The costing method that treats all fixed costs as period costs is:

Absorption costing is a costing method in which all costs attributed to the production of a product are estimated. This costing method entails a full estimation of total expenses incurred in manufacturing a product. 

Direct costs such as costs of procuring raw materials, labor wages and indirect costs such as costs of acquiring a facility, utility costs and others are calculated in absorption costing. The absorption costing method accumulates all costs of a finished product including overhead costs and direct costs. 

Under U.S. GAAP, all non-manufacturing costs (selling and administrative costs) are treated as period costs because they are expensed on the income statement in the period in which they are incurred. 

Although absorption costing is used for external reporting, managers often prefer to use an alternative costing approach for internal reporting purposes called variable costing. 

Variable costing requires that all variable production costs be included in inventory, and all fixed production costs (fixed manufacturing overhead) be reported as period costs. 

Thus all fixed production costs are expensed as incurred.

The only difference between absorption costing and variable costing is in the treatment of fixed manufacturing overhead. 

Using absorption costing, fixed manufacturing overhead is reported as a product cost. 

Using variable costing, fixed manufacturing overhead is reported as a period cost. 

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Absorption Costing vs. Variable Costing

Absorption costing and variable costing are two distinct methods of assigning costs to the production of goods and services. 

The difference between absorption costing and variable costing is in the treatment of fixed manufacturing overhead costs. 

Absorption costing treats fixed manufacturing overhead as a product cost (included in inventory on the balance sheet until sold), while variable costing treats fixed manufacturing overhead as a period cost (expensed on the income statement as incurred).

When comparing absorption costing with variable costing, the following three rules apply: 

(1) When units produced equals units sold, profit is the same for both costing approaches. 

(2) When units produced is greater than units sold, absorption costing yields the highest profit. 

(3) When units produced is less than units sold, variable costing yields the highest profit.

Impact of Absorption Costing and Variable Costing on Profit

 If a company uses just-in-time inventory, and therefore has no beginning or ending inventory, profit will be exactly the same regardless of the costing approach used. 

However, most companies have units of product in inventory at the end of the reporting period. 

Since absorption costing includes fixed manufacturing overhead as a product cost, all products that remain in ending inventory (i.e., are unsold at the end of the period) include a portion of fixed manufacturing overhead costs as an asset on the balance sheet. 

Since variable costing treats fixed manufacturing overhead costs as period costs, all fixed manufacturing overhead costs are expensed on the income statement when incurred. 

Thus if the quantity of units produced exceeds the quantity of units sold, absorption costing will result in higher profit.

Advantages of Using Variable Costing

Variable costing provides managers with the information necessary to prepare a contribution margin income statement, which leads to more effective cost-volume-profit (CVP) analysis. 

By separating variable and fixed costs, managers are able to determine contribution margin ratios, break-even points, and target profit points, and to perform sensitivity analysis. 

Conversely, absorption costing meets the requirements of U.S. GAAP, but is not as useful for internal decision-making purposes.

Another advantage of using variable costing internally is that it prevents managers from increasing production solely for the purpose of inflating profit. 

However, in the short run, the manager will increase profit by increasing production. 

This strategy does not work with variable costing because all fixed manufacturing overhead costs are expensed as incurred, regardless of the level of sales.

Advantages of Absorption Costing

The use of the absorption costing method comes with a lot of benefits. The major benefits of this costing method include;

• Absorption costing method reflects fixed costs that are attributable to the production of goods and services. It identifies the necessity of fixed costs when estimating costs involved in production.
• It is a more accurate costing method when compared to other traditional costing methods and even its counterpart; variable costing.
• Absorption costing also account for the expenses of unsold products, this is important for external reporting as required by GAAP.
• This method achieves a better and higher net income estimation. This is because it helps to achieve less fluctuation in net profits.

Disadvantages of Absorption Costing

Despite the good benefits that companies can derive from using the absorption costing method, it has some disadvantages. The major dark sides of this costing method include the fact that it results in the increase of net income. Because this method accounts for fixed costs, the higher the goods produced at a time, the lesser the fixed costs that will be attributable to the production of the goods, which in turn causes the net income to increase. Hence, the fixed costs accounted for in this method is less favorable compared to variable costing. Another disadvantage of absorption costing is that cost volume profit (CVP) is difficult to analyze when it is being used.

Related Topics

Absorption costing, sometimes called “full costing,” is a managerial accounting method for capturing all costs associated with manufacturing a particular product. The direct and indirect costs, such as direct materials, direct labor, rent, and insurance, are accounted for by using this method.

Absorption costing is required by generally accepted accounting principles (GAAP) for external reporting.

• Absorption costing differs from variable costing because it allocates fixed overhead costs to each unit of a product produced in the period.
• Absorption costing allocates fixed overhead costs to a product whether or not it was sold in the period.
• This type of costing method means that more cost is included in the ending inventory, which is carried over into the next period as an asset on the balance sheet.
• Because more expenses are included in ending inventory, expenses on the income statement are lower when using absorption costing.

Absorption costing includes anything that is a direct cost in producing a good in its cost base. Absorption costing also includes fixed overhead charges as part of the product costs. Some of the costs associated with manufacturing a product include wages for employees physically working on the product, the raw materials used in producing the product, and all of the overhead costs (such as all utility costs) used in production.

In contrast to the variable costing method, every expense is allocated to manufactured products, whether or not they are sold by the end of the period.

Absorption costing means that ending inventory on the balance sheet is higher, while expenses on the income statement are lower.

The differences between absorption costing and variable costing lie in how fixed overhead costs are treated. Absorption costing allocates fixed overhead costs across all units produced for the period. Variable costing, on the other hand, lumps all fixed overhead costs together and reports the expense as one line item separate from the cost of goods sold (COGS) or still available for sale.

Variable costing does not determine a per-unit cost of fixed overheads, while absorption costing does. Variable costing will yield one lump-sum expense line item for fixed overhead costs when calculating net income on the income statement. Absorption costing will result in two categories of fixed overhead costs: those attributable to the cost of goods sold, and those attributable to inventory.

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Assets, such as inventory, remain on the entity’s balance sheet at the end of the period. Because absorption costing allocates fixed overhead costs to both cost of goods sold and inventory, the costs associated with items still in ending inventory will not be captured in the expenses on the current period’s income statement. Absorption costing reflects more fixed costs attributable to ending inventory.

Absorption costing ensures more accurate accounting for ending inventory because the expenses associated with that inventory are linked to the full cost of the inventory still on hand. In addition, more expenses are accounted for in unsold products, which reduces actual expenses reported in the current period on the income statement. This results in a higher net income calculation compared with variable costing calculations.

Because absorption costing includes fixed overhead costs in the cost of its products, it is unfavorable compared with variable costing when management is making internal incremental pricing decisions. This is because variable costing will only include the extra costs of producing the next incremental unit of a product.

In addition, the use of absorption costing generates a situation in which simply manufacturing more items that go unsold by the end of the period will increase net income. Because fixed costs are spread across all units manufactured, the unit fixed cost will decrease as more items are produced. Therefore, as production increases, net income naturally rises, because the fixed-cost portion of the cost of goods sold will decrease.

Absorption costing results in a higher net income compared with variable costing.

Assume that ABC Company makes widgets. In January, it makes 10,000 widgets, of which 8,000 are sold by the end of the month, leaving 2,000 still in inventory. Each widget uses $5 of labor and materials directly attributable to the item. In addition, there are $20,000 of fixed overhead costs each month associated with the production facility. Under the absorption costing method, ABC will assign an additional $2 to each widget for fixed overhead costs ($20,000 total ÷ 10,000 widgets produced in the month).

The absorption cost per unit is $7 ($5 labor and materials + $2 fixed overhead costs). As 8,000 widgets were sold, the total cost of goods sold is $56,000 ($7 total cost per unit × 8,000 widgets sold). The ending inventory will include $14,000 worth of widgets ($7 total cost per unit × 2,000 widgets still in ending inventory).

Absorption costing and variable costing treat fixed overhead costs differently. Absorption costing allocates fixed overhead costs across all units produced for the period. Variable costing, on the other hand, adds all fixed overhead costs together and reports the expense as one line item separate from the cost of goods sold or still available for sale. In other words, variable costing will yield one lump-sum expense line item for fixed overhead costs when calculating net income, while absorption costing will result in two categories of fixed overhead costs: those attributable to the cost of goods sold, and those attributable to inventory.

The main advantage of absorption costing is that it complies with generally accepted accounting principles (GAAP), which are required by the Internal Revenue Service (IRS). Furthermore, it takes into account all of the costs of production (including fixed costs), not just the direct costs, and more accurately tracks profit during an accounting period.

The main disadvantage of absorption costing is that it can inflate a company’s profitability during a given accounting period, as all fixed costs are not deducted from revenues unless all of the company’s manufactured products are sold. Additionally, it is not helpful for analysis designed to improve operational and financial efficiency or for comparing product lines.