One disagreement, one question
Across this rung you have been tracing cost to product — job by job, process by process, activity by activity. Each system answered *how* to spread cost onto the things you make. This last guide steps back and asks a sharper question that sits underneath all of them: when fixed factory overhead must be assigned, should it ride along *inside* the product, or be charged straight to the month it belongs to? Both answers are defensible. That is exactly why the choice matters — it changes the profit number without changing a single real-world fact about the factory.
Recall from the managerial rung that the three [[manufacturing-costs|manufacturing costs]] are direct materials, direct labour, and factory overhead — and that overhead itself splits into variable parts (electricity that rises with output) and fixed parts (the rent, the plant manager's salary, the machine's depreciation) you learned to separate when you studied cost behaviour. Direct materials, direct labour, and *variable* overhead are not in dispute: everyone treats them as product costs that sit in inventory until the goods sell. The entire argument is about that one stubborn pile — fixed manufacturing overhead. Where it goes is the only thing the two methods disagree on.
Two ways to file fixed overhead
Absorption costing (also called *full costing*) says fixed factory overhead is a genuine cost of making the product, so it must be absorbed into each unit — divide the period's fixed overhead by the units produced and bury that slice inside every unit's cost. A unit then carries materials, labour, variable overhead, *and* its share of fixed overhead. Until that unit sells, its whole cost — fixed slice included — sits in inventory as an asset and touches no expense line. Variable costing (also called *direct* or *marginal costing*) disagrees: it treats only the costs that rise and fall with output as product costs, and declares fixed factory overhead a [[product-vs-period-costs|period cost]] — expensed in full in the month it is incurred, the same way rent on the head office is, no matter how many units were made or sold.
Make this concrete. A workshop makes desks. Per desk: materials 40, labour 20, variable overhead 10 — that is 70 of variable cost. Fixed factory overhead is 30,000 for the month. Under absorption costing, if the shop makes 1,000 desks, each desk also absorbs 30,000 / 1,000 = 30 of fixed overhead, so a finished desk is recorded at 100. Under variable costing, the desk's product cost is just 70; the whole 30,000 of fixed overhead is hurled straight onto this month's income statement as one lump, regardless of how many desks were built. Same factory, same bills — two different numbers stamped on the very same desk.
What is a PRODUCT cost (sits in inventory until sold)?
Absorption Variable
Direct materials ....... yes yes
Direct labour .......... yes yes
Variable overhead ...... yes yes
FIXED overhead ......... yes NO <-- the whole fight
Product cost per desk: 100 70
Fixed overhead under variable costing -> expensed now, in fullWhy the two profits differ: it is all about the inventory door
Here is the heart of it. If a factory makes exactly as many units as it sells, the two methods report the *same* income — every desk's fixed-overhead slice gets expensed either way, just through different doors. The numbers split apart only when production and sales volumes differ, because then some fixed overhead gets *trapped in unsold inventory*. Under absorption costing, fixed overhead attached to desks that were built but not yet sold rides into next period inside inventory; it is deferred, not expensed. Under variable costing, that same fixed overhead was already expensed in full this month. So when you build more than you sell, absorption costing parks some fixed cost on the balance sheet and reports a *higher* profit than variable costing.
Run our desks through it. The shop makes 1,000 desks but sells only 800. Under absorption costing, each unsold desk carries 30 of fixed overhead, so 200 desks x 30 = 6,000 of fixed overhead is held in ending inventory and *not* expensed this month — absorption profit is therefore 6,000 higher than variable profit. Flip it: next month the shop makes 800 but sells 1,000, drawing inventory down. Now the 6,000 that was stored last month gets released into cost of goods sold *on top of* this month's fixed overhead, and absorption profit falls 6,000 *below* variable profit. Over the full life of the business, the two methods report the same total profit — they only disagree about *which period* gets the fixed cost.
Why variable costing speaks the language of decisions
Variable costing lines up cleanly with the way managers actually think, because it leads straight to the [[contribution-margin|contribution margin]] — sales minus all variable costs — that you met earlier. Contribution margin tells you how much each extra sale contributes toward covering the fixed costs and then toward profit. With fixed overhead pulled out of unit cost and shown as one honest lump below the line, a manager can read the income statement and immediately see the levers of cost-volume-profit analysis: how profit moves with volume, and where the break-even point sits. Under absorption costing those levers are smeared, because a chunk of fixed cost is hiding inside unit cost and shifting around with production volume.
There is a subtler trap absorption costing sets for decisions. Because each unit carries a fixed-overhead slice, the absorption unit cost looks like it rises when you make fewer units and falls when you make more — yet the fixed costs themselves did not budge at all. A manager who treats that per-unit figure as the 'real' cost of one more desk can reject a profitable special order or misprice a product, fooled by a fixed cost masquerading as a variable one. For nearly every short-run decision — should we accept this order, drop that product, make or buy the part — the relevant number is the *variable* cost plus any fixed cost that genuinely changes with the decision. Variable costing puts that number in front of you; absorption costing makes you dig for it.
Why absorption costing rules the outside world
If variable costing is so clear for decisions, why is it banned from the financial statements you file with the world? Because external reporting standards — both GAAP and IFRS — require absorption costing for inventory and cost of goods sold. Their reasoning is the matching idea taken seriously: making a product genuinely consumes the factory's fixed capacity — the rent, the supervision, the equipment — so a fair cost of that product should include its share of those fixed resources. To value inventory at only its variable cost, they argue, understates what it truly took to produce. So the asset on the balance sheet, and the expense when it sells, must carry full cost. This is the same external-versus-internal divide you met when you first compared product and period costs and managerial against financial accounting.
So well-run companies keep both books in spirit: absorption costing for the audited statements that go to investors and tax authorities, and a variable-costing view internally for pricing, planning, and judging which products earn their keep. They are not in conflict — they answer different questions. One asks 'what is this inventory worth on our balance sheet under the rules?' The other asks 'if we sell one more, or drop this line, what actually happens to profit?' A capable accountant can move between them and, crucially, explain to a manager why this month's reported profit jumped even though sales were flat — usually the answer is that the factory built up inventory and quietly deferred some fixed overhead.