The Effect of Inventory: Videos & Practice Problems

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How does inventory change affect income under absorption costing and variable costing?

Inventory changes impact income differently under absorption and variable costing due to how fixed manufacturing overhead is treated. Under absorption costing, fixed overhead is assigned to products and included in inventory costs. When inventory increases, some fixed overhead costs are deferred in ending inventory, resulting in higher reported income because not all fixed overhead is expensed in the current period. Conversely, when inventory decreases, fixed overhead from prior periods is released from inventory into cost of goods sold, lowering income. Under variable costing, fixed overhead is treated as a period cost and expensed fully in the current period regardless of inventory changes. Therefore, variable costing income remains consistent with fixed overhead recognized each period. When inventory remains constant, both methods report the same income since the total fixed overhead recognized matches in both costing methods.

Why does absorption costing report higher income when inventory increases?

Absorption costing reports higher income when inventory increases because fixed manufacturing overhead costs are included in the cost of products and thus become part of inventory value. When inventory increases, some of these fixed overhead costs are "stored" in ending inventory and not expensed as cost of goods sold in the current period. This deferral of fixed overhead reduces expenses on the income statement, increasing net income. In contrast, variable costing treats fixed overhead as a period cost, expensing it fully in the current period regardless of inventory levels. Therefore, absorption costing shows higher income during periods of increasing inventory due to the timing of fixed overhead expense recognition.

What happens to income under absorption and variable costing when inventory decreases?

When inventory decreases, absorption costing reports lower income compared to variable costing. This occurs because fixed overhead costs that were previously deferred in inventory are now released into cost of goods sold as the inventory is sold. This increases expenses in the current period under absorption costing. Variable costing, however, expenses all fixed overhead in the period incurred, so it does not defer or release fixed overhead costs through inventory changes. As a result, during periods of decreasing inventory, absorption costing income is lower since it includes fixed overhead from prior periods, while variable costing income remains consistent.

When do absorption costing and variable costing report the same income?

Absorption costing and variable costing report the same income when inventory levels remain constant between periods. In this situation, the number of units produced equals the number of units sold, so there is no change in inventory. Because fixed manufacturing overhead costs are fully assigned to products and sold in the same period, there is no deferral or release of fixed overhead costs in inventory. Consequently, both costing methods recognize the same total fixed overhead expense in the period, resulting in equal net income reported on the income statements.

How is fixed manufacturing overhead treated differently in absorption costing versus variable costing?

In absorption costing, fixed manufacturing overhead is treated as a product cost and included in the cost of inventory. This means fixed overhead is allocated to each unit produced and remains in inventory until the units are sold, at which point it becomes part of cost of goods sold. In variable costing, fixed manufacturing overhead is treated as a period cost and expensed entirely in the period incurred, regardless of production or sales volume. This fundamental difference causes income to vary between the two methods depending on changes in inventory levels.