing
Variable manufacturing cost	$7.00	$7.00
Fixed manufacturing cost	–	1.20
Total inventoriable cost	7.00	8.20

The main difference between variable costing and absorption costing is the way in which fixed manufacturing costs are accounted for:

Under variable costing, fixed manufacturing costs are treated as an expense of the period.
Under absorption costing, fixed manufacturing costs are inventoriable costs. In our example, the fixed manufacturing cost is $1.20 per meter ($60 000/50 000 meters) produced.

When comparing variable and absorption costing, we must also take into account whether we are looking at short- or long-term numbers. In the income statements below, you can see the comparison of variable and absorption costing and not the difference in contribution margin and gross margin but our operating profit is the same.

Panel A: Variable costing		Panel B: Absorption costing
Profit using variable costing		Profit using absorption costing
Sales revenue	$750,000	$750,000	Sales revenue
Less: Variable cost of goods sold			Less: Cost of goods sold
Beginning inventory	0	0	Beginning inventory
Add: Variable cost of production	350,000	410,000	Add: Cost of production
Available for sale	350,000	410,000	Available for sale
Less: Ending inventory	0	0	Less: Ending inventory
Variable cost of goods sold	350,000	410,000	Cost of goods sold
Variable S&A expenses	50,000
Contribution margin	350,000	340,000	Gross margin
Fixed manufacturing overhead	60,000
Fixed S&A expenses	50,000	100,000	S&A expenses
Operating profit	240,000	240,000	Operating profit

The statements have been set up with the numbers placed together in the middle so that you can easily see the differences under the two costing approaches. As you can see, variable costs are separated out on the variable income statement and included in the product costs on the absorption statement. Recall our discussion of contribution margin and gross margin from an earlier lesson; contribution margin is the difference between total revenues (TR) and total variable costs (VC), whereas gross margin is total revenues less cost of goods sold. As you will see from the income statements, the variable costing income statement (panel A) uses the contribution margin format, whereas the absorption costing income statement (panel B) uses the gross margin format. The distinction between variable costs and fixed costs is central to variable costing; this is highlighted by using the contribution margin format. Similarly, the distinction between manufacturing and non-manufacturing costs is central to absorption costing. This is highlighted by using the gross margin format. The difference between variable costing and absorption costing is explained by the way in which manufacturing costs are accounted for. If inventory levels change, operating profit will differ between the two methods because they account for fixed manufacturing costs differently. Let's look at how to reconcile the income difference between the two methods of costing. [SLIDE 3] To gain a good understanding of the reconciliation of income between the two costing methods, we will look at a three-year comparison of Timber's income statements in both formats. We can see that in 2015 and 2016, Timber Ltd's production differed from its sales. Our assumptions from 2014 data apply for 2015 and 2016. As we review the income statements presented under variable costing and absorption costing for 2014, 2015 and 2016, keep in mind the following point about absorption costing as you study panel B. The absorption costing production cost includes all fixed manufacturing costs. The additional $60,000 cost of production ($410,000 – $350,000) is made up of the $1.20 fixed manufacturing cost per meter of timber produced ($1.20 * 50,000 meters). Here's a summary of the operating profit differences for Timber Ltd during the 2014–2016 period:

	2014	2015	2016
Absorption costing operating profit	$240,000	$211,000	$269,000
Variable costing operating profit	240,000	205,000	275,000
Difference: Absorption divided by Variable	0	6,000	(6,000)
Difference as a percentage of absorption costing operating profit	0%	2.8%	(2.2%)

The question is, "Why do variable costing and absorption costing usually report different operating profit numbers?" In general, if inventory increases during an accounting period, less operating profit will be reported under variable costing than under absorption costing. Conversely, if inventory decreases, more operating profit will be reported under variable costing than under absorption costing. The difference in reported operating profit is because of how fixed manufacturing costs move into inventories as inventories increase and move out of inventories as inventories decrease. So let's see how we reconcile this difference. [SLIDE 4] There are two formulas to reconcile the difference between operating profit under absorption costing and variable costing. Option 1 is we can reconcile by focusing on fixed manufacturing costs in beginning inventory and ending inventory, as shown below:

	Absorption costing operating profit	-	Variable costing operating profit	=	Fixed manufacturing costs in ending inventory under absorption costing	-	Fixed manufacturing costs in beginning inventory under absorption costing
2014	$240,000	-	$240,000	=	($1.20 x 0 units)	-	($1.20 x 0 units)
			0	=	0

2015	211,000	-	205,000	=	($1.20 x 5,000 units)	-	($1.20 x 0 units)
			6,000	=	6,000

2016	269,000	-	275,000	=	($1.20 x 0 units)	-	($1.20 x 5,000 units)
			(6,000)	=	(6,000)

Fixed manufacturing costs in ending inventory are deferred to a future period under absorption costing. For example, $6,000 of fixed manufacturing overhead is deferred to 2016 at the end of 2015. Under variable costing, all $60,000 of fixed manufacturing costs are treated as an expense of 2015. Recall from a previous lesson that: Beginning inventory + Cost of goods manufactured = Cost of goods sold + Ending inventory With that in mind, option 2 is we could reconcile by using the way in which fixed manufacturing costs move between meters of timber produced and meters sold during the financial year.

	Absorption costing operating profit	-	Variable costing operating profit	=	Units produced	-	Units sold	*	Budgeted fixed manufacturing cost rate
2014	$240,000	-	$240,000	=	(50,000	-	50,000)	*	$1.20
			0	=	0

2015	211,000	-	205,000	=	(50,000	-	45,000)	*	$1.20
			6,000	=	6,000

2016	269,000	-	275,000	=	(50,000	-	55,000)	*	$1.20
			(6,000)	=	(6,000)

Using either option will help us reconcile the difference in variable and absorption costing operating profit. The difference is the amount of fixed cost applied to production under the absorption method that remains in inventory at the end of the period and is deferred until the products are sold in a following period. The equation form of calculating the difference is: Manufacturing overhead deferred in (released from) inventory = Fixed manufacturing overhead in ending inventories - Fixed manufacturing overhead in beginning inventories Therefore, if we take net operating income for variable costing income statement and add or deduct fixed manufacturing overhead deferred in or released from inventory under the absorption costing method, we will get the amount calculated as net operating income or loss on the absorption costing income statement. [SLIDE 5] As we have seen in this lesson, there are differences in how variable and absorption costing report operating profit and net income. Managers find that the variable costing approach offers three advantages when planning and controlling for the organization. The appealing advantages of the variable costing method are:

The enablement of the use of CVP analysis
Explains changes in net operating income
Supports managerial decision making

As we look at each of these advantages, we will see why it is the preferred method for planning. CVP analysis requires that fixed and variable cost components be broken down and separated. The variable costing income statement format categorizes fixed and variable costs making it easier to utilize CVP analysis to assist in making decisions on the company's performance and operations. Absorption costing assigns fixed overhead costs to units produced and thus makes CVP analysis difficult to use. Variable costing income statements are easier to understand. Variable costing income is only affected by changes in unit sales and is not affected by the number of units produced. Absorption costing is influenced by both changes in unit sold and units produced. Because of this, absorption costing statements can be confusing and easily misinterpreted. The variable costing method correctly identifies additional variable costs incurred when one more unit is produced. Variable costing also emphasizes the impact of total fixed costs on profits. In contrast, absorption costing adds fixed overhead costs to the units produced, so it can be misleading that it is variable with respect to the number of units produced. This can result in inappropriate pricing or product elimination decisions. As we can see in this lesson, choosing the appropriate costing method for the organization is important. Management is able to plan, control and make decisions regarding the organization when the correct information is accessible and easily interpreted. As we continue to the next lesson, we will take a deeper look at how the variable costing and the contribution approach can help with creating income statements for organizations with more than one business segment.