Absorption vs variable costing: why is the profit different?

Two income statements for the same factory, the one-line reconciliation, and how much profit overproduction can manufacture.

Julian R. Sterling · from Cost Accounting

Absorption and variable costing report different profits only when inventory changes, and the difference is exactly the change in inventory units times the fixed overhead rate per unit. On an illustrative product with fixed manufacturing overhead of 12.00 a unit, building 6,000 units of stock lifts absorption profit to 102,000 against 30,000 under variable costing: a gap of 72,000, which is 6,000 × 12.00. When the stock is sold the next year, the gap reverses and the two-year totals are identical.

Worked in full in Cost Accounting by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →

The question matters because the two methods answer different needs. Absorption costing is what external reporting requires: inventory carries its share of fixed production overhead. Variable costing is what most internal decisions need, because fixed overhead does not change with the next unit. A manager who reads one while being paid on the other can make the factory look more profitable simply by producing more than it sells.

The assumptions

One product, two years, no opening inventory, standard costs equal actual.
Input	Value
Selling price per unit	40.00
Variable manufacturing cost per unit (material, labour, variable overhead)	18.00
Variable selling cost per unit	2.00
Fixed manufacturing overhead a year	600,000
Fixed selling and administrative cost a year	250,000
Normal production volume (denominator for the fixed rate)	50,000
Year 1: production / sales	50,000 / 44,000
Year 2: production / sales	44,000 / 50,000

Step 1: the two unit costs

Fixed overhead rate = fixed manufacturing overhead ÷ normal volume = 600,000 ÷ 50,000 = 12.00

Absorption unit cost = 18.00 + 12.00 = 30.00 Variable unit cost = 18.00

Contribution per unit = 40.00 − 18.00 − 2.00 = 20.00

Variable selling cost is never inventoried under either method; only production costs go into stock.

Step 2: year 1, building stock

Year 1: 50,000 made, 44,000 sold, 6,000 into closing inventory.
Line	Variable costing	Absorption costing
Revenue	1,760,000	1,760,000
Cost of goods sold (44,000 units)	-792,000	-1,320,000
Volume variance		0
Variable selling cost	-88,000	-88,000
Fixed manufacturing overhead (period cost)	-600,000
Fixed selling and administrative	-250,000	-250,000
Operating profit	30,000	102,000

Variable costing expenses all 600,000 of fixed overhead in the year it is incurred. Absorption costing charges 12.00 to each of the 50,000 units made, so 528,000 goes through cost of sales with the 44,000 units sold and 72,000 sits in the balance sheet inside the 6,000 units of closing stock, valued at 180,000 against 108,000 under variable costing.

Step 3: year 2, selling the stock

Year 2: 44,000 made, 50,000 sold, inventory back to zero.
Line	Variable costing	Absorption costing
Revenue	2,000,000	2,000,000
Cost of goods sold (50,000 units)	-900,000	-1,500,000
Volume variance (6,000 units under normal × 12.00)		-72,000
Variable selling cost	-100,000	-100,000
Fixed manufacturing overhead (period cost)	-600,000
Fixed selling and administrative	-250,000	-250,000
Operating profit	150,000	78,000

Now absorption profit is the lower one. The 72,000 of fixed overhead deferred in year 1 is released into cost of sales with the stock, and that release is the whole gap. The 72,000 volume variance is not a second charge: it is the part of this year's 600,000 that 44,000 units at 12.00 could not absorb, so absorption costing still expenses the full year's overhead, plus the 72,000 brought forward. Over the two years both methods report 180,000. Nothing was earned; profit was moved from one year to the next.

The reconciliation formula

Absorption profit − variable profit = (closing units − opening units) × fixed overhead rate

Year 1: (6,000 − 0) × 12.00 = +72,000. Year 2: (0 − 6,000) × 12.00 = −72,000.

In Excel, with closing units in B1, opening in B2 and the rate in B3: =(B1-B2)*B3. If the fixed rate changes between years, use closing fixed overhead in inventory minus opening fixed overhead in inventory instead.

What if: how much profit can production buy?

Hold year 1 sales at 44,000 units and change only production. Variable costing profit does not move, because it depends on sales. Absorption profit rises with every unit put into stock, because each one carries 12.00 of this year's fixed overhead into next year.

Year 1 profit at 44,000 units sold, by production volume.
Units produced	Inventory build	Variable costing profit	Absorption costing profit	Gap	Absorption ÷ variable
44,000	0	30,000	30,000	0	1.0x
46,000	2,000	30,000	54,000	24,000	1.8x
50,000	6,000	30,000	102,000	72,000	3.4x
54,000	10,000	30,000	150,000	120,000	5.0x
60,000	16,000	30,000	222,000	192,000	7.4x

At 60,000 units the reported profit is 7.4 times the economic result of the year, and the factory has spent cash on 16,000 units nobody has ordered. Where a bonus is paid on absorption profit, this is the cheapest lever available to the person who sets the production schedule.

The common mistakes

Reading a profit increase in a year of falling sales as an operating improvement without checking the inventory movement first. Run the reconciliation formula before the variance commentary.
Using the absorption unit cost of 30.00 to price an extra order. The incremental cost is 18.00 plus 2.00 of selling cost; the 12.00 of fixed overhead is spent whether or not the order is taken, as long as there is spare capacity.
Re-computing the fixed rate on actual output each year. That makes the unit cost rise as volume falls and hides the volume variance inside product cost; the denominator choice is worked in how to calculate the predetermined overhead rate.
Forgetting that the two methods converge only when inventory returns to its starting level. A business that keeps building stock reports an absorption premium every year until the build stops.

Takeaway

The gap is inventory change times the fixed rate: 6,000 units at 12.00 is 72,000 this year, given back the next. Absorption costing belongs in the statutory accounts; variable costing belongs on the desk of anyone pricing orders or judging a quarter. Cost Accounting follows what the fixed overhead rate does to one factory's product costs and to the orders it wins and loses, and the free workbook for this case lets you change the volumes and watch the rate and the margins move.

Questions readers ask

When does absorption costing give a higher profit than variable costing?

Whenever production exceeds sales, so that inventory rises. Each unit added to stock carries its share of fixed manufacturing overhead into the balance sheet instead of the income statement. With a fixed rate of 12.00 a unit, a 6,000 unit build defers 72,000 and absorption profit is 72,000 higher. When inventory falls, absorption profit is the lower of the two.

Is variable costing allowed for external financial reporting?

Generally not. Financial reporting standards require inventory to include fixed production overhead, allocated on normal capacity, so absorption costing is used in the published accounts. Variable costing is a management tool. Many companies keep both and reconcile them each period with one line: change in inventory units times the fixed rate, 72,000 in the example.

Can managers inflate profit under absorption costing?

Yes, by producing more than they sell. In the example, with sales fixed at 44,000 units, raising production from 44,000 to 60,000 lifts absorption profit from 30,000 to 222,000 while the variable costing result stays at 30,000. The extra profit is fixed overhead parked in 16,000 units of unsold stock, and it reverses when the stock is sold or written down.

Read the whole case

This article is one calculation from Cost Accounting. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.

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