Two ways to treat fixed factory overhead - load it into the product or hold it as a period cost - that agree on cash but disagree on reported profit the moment production and sales part ways.
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Absorption vs Variable (Direct) Costing
Quick answer. Two ways to treat fixed factory overhead - load it into the product or hold it as a period cost - that agree on cash but disagree on reported profit the moment production and sales part ways.
Absorption costing (also called full costing) treats fixed manufacturing overhead as part of the cost of each unit, so that overhead sits in inventory on the balance sheet until the unit is sold. Variable costing (also called direct or marginal costing) treats the same fixed overhead as a period cost, expensed in full in the period it is incurred, so that only variable production costs attach to the unit. The two methods report the same profit when production equals sales, but they diverge whenever inventory changes: building inventory defers fixed overhead into the balance sheet and raises absorption profit, while drawing inventory down releases previously deferred overhead and lowers it. Accounting standards - IAS 2 and US GAAP - require absorption costing for external inventory valuation, so financial statements use it. Variable costing is an internal management tool: it isolates contribution margin, keeps profit tied to sales rather than production, and stops managers from flattering earnings by overproducing.
Every manufacturing cost is either variable (direct materials, direct labour, variable overhead) or fixed (factory rent, supervisor salaries, depreciation of the plant). Both methods agree on how to treat the variable costs: they attach to the unit and follow it into inventory and then to cost of sales. The methods split on one question only - what to do with fixed manufacturing overhead.
Under absorption costing, fixed overhead is absorbed into the unit through an overhead rate, so a share of the factory's fixed cost rides inside every unit of inventory. It becomes an expense only when that unit is sold. Under variable costing, fixed overhead never touches the unit; it is charged straight to the period as an operating expense, regardless of how many units were made or sold. The unit cost under variable costing is therefore lower, and the balance sheet carries less value in inventory. Nothing about the underlying business changes - the same cash is spent either way - but the timing of when fixed overhead hits the income statement moves.
The whole difference lives in inventory movement. When production equals sales, every unit made is sold, no fixed overhead is left sitting in inventory, and both methods report identical profit.
When production exceeds sales, inventory grows. Absorption costing parks part of this period's fixed overhead inside those unsold units, deferring it to a future period; variable costing expenses all of it now. So absorption profit is higher than variable profit, by exactly the fixed overhead held in the inventory increase. When sales exceed production, inventory shrinks, and units sold this period carry fixed overhead deferred from earlier periods on top of this period's charge; absorption profit is lower than variable profit. The gap between the two profit figures each period equals the change in inventory units multiplied by the fixed overhead rate per unit. Over the full life of the product, when all inventory is eventually sold, the two methods report the same cumulative profit - they only disagree about which period gets the charge.
This is also why variable costing is prized for control: because fixed overhead cannot be buried in inventory, a manager cannot lift reported profit simply by running the plant hard and building stock. Under absorption costing, overproduction can flatter earnings, which is a real incentive problem that internal reporting is designed to remove.
A plant makes a single product. Selling price is €100 per unit; variable production cost is €60 per unit; fixed manufacturing overhead is €400,000 for the year; fixed selling and administrative cost is €100,000 (illustrative figures, not client data). In year one the plant produces 20,000 units and sells 15,000, so 5,000 units go into inventory.
The fixed overhead rate is €400,000 / 20,000 = €20 per unit. Under absorption costing, each unit costs €60 + €20 = €80. Cost of sales is 15,000 × €80 = €1,200,000; the 5,000 units in closing inventory carry 5,000 × €20 = €100,000 of fixed overhead into the balance sheet. Profit is revenue €1,500,000 minus cost of sales €1,200,000 minus selling and admin €100,000 = €200,000.
Under variable costing, the unit cost is €60. Contribution is 15,000 × (€100 - €60) = €600,000. From this we subtract the full €400,000 of fixed overhead and €100,000 of selling and admin, giving profit of €100,000. The two figures differ by exactly €100,000 - the 5,000-unit inventory increase multiplied by the €20 fixed overhead rate. In year two, if the plant sells those 5,000 units on top of production, the relationship reverses and variable-costing profit comes out higher by the same €100,000.
| Feature | Absorption (full) costing | Variable (direct) costing |
|---|---|---|
| Fixed manufacturing overhead | Product cost - held in inventory until sold | Period cost - expensed as incurred |
| Unit cost | Higher (includes fixed overhead) | Lower (variable cost only) |
| Inventory value on balance sheet | Higher | Lower |
| Profit driven by | Production and sales | Sales only |
| Income statement format | Gross margin (sales - full cost of sales) | Contribution margin (sales - variable cost) |
| Permitted for external reporting | Yes - required by IAS 2 and US GAAP | No - internal decision-making only |
| Overproduction can inflate profit | Yes | No |
The choice is not either-or. Financial statements must use absorption costing, and most firms run variable costing alongside it for internal decisions. The reconciling item between the two is always the same: the change in fixed overhead sitting in inventory.
Absorption costing. It is required for external reporting and tax because it matches all production costs - fixed and variable - against revenue when the product is sold, which the standards regard as the faithful measure of inventory. Its weakness is managerial: it lets fixed overhead be capitalised into stock, so profit can rise on overproduction and a full cost per unit can mislead a short-run pricing or make-or-buy decision, because part of that "unit cost" does not vary with the unit at all.
Variable costing. It isolates contribution margin, ties profit to sales, and removes the overproduction incentive, which makes it the right lens for break-even, pricing above variable cost, and product-line decisions. Its limit is that it is not accepted for external inventory valuation, and it understates the long-run cost of a product by leaving out the fixed capacity the product genuinely consumes. That gap - fixed capacity cost that is real but volume-insensitive - is exactly what time-driven activity-based costing sets out to assign properly. This is the bridge to the rest of this encyclopedia: understanding how fixed overhead behaves is the same question that drives cost-to-serve, the whale curve of customer profitability, and TDABC, where capacity cost is traced to the products and customers that actually use it rather than smeared across units by a blanket overhead rate.
Horngren, C. T., Datar, S. M. & Rajan, M. V. Cost Accounting: A Managerial Emphasis (chapters on variable and absorption costing). · Garrison, R. H., Noreen, E. W. & Brewer, P. C. Managerial Accounting (variable versus absorption costing and its effect on income). · Drury, C. Management and Cost Accounting (marginal and absorption costing). · IFRS Foundation, IAS 2 Inventories (allocation of fixed production overhead to inventory). · CIMA, Official Terminology (definitions of absorption costing, marginal costing and contribution). · Kaplan, R. S. & Cooper, R. Cost & Effect (limits of volume-based overhead absorption).
Absorption costing puts fixed overhead into the unit, variable costing puts it into the period, and the two only disagree once inventory moves. Neither of them tells you how much capacity you paid for and left standing. The capacity calculator does, one team or machine group at a time.
Proof
A distributor in New Zealand. €1.335M of cost-to-serve made visible, then halved, and 830 loss-making customers brought down to 295.
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Cost and profitability practitioner for 25+ years. Presented the Damco cost-to-serve case at Managing for Profit (Amsterdam RAI, December 2009), on the same programme as Robert S. Kaplan.
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