Variable and absorption costing generate different levels of cost and net income in cost accounting, so it’s important to understand the differences so you can select a costing method to use internally for decision-making.

Say your business manufactures handsaws. Here is a summary of production, sales, and costs in Year 1.

 Production (units) 3,000 Sales (units) 2,500 Sales (at \$25 per unit) \$62,500 Fixed manufacturing costs \$21,000 All other product costs \$33,000

Because you didn’t sell all of your production, you created ending inventory:

Ending inventory = units produced – units sold
Ending inventory = 3,000 – 2,500
Ending inventory = 500

Your fixed manufacturing costs are \$7 per unit produced (\$21,000 ÷ 3,000 units). Absorption costing requires you to assign \$3,500 of fixed manufacturing costs to ending inventory (\$7 x 500 units). The next table outlines the profit in Year 1, comparing variable and absorption costing.

 Variable Costing Absorption Costing Sales (at \$25 per unit) \$62,500 \$62,500 Fixed manufacturing costs \$21,000 \$17,500 All other costs \$27,500 \$27,500 Total costs \$48,500 \$45,000 Profit \$14,000 \$17,500

Absorption costing deferred \$3,500 of fixed manufacturing costs. The fixed manufacturing costs are only \$17,500. You see that absorption costing has a \$3,500 higher profit (\$17,500 versus \$14,000).

In Year 2, assume that your sales and sales price are the same. You also sell all your production, plus the 500 units that were in ending inventory. Your sales (2,500 units) are 500 units more than your production (2,000 units). Because you produced less in Year 2, the all-other-cost number declines to \$22,500. Less production means less cost. Check out this next table.

 Production (units) 2,000 Sales (units) 2,500 Sales (at \$25 per unit) \$62,500 Fixed manufacturing costs \$21,000 All other costs \$22,500

Variable and absorption costing are the same if you sell all of your production. You don’t produce any ending inventory, so you don’t defer any fixed manufacturing costs into inventory items. Here is the profit in Year 2.

 Variable Costing Absorption Costing Sales (at \$25 per unit) \$62,500 \$62,500 Fixed manufacturing costs \$21,000 \$24,500 All other costs \$27,500 \$27,500 Total costs \$48,500 \$52,000 Profit \$14,000 \$10,500

Five hundred units from Year 1 ending inventory are sold in Year 2. In the third table, production of 2,000 is 500 units less than sales of 2,500. You had 500 units available for sale at the beginning of Year 2.

Fixed manufacturing costs for Year 2 are the same for both methods (\$21,000). However, absorption costing added the \$3,500 fixed manufacturing cost that was deferred in Year 1. The fixed manufacturing cost is \$24,500 (\$21,000 + \$3,500).

The variable costing profit in Year 2 is \$3,500 higher than the absorption costing profit (\$14,000 versus \$10,500). In Year 1, variable costing profit was \$3,500 lower than the absorption costing. When Year 1 ending inventory is sold in Year 2, absorption picks up the fixed manufacturing cost that was deferred.

Over two years, all the production is sold. The total profit over two years is the same for both costing methods.

You’re probably wondering about which method to use. Your profit eventually is the same under either method. In the long run, there is no advantage to using one method over another.

You should select a method and stick with it. By doing so, you’re applying the principle of consistency. For a financial statement reader to compare your results year by year, you need to use the same method. It’s the old idea of an apples-to-apples comparison.