Lessons · Accounting · absorption costing against variable costing
Absorption costing against variable costing
Under absorption costing, fixed production overhead goes into the cost of a unit and sits in inventory until the unit is sold. Under variable costing it is charged to the period. The two give different profits whenever inventory changes.
Hone is a place to practise a career, one idea a day. This is one of its lessons, written out in full and free to read without an account.
In beta. This lesson was written for Hone and has not yet been checked by a qualified accountant. Practice material, not professional advice. What that means.
What it is for
It explains a result that otherwise looks like a mistake: a factory produces more than it sells, and profit goes up while nothing was sold to cause it. The extra units carried fixed overhead into inventory with them. It is also why production volume can be used to flatter a period's profit, which is worth recognising when somebody else's figures are in front of you.
How to think about it
Compare the change in inventory. If inventory rose, absorption profit is higher by the fixed overhead per unit times the increase. If inventory fell, absorption profit is lower by the same reasoning.
Worked example
Fixed production overhead 2.00 a unitThe part treated differently by the two methods.
Produced 10,000, sold 9,000: inventory up 1,000More made than sold.
Absorption profit is higher by 1,000 × 2.00 = 2,000That much fixed overhead stayed in inventory instead of going to the income statement.
Sell those 1,000 next period and it reversesNothing was created. The charge was deferred.
Your turn
Inventory rose 1,000 units and fixed overhead is 2.00 a unit. Write the line for the difference in profit.
Difference = 1,000 × = 2,000
Solve one, graded on the server
The trap
Reading rising profit in a period of rising inventory as improved trading. Until the goods are sold, the improvement is a timing difference, and it reverses.