Variable and Absorption Costing
Variable and Absorption Costing
Both methods record the same revenue and total resource spending. They differ in when fixed production overhead enters profit.
| Method | Product cost includes | Main use |
|---|---|---|
| Absorption costing | Variable production cost + allocated fixed production overhead | External inventory measurement under applicable rules |
| Variable costing | Variable production cost only | Internal contribution analysis |
Northstar case
- units produced: 1,000;
- units sold: 800;
- selling price: £600;
- variable production cost: £300 per unit;
- fixed factory overhead: £120,000, or £120 per produced unit;
- variable selling cost: £20 per unit sold;
- fixed selling/administration: £30,000.
Variable-costing statement
| £ | |
|---|---|
| Sales: 800 × £600 | 480,000 |
| Variable production cost sold: 800 × £300 | (240,000) |
| Variable selling cost: 800 × £20 | (16,000) |
| Contribution margin | 224,000 |
| Fixed factory overhead | (120,000) |
| Fixed selling/administration | (30,000) |
| Profit | 74,000 |
Absorption-costing statement
Absorption product cost is £300 + £120 = £420.
| £ | |
|---|---|
| Sales | 480,000 |
| Cost of sales: 800 × £420 | (336,000) |
| Gross profit | 144,000 |
| Variable selling cost | (16,000) |
| Fixed selling/administration | (30,000) |
| Profit | 98,000 |
Reconcile, do not memorise
Ending inventory contains 200 units. Absorption costing defers:
Therefore:
When production exceeds sales, absorption profit is higher under these facts. When sales exceed production and prior fixed overhead leaves inventory, the direction reverses.
External-reporting boundary
IAS 2 includes systematic allocation of variable and fixed production overhead in inventory cost. Fixed overhead uses normal capacity; abnormal idle-capacity cost is expensed rather than hidden in inventory. Variable costing is useful internally but does not replace the applicable external inventory requirements.
Behavioural risk
A manager rewarded only on absorption profit may overproduce to defer fixed overhead. Countermeasures include:
- inventory and cash targets;
- normal-capacity discipline;
- write-down review;
- measures of demand, throughput and obsolete stock;
- multi-period performance evaluation.
Quick check
If Northstar produced and sold exactly 1,000 units with no opening inventory, would the two profit figures differ?