There are two major costing methods used for creating income statements in managerial accounting: absorption costing and variable costing. These two methods vary based on the way that fixed overhead is applied to the product cost. Product cost includes direct materials, direct labor, and overhead. These are the costs that are included in cost of goods sold and inventory. Only these costs can be included in inventory.

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#### Absorption Costing

Absorption costing is what you probably think of when you think of product costing. Since the beginning of your managerial accounting course, you have been told that product cost consists of direct materials, direct labor, and overhead. Since we have introduced cost behavior into the course, we know that overhead can be either variable or fixed (direct materials and direct labor are variable costs).

Under absorption costing, we are going to take into account all of the variable product costs and absorb the fixed overhead into the cost of the product.

Let’s look at an example.

Here is some basic cost information for a business. What information is important when we are calculating product cost using absorption costing?

Direct materials, direct labor, variable overhead, and fixed overhead should all be included in the cost of the product using absorption costing. Direct materials, direct labor, and variable overhead are already expressed in per unit figures but fixed overhead is not. We must allocate the fixed overhead to each of the units.

There are two figures we are given: units produced and units sold. Which do you think we should use? You want to make sure that fixed overhead is allocated to all of the units. Therefore, you should use units produced. Using units produced will allow overhead to be allocated to all of the units, those that were sold and those that are still remaining in inventory.

Allocate overhead by dividing the fixed overhead by the number of units. This will give us fixed overhead per unit.

Fixed overhead per unit = \$48,000/10,000 units

Fixed overhead per unit = \$4.80 per unit

NOTE: Fixed overhead per unit will only be \$4.80 per unit when 10,000 units are produced. This is not a variable rate. The rate is not constant. If the company produced 20,000 units, the rate would be \$2.40 (\$48,000/20,000). This rate will fluctuate as production changes.

With the fixed overhead now expressed as a per unit figure, we can add it to the direct materials, direct labor, and variable overhead to calculate the absorption cost per unit. Under absorption costing, the cost per unit is \$48.80.

Absorption costing is required by GAAP and must be used on the external financial statements.

#### Variable Costing

Variable costing is just another form of product costing. As the name implies, only variable product costs are used to calculate the cost per unit of a product. Therefore, we will not include any of the fixed overhead in the cost of the product.

It might be tempting to include variable selling cost because it is also a variable cost, but remember that selling cost is a period cost and is expensed when incurred. Only include product costs in the calculation: direct materials, direct labor, and variable overhead. Notice that the product cost is lower because no fixed overhead is included.

In the next post, we will look at the traditional (absorption) income statement and the contribution margin (variable) income statement.

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