# Income Statements: Variable Cost vs Absorption Cost

## Things You Must Know

### Introduction to Accounting

#### Medium Practice Test

Absorption Cost (also called Full Cost)

Includes all product costs as inventory costs: direct materials, direct labor, variable manufacturing overhead and fixed manufacturing overhead, in accordance with GAAP

Variable Cost

Includes direct materials, direct labor and variable manufacturing overhead as inventory costs. Fixed manufacturing overhead is considered a period expense.

Variable Cost is not in accordance with GAAP.

Costs are separated as variable and fixed (cost behavior) which is helpful for internal analysis.

Income Statement Formats:

Absorption Cost: Sorts costs by product and period

Sales
– CGS ( DM, DL, FOH + VOH) per unit x units sold
=Gross Profit
– Period Expenses   fixed and variable
=Income Before Tax

Variable Cost: Sorts costs by variable and fixed

Sales
– Variable Product Costs (DM + DL + VOH) per unit x units sold
= Product Contribution Margin
– Variable non-manufacturing period expenses per unit x units sold
= Total Contribution Margin
– Fixed Expenses           ALL – including manufacturing overhead
= Income Before Taxes

Variable Costs are shown in total, computed as cost per unit x quantity of units sold

If you are not given the quantity of units sold, you must calculate it as follows:

Beginning Finished Goods Inventory in Units
+ Units Produced This Period
– Ending Finished Goods Inventory in Units
= Quantity of Units Sold

Units sold is equal to total sales dollars divided by sales price per unit

Also use the above formula for determining units produced.
The problem will give you beginning inventory, ending inventory and units sold.
Plug this information into the formula and solve for units produced.

The real difference in the two methods:

Fixed manufacturing overhead costs are treated differently:

Absorption cost:
Fixed MOH is a product cost that becomes part of inventory

Fixed MOH is not expensed until the product is sold

Variable cost
Fixed MOH is a period cost and is treated as if it were ALL incurred regardless of the level of production.

Since inventory costs are not expensed until sold, the two income statements will give different operating income.

The difference in income on the two statements is reconciled:

– Units Sold
= Change in Inventory in units
x Fixed Overhead Rate per unit (see below to compute)
= Difference in Income for the two statements

When the change in inventory is negative –
Absorption Income will be lower

When the change in inventory is positive –
Absorption Income will be higher

Income will be the same on both statements when –
units produced = units sold

Calculate the Fixed Overhead Rate Per Unit:

Total Units Produced

Compute total numbers for each income statement:

Variable Cost:

All total variable costs are calculated as:

Variable cost per unit x number of units sold = total variable cost \$

All fixed costs, including manufacturing overhead are reported on the income statement at the given amount.

Absorption Cost:

All variable costs are calculated as:

Variable cost per unit x number of units sold = total variable cost \$

Fixed overhead is converted to a cost per unit using the above formula, and the total FOH in cost of goods sold is:

FOH \$ per unit x units sold this period

All fixed costs, except manufacturing overhead, are reported on the income statement at the given total amount

Variable Cost Income Statement:

Is not affected by changes in inventory

Is used for internal reporting. Does not meet GAAP requirements – under GAAP product costs are not expensed in the period incurred, they become inventory. Variable cost expenses fixed manufacturing overhead.

Gives operating income that is closer to cash flows

Works well with cost volume profit analysis because all product costs are variable costs and all costs are sorted as variable or fixed

Treats fixed manufacturing overhead as a period cost because it is viewed as if it were all incurred no matter how many units were produced and it would all be incurred if only one unit was produced

Absorption Cost Income Statement:

Income increases as production increases and decreases as production decreases. Fixed manufacturing overhead costs go to the balance sheet when incurred and are not expensed until sold.

Managers can manipulate income by changing the number of units produced
Producing more products gives a higher income.

Cost of goods sold consists of all product costs, fixed and variable.

Use a different format for each (see above), however, all amounts will be the same on both statements with the exception of fixed manufacturing overhead.

The classification of costs under absorption cost and variable cost:

Fixed manufacturing overhead is the only difference

 Absorption Cost Variable Cost Treated as product cost: Becomes inventory Direct materials Direct Labor Variable M O/H Fixed M O/H Direct materials Direct labor Variable M O/H
 Treated as period expense: Selling Selling Expensed as incurred General & Admin General & Admin Fixed M O/H