Materials, labor, and overhead are combined to make products to sell. The combination of these three costs are what is used to determine the cost of goods expense and inventory valuation amounts. From an internal management standpoint, knowing how costs are associated to the products is critical in understanding pricing options and deploying product manufacturing upgrades. However, one group of costs are treated differently across two managerial costing methods. These two methods — used for internal use and not incorporated into financial statements — help management develop strategies regarding products offered.
Variable Versus Absorption Costing
The two methods for internally reporting inventory costs are the variable costing method and absorption costing method. Both methods consider direct materials, direct labor, and variable manufacturing overhead as a part of product costs. This means that costs are reported as inventory and only become an expense when the inventory is sold. In addition, both methods report selling and administrative costs as period costs. Regardless if the expense is fixed or variable, the expense is reported in the period is occurs, not when the inventory is sold.
Difference Between Methods
The sole difference between these two methods is a big one — absorption costing includes fixed manufacturing overhead as a period cost, while variable costing does not. This means certain expenses are built into the price of a good (under absorption costing), and these same expenses are reported when the immediately occur (under variable costing). Absorption costing leads to higher inventory balances, lower initial expenses, and higher net income. Although the total expenses reported will eventually balance out, this initial difference is often enough to sway the decision making process for management.
Only fixed manufacturing overhead costs represent the difference between the two methods. These costs include the salary of supervisors and staff necessary to produce the products. Note this does not include wages, as these represent variable direct labor expenses. Insurance to cover manufactured goods can also be a fixed cost. Finally, depending on the management’s discretion, depreciation and maintenance costs can be treated at fixed costs if a repetitive expense occurs.
Example of Costing Difference
Imagine a company with direct material expenses of $15 per unit and direct labor expenses of $20 per unit. In addition, each unit produced results in $5 of variable overhead. Upon the production of 1,000 units, the company incurred $30,000 ($30 per unit) of fixed manufacturing overhead.
Under variable costing, only the variable costs are transferred to inventory. In this situation, the inventory cost $40, or $15 + $20 + $5. These costs are reported on the balance sheet as inventory costs until the goods are sold. Meanwhile, the $30,000 of fixed manufacturing overhead is reported as a period cost. This means it is reported as an expense immediately. In contrast, absorption costing reports all of the costs as inventory. Each unit has a valuation of $70. Most importantly, none of the costs above are expenses in the current period. Therefore, absorption costing will result in net income $30,000 higher than variable costing. It is important for internal users to understand how these two methods report results so the appropriate decisions.