Absorption and variable costing

Learning goals

• Calculate unit product cost under absorption and variable costing.
• Reconcile profit when production differs from sales.
• Explain why fixed-overhead inventory changes can distort incentives.

Prerequisite check

Variable manufacturing cost changes with units; total fixed manufacturing overhead is fixed within the relevant range. External inventory measurement uses absorption costing, while variable costing is an internal contribution-format tool.

Vocabulary

• Absorption costing: product cost includes variable and allocated fixed manufacturing cost.
• Variable costing: product cost includes variable manufacturing cost; fixed manufacturing overhead is period expense.
• Contribution margin: sales less all variable costs.
• Fixed overhead deferral: fixed manufacturing overhead held in absorption inventory.
• Relevant range: activity span within which cost assumptions reasonably hold.

Core idea

Both methods record the same total fixed manufacturing overhead over time; they differ in timing. If production exceeds sales, absorption costing defers some fixed overhead in inventory and reports higher profit. If sales exceed production, previously deferred overhead is released and absorption profit is lower.

Why this treatment makes sense

Absorption costing assigns all manufacturing cost to units for external inventory. Variable costing highlights contribution for internal decisions. Understanding the reconciliation prevents managers from improving current profit merely by overproducing.

A repeatable method

1. Separate variable manufacturing, fixed manufacturing, and selling/administrative costs.
2. Compute fixed overhead rate = budgeted fixed MOH/normal or supplied production base.
3. Build absorption and variable unit product costs.
4. Track units produced, sold, and inventory change.
5. Prepare contribution and absorption statements if required.
6. Reconcile profit: inventory-unit change × fixed MOH per unit.
7. Investigate capacity, obsolescence, and incentive consequences.

Worked example

Saskatoon Cycle makes 10,000 helmets and sells 8,500 at $70. Variable manufacturing cost is $32/unit; fixed manufacturing overhead $120,000; variable selling cost $4/unit; fixed selling/admin $90,000. No beginning inventory.

Fixed MOH rate = $12/unit. Absorption unit cost = $44; variable unit product cost = $32. Ending inventory is 1,500 units.

Variable profit: sales $595,000 − variable COGS $272,000 − variable selling $34,000 = contribution $289,000; less fixed MOH $120,000 and fixed S&A $90,000 = $79,000.

Absorption profit is $79,000 + 1,500 × $12 = $97,000. The $18,000 difference is fixed MOH deferred in ending inventory, not extra economic performance.

Journal, ledger, and statement connection

External ledgers carry absorption inventory and COGS. A management reconciliation reformats costs for variable analysis; it does not replace external records. Production, sales, and inventory units must reconcile before explaining profit differences.

Common mistakes

• Treating fixed selling cost as a product cost under absorption costing.
• Using sales units to calculate fixed MOH rate when production base is supplied.
• Saying variable costing ignores fixed cost; it expenses it in the period.
• Interpreting absorption profit growth from inventory buildup as stronger demand.

Guided practice

Fixed MOH $80,000 over 20,000 units = $4/unit. Inventory rises 3,000 units, so absorption profit exceeds variable profit by $12,000.

Independent practice

Level 1 — unit costs: Variable manufacturing $18/unit; fixed MOH $6/unit. Find absorption and variable unit product costs.

Level 2 — reconcile: Production 12,000, sales 10,500, fixed MOH rate $5/unit. If variable profit is $64,000, find absorption profit.

Level 3 — ethics: A plant manager produces 5,000 unnecessary units before year-end to earn a profit bonus. Explain the accounting effect and two control responses.

Self-check and solutions

Level 1: Absorption $24; variable $18.

Level 2: Inventory rises 1,500 units; fixed MOH deferred $7,500; absorption profit $71,500.

Level 3: Absorption profit rises by fixed overhead stored in unsold inventory while cash, storage risk, and obsolescence may worsen. Use inventory/cash/quality metrics in bonuses and require demand-based production approval or capacity-variance review.

Retrieval practice

1. Which method includes fixed manufacturing overhead in inventory?
2. When is absorption profit higher?
3. Does variable costing remove fixed cost?

Answers: absorption; when inventory increases; no.

Exam-style application

Prepare both income formats, reconcile profit mathematically, and write a board note explaining whether improved absorption profit came from sales, cost control, or inventory buildup.

Lesson summary

Absorption and variable costing differ in the timing of fixed manufacturing overhead; their reconciliation is essential for honest performance interpretation.