Absorption vs.

Variable Costing
Product cost includes Direct Materials, direct labor and overhead. Period costs are selling, general and administrative
costs.

Contribution Margin is Sales – Variable Costs.

Absorption Costing (or full costing):

• Typically used for financial reporting (GAAP)

• ALL manufacturing costs are included in the cost (direct materials, direct labor, fixed and variable overhead)
• Can be misleading as some costs are not affected by products
• Fixed manufacturing overhead costs are applied to units PRODUCED and not just unit sold

Variable Costing:

• ONLY includes variable costs meaning costs that increase with volume
• Does not include FIXED costs as volume levels do not change these costs (fixed costs treated as period costs not
product costs)
• Can provide more accurate information for decision makers as costs are better tied to production levels
• Can be applied to ALL costs and not just product costs.

Comparing Absorption and Variable Cost per unit:

Absorption Variable
Direct Materials Include Include
Direct Labor Include Include
Overhead:
Variable Overhead Include Include
Fixed Overhead Include DO NOT include
Total Product Costs Sum sum
÷ Total Units ÷ Total Units ÷ Total Units
Product Cost per Unit = Cost per unit = Cost per unit

Note: Same formula can be applied for each cost (Cost ÷ Units) to get direct material cost per unit, direct labor per unit,
etc.

Income Statement Formats:

• Absorption Costing – this is your standard income statement showing Sales – Cost of Goods sold = Gross
Margin (or Gross Profit) – Operating Expenses = Net Income and is based on the number of units SOLD.
• Variable Costing – this is a Contribution Margin Income Statement showing Sales – VARIABLE expenses =
Contribution Margin – Fixed Expenses = Net Income and is based on the number of units PRODUCED not
sold.
• Net income on the two reports can be different if units produced do not equal units sold.