Absorption Costing requires that a company expense (write off) any selling & administrative costs for the period and the cost of goods sold, which includes direct material, direct labor, and both variable and fixed manufacturing overhead. The cost of goods sold per unit is all the variable production costs per unit, but also added to the total fixed cost per unit sold. Absorption Costing produces the highest income out of the three costing methods when the number of units sold is less than the number of units produced because more costs are deferred to inventory instead of being expensed immediately. Conversely, that means that Absorption Costing has the lowest income when the number of units sold is greater than the number of units produced. This is because the company will have to sell units that are in inventory, meaning that the total fixed cost that they are assigning to their sales is for all their production for the period and for some fixed costs from a previous period.
Absorption Costing has a glaring flaw: all else the same, increasing production will increase net income. This is true because the fixed cost will be divided among more units, lowering the cost of goods sold per unit. Absorption Costing is the standard method of costing under GAAP because it follows the Matching Principle, all costs go with their respective revenues. Another advantage of using Absorption Costing is that you can set prices that cover the cost of goods sold per unit because it includes fixed cost.
Variable Costing requires that a company expense any selling & administrative costs and all fixed overhead costs for the period. The cost of goods sold rate is simply all the variable production costs per unit. Variable Costing produces an amount of income in between the amounts of income produced by Absorption and Throughput Costing. It will produce an income less than the Absorption income and greater than the Throughput income if production is greater than sales, and it will produce an income greater than the Absorption income and less than the Throughput income if production is less than sales.
Variable Costing is the method of costing used in the Cost-Volume Profit Model (CVP Model). This model is used to predict a company’s net income given a certain number of sales or amount of sales dollars, and also to calculate the company’s break-even point. It also lacks the flaw that Absorption Costing has: net income will only increase if the number of units sold increases.
Throughput Costing requires that a company expense all costs other than direct material costs as costs of the period. The cost of goods sold rate is simply the amount of direct materials required to produce each unit.
Throughput Costing produces an income that is the lowest of the three costing methods when production is greater than sales, and it will produce the greatest income when sales is greater than production.