Absorption Costing

 External financial reporting (GAAP)

 Product costs include direct materials, direct labor, variable overhead, and fixed overhead. (Product
costs are part of inventory. When the product is sold, the costs are COGS.)
 Thus, absorption costing assigns fixed MOH to units produced. If the units are sold, the fixed MOH
appears as COGS. If the units are not sold, the fixed MOH goes into inventory.

Variable Costing (Direct Costing)

 Product costs include direct materials, direct labor, and variable overhead
 Fixed overhead is treated as a period cost (not inventory) and therefore is expensed in the period
incurred.

Absorption costing will produce the following results (compared to variable costing)
Production > Sales Production < Sales Production = Sales
Ending inventory ↑ ↓ =
COGS ↓ ↑ =
Net Income ↑ ↓ =

Example:
A company incurs the following unit costs:
DM 5
DL 15
VOH 3
Variable Marketing 1.25
Fixed overhead is $20,000.
Fixed marketing and administrative expenses are $12,000.
The company sold 1000 units.

Absorption Costing If 1000 units are produced If 1250 units are produced
Sales ($60 selling price) 60,000 60,000
COGS 43,000 39,000
Gross Profit 17,000 17,000
Var. marketing expenses (1,250) (1,250)
Fixed market and admin. (12,000) (12,000)
Operating Income 3,750 7,750

Variable Costing If 1000 units are produced If 1250 units are produced
Sales ($60 selling price) 60,000 60,000
Variable COGS 23,000 23,000
Variable marketing 1,250 1,250
Contribution margin 35,750 35,750
Fixed factory OH (20,000) (20,000)
Fixed market and admin. (12,000) (12,000)
Operating Income 3,750 3,750