Chapter 6 Key Points

Absorption vs. Variable Costing

Product cost includes Direct Materials, direct labor and overhead.   Period costs are selling, general and administrative costs.

Contribution Margin is Sales – Variable Costs.

Absorption Costing (or full costing):
  • Typically used for financial reporting (GAAP)
  • ALL manufacturing costs are included in the cost (direct materials, direct labor, fixed and variable overhead)
  • Can be misleading as some costs are not affected by products
  • Fixed manufacturing overhead costs are applied to units PRODUCED and not just unit sold
  • Fixed manufacturing overhead per unit calculated as Fixed manufacturing costs divided by units PRODUCED.
  • Cost of goods sold = units sold x absorption cost per unit (including direct materials, direct labor, fixed and variable overhead)

Variable Costing:
  • ONLY includes product variable costs meaning costs that increase with volume (DM, DL & Variable OH)
  • Does not include FIXED costs as volume levels do not change these costs (fixed costs treated as period costs not product costs)
  • Can provide more accurate information for decision makers as costs are better tied to production levels
  • Can be applied to ALL costs and not just product costs.

Comparing Absorption and Variable Cost per unit:
  Absorption Variable
Direct Materials Include Include
Direct Labor Include Include
   Variable Overhead Include Include
   Fixed Overhead Include DO NOT include
Total Product Costs Sum sum
÷ Total Units ÷ Total Units ÷ Total Units
Product Cost per Unit = Cost per unit = Cost per unit
Note: Same formula can be applied for each product cost (Cost ÷ Units produced) to get direct material cost per unit, direct labor per unit, etc.

Income Statement Formats:
  • Absorption Costing – this is your standard income statement showing Sales – Cost of Goods sold = Gross Margin (or Gross Profit) – Operating Expenses = Net Income and cost of goods sold is based on the number of units SOLD x absorption cost per unit.
  • Variable Costing – this is a Contribution Margin Income Statement showing Sales – VARIABLE expenses = Contribution Margin – Fixed Expenses = Net Income and variable expenses are based on number of units sold x variable cost per unit.
  • Net income on the two reports can be different if units produced do not equal units sold.

Click Absorption Variable Key Takeaway for a printable copy.

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