this is from my accounting notes
Absorption Costing vs Variable Costing
Remember: An asset is a resource of the company that gives a future economic benefit. Inventories are assets because they give future benefits to the company in the terms of sales revenue.
Absorption costing: includes all manufacturing costs --- including direct materials, direct labor, and BOTH variable and fixed manufacturing overhead.
Absorption Costing = Full Costing
Under absorption costing, fixed overhead is a product cost until sold.
Absorption costing makes no distinction between fixed and variable costs thus is not suited for CVP analysis.
Sales less Absorption Cost of Goods Sold will equal Gross Profit
Functional Analysis of the Income Statement
Variable costing: Includes only variable manufacturing costs --- direct materials, direct labor, and variable manufacturing overhead.
The entire amount of fixed costs are expenses in the year incurred.
When calculating Contribution Margin, Variable Cost of Goods Sold and Variable Selling and Administrative Expenses and subtracted from Sales.
Behavioral Analysis of the Income Statement
Variable costing can be used for Cost Volume Profit (Break-even Analysis)
Rules about Absorption Costing versus Variable Costing.
Rules about unit sales and production under the two costing methods.
If sales are variable and production constant.
A. When production is equal to sales, then absorption costing and variable costing will give the same amount of net income.
b. When production is greater than sales, then Net Income under absorption costing will be greater than net income under variable costing because a portion of the fixed costs was deferred to other years under the absorption method.
c. When production is less than sales, then Net Income under absorption costing will be less than net income under variable costing because a portion of the fixed costs that were deferred from previous years will be absorbed into this years cost of goods sold.
d. The value of inventory will be greater under the absorption method because of the deferred costs, however the total unit count will be the same for each accounting method.
e. Over the long-term, net income will be equal under both methods.
If sales are constant and production is variable then:
a. Net income under variable costing is not influenced by the fluctuations in sales (given a constant production) because none of the fixed manufacturing costs are deferred.
b. Net income under absorption costing is influenced by the fluctuations in sales (given a constant production) because a portion of the fixed manufacturing costs are deferred and may be used each year to increase costs.