Difficulty: Intermediate | Prerequisites: Understanding of fixed vs variable costs, basic income statement structure.
This topic tackles a deceptively simple question: should fixed manufacturing overhead be treated as a product cost (attached to inventory) or a period cost (expensed immediately)? The answer determines which costing method you are using, and it changes reported profit whenever production and sales volumes differ. Absorption costing is required by GAAP for external reporting. Variable costing is preferred by managers for internal decision-making because it aligns profit more closely with sales volume. If you understand the fixed-vs-variable cost distinction and how inventory absorbs costs, you are ready.
Absorption costing treats all manufacturing costs (including fixed manufacturing overhead) as product costs that attach to inventory. Variable costing treats only variable manufacturing costs as product costs and expenses all fixed manufacturing overhead as a period cost. When production exceeds sales, absorption costing reports higher income because some fixed overhead is deferred in inventory. When sales exceed production, variable costing reports higher income because fixed overhead from prior periods is released.
Variable costing (direct costing)
A costing method that includes only variable manufacturing costs (direct materials, direct labour, variable manufacturing overhead) in product costs. All fixed manufacturing overhead is expensed as a period cost in the period incurred.
Think of it as: "Only costs that change with production go into inventory."
Absorption costing (full costing)
A costing method that includes all manufacturing costs, both variable and fixed, in product costs. Fixed manufacturing overhead is allocated to units produced and flows into inventory until sold.
Think of it as: "Inventory absorbs everything it costs to make the product, including the factory's fixed costs."
Period costs
Costs that are expensed in the income statement in the period they are incurred, rather than attached to inventory.
Under variable costing, period costs include all fixed costs (fixed manufacturing overhead plus fixed selling and administrative expenses).
Under absorption costing, period costs include only selling and administrative expenses (both fixed and variable). Fixed manufacturing overhead is a product cost.
Product costs
Costs that are attached to units of inventory and expensed as cost of goods sold when those units are sold.
Fixed manufacturing overhead deferred in inventory
When production exceeds sales, unsold units sit in ending inventory. Under absorption costing, each unit carries a share of fixed manufacturing overhead. The portion of fixed overhead sitting in ending inventory is "deferred" to a future period.
Fixed manufacturing overhead released from inventory
When sales exceed production, units from beginning inventory are sold. Under absorption costing, the fixed overhead those units carried is "released" and expensed in the current period.
The only difference between the two methods is the treatment of fixed manufacturing overhead (FMOH).
Absorption costing: FMOH is a product cost. It is included in the per-unit cost of inventory. It flows to cost of goods sold when units are sold.
Variable costing: FMOH is a period cost. It is expensed in full in the period incurred, regardless of how many units are produced or sold.
All other costs are treated identically. Variable manufacturing costs are product costs under both methods. Selling and administrative expenses (both fixed and variable) are period costs under both methods.
The income difference arises whenever production does not equal sales, because absorption costing defers or releases FMOH through inventory.
Production > Sales (inventory builds): Absorption costing income > Variable costing income. Some FMOH is deferred in ending inventory and not expensed this period.
Production < Sales (inventory drawn down): Absorption costing income < Variable costing income. FMOH from a prior period's inventory is released and expensed this period.
Production = Sales: Both methods give the same income.
The income difference equals the change in FMOH in inventory:
Absorption income = Variable income + FMOH deferred in ending inventory - FMOH released from beginning inventory.
Variable production costs = $8,000 for 4,000 units = $2.00 per unit variable cost. FMOH = $4,800, so FMOH per unit = $4,800 / 4,000 = $1.20.
Produced 4,000 units, sold 3,600, so 400 units remain in ending inventory.
Variable costing inventory cost per unit: $2.00 (variable costs only).
Absorption costing inventory cost per unit: $2.00 + $1.20 = $3.20.
Ending inventory difference: 400 units x $1.20 = $480. The ending inventory under variable costing is $480 lower than under absorption costing.
Absorption costing income is $480 higher than variable costing income (because $480 of FMOH is deferred in inventory, not expensed).
Last year: Variable costing NOI = $76,000. FMOH released from inventory = $5,000 (meaning inventory decreased, so sales > production). Absorption costing NOI = $76,000 - $5,000 = $71,000.
This year: Variable costing NOI = $94,000. FMOH deferred in inventory = $22,000 (meaning inventory increased, so production > sales). Absorption costing NOI = $94,000 + $22,000 = $116,000.
When variable costing income > absorption costing income, it means inventory decreased (sales > production). When variable costing income < absorption costing income, inventory increased (production > sales).
Year 8: Variable $45,000, Absorption $15,000. Variable > Absorption by $30,000, so inventory decreased (sold more than produced).
Year 9: Variable $19,000, Absorption $9,000. Variable > Absorption by $10,000, so inventory decreased again.
Year 10: Variable $(7,000), Absorption $3,000. Absorption > Variable by $10,000, so inventory increased (produced more than sold).
Over the three years combined: Variable total = $57,000, Absorption total = $27,000. Variable > Absorption by $30,000 total, so over those three years Dull sold more units than it produced (inventory fell in net terms). Option B is correct.
Note: Variable costing was negative in Year 10, meaning the company operated below break-even in Year 10. So option A (operated above break-even in each year) is false.
\text{Absorption costing unit cost} = \text{Variable manufacturing cost per unit} + \text{FMOH per unit}\text{Variable costing unit cost} = \text{Variable manufacturing cost per unit only}\text{FMOH per unit} = \frac{\text{Total fixed manufacturing overhead}}{\text{Units produced}}\text{Absorption NOI} = \text{Variable NOI} + \text{FMOH deferred in ending inventory} - \text{FMOH released from beginning inventory}\text{Inventory difference} = (\text{Units in ending inventory}) \times \text{FMOH per unit}Absorption costing is required under GAAP and IFRS for external financial statements, which is why every public company uses it for reporting to shareholders and tax authorities. Variable costing is used internally by managers because it removes the distortion that comes from production volume changes: under absorption costing, a manager could boost reported profit simply by overproducing (building inventory), which defers fixed overhead to future periods. Variable costing prevents this because all FMOH is expensed immediately.
Students often think that variable costing expenses all fixed costs. This is mostly true, but be precise: under variable costing, all fixed costs are period costs. Under absorption costing, only selling and administrative costs are period costs; fixed manufacturing overhead is a product cost.
Students sometimes confuse which method gives higher income. The rule is straightforward: whichever method puts more costs on the income statement this period gives lower income. If inventory grows (production > sales), absorption defers costs, so absorption income is higher.
Students sometimes think absorption costing is "wrong" because it can be manipulated through production levels. Absorption costing is required for external reporting. Variable costing is preferred for internal decisions. Both have a role.
⚠️ Under variable costing, period costs include all fixed costs, not just fixed selling and administrative. Fixed manufacturing overhead is also a period cost under variable costing.
⚠️ Know how to reconcile variable and absorption costing income using the FMOH deferred/released formula.
⚠️ When production > sales, absorption income > variable income. When production < sales, the reverse.
⚠️ The Corbin Company problem tests your ability to calculate per-unit costs under both methods and the inventory/income difference. The Dull Corporation problem tests your ability to infer production vs sales from the income difference.
⚠️ The bonus question asks you to explain the difference between the two methods and the rationale. The rationale: absorption costing matches all manufacturing costs to the units produced (matching principle for external reporting); variable costing separates fixed overhead because those costs are incurred regardless of how much is produced and are better treated as period costs for decision-making.
True or False: Under variable costing, fixed manufacturing overhead is a product cost. (False. It is a period cost.)
Fill in the blank: When production exceeds sales, absorption costing income is ________ than variable costing income. (Higher.)
True or False: The only cost treated differently between the two methods is fixed manufacturing overhead. (True.)
Fill in the blank: Under variable costing, period costs include all fixed costs: fixed ________ overhead and fixed ________ and ________ expenses. (Manufacturing; selling; administrative.)
Q: Under variable costing, which costs are treated as period costs?
A: All fixed costs, including fixed manufacturing overhead, fixed selling expenses, and fixed administrative expenses.
Q: Corbin Company produced 4,000 units (variable production costs $8,000, FMOH $4,800) and sold 3,600. Under variable costing, what is the per-unit inventory cost?
A: $2.00 per unit. Variable costing only includes variable manufacturing costs: $8,000 / 4,000 = $2.00.
Q: In the Corbin Company example, by how much does the ending inventory differ between the two methods?
A: $480 lower under variable costing. The 400 unsold units each carry $1.20 of FMOH under absorption costing but $0 under variable costing: 400 x $1.20 = $480.
Q: Salonia Corporation's variable costing NOI was $76,000 last year. FMOH released from beginning inventory was $5,000. What was absorption costing NOI last year?
A: $71,000. Absorption NOI = $76,000 - $5,000 = $71,000. FMOH was released (inventory shrank), so absorption income is lower.
Q: Briefly explain the difference between variable costing and absorption costing and the rationale for each.
A: Variable costing treats fixed manufacturing overhead as a period cost; absorption costing treats it as a product cost attached to inventory. The rationale: absorption costing assigns all manufacturing costs to units produced under the matching principle, which is why GAAP requires it for external reporting. Variable costing expenses fixed overhead immediately because those costs are incurred regardless of output, making profit a function of sales volume alone, which is more useful for internal planning and control.
This topic connects to CVP analysis because the contribution-format income statement used in CVP is a variable costing statement. It also connects to activity-based costing, which provides a different way of allocating overhead to products. Understanding how inventory changes affect income under absorption costing is essential for budgeting, because a production budget that builds inventory will boost absorption costing income even if sales are flat.
Variable costing, direct costing, absorption costing, full costing, fixed manufacturing overhead, FMOH, product cost, period cost, deferred overhead, released overhead, inventory costing, contribution format income statement, GAAP costing, ACCT 3001, management accounting