If the 8,000 units are sold for $33 each, the difference between absorption costing and variable costing is a timing difference. Under absorption costing, the 2,000 units in ending inventory include the $1.20 per unit share, or $2,400 of fixed cost. That cost will be expensed when the inventory is sold and accounts for the difference in net income under absorption and variable costing, as shown in Figure 6.14. Absorption costing is an accounting method used to determine the full cost of producing a product or service. Additionally, when there is unsold inventory, absorption costing can result in higher reported profits because fixed overhead costs are deferred into inventory until the products are sold.

This is contrary to variable costing, where incremental production bears the same variable costs of production. Also, the method of variable costing does not depict a correct picture of the accounting profits or losses. This cost includes direct production costs like materials and wages as well as a share of fixed costs allocated to each unit. Understanding accurate unit costs is key for inventory valuation and pricing decisions. When using variable costing, all variable production costs must be accounted for in inventory, and all fixed production costs (fixed manufacturing overhead) must be recorded as period expenses. Therefore, all fixed manufacturing expenses are deducted as they are incurred.

Overhead Absorption Rate Formula

This results in fixed costs impacting COGS rather than flowing straight to the income statement. The absorption costing method adheres to GAAP and provides an accurate, full-cost valuation of inventory. While more complex than variable costing, absorption costing gives managers and investors a clearer view of product profitability. In absorption costing, the variable and fixed selling expenses are considered as period costs. Whereas, direct material and labor, along with variable and fixed manufacturing costs, are considered product costs.

This distinction should be implemented in order to construct a flexible budget. It reveals inefficient or efficient production resource utilization by displaying under- or over-absorption of manufacturing overheads. To put it another way, all manufacturing costs are absorbed into the price of the finished goods.

Determining the actual cost of production

absorption costing captures all manufacturing costs, including direct materials, direct labor, and both variable and fixed overhead, in the valuation of inventory. Absorption costing can skew a company’s profit level due to the fact that all fixed costs are not subtracted from revenue unless the products are sold. By allocating fixed costs into the cost of producing a product, the costs can be hidden from a company’s income statement in inventory. Hence, absorption costing can be used as an accounting trick to temporarily increase a company’s profitability by moving fixed manufacturing overhead costs from the income statement to the balance sheet. In addition, absorption costing takes into account all costs of production, such as fixed costs of operation, factory rent, and cost of utilities in the factory. It includes direct costs such as direct materials or direct labor and indirect costs such as plant manager’s salary or property taxes.

This is the allocation of the cost of machinery and equipment over their useful life. Depreciation is considered a fixed cost in absorption costing because it remains constant regardless of production levels. Absorption costing is typically used in situations where a company wants to understand the full cost of producing a product or providing a service. This includes cases where a company is required to report its financial results to external stakeholders, such as shareholders or regulatory agencies. In determining absorption costing, you first need to know what kind of expenses you’re producing. Before calculating absorption costing, get your Variable Manufacturing Overhead Costs and Overhead Costs.