Absorption vs. variable costing
Also known as: full costing vs. direct costing
Absorption costing and variable costing are two methods of valuing inventory that differ in how they treat fixed manufacturing overhead. Absorption costing includes it in product cost, while variable costing expenses it in the period incurred.
Absorption costing and variable costing are two approaches to assigning manufacturing costs to products. Both methods treat direct materials, direct labor, and variable manufacturing overhead as product costs. The difference is fixed manufacturing overhead: absorption costing (also called full costing) attaches it to each unit produced, while variable costing (also called direct costing) expenses the entire amount as a period cost.
This distinction changes both inventory values and reported income whenever production and sales differ. Under absorption costing, fixed overhead is capitalized into ending inventory and only hits the income statement when the units are sold. Suppose a company incurs $100,000 of fixed overhead, produces 10,000 units, and sells 8,000. Absorption costing leaves $20,000 of that overhead ($10 per unit × 2,000 unsold units) sitting in inventory, so absorption income is $20,000 higher than variable costing income for the period.
The general rule: when production exceeds sales, absorption income is higher; when sales exceed production, variable income is higher; when they are equal, the two methods report the same income. US GAAP requires absorption costing for external financial reporting, but managers often prefer variable costing internally because it pairs naturally with contribution margin analysis and prevents income from being inflated simply by overproducing.
The CMA Part 1 exam tests this topic heavily. Expect to reconcile income between the two methods, compute per-unit product costs under each, and explain why the difference equals the fixed overhead deferred in (or released from) inventory.
Key takeaways
- Absorption costing treats fixed manufacturing overhead as a product cost; variable costing treats it as a period expense.
- When production exceeds sales, absorption costing reports higher income because fixed overhead is deferred into ending inventory.
- US GAAP requires absorption costing for external reporting, while variable costing supports internal contribution margin analysis.
- The income difference between the methods equals the fixed overhead per unit times the change in inventory units.
- CMA Part 1 tests per-unit cost computations and income reconciliations between the two methods.