Businesses combine materials, labour, and overhead to make products to sell. Likewise, the combination of these three costs determines a company’s cost of goods expense and inventory valuation amounts. From an internal management standpoint, knowing how costs associate to your products proves critical in understanding pricing options and deploying product manufacturing upgrades. Keep in mind that one group of costs gets treated differently across two managerial costing methods. Used for internal processes and not incorporated into financial statements, these two methods — variable and absorption costing — help you develop strategies regarding the products your company offers.
Comparing Variable and Absorption Costing Methods
Companies use either the variable costing method or absorption costing method to internally report inventory costs. Both methods consider direct materials, direct labour, and variable manufacturing overhead as a part of product costs. This means that you report these costs as inventory, and they only become an expense when you sell that inventory. In addition, both methods report selling and administrative costs as period costs. Regardless of whether you’re dealing with fixed or variable costs, you report the expense in the period it occurs, not when you sell the inventory.
The sole difference between these two methods proves an important one — absorption costing includes fixed manufacturing overhead as a period cost, while variable costing doesn’t. This means companies build certain expenses into the price of goods (under absorption costing), and they report these same expenses when they immediately occur (under variable costing). Absorption costing leads to higher inventory balances, lower initial expenses, and higher net income. Although the total expenses on the business reports eventually balance out, this initial difference often sways management’s decision-making process.
Fixed Manufacturing Overhead Costs
Only fixed manufacturing overhead costs represent the difference between the two methods. These costs include the salary of supervisors and staff necessary to produce the products. Note that this doesn’t include wages, as these costs represent variable direct labour expenses. This means that insurance that covers manufactured goods can also be a fixed cost. Finally, you can treat depreciation and maintenance costs as fixed costs if a repetitive expense occurs.
Illustrating the Costing Difference
Imagine your company has direct material expenses of $15 per unit and direct labour expenses of $20 per unit. In addition, each unit produces results in $5 of variable overhead. Upon the production of 1,000 units, your company incurs $30,000 ($30 per unit) of fixed manufacturing overhead.
Variable costing only transfers the variable costs to inventory. In this situation, your inventory cost goes down as $40, broken down as $15 for direct material expenses + $20 for direct labour expenses + $5 of variable overhead. You report these costs on a balance sheet as inventory costs until you sell the goods and report the $30,000 of fixed manufacturing overhead as a period cost. This means you report this expense immediately.
In contrast, absorption costing reports all the costs as inventory. Each unit has a valuation of $70, or $15 for direct material expenses + $20 for direct labour expenses + $5 of variable overhead + $30 of fixed manufacturing overhead. More importantly, since none of these costs occur in the current period, using the absorption costing method results in a $30,000 higher net income than the variable costing method.
When making decisions concerning internally reporting your company’s costs, having a firm understanding of variable and absorption costing methods helps immensely. QuickBooks Online helps you keep track of all your company’s expenses and lets you easily run financial reports from its user-friendly interface. Join the 4.3 million customers who use QuickBooks today to help your business thrive for free.